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MM assumed- Unselfish Manager, acting in shareholders’ interests.

MM Irrelevance Theorem - Firm Value and WACC independent of Capital Structure- Capital Structure does not matter- Pie Model. Problem: No prescription to firms on how to finance projects. Introduce tax relief on debt => 100% debt! Personal Taxes. Bankruptcy Costs. Traditional View.

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MM assumed- Unselfish Manager, acting in shareholders’ interests.

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  1. MM Irrelevance Theorem- Firm Value and WACC independent of Capital Structure- Capital Structure does not matter- Pie Model. • Problem: No prescription to firms on how to finance projects. • Introduce tax relief on debt => 100% debt! • Personal Taxes. • Bankruptcy Costs. • Traditional View.

  2. MM assumed- Unselfish Manager, acting in shareholders’ interests. - Symmetric Info between managers and investors (no inside info). Reasons for Optimal Capital Structure. Selfish Manager – Private Benefits, lack of effort etc. Asymmetric Information- Manager knows more about his firm than the outside investors.

  3. Agency Costs (Selfish Manager). Jensen and Meckling (1976). If firm issues equity (reduced managerial ownership of firm value), Manager pursues private benefits (private jet, plush offices, time off to play golf), reducing firm value. -If firm issues debt, manager has incentive to take risky projects (risk-shifting). Trade-off: Optimal Capital Structure. V* D/E D/E*

  4. Agency Costs (continued). Hart (1984)- Effort Level. Equity holders are ‘soft’- Manager can reduce effort. Debt holders can liquidate the firm=> Bankruptcy => manager losing job. This threat may lead to manager working harder => Increasing firm value. Therefore, increasing debt increases firm value.

  5. Agency Costs- Continued. Free cashflow (Jensen 1986). -Managers may have pet negative NPV projects. Equity => free cashflow => managers can take these bad projects => firm value falling. Debt => reduces free cashflow. Managers cannot take the bad projects => Firm value rises. - Important in Mergers- See 4th year course.

  6. Asymmetric Information. Manager has inside information. Issuing debt or equity may reveal this information to the market. Myers-Majluf. -Firm has 50/50 chance of good or bad news. Market values this firm at an average. Then Manager observes this news – market does not. If bad news arrives, firm is currently overvalued in the market – manager will issue shares – This signals bad news, and share price falls. If Good news arrives, firm is undervalued in the market, and manager will not issue shares. Therefore, Issuing equity signals bad news, firm value falls.

  7. Asymmetric Information (continued). Ross (1977)- Debt has bankruptcy threat. Manager has compensation based on firm value, but is penalised financially if firm goes bankrupt. Market cannot observe whether manager is good or bad. Good manager issues debt- signals that he is not too worried about bankruptcy – therefore, firm value rises. Bad Manager is worried about bankruptcy- does not issue debt. Firm Value falls. Empirical Evidence- Issuing equity causes firm value to fall- Debt causes firm value to rise- contrary to MM. Agency Costs and Signalling are explored in more detail in 4th YR.

  8. Practical Methods (Damadoran): • Trade-off Models. • Pecking Order Theory: Retained Earnings/ Debt/ equity. • Life-cycle model: Young firms less debt? Older firms more debt? • Benchmarking.

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