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Flashcards in Package 6 Deck (67)
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1

CAPITAL STRUCTURE
3 theories of Debt-Equity Choices

Trade off
Pecking order
FCF

2

CAPITAL STRUCTURE
Modigliani and Miller Proposition

Financing doesn’t matter (in perfect financial
markets!) -> in real world financing structure does matter

3

CAPITAL STRUCTURE
Two types of Costs of financial distress and bankruptcy

a) Direct (liquidation & reorganization costs)
b) Indirect (agency costs: debt overhang, risk shifting, playing for
time, cashing out)

4

CAPITAL STRUCTURE
four types of Debt vs equity-holder conflicts

1) Investment in riskier assets
- increases upside for shareholders, downside is born by creditors
2) Borrow more
- use borrowed money to pay to shareholders
3) Debt overhang
- cut back capex, because the value goes to debt-holders
4) “Play for time”
- postpone announcement of bankruptcy

5

CAPITAL STRUCTURE
The sense of Capital Structure

The study of capital structure tries to explain the mix of securities and financing sources used by corporations to finance real investment (This study analyzes particularly U.S corporations).

6

CAPITAL STRUCTURE
Explain The tradeoff theory

o The tradeoff theory- firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress.

7

CAPITAL STRUCTURE
Explain The pecking order theory

o The pecking order theory- firm will borrow, rather than issue equity, when internal cash flow is not sufficient to fund capital expenditure.

8

CAPITAL STRUCTURE
Explain Free cash-flow theory

o The free cash flow theory- dangerously high level of debt will increase value, despite the threat of financial distress.

9

CAPITAL STRUCTURE
List 4 arguments why in the reality financing does metter

o Taxes – tradeoff theory
o Differences in information – pecking order theory
Managers issue equity when they see that there is asymmetrical difference between managers and shareholders. In case that managers consider that price of shares is too high they will issue equity otherwise, it is more reasonable for the company to issue debt.
o Agency costs – free cash flow theory
o In case that managers use company’s money in a unreasonable manner, equity-holders will perform an LBO, which will increase the debt level of the company and will tend to limit managers’ expenditures.
o Innovation –“if new securities or financing tactics didn't matter, they wouldn't appear”

10

CAPITAL STRUCTURE
In general, industry debt ratio is low when

o Profitability and business risk are high
Riskier firms tend to borrow through equity, because otherwise they would have to face high cost of debt.
o Growth opportunities are valuable
Growing companies rather tend to issue equity than debt, because debt restricts their investment choices.

11

CAPITAL STRUCTURE
Why due to pecking order theory equity holders invest in risky assets

They understand that they have nothing to lose

12

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What determines firms’ target debt ratios?

Tax exposure (weak explanatory power)
Cash flow Volatility↑ -> D ↓
Firm’s size↑ -> D ↑
Assets tangibility/liquidity (fixed assets/TA)↑ -> D↑
M/B ratio↑ -> D↓
Product uniqueness↑ -> D↓
Industry effects
Firm fixed effects

13

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does tax exposure determines target debt ratio

Tax shields do affect financing when they change marginal tax rate

14

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does Cash flow Volatility determines target debt ratio

Higher systematic risk - > lower debt ratios

15

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why small firms have smaller Debt

1) High costs of refinancing for small companies
2) Size correlates with other factors that affect D/E ratio
(diversification, volatility of CFs, probability of bankruptcy, etc.)
3) Large firms -> easier to sell assets in case of bankruptcy + good reputation
-> banks are more willing to provide credit
4) Large firms -> better access to public debt markets

16

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher Assets tangibility/liquidity (fixed assets/TA) determines target debt ratio's rise

1) Tangible assets better preserve their value during default
2) Tangible assets are more easily redeployed
3) More tangible assets -> Debt-equity problems ↓

17

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher M/B ratio determines target debt ratio's downwards

1) higher M/B -> prospects for growth -> use retained earnings
2) Overvalued equity -> issue more equity

BUT the relationship is partly mechanical (high equity causes more equity in capital structure)

18

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
Why does higher Product uniqueness determines target debt ratio's downwards

Non-financial stakeholders are concerned about financial health
(workers, customers, suppliers)

19

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What is industry effect on Debt ratio

Competitive industry -> low debt ratio to survive price wars

20

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What is firm fixed effect

Management preferences, governance, geography, competitive threats,
“corporate culture”, etc.

21

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What causes firms to deviate from the
target debt ratios?

1.Profitability
2. Market timing
3. Past stock returns (if high -> less debt)
4. Managerial preferences and
entrenchment

22

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does profitability causes firms to deviate from the
target debt ratios?


• Pecking order theory -> higher
profits-> less debt
• BUT also More profitable firms ->
higher tax exposure -> more debt
• Profitability might be a proxy for
asset productivity
• Profitability as a proxy for CEO power
-> managerial preferences

23

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How does market timing causes to deviate from the
target debt ratios

• Taking advantage of mispricing
• New equity issued when Co shares
are overvalued in the market

24

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How do Past stock returns cause to deviate from the
target debt ratios

• High stock returns recently
-> high growth opportunities
-> equity is high-priced
-> issue more equity

25

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
How do Managerial preferences and
entrenchment cause to deviate from the
target debt ratios

• Equity vs. debt holders problems
• Agency problems -> low debt, if
managers have the discretion to
organize “easy life” for themselves
• Managers own a lot of stock &
options (agency problems ↓) ->
more debt
• If powerful CEO -> debt ratios likely
to reflect managerial preferences

26

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for customers?

• Debt may damage the firm-customer relationship, leading to poor performance
• In case of industry downturn -> highly leveraged firms +high R&D -> sales↓
• Overleveraged firms are less likely to survive industry deregulation

27

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for the suppliers?

• If relationship-specific investments are needed -> suppliers demand lower leverage
• If suppliers with high R&D -> lower leverage
• If entered into SA (strategic alliance) -> lower leverage

28

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for the employees?

• High leverage -> lower wages, lower pension funding
• High leverage -> more frequent lay-offs during recessions (debt forces management to make “unpleasant choices”)
• High leverage -> labor unions less aggressive
• Threat of unionization -> higher debt ratios

29

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for the competitors?

• High debt -> output ↓ + prices ↑
• Highly leveraged firms forced out of the market if competition drives prices down
• If leverage is uniformly high in the industry -> high industry prices, low compensations
• If competitors at the industry level have low leverage, but Co – high leverage ->
lower sales growth of this Co

30

EMPIRICAL CAPITAL STRUCTURE:
A REVIEW
What are the consequences of leverage
for the Investment decisions?

• Debt overhang problem (Co likely to surpass NPV>0 projects because Co cannot
take more debt to finance them)
• Debt as disciplinary mechanism -> lower investments (good for firms with poor
growth prospects)
• High leverage -> high pressure on managers to find projects with NPV>>0
• Debt covenant violations -> leverage declines (rather than investment
opportunities