1. 12-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Chapter 12 Principles of Capital Structure

2. 12-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Learning Objectives Explain the effects of financial leverage. Distinguish between business risk and financial risk. Understand the capital structure irrelevance theory of Modigliani and Miller (MM). Explain the roles of taxes and other factors that may influence capital structure decisions. Understand the concept of an optimal capital structure, based on a trade-off between the benefits and costs of using debt. Explain the pecking order theory of capital structure. Outline Jensen’s free cash flow theory.

3. 12-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Introduction Capital structure: –The mix of debt and equity finance used by a company. Optimal capital structure: –The capital structure that maximises the value of a company. –Does the value of the net operating cash flow stream depend on how it is divided between payments to lenders and shareholders?

4. 12-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Effects of Financial Leverage Business risk: –The variability of future net cash flows attributed to the nature of the company’s operations (the risk faced by shareholders if the company is financed only by equity). Financial risk: –The risk involved in using debt as a source of finance. Effects of financial leverage: –Expected rate of return on equity is increased. –Variability of returns to shareholders increases. –Increasing leverage involves a trade-off between risk and return.

5. 12-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Effects of Financial Leverage (cont.) Measures of financial leverage: –Debt to equity, debt to total assets, and interest coverage. Leverage varies significantly between companies –Differences in leverage can be related to industry membership and asset type. For example, Computershare, which is a service company, relies much less on debt finance than Bluescope Steel, a steel manufacturer, and Amcor, a packaging manufacturer. –Since expected return and risk increase due to financial leverage, question arises as to whether the expected return is enough for the increase in risk — so that company value remains unchanged by leverage.

6. 12-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Modigliani and Miller Analysis Assumptions: –Capital markets are perfect. –Companies and individuals can borrow at the same interest rate. –There are no taxes. –There are no costs associated with the liquidation of a company. –Companies have a fixed investment policy so that investment decisions are not affected by financing decisions.

7. 12-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University MM’s Proposition 1 The market value of any firm is independent of its capital structure. If a company has a given set of assets, changing debt to equity will change the way net operating income is divided between lenders and shareholders but will not change the value of the company. Value of a company is given by:

8. 12-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Proposition 1: Proof Two companies that have the same assets but different capital structures are, under the assumptions, perfect substitutes. As such, perfect substitutes should have the same value. There is no reason for investors to pay a premium for shares of levered companies because investors can borrow to create home-made leverage. Home-made leverage — is a perfect substitute for corporate leverage. The central mechanism in MM’s proof is the substitutability between corporate debt and personal debt.

9. 12-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Proposition 1: Proof If a leveraged company (L) is overvalued compared to unleveraged (U) company, then an investor in levered company’s shares can replicate his/her risk and return by investing instead in the shares of an unleveraged company and adjusting the debt–equity ratio by borrowing personally. Similarly, if an unleveraged company (U) is overvalued compared to leveraged (L) company, then an investor in unleveraged company’s shares can replicate his/her risk and return by investing instead in the shares of a leveraged company and adjusting the debt–equity ratio (to zero) by lending personally.

10. 12-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University What if … The companies were not selling for the same price? Arbitrage profits could be earned. An opportunity to make riskless profits exists and arbitragers will exploit this. Arbitrage involves buying an asset and simultaneously selling it for a higher price, usually in another market, so as to make a risk-free profit. An Arbitrage Illustration: Example: Two firms: U and L. Firm U is unlevered and Firm L is levered. Firm L has borrowed $400 000 at 7.5%. Both firms make a profit of $900 000. Required return is 10%. We want to show that these two companies are equivalent, otherwise there must be an arbitrage opportunity.

11. 12-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University An Arbitrage Opportunity Illustration (cont.) Firm U (unleveraged): – Value of equity = $900 000/0.10 = $9 000 000 – Value of firm = D + E = 0 M + 9 M = $9 000 000 Firm L (leveraged) : Value of firm = D + E = 4 M + 6 M =$10 000 000

12. 12-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Arbitrage Process The results suggest we sell Firm L and buy Firm U. Calculate the investor’s dollar investment and the return this is generating: –Investment:  10% of equity of L: 10% x 6 000 000 = $600 000 –Return:  10% x net income of L: 10% x 600 000 = $60 000 p.a. Borrow an amount such that personal financial leverage is equivalent to the Firm L’s financial leverage. –Firm L’s financial leverage: 4M/6M –Gear individual the same: D/600 000 = 4/6 –Hence, investor should borrow $400 000 at 7.5%

13. 12-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Arbitrage Process (cont.) To show a higher return for the same investment: –work out funds available to invest in the unlevered firm: Sell shares in L$600 000 Borrowings$400 000 Total available$1 000 000 So, we have shorted Firm L and borrowed and will invest in Firm U. Work out the return if all of these funds are invested in Firm U: This ($100 000) is a gross return and does not factor in costs.

14. 12-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Arbitrage Process (cont.) Work out the net return: –Return from unlevered firm $100 000 –less Interest on borrowings $ 30 000 –Net return $ 70 000 p.a. This represents an increase in income of $10 000 per year, as the investor’s old return, by investing in Firm L, was only $60 000 p.a. It is not necessary for arbitrage transactions to involve personal borrowing. The only requirement is that investors are able to trade in both debt securities and shares. The point is that, if such equivalent firms are not offering the same return, arbitrage is possible. Eventually, the market will force returns to be the same — implying the degree of leverage does not have any impact on firm value and can be replicated by investors.

15. 12-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University MM’s Proposition 2 The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a financial risk premium, which depends on the degree of financial leverage: While Proposition 1 is a law of conservation of value, Proposition 2 is based on the natural conservation of risk.

16. 12-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University MM’s Proposition 3 The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed. The key factor determining the discount rate or a proposal is the level of risk associated with the project. This is consistent with the irrelevance of the financing decision: Proposition 1.

17. 12-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Why is MM’s Analysis Important? Showing what does not matter can also show, by implication, what does matter (Miller, 1988). By implication, if capital structure does in fact matter, then taxes and default risk could be good places to look for reasons why it matters. An understanding of the MM proposition helps to distinguish between logical and illogical reasons for particular financing decisions. The fundamental MM message is that any combination of finance sources is as good as another. No matter how many sources of finance are used, the resulting capital structure is just another way of dividing the NCF between the people who have contributed the capital that sustains the company’s operations.

18. 12-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Including Factors MM Excluded Capital market imperfections will impede the MM 1958 propositions: –Company Income taxes. –Transaction costs. –Costs associated with financial distress. –Agency costs. –Different cost of borrowing for corporations and individuals. –Non-constant cost of debt.

19. 12-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Effects of Taxes on Capital Structure Under a Classical Tax System Company Income taxes: –Leaving all original assumptions in place except to relax the assumption of no corporate tax, MM extended their analysis. Classical system: –Leverage will increase a firm’s value because interest on debt is a tax deductible expense resulting in an increase in the after-tax net cash flows to investors. –The main implication of Proposition 1 with company tax is clear but extreme: A company should borrow so much that its company tax bill is reduced to zero.

20. 12-20 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Effects of Taxes on Capital Structure Under a Classical Tax System (cont.) Company tax and personal tax: –In practice, company tax system and personal tax system interact in complex ways. –The preferred source of finance depends on comparison between (1 – tp) and (1 – tc)(1 – ts). Personal taxes (Miller, 1977): –Suggested that the presence of taxes on personal income may reduce the tax advantage associated with debt financing. –Why? Firms could save corporate taxes by raising the D/E ratio, but investors would pay additional personal tax and, therefore, require higher returns to compensate for this fact and the higher associated risks.

21. 12-21 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Effects of Taxes on Capital Structure Under a Classical Tax System (cont.) Proposition 1: (with company tax) –Value of a levered firm is equal to the value of an unlevered firm of the same risk class plus the present value of the tax saving: where represents the present value of the tax shield associated with interest payments. –The gain from leverage can be identified as: where: corporate tax rate personal tax rate on equity personal tax rate on debt c s p t t t   

22. 12-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Miller’s Analysis Implications: –There is an optimal debt–equity ratio for the corporate sector as a whole, which will depend on the company income tax rate and on the funds available to investors who are subject to different tax rates. –Securities issued by different companies will appeal to different clienteles of investors. Consequently, in equilibrium there is no optimal debt–equity ratio for an individual company. –Shareholders of levered companies end up receiving no benefit from the company tax savings on debt because the saving is passed on to lenders in the form of a higher interest rate on debt.

23. 12-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Effect of Taxes on Capital Structure: Imputation Tax System The imputation tax system: –Income distributed as franked dividends to resident shareholders is effectively taxed only once at the shareholder’s personal tax rate. –Interest paid to lenders is taxed only once at lender’s personal tax rate. The imputation system has the potential to lead to neutrality between debt and equity. However, there is a possible bias towards equity for investors with personal income tax rates greater than the company tax rate, who may favour companies retaining, rather than distributing, profits to achieve a lower tax burden. In summary, the imputation system has the potential to be neutral and any bias will favour equity rather than debt.

24. 12-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs There are non-tax factors that can cause a company’s value to depend on its capital structure. Financial distress: –Situation where a company’s financial obligations cannot be met or can be met only with difficulty. In serious cases, financial distress can lead to liquidation of the company. Indirect Costs of Financial Distress: –Financial distress leads a range of stakeholders to behave in ways that can disrupt its operations and reduce its value. –Effect of lost sales and reduced operating efficiency. –Cost of managerial time devoted to attempts to avert failure (less attention paid to issues such as product quality and employee safety).

25. 12-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Bankruptcy costs: –Direct and indirect costs. –Due to issuing risky debt, a company gives outsiders a potential claim against its assets that decreases the value of the claims held by investors. Incorporating the benefits and costs of debt leads to the following expression of the value of a leveraged firm: The PV of expected bankruptcy costs depends on the probability of bankruptcy and PV of costs incurred if bankruptcy occurs.

26. 12-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs: –Agency costs arise from the potential for conflicts of interest between the parties forming the contractual relationships of the firm. –Management may make decisions that transfer wealth from lenders to shareholders. –Sources of potential conflict:  Claim dilution.  Dividend payout.  Asset substitution.  Underinvestment.

27. 12-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs (cont.): – Claim dilution:  A company may issue new debt that ranks higher than existing debt.  Holders of the old debt now have a less secure claim on the company’s assets.  Wealth can be transferred from the holders of the old debt to shareholders. –Dividend payout:  A company may significantly increase its dividend payout.  This decreases the company’s assets and increases the riskiness of its debt.  Again, this results in a wealth transfer from lenders to shareholders.

28. 12-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs (cont.) –Asset substitution:  A company’s incentive to undertake risky investments increases because of the use of debt.  If risky investments prove successful, most of the benefits will flow to shareholders, but if it fails, most of the costs will be borne by lenders.  Undertaking such investments (negative NPV) causes the total value of the company to decrease, but the value of the shares will increase and the value of the debt will fall.

29. 12-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs (cont.) – Underinvestment:  A company may reject proposed low-risk investments that have a positive net present value.  If a company’s debt is very risky it may not be in the interest of shareholders to contribute additional capital to finance new investments.  Although the investment is profitable, shareholders may lose because the risk of the debt will fall and its value will increase.

30. 12-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs (cont.): – Potential conflict of interest between lenders and shareholders, and the likelihood of conflict increases with greater financial leverage. – Costs borne by shareholders: Higher interest rates, restrictive covenants: – Conflicts of interest between shareholders and managers. Can be reduced by aligning the objectives of managers with those of shareholders:  Employee share ownership schemes.  Remuneration for top-level managers in the form of options.

31. 12-31 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Costs of Financial Distress and Agency Costs (cont.) Agency Costs (cont.) – Would it be best to eliminate the costs associated with the separation of ownership and control by having a company’s equity capital provided only by its managers? – No  Few individuals have the combination of wealth and skills to both own and manage a company involved in activities such as large-scale industrial operations.  While uniting the functions of management and provision of capital has advantages in terms of agency costs, it has disadvantages in terms of risk bearing (investors can easily diversify simply by combining the shares of many companies in a portfolio).

32. 12-32 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Incentive Effects of Debt Tendency for managers to overinvest. The more likely overinvestment, the higher the company’s free cash flow. Such free cash flows should ideally be paid out; however, dividends are at the discretion of management. Borrowing forces the payout of cash, which reduces the potential for overinvestment. Optimal Capital Structure –Trade-off theory:  The possibility of a trade-off between the opposing effects of the benefits of debt finance and the costs of financial distress may mean that an optimal capital structure exists. Management should aim to maintain a target debt–equity ratio.

33. 12-33 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry Pecking order theory: –In raising finance, managers follow a pecking order in which internal funds are preferred, followed by debt, hybrid securities and then, as a last resort, a new issue of ordinary shares. Myers explains this pecking order based on information asymmetry. –Information asymmetry is a situation where all relevant information is not known by all interested parties. Typically, this involves company insiders (managers) having more information about the company’s prospects than outsiders (shareholders and lenders).

34. 12-34 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) Example: –A company has 100 000 ordinary shares with a market price of $4.50, but management believes that the true value of the shares is $5. –The company has an investment opportunity that requires an outlay of $200 000, has an NPV of $17 000 and will have to be financed externally. –The existence of the investment opportunity is not known to the market and is, therefore, not reflected in the current share price.

35. 12-35 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) –Information asymmetry exists with respect to both the company’s existing assets and the new investment. –Should the investment be implemented? –How should it be financed? Let’s consider four scenarios: 1)Suppose that investment had been made before the market learnt the true value of the existing assets — and then new shares are issued.  Initially share price is $4.50.  The number of new shares to be issued is 44 444.  What is the value of shares after the issue?

36. 12-36 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.)  Since this value > $4.50, shareholders will benefit from the issue and the project in the short term. old market value+cash raised+NPV of Project Number of shares on issue $450,000 + $200,000 +$17,000 144,444 $4.62 Ps   

37. 12-37 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.)  In the long term, the share market learns the true value of the existing assets and the share price will be:  In this case, the new shareholders gain both in short term and long term, but the old shareholders will only gain in short term because $4.62 exceeds $4.50. But in the long term, shareholder is better off without the new investment and the new share issue. ($4.96 < $5.00). L $500,000+$200,000+$17,000 144,444 $4.96 P  

38. 12-38 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) 2)Investment made after the market learns the true value of the existing assets — and new shares are issued.  In the short term, share price remains $4.50 but in the long run, share price increases from $4.50 to $5.00.  After the new investment is announced and the new shares are issued, the share price is:  Both old and new shareholders benefit as they both gain 12 cents per share in the long run. $500,000+$200,000+$17,000 140,000 $5.12   Ps

39. 12-39 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) 3)Investment made before the market learns the true value of the existing assets — and new debt is issued.  If company borrows to finance the project, all the benefit of the positive NPV will go to the current shareholders. After new investment is announced and new debt is issued the share price is:  In the short term, shareholders gain 17 cents. While in the long term share price is $5.17, this means the shareholders gain by 17 cents per share. $500,000+$200,000+$17,000 140,000 Ps 

40. 12-40 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) 4)Investment made after the market learns the true value of the existing assets — and new debt is issued.  In the short term, share price remains $4.50, but in the long run share price increases from $4.50 to $5.00.  After the new investment is announced and the new debt is issued the share price is:  In this scenario, the shareholders gain in the long term by 17 cents per share.  In summary, without the new investment the short-term outcome is a share price of $4.50 while the long-term outcome is a share price of $5.00. The clear winner is Scenario 3. $500,000+ $17,000 100,000 P L 

41. 12-41 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Capital Structure with Information Asymmetry (cont.) What do the previous scenarios imply about financing policy? –If there is information asymmetry, and management believe that its company’s shares are undervalued, they will prefer to borrow. –If management believe the shares are overvalued, they will prefer to issue new shares (p. 392). Difference between pecking order theory and trade-off theory is that pecking order theory does not depend on target debt–equity ratio. Instead, it is about availability of internal funds and information asymmetry.

42. 12-42 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Implication of Information Asymmetry for Financing policy Information asymmetry can cause the share market to undervalue or to overvalue a company. If share is undervalued — prefer to borrow. If share is overvalued — prefer to issue new shares. However, outside investors understand managers’ motives and, therefore, will tend to react to the announcement of a share issue by reducing the company’s share price because the chances are that the issue signals bad news. The main implication for managers is that there are advantages in restricting financial leverage so the company could borrow at a short notice if a profitable investment arises.

43. 12-43 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Jensen’s Free Cash Flow Theory Information asymmetry implies that reserve borrowing capacity is valuable, but it is important to note that its value can differ between companies depending on investment prospects. Reserve borrowing capacity is more valuable for high growth companies. In more mature, stable companies it can cause free cash flows. When reserve borrowing capacity results in FCF, it offers slack for management. These reserves may not generate adequate returns and should be paid out to investors rather than retained in the company. Jensen (1986) argues that free cash flows should be paid out to investors in order to avoid poor use of funds by managers. Ways of returning funds include dividends and share buyback schemes. Debt offers a control effect — generating a credible commitment not to misuse free cash flow, as it is required to service debt.

44. 12-44 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary Leverage and its effects on financial risk. Modigliani and Miller — capital structure does not change the value of an entity. If the company tax saved by borrowing is different from the extra tax incurred at the investor level, capital structure can affect the value of companies. Issue of debt has a range of associated costs and benefits such as expected bankruptcy costs and agency costs. –There is a trade-off between costs and benefits in determining optimal capital structure — trade-off theory.

45. 12-45 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary (cont.) The trade-off theory suggests that management should aim to maintain a target debt–equity ratio. An alternative to the trade-off theory is the pecking order theory: –Information asymmetry can lead managers to have a preference for debt over equity. –The pecking order approach does not rely on the existence of a target debt–equity ratio. Jensen argues that free cash flows have the potential to be misused by management. One way to control use of free cash flow and enhance firm value is to increase debt levels, though there are associated risks.