James Song Jan 30, 2007

1. Corporate Financing and investment Decisions when Firms Have Information That Investors Do Not Have James Song Jan 30, 2007

2. Optimal Capital Structure • In perfect markets, capital structure is irrelevant. • If markets are perfect (except for tax), then the optimal capital structure is 100% debt.

3. Total firm value 100% debt 100% equity The market is not perfect at all • There are costs of debt that we’ve missed. At some point, those costs must outweigh debt’s tax benefits

4. Convex curve of cost of capital • The optimal capital structure is the one that maximizes the value of the firm, is in between the extremes. • The value of firm is to shareholders. • Numerous problems are associated with the confusing responsibility.

5. Bankruptcy Cost • It is not the event of going bankrupt that matters, it is the costs of going bankrupt that matter. • If ownership of the firm’s assets was transferred costlessly to its creditors in the event of bankruptcy, optimal capital structure would still be 100% debt. • When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to using leverage.

6. Choice for debt • Balance between tax shelter with bankruptcy cost. • Later we will discuss more about other trade offs for debt • lowering monitoring cost vs. cost of debt; • lowering cost of capital vs. value-destroying project investment; • Clientele of investors vs. political risks

7. Cost of bankruptcy • Costs of bankruptcy-related litigation • Cost of management time diverted to bankruptcy process • Loss of customers who don’t want to deal with a distressed firm • Loss of employees who switch to healthier firms • Strained relationships with suppliers • Lost investment opportunities • Reputation and emotional loss

8. More concerns for bankruptcy cost • When the firm’s product requires that the firm stay in business (e.g., when warranties or service are important) • When the firm must make additional investments in product quality to maintain customers

9. Estimation of Bankruptcy Cost • Legal, auditing and administrative costs (include court costs) – 1% - 10% of firm value • Bankruptcy governed by Federal law and filings are made in Federal bankruptcy courts • Chapter 7 (Liquidation) • Chapter 11 (Reorganization) • In liquidation, a trustee is usually appointed to liquidate firm’s assets. • In reorganization, firm’s management continues to operate firm, can propose reorganization plan. • Reputation cost: shareholders refuse to contribute funds; labor refuse to work for you; etc.

10. Agency Costs • Agency costs arise as soon as an entrepreneur sells a fraction a of her firm to outside investors. • Entrepreneur enjoys private benefits of control (perquisites), but bears only (1- a ) of the cost of “perks.” • Separation between ownership and control of a firm gives rise to agency costs of outside equity.

11. Agency Costs Of Outside Debt • Debt helps mitigate these costs, but debt has its own agency costs • Expropriate bondholders wealth by paying excessive dividends • Bait And Switch: Promise to use borrowed money for safe investment, then use to buy high/risk, high/return asset

12. Agency Cost • Bondholders protect themselves with positive and negative covenants in lending contracts. • Agency costs of debt are burdensome, but so are solutions.

13. Trade-Off Theory • Agency Cost / Tax Shield Trade-Off Model Of Corporate Leverage • Companies trade off tax and agency cost benefits of debt against the costs of bankruptcy and agency costs of debt. • Firm maximized at a unique optimal debt level • Empirical research offers support for the model, but the model is far from perfect in its predictions. • Weaknesses lead to development of Pecking Order Theory.

14. Weakness of Trade-Off Theory • Trade-off theory cannot explain three empirical capital structure facts: • Most profitable firms in an industry use least debt. • Stock market responds to leverage-increasing events strongly positive; negative reaction to leverage-decreasing events. • Firms issue debt frequently, but rarely issue equity.

15. Pecking Order Theory • Myers (1984), Myers & Majluf (1984) propose pecking order theory of corporate leverage. • Assumptions: There are information asymmetry between managers and investors. • Manager acts in best interests of existing shareholders.

16. Managerial Behavior • Two key predictions about managerial behavior • Firms hold financial slack so they don’t have to issue securities. • Firms follow pecking order when issuing securities: sell low-risk debt first, equity only as last resort.

17. Signaling And Other Asymmetric Information Models • Third group of models, based on asymmetric information between managers and investors, predict managers will use a costly signal: • A simple statement of high firm value not credible • Must take action that is too costly for weak firm to mimic • Crude signal: Drive BMW cars; only wealthy can afford • If signaling can differentiate between strong and weak firms based on signal, a signaling equilibrium results. • Investors identify stronger firms, assign higher market value • If signaling cannot differentiate between strong and weak firms, a pooling equilibrium results. • Investors assign low average value to all firms. • Models predict high value firms use high leverage as signal. • Makes sense, but empirics show the opposite—most profitable & highest market/book firms use least leverage.

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19. Model of Perking Order Theory • Before we start, we clear couple issues as below • Because we are talking about the probability that high value projects are not financed through external equity capital, so we assume that these “high value projects” have high return R that always covers initial investment I, so debt financing part is risk-free. • But because of the concave capital cost, entrepreneur has to issue external equity in our perking order theory model.

20. Model of Perking Order Theory • We will first assume that the firm’s type can take only two possible values: it can be either high or low. • At period 0, • XL - Low value firm worth $0 • XH - High value firm worth $200 • The new project demands new equity finance of I = 30, R=50

21. When information is perfect • Required investment (or the amount in SEO) • 30=I = a(X+R)=a(200+50), a* = 0.12 or 12% • After SEO, entrepreneur wealth is • W = (1-a*)(X+R) = $220 > $200

22. Next we will first use discrete model to analyze the imperfect information models, then use continuous model to analyze it.

23. When information is not perfect – Discrete model • Assume firm could be low value with probability p, then see next page

25. Conclusion from discrete model • The profitable project will not be financed if p>0.5!

26. When information is not perfect – continuous model • See next page

28. Conclusion • Retained earning, debt is better than external equity capital