Corporate Finance

1. Corporate Finance Capital structure by Yanzhi Wang

2. Very early papers • Trade-off theory • In perfect and efficient markets, capital structure is irrelevant. (Modigliani and Miller(1958)) • The trade-off theory determines an optimal capital structure by adding various imperfections. Including →Taxes :(modigliani and miller(1963) 、Miller and Scholes(1978)、Defngelo and masulis(1980)) →Financial distress cost: Myers(1977) →Agency costs: jensen(1986)、Fama and Miller(1972)、Harris and Raviv(1991)

3. Shyam-Sunder and Myers (1999) • Summary: • This paper tests traditional capital structure models against the alternative of a pecking order model of corporate financing. This paper checks the statistical power of their tests against alternative hypotheses. • We find that a simple pecking order model explains much more of the time-series variance in actual debt ratios than a target adjustment model based on the static tradeoff theory. • Moreover, we show that the pecking order hypothesis can be rejected if actual financing follows the target-adjustment specification. On the other hand, this specification of the static tradeoff hypothesis will appear to work when financing follows the pecking order.

4. Static tradeoff theory • It assumes an optimal capital structure of a firm. • A value-maximizing firm would equate benefit and cost at the margin, and operate at the top of the value curve. The curve would top out at relatively high debt ratios for safe, profitable firms with plenty of taxes to shield and assets whose values would escape serious damage in financial distress.

5. Static tradeoff theory- Empirical finding • Schwartz and Aronson (1967), have documented evidence of strong industry effects in debt ratios, which they interpret as evidence of optimal ratios. • Long and Malitz (1985) show that leverage ratios are negatively related to research and development expenditures, which they use as a proxy for intangible assets. • Taggart (1977), Marsh (1982), Auerbach (1985), Jalilvand and Harris (1984) and Opler and Titman (1994) find mean reversion in debt ratios or evidence that firms appear to adjust toward debt targets.

6. Pecking order theory • By Myers and Majluf (1984) • In the pecking order theory, there is no well-defined optimal debt ratio. The attraction of interest tax shields and the threat of financial distress are assumed second-order. • Debt ratios change when there is an imbalance of internal cash flow, net of dividends, and real investment opportunities. Highly profitable firms with limited investment opportunities work down to low debt ratios. Firms whose investment opportunities exceed internally generated funds borrow more and more. • Changes in debt ratios are driven by the need for external funds, not by any attempt to reach an optimal capital structure.

7. Pecking order theory- Empirical finding • Myers (1984) argues that the negative valuation effects of equity issues or leverage-reducing exchange offers do not support the tradeoff story. That is, if changes in debt ratios are movements towards the top of the curve (as in Fig. 1), both increases and decreases in leverage should be value enhancing, and there should be NO negative valuation effect. • Kester (1986), Titman and Wessels (1988) and Rajan and Zingales (1995) find strong negative relationships between debt ratios and past profitability. (Remember! STT predicts positive relationship in this profitability test)

8. Pecking order model • Funds flow deficit is where • The pecking order hypothesis to be tested is:

9. Pecking order model • If DEF is negative (by firm i). We expect a=0 and bPO=1. The pecking order coefficient is bPO. • This is the simplest version of the pecking order (as expressed in above equation) butcannot be generally correct. It may, however, be a good description of financing over a wide range of moderate debt ratios.

10. Static tradeoff model • The simple form of the target adjustment model states that changes in the debt ratio are explained by deviations of the current ratio from the target. The regression specification is: • where D*it is the target debt level for firm i at time t. We take bTA, the target-adjustment coefficient. • The target D* is generally unobservable. • What should we do?

11. Data and sample selection • Sample includes all firms on the Industrial Compustat files. • Financial firms and regulated utilities were excluded. • The sample period overs 1971-1989 because Compustat includes flow of funds statements from 1971. The requirement for continuous data on flow of funds restricts our sample to 157 firms.

12. Regression results for target adjustment and pecking order models • Coefficients of TA and BO are all consistent with the predictions. • R-sq of pecking order model is much higher

13. Test of power • Statistical power is often investigated using Monte Carlo simulation on hypothetical data. In this case we start with the actual investment outlays and operating results of our sample companies. We then generate hypothetical time series of debt issues or retirements, one series for each of the 157 sample companies, using either the target adjustment model, Eq. (3), or the pecking order model, Eq. (2).

14. Test of power • Actual data indicates what they found in previous table

15. Test of power • Pecking specification rejects pecking order theory when using simulated target adjustment series. • Target-adjustment specification fits the simulated pecking order series just as well as the actual data! This is clearly a false positive.

16. Frank and Goyal (2003) • Summary: • This paper tests the pecking order theory. • Contrary to the pecking order theory, net equity issues trackthe financing deficit more closely than do net debt issues. Financing deficit is less important in explaining net debt issues over time for firms of all sizes.

17. Tests on capital structure theories • Rajan and Zingales (1995) use a different information set and international data to account for corporate leverage. • Shyam-Sunder and Myers (1999) find strong support for this prediction in a sample of 157 firms that had traded continuously over the period 1971 to 1989. Yet, 157 firms is a relatively small sample from the set of all publicly traded US firms. • Frank and Goyal (2003) study the extent to which the pecking order theory of capital structure provides a satisfactory account of the financing behavior of publicly traded US firms over the 1971 to 1998 period.

18. Three tasks • First, the paper provides evidence about the broad patterns of financing activity, which include checks on the significance of external finance (bond and equity issues). • Second, the paper examines a number of implications of the pecking order in the context of Shyam-Sunder and Myers’ (1999) regression tests. • Finally, the paper examines whether the pecking order theory receives greater support among firms with severe adverse selection problems. • Small high-growth firms are often thought of as firms with large information asymmetries.

19. Pecking order model • We can use the flow of funds data to provide a partially aggregated form of the accounting cash flow identity as: • Shyam-Sunder and Myers’ (1999) setting: • Shyam-Sunder and Myers (1999) include the current portion of long-term debt (Rt) as part of the financing deficit beyond its role in the change in working capital. • This paper reports only the results for which the current portion of long-term debt is not included as a separate component of the financing deficit. This choice favors the pecking order, but it does not affect the conclusions.

20. Pecking order model • Changes in cash are included in changes in net working capital (ΔW). Changes in cash could be correlated with the amount of debt issued. This could arise in the presence of debt and equity issues, with excess proceeds parked for some period of time in excess cash balances. Inclusion of cash favors the pecking order theory. • The pecking order theory treats the financing deficit as exogenous. The financing deficit includes investment and dividends, which are probably endogenously determined.

21. Disaggregation of the financing deficit • Consider the following specification: • A unit increase in any of the components of DEFit must have the same unit impact on ΔDit, i.e.,

22. Other information on leverage • To test the pecking order, the paper considers tangibility, M/B, sales and profitability as key conventional variables. • Firms with few tangible assets would have greater asymmetric information problems. Thus, firms with few tangible assets will tend to accumulate more debt over time and become more highly levered. However, tangibility is negatively related to the lower distress cost, in a way few tangible assets lead to less debt. • Firms with high market-to-book ratios are often thought to have more future growth opportunities. Debt could limit a firm’s ability to seize such opportunities when they appear.

23. Other information on leverage • Large firms are usually more diversified, have better reputations in debt markets, and face lower information costs when borrowing. • The predictions on profitability are ambiguous. The tradeoff theory predicts that profitable firms should be more highly levered to offset corporate taxes. Yet profitable firms have more internet capital, so debt should be lowered. • What sign of coefficient is expected?

24. Deficit, issuance of debt and equity • Which one correlates deficit?

25. Pecking order test • What does gap mean here? • Does the table result support POT?

26. Pecking order test • Disaggregation of the financing deficit

27. Other information on leverage

28. Baker and Wurgler (2002) • Firms usually issue equity when their market values are high, relative to book and past market values, and repurchase equity when their market values are low. • This paper documents that the resulting effects on capital structure are very persistent. As a consequence, current capital structure is strongly related to historical market values. The results suggest the theory that capital structure is the cumulative outcome of past attempts to time the equity market.

29. Introduction • Pecking order theory • Static version →Myers and Majluf(1984) predicts that managers will follow a pecking order, using up internal funds first, then using up risky debt, and finally resorting to equity. • Dynamic version →Myers(1984) suggests that High growth firms reduce leverage in order to avoid raising equity as investment opportunities arise in the future.

30. Introduction • Managerial entrenchment theory →Zwiebel(1996) suggests that high valuations and good investment opportunities facilitate equity finance, but at the same time allow managers to become entrenched. They may refuse to raise debt to rebalance in later periods.

31. Introduction • Market timing phenomenon →Equity market timing refer to the practice of issuing shares at high prices and repurchasing at low prices. →Firm issue equity when the cost of equity is relatively low and repurchase equity when the cost is relatively high. →Firms tend to issue equity at times when investors are rather to enthusiastic about earnings prospects →Managers admit to market timing in anonymous surveys. (Graham and harvey(2001)).

32. Variable definitions • Book equity as total assets less total liabilities and preferred stock plus deferred taxes and convertible debt. • Market equity is defined as common shares outstanding times price. • Market leverage as book debt divided by the result of total assets minus book equity plus market equity. • (e/A) as the change in book equity minus the change in balance sheet retained earnings divided by assets • (△RE/A) as the change in retained earnings divided by assets • (d/A) as the residual change in assets divided by assets.

33. Recent calendar trends in this sample include a decrease in market leverage, an increase in equity issues, and a decrease in internal finance. The concurrent increase in equity issues is suggestive of market timing.

34. Market-to-book and market timing • Using three other variables that Rajan and Zingales(1995) find to be correlated to leverage in several developed countries. • Market-to-bookis defined as assets minus book equity plus market equity all divided by assets. • Asset tangibility is defined as net plant, property, and equipment divided by total assets • Profitability is defined as earnings before interest, taxes, and depreciation divided by total assets. • Size is measured as the log of net sales.

36. External finance weighted average • Market timing could be just a local opportunism whose effect is quickly rebalance to some target leverage ratio • Market timing may have persistent effects, and historical valuations will help to explain why leverage ratios differ: external finance weighted-average • The variable takes high values for firms that raised external finance when the market-to-book ratio was high and vice-versa.

37. Controlling for current investment opportunities in the form of current market-to-book leaves the past within-firm variation to do a better job of picking up. • M/Befwa is the residual influence of past, within-firm variation in market-to-book.

41. Alta (2006) • This paper examines the capital structure implications of market timing, and isolates timing attempts in the initial public offering. • This paper finds that compared with cold-market IPOs, hot-market IPO firms issue substantially more equity, and lower their leverage ratios. • However, immediately after going public, hot-market firms increase their leverage ratios by issuing more debt and less equity relative to cold-market firms. • At the end of the second year following the IPO, the impact of market timing on leverage completely vanishes.

42. Long-term impact of market timing on capital structure • Baker and Wurgler (2002) find persistent timing effects on leverage that extend beyond 10 years. • The market-to-book ratio is likely to proxy for underlying firm characteristics (most notably the long-term growth), a spurious relation between history and capital structure may obtain. • More growth opportunities lead to more needs which are recorded in the history, market-to-book ratio is higher for high growth stocks. This is less relevant to the market timing.

43. IPO and capital structure • This paper focuses on a single financing event, the initial public offering, in an attempt to capture market timing and its impact on capital structure. • Investors face more uncertainty and a higher degree of asymmetric information when valuing IPO firms than they face in the case of mature public companies. Hence, IPOs offer more room for misvaluation. • Market timing attempt is most apparent in the IPO market. • IPO sample is likely to be highly revealing of pure market timing motives that are distinct from long-range financing policy requirements.

44. Main market timing measure • My measure of market timing is direct and very simple: whether the IPO takes place in a hot issue market, characterized by high IPO volume in terms of the number of issuers, or a cold issue market • If issuers regard hot markets as windows of opportunity with a temporarily low cost of equity capital, they should react by issuing more equity than they would otherwise do. • Conversely, cold-market IPOs are likely to keep their equity issues to a necessary minimum, as market conditions are less favorable than average. • Quantifying market timing attempts this way has the advantage of not picking up firm-level characteristics; the timing measure is instead a function of market conditions.

45. Data and sample selection • The initial sample consists of all IPOs between January 1, 1971, and December 31, 1999, reported by the Securities Data Company (SDC). • The sample excludes spinoffs, unit offers, financial firms with SIC codes between 6000 and 6999, and firms with book values of assets below $10 million in 1999 dollars at the end of the IPO year. This paper further restricts the sample to those firms for which COMPUSTAT data are available for the last fiscal year before the IPO.

46. Variable definitions • Book debt, D, is defined as total liabilities (COMPUSTAT Annual Item 181) and preferred stock (Item 10) minus deferred taxes (Item 35) and convertible debt (Item 79). • Book equity, E, is total assets (Item 6) minus book debt. • Book leverage, D/A, is then defined as book debt divided by total assets. • Market-to-book ratio, M/B, is book debt plus market equity (common shares outstanding (Item 25) times share price (Item 199)) divided by total assets. As in Baker and Wurgler (2002), I drop observations for which M/B exceeds 10.0. • Net debt issues, d/A, is the change in book debt. Net equity issues, e/A, is the change in book equity minus the change in retained earnings (Item 36). • Newly retained earnings, RE/A, is the change in retained earnings. • Profitability is measured by EBITDA/A, which is earnings before interest, taxes, and depreciation (Item 13). • SIZE is the logarithm of net sales (Item 12) in millions of 1999 dollars.

47. Hot and Cold Markets • Hot (cold) months are then defined as those that are above (below) the median in the distribution of the detrended monthly moving average IPO volume across all the months in the sample.

48. Market timing effects on issuance activity

49. Alternative explanations • Hot-market firms could issue more equity than their cold-market counterparts for reasons other than market timing. • Hot-market firms may be severely overleveraged before going public, and may attempt to revert back to their leverage targets at the IPO. • Another potential explanation for the equity issue activity of hot-market firms is that they grow faster. If hot-market firms invest at higher rates, or expect to do so in the near future, then they are likely to finance part of this growth by raising equity capital.

50. Test on alternative explanations