25765 Corporate Finance Topic 7

1. 25765 Corporate FinanceTopic 7 Capital Structure:Additional Theories

2. Part 1:Agency Theory andAgency Benefits of Debt • Agency Relation • An agency relation exists between two persons when one person (agent) acts on behalf of the other person (principal) • e.g., relation between shareholders (principals) and managers (agents) • Agency problem refers to the potential conflicts of interests of agents and principals • Conflicts arise when the agents’ interests are not aligned with the principal’s interests and the agents follows their own interests

3. Separation of Ownership and Control andAgency Costs of Equity • Most large public corporations are owned by small, dispersed shareholders and are effectively controlled by managers who own small amount of their firms’ shares • There is a separation between ownership and control • This separation means that Interests of managers are not generally aligned with those of the shareholders • Agency Costs of equity • Costs due to the conflicts of interests between the firm’s shareholders and managers

4. Agency Costs of EquityConstituents • Agency Costs of equity include: • Excessive Perquisites (Perks) • Perks include fancy offices, corporate jets, company cars etc. • Excessive perks reduce firm value • Inefficient Investments • Empire building: Growing firm beyond its optimal size • Risk aversion: Takingdiversifying and/or safe investments • Entrenching investments: Investments that make it difficult to fire the manager

5. Agency Costs of EquityConstituents • Monitoring Costs • Shareholders understand the manager’s incentive to consume excessive perks and to make inefficient investments • So they “invest” in monitoring the managers • Monitoring is value-added up to a point, but since monitoring is costly: • Optimal level of monitoring balances benefit and costs of monitoring

6. Delegated Monitoring byDirectors and Auditors • Dispersedly owned corporations are not likely to be directly monitored by the (small) shareholders • Corporations rely on delegated monitoring: • Board of Directors • Hires the executive team, sets its compensation, approves major investments and acquisitions, and dismisses executives if necessary • Independent auditors • Measure and provide opinion about the performance of the company

7. Delegated Monitoring byInstitutional Investors, Debtholders and Rating Agencies • Institutional investors / Fund managers • Because of their large stakes, institutional investors have better incentive to actively monitor the managers • Debtholders • Banks and bondholders monitor firms to protect their investments • Bond rating agencies • Moody’s, S & P, Fitch

8. Extension of Trade-off Theory:Agency Benefits of Debt • Monitoring by Debtholders • Creditors of the firm closely monitor the actions of managers, providing an additional layer of management oversight • Free Cash Flow Hypothesis • Leverage commits the firm to making future interest payments, reducing free cash flows and wasteful investment by managers • Free cash flow is cash flow in excess of that required to fund all positive NPV projects and interest/debt payments • When cash is tight, managers are motivated to run the firm more efficiently

9. Extension of Trade-off Theory:Agency Benefits of Debt • Agency Benefits of Debt • leverage reduces agency costs of equity through monitoring and reduction in FCF,and increases firm value • We can incorporate the agency benefits of debt in the trade-off framework • The value of the levered firm now: • VL = VU + PV(Interest Tax Shield) - PV(Financial Distress Costs) + PV(Agency Benefits of Debt)

10. Agency Costs andCorporate Governance • Corporate Governance • The system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud • The role of the corporate governance system is to mitigate the conflict of interest that results from the separation of ownership and control • Leverage is part of the mix of corporate governance mechanisms of most corporations

11. Agency Benefits of DebtImplications for Optimal Leverage • Free cash flow (ROA & M/B) • Mature, low-growth firms • Mature, low-growth firms tend to have high free cash flows with few good investment opportunities • Prone to wasteful investments if they do not return cash to investors • High ROA firms with low investment needs (low M/B) should have higher leverage • R&D-intensive, high-growth firms • Firms with high R&D costs and future growth opportunities tend to have low current free cash flow • They do not need debt to control managerial spending • These firms typically maintain low debt levels

12. Part 2:Stakeholder Theory (GT Ch 17) • Non-financial stakeholders of a firm include firm’s: • Customers • Suppliers • Employees • Community • A financially distressed firm is more likely to be liquidated in the future • Non-financial stakeholders can be hurt by a firm’s financial difficulties • They may be less interested in doing business with a firm in financial distress

13. Stakeholders and Capital StructureCustomers • Customers • Customers may require a discount to purchase products of a distressed firm or may avoid purchasing altogether • Revenues decline • Especially for firms selling specialised products and products requiring servicing • Examples: Chrysler, Apple • Under financial distress, the long-run value of reputation may be less important than the short-run need to avoid bankruptcy • Firm may reduce quality of product to cut costs • When quality is not easily observable, customers may avoid the product • Example: Eastern Airlines

14. Stakeholders and Capital StructureSuppliers • Suppliers • Suppliers may avoid doing business with a distressed firm or may charge higher prices • Firm’s costs increase • Suppliers do not provide favorable credit terms • Firm’s working capital investment requirement increases

15. Stakeholders and Capital StructureEmployees • Who would you rather work for? • A highly levered firm may be a less attractive employer • More likely to go bankrupt and liquidate • More likely to lay off workers in economic downturns • Offers employees less opportunity for advancement • High debt ratio can be costly for firms trying to attract talent • But can be advantageous for some other firms …

16. Benefits of Financial Distress:Committed Stakeholders • Bargaining with Unions • Financial distress can benefit some firms by improving their bargaining positions with their stakeholders • Especially when firms have committed stakeholders (e.g., employees) • High leverage may facilitate employee concessions in wage negotiations • Employees fear that higher wages may push firm towards bankruptcy • Examples: Chrysler, Texas Air, American Airlines (see article)

17. Benefits of Financial Distress:Committed Stakeholders • Bargaining with the Government • Financial distress can be beneficial to the firm as it may receive below-market financing • Local and national communities are stakeholders bearing spillover costs of financial distress • Non-financial stakeholders, such as organised union employees, are politically important • Governments provide subsidies, e.g., loan guarantees, to distressed firms • Only the largest firms can get the benefit

18. Summary:Stakeholder Theory • Financial distress is especially costly for firms with • Products with quality that is important yet unobservable • Products that require future servicing (durable goods) • Employees and suppliers who require specialized capital or training (high R&D/Sales and high selling expenses/sales) • These firms should have relatively less debt • Financial distress is less costly for firms with • Products where quality can be easily assessed • Nondurable goods and services • Less specialized products • These firms should have relatively more debt

19. Summary:Stakeholder Theory • Financial distress can benefit some firms by improving their bargaining positions with their stakeholders • High leverage may facilitate employee concessions in economic downturns • Financially distressed firm may receive below-market financing from the Government

20. Part 3:Signalling, Pecking Order and Other Theories • So far we have assumed that managers, shareholders and creditors have the same information and securities are fairly priced • In reality, there is asymmetric information between the managers and the investors • Managers know more about the firm’s prospects, risks, and values than outside investors • Implication: • Investors may infer information about the firm value from firm’s financing choices

21. Stock price reaction to Equity Issue Announcements • Event study evidence shows: • Stock prices fall on announcements of equity issues • Average cumulative excess returns from 10 days before to 10 days after announcement for 531 common stock offerings (Asquith and Mullins (1986))

22. The Information Content ofThe Debt-Equity Choice • Generally: • Stock prices fall on leverage-decreasing announcements • Stock price rise on leverage-increasing announcements • Debt-equity choice conveys information to investors: • A debt issue signals confidence to repay the debt • An equity issue signals possibly overpriced shares • Caveat • Announcement effects do not necessarily mean changes in intrinsic value

23. A Debt Signaling Model Based onTax Gain & Financial Distress Costs • The firm’s capital structure is optimized where the marginal tax benefit of debt equals the marginal cost of financial distress • Higher anticipated profits increases marginal tax benefits of debt and reduces marginal financial distress costs, increasing optimal leverage ratio • Increased debt ratio is a favorable signal: • It indicates confidence in generating enough future cash flows to pay interests and in handling financial distress costs • Costly for firms with poor prospects to signal with debt • Likely to defaulon debt payments leading to financial distress • High cost of false signal makes debt signal credible

24. Pecking Order of Financing • Firms prefer to finance investments with retained earnings rather than external sources of funds Sources of Funds: US Corporations 1979-97

25. Pecking Order of Financing • If external financing is required, firms issue the safest security first • Straight debt – first, Convertibles – next, Equity – last • The “pecking order” or hierarchy of financing is as follows: • Internal funds • External funds • Debt • Convertibles • Equity • Firms adapt their target dividend payout ratios to their anticipated investment needs

26. Explanation of Pecking Order based onInformation Aysmmetry • Information Asymmetry • Managers issue stock when they believe their shares are overvalued • Investors see an equity issue as indication of overvaluation • Stock price falls on announcements of new shares issues • Negative stock market reaction to equity issues deter firms from issuing equity

27. Explanation based onTransaction Costs and Agency Problem • Transaction Costs • Managers try to minimise transaction costs of financing • Internal financing has no transaction costs • Debt has less transaction costs than equity • Agency Problem • Managers dislike financial market scrutiny of investments • Internal financing involves the least scrutiny • Debt financing involves less scrutiny than equity financing

28. Implication of the Pecking Order Theory • “Financial slack” is valuable • If external finance is costly due to information asymmetry, managers would sometime have to pass up positive NPV projects rather than issuing securities in unfavourable conditions • This can be avoided by having financial slack • Financial Slack = internal cash, marketable securities, or unused debt capacity • In industries where investment opportunities are uncertain and need to be taken quickly, this type of flexibility is more valuable

29. Comparing Trade-off Theory with Pecking Order Theory • Pecking-order theory is at odds with trade-off theory • In pecking order theory: • There is no optimal/target leverage • Current leverage is a result of company’s cumulative requirement for external financing • In trade-off theory, each firm has an optimal/target leverage • Profitable firms use less debt • In trade-off theory, profitable firms have a higher target or optimal leverage ratio • Empirical evidence shows that profitable firms have lower leverage – consistent with the Pecking Order Theory

30. Security Mispricing Theory • All theories discussed above assume semi-strong EMH • However, recent evidence on market anomalies casts doubt on this assumption • If it is the case that the investors in the equity market over- or under-value securities at times then: • Managers might be able to increase firm value by issuing over-valued securities and buying back under-valued securities • There is some evidence that managers indeed try to time the market in their security issue decisions

31. Security Mispricing Theory • One of the principal reasons given for share buybacks is that the stock of the firm is undervalued • Baker and Wurgler (2002) • Firms are more likely to issue equity when their market values are high, relative to book and past market values, and to repurchase equity when their market values are low • Differences in capital structures across firms is to a large extent due to their past attempts to time the equity market

32. Predation / Product market competition Theory • Very highly levered firms might be vulnerable to predatory pricing from its rivals [Bolton and Scharfstein (1990)] • If a low leveraged rival initiates price competition by reducing prices, the highly leveraged firm will not be able to match the rival’s price • If the highly leveraged firm reduces its prices, it will not be able to meet its interest payments and will default on its debt

33. Predation / Product Market Competition Theory • Chevalier (1995) • Finds evidence of predatory pricing driven by leverage • Pricing behaviour of supermarket chains following leveraged buyouts (LBO) shows: • Markets where rival firms have low leverage, prices generally fall following the LBO & • LBO firms are often forced to exit the market • Suggests that low leverage firms “prey” on highly levered ones

34. Managerial Inertia Theory • An implication of the trade-off theory is that firms should rebalance their capital structure to get back to the target leverage • If value of equity goes up, firms should issue debt or retire equity to get back to the target leverage • Welch (2004) • Firms generally do not act to adjust capital structure when stock prices go up and D/E goes down • Firms do not counter-balance stock return induced D/E changes • Stock returns can explain large part of D/E dynamics over time • Variations in leverage ratios of firms can largely be explained by managerial inertia • Note: Welch defines D/E using market value of equity