Corporate Capital Structure: Recent Research and Events

1. Corporate Capital Structure:Recent Research and Events Kevin Davis Commonwealth Bank Chair of Finance, University of Melbourne Director, Melbourne Centre for Financial Studies kevin.davis@melbournecentre.com.au 03 9666 1010

2. Outline • Lessons of the sub-prime crisis • Thinking about Capital Structure • Capital Structure Theory • Capital Structure Evidence • Some Current Issues and Techniques

3. Lessons of the sub-prime crisis • Capital structure matters • Potential exposure to financial distress costs • High leverage • Rollover risk • Undiversified financing • Robustness of “untested” financing innovations • Complex, opaque corporate structures • Credit risk premiums variable and important

4. Thinking about Capital Structure • Leverage (Gearing) – debt/equity • Market value or book value? • Effect on share price volatility • Interest coverage • Credit ratings and market ratings (CDS spreads) • Hybrids • Maturity • Governance and Market Discipline implications • eg infrastructure funds, market value leverage covenants

5. Capital Structure Theory • Ongoing debate – “trade-off” versus “pecking-order” • Compromise – reality? • Firms issue cheapest securities • “windows of opportunity” – undervalued equity • Firms don’t closely manage “market value” leverage • Reluctance to issue equity • Information effects and negative market response) • Consequently • Long lasting fluctuations around some “target’ • Capital structure is cumulation of past decisions • Market value leverage inversely related to recent stock price movement • Management builds up financial slack when possible

6. Some Facts • Debt ratios vary more by country than by industry • Generally in range 0.2-0.3 (of assets) • Australia has low ratio • Imputation – what is the gain to shareholders from reducing company tax? • Average debt maturity relatively low • Around 6 months internationally • Australian corporate debt market relatively small • Both long term and short term (CP) • “intermediated debt” and role of banks

7. Firm characteristics and leverage Firm Characteristic Leverage Larger Higher Growth Lower Tech sector Lower More tangible assets Higher More profitable Less Past performers Less

8. Capital Structure Management Developments • Increased importance of share buybacks • Off-market buybacks and franking credits • Rights issues versus placements and retail subscription offers • Increased use of hybrids • Evolution of converting preference share structure • Use of dividend underwriting • Maintenance of cash position with high, stable dividend rates • Future role of ratings and CDS spreads • Impact of Sons of Gwalia judgement

9. Concluding remarks • Important to understand and consider • Relative cost of equity and debt (and tax issues) • Real cost of options inherent in hybrid, innovative financing • Information effects of announcements • Organizational structure consequences and market perceptions of opportunistic financing involving subsidiaries and intra-firm linkages • Potential governance implications • Currently: high cost of capital; premium on liquidity; importance of having both bank relationships and funding flexibility