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Chapter 6

Chapter 6. CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin. Choosing Capital Structure In Practice. Survey evidence indicates that dilution and market timing are the top factors that influence managers’ decisions about issuing new equity.

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Chapter 6

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  1. Chapter 6 CAPITAL STRUCTURE Behavioral Corporate Finance by Hersh Shefrin

  2. Choosing Capital Structure In Practice • Survey evidence indicates that dilution and market timing are the top factors that influence managers’ decisions about issuing new equity. • The top factor influencing financial executives’ decisions about new debt is financial flexibility. • As a group, managers report that they attempt to target values for their firms’ debt-to-equity ratios. • However, this factor is rated fifth in importance.

  3. Long Lasting Effect? • Empirical evidence indicates that firms issue new equity when stock prices have recently risen and market-to-book ratios are high. • This suggests that managers issue equity when that equity is most likely to be overpriced. • Some have concluded that this is no short-run phenomenon, that fluctuations in market value can have very long-run impacts on capital structure.

  4. Traditional Explanation • Some empirical studies conclude that executives do establish target debt-to-equity ratios. • Managers attempt to close half the gap between current ratios and target ratios in less than two years. • These studies suggest that market timing is a minor consideration. • However, other empirical studies conclude that market timing is a major consideration, so the issue is not settled.

  5. Convertible Debt • More than 55% of CFOs who issue convertible debt view it as an inexpensive way to issue “delayed” common stock. • 50% claim to issue convertible debt because their stock is currently undervalued. • Behavioral issues: convertible debt framed as both cheap debt and cheap equity.

  6. Debt Puzzle • Firms with low expected costs of financial distress use debt conservatively. • Large liquid firms in non-cyclical industries use debt conservatively. • During the early 1990s, the unexploited tax shield by U.S. firms was about the same as the actual tax shields. • The tax benefit of debt has been estimated to be about 7% of firm value, after taking into account the effect of personal taxes.

  7. Traditional Pecking Order Empirical Evidence • When large firms engage in substantial investments, they tend to rely on debt financing. • However, they do not appear to exhaust their cash reserves before undertaking debt. • Therefore, managers do not behave in strict accordance with pecking order theory. • FEI survey finds little evidence to suggest that executives believe that the source of the undervaluation is perceived information asymmetry.

  8. Behavioral APV • Behavioral APV reflects errors and biases by managers, the market, or both. • Behavioral APV calculation indicates whether managers of financially constrained firms with positive NPV projects, but whose equity is undervalued, should invest or repurchase.

  9. Project Hurdle Rate Three key variables determine the appropriate adjustment to project hurdle rate. • the firm’s financing constraints • degree of mispricing • the impact of the firm’s repurchase activity on the price of its shares

  10. Repurchasing • Average market response to announcement of an open market repurchase is 3.5%. • Investors appear to underreact to repurchases, in that stock prices drift upwards when firms repurchase shares. • Stocks of firms who repurchase shares earn four-year abnormal returns of 12.1%. • 45.3% for firms with high book-to-market equity. • Example: AutoNation.

  11. Sensitivity of Investment to Cash Flow • Firms’ acquisition activity increases when they are the recipients of large cash windfalls coming from legal settlements unrelated to their ongoing lines of business. • Reinsurance companies reduce the supply of earthquake insurance after their capital positions have been impaired by large hurricanes. • When cash flow increases or leverage decreases in one division of a firm, investments in other divisions of the firm increase significantly.

  12. Behavioral Explanation • Excessively optimistic, overconfident managers of cash poor firms reject positive NPV projects because they overvalue the equity of their firms, and won't issue new shares to fund the project. • Excessively optimistic, overconfident managers of cash rich firms adopt negative NPV projects because they overvalue the cash flows from those projects and adopt them. • Example: Adaptec.

  13. Excessively Optimistic, Overconfident CEOs • The press often describes some CEOs as “optimistic” and “confident.” • Longholders hold stock options too long. • Example: Scott McNealy of Sun Microsystems. • Empirical evidence that firms with longholder CEOs have investment policies that are excessively sensitive to cash flows.

  14. Conflict Between Short-term and Long-term Horizons • Consider a firm whose book-to-market equity ratio is low, and whose stock price has increased rapidly. • Such a firm might earn low returns long-term because its stock is overpriced. • Managers who adopt projects for short-term gain effectively act as if they use low discount rates in their capital budgeting analysis. • Challenge is balancing interests of short-term and long-term investors.

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