Barclay-Smith (1996) Financial Architecture

1. Barclay-Smith (1996) Financial Architecture • Barclay-Smith-Watts (1995): The most important determinant of a company’s leverage ratio is the nature of its investment opportunities. • Companies whose value consists largely of intangible growth options have significantly lower leverage ratios. • For high-growth firms the underinvestment problem associated with heavy debt financing is especially very costly.

2. Barclay-Smith (1996) Financial Architecture • Financial Architecture • Leverage • Maturity • Convertibility, Call provisions • Priority • Placement (private/public)

3. Barclay-Smith (1996) Financial Architecture • Table 1, Sources of corporate debt • Commercial paper (maturity: 35 days) • Bank debt (6 years) • Non-bank private debt (15 years) • Public debt (18 years) • Issue costs are larger for commercial paper and public debt. • Issuer size are larger for public debt ($3.4 billion) than private debt ($2.3 billion). • Issue size larger for public debt ($80 million) compared to private debt ($40 million).

4. Barclay-Smith (1996) Financial Architecture • Bond covenants restrict a firm’s investment, payout, and financing policies. • Affirmative covenants • Requiring the firm to maintain specific working capital balances. • Negative covenants • Prohibiting the firm from issuing additional debt unless a specified financial ratio is maintained. • A maximum on dividends places a minimum on new investments. Firm’s Cashflow Identity: New Debt + New Equity + Earnings = Dividends + Debt Repayment + New Investments

5. Barclay-Smith (1996) Financial Architecture • Bank debt and non-bank private debt contain most extensive covenants. • Public debt contain few and commercial paper contain even fewer covenants, partially because they are protected by cross-default provisions.

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7. Barclay-Smith (1996) Financial Architecture • Table 2 • Rights in bankruptcy • Lessor has the right to repossess the leased asset. • Secured debtholders hold title to pledged assets. • Inverse relation between priority of claim and the right to set corporate policy (hire/compensate/fire managers, set investment policy). • Debt covenants restrict investment, financing, and dividend decisions, but do not give debtholders the right to initiate corporate policy.

8. Barclay-Smith (1996) Financial Architecture • Table 3, 6000 firms over 1981-1994 • Debt to total capital ratio is 21%. (Total capital is market value of equity plus book value of other liabilities.) • Average amount of debt payable in more than one year is 16% of total capital, and 69% of total debt. • Average amount of debt payable in more than five year is 8% of total capital, and 32% of total debt. • Debt of different priorities • Capitalized leases: 11% • Secured debt: 40% • Ordinary debt: 38% • Subordinated debt: 10%

9. Barclay-Smith (1996) Financial Architecture • Investment Opportunity Set and Financial Structure • Underinvestment problem: With risky debt outstanding, shareholders are tempted to not undertake positive NPV projects. • Investing-in-high-risk-projects problem: With risky debt outstanding, shareholders are tempted to undertake negative NPV but high risk projects.

10. Barclay-Smith (1996) Financial Architecture • Maturity and investment opportunities. • Management of a high-growth firm that chooses to issue debt can better protect the firm’s ability or willingness to make valuable investments by having debt come due before the firm must make those investments. • Having 100% equity and large cash reserves provides most flexibility. (Potential problem with large cash reserves: The “disagreement” between Chrysler and Iaacoca/Kerkorian.) • If the firm decides to issue some debt, short-term debt is more flexible than long-term debt.

11. Barclay-Smith (1996) Financial Architecture • Priority and investment opportunities. • High growth firms might prefer to issue unsecured debt to maintain as much operating flexibility as possible. But potential lenders respond to the greater uncertainty in such situations by demanding security in the form of receivables or inventory, since high-growth companies have few long-term tangible assets. • Hence, growth firms will prefer high-priority claims such as secured debt. (Such firms will also avoid complicated capital structures.)

12. Barclay-Smith (1996) Financial Architecture • Table 4 • “Leverage” regression in column 1 • Firms that have greater investment opportunities (market-to-book ratio) use less debt. • Larger firms use more debt. • “Short-term debt” regression in column 2 • Firms that have greater investment opportunities use less short-term debt. • Larger firms use less short-term debt. • “Long-term debt” regression in column 3 • Firms that have greater investment opportunities use less long-term debt. • Larger firms use more long-term debt

13. Barclay-Smith (1996) Financial Architecture • Table 4 continued • Regressions under “Priority” • Firms that have greater investment opportunities use • less capitalized leases • less secured debt • less ordinary debt • less subordinated debt. • Larger firms use • less capitalized leases • less secured debt • more ordinary debt • more subordinated debt.

14. Barclay-Smith (1996) Financial Architecture • Case study: Telecommunications Industry • Technological progress starting about the mid-80s (and this trend is still continuing) in this industry led to significant increase in investment opportunities. • Deregulation of this industry, also starting about the mid-80s, allowed firms in this industry to invest in these opportunities. • The above considerations would suggest a significant decrease in leverage in this industry.

15. Graham-Harvey (2001): Theory-Practice of Corporate Finance • Survey of 392 CFOs. • Fig 1 • Panel A: Range of firm sizes. • Panel C: Range of industries. • Panel E: Range of debt ratios. • Panel K: About 38% of CEOs have an MBA. • Panel N: Sample includes private and public companies.

16. Graham-Harvey (2001): Theory-Practice of Corporate Finance • Fig 2: Popularity of different capital budgeting techniques (in order): • IRR • NPV • Hurdle rate • Payback • Large firms, highly levered firms, and firms with MBA-CEOs more likely to use NPV method.

17. NPV and IRR Security Market Line (CAPM) Accept Expected Return Reject Rf Beta

18. NPV and IRR Expected Return Accept IRR Cost of Capital Reject Beta

19. NPV and IRR Security Market Line (CAPM) A Expected Return B Cost of Capital C D Rf Beta A: CAPM (Accept), CoC (Accept) B: CAPM (Reject), CoC (Accept) C: CAPM (Accept), CoC (Reject) D: CAPM (Reject), CoC (Reject)

20. NPV and IRR Security Market Line (CAPM) A Expected Return B Cost of Capital C D Rf Beta A: CAPM (Accept), CoC (Accept) B: CAPM (Reject), CoC (Accept): Take turkeys. C: CAPM (Accept), CoC (Reject): Turn down winners. D: CAPM (Reject), CoC (Reject)

21. Graham-Harvey (2001): Theory-Practice of Corporate Finance • Fig 3: Popularity of different methods for calculating cost of equity capital (in order): • CAPM • Average historical return • Multibeta CAPM • Large firms, low levered firms, and firms with MBA-CEOs more likely to use CAPM.

22. Graham-Harvey (2001): Theory-Practice of Corporate Finance • Fig 5: Factors that CFOs thought determined the appropriate amount of debt (in order): • Financial flexibility (p. 218: minimizing interest obligations such that they do not need to shrink their business in case of an economic downturn). • Credit rating. • Earnings and cash flow volatility. • Insufficient internal funds. • Level of interest rates. • Interest tax savings. • Transaction cost and fees. • Equity misvaluation. • Comparable firm debt levels. • Bankruptcy/distress costs.

23. Graham-Harvey (2001): Theory-Practice of Corporate Finance • Fig 7: Factors that CFOs thought relevant in deciding whether or not to issue stock (in order): • Earnings per share dilution. • Stock misvaluation. • Recent rise in stock price. • Providing shares for employee/bonus stock option plans. • Maintaining target debt-to-equity ratio. • Diluting holding of certain shareholders. • Stock is least risky source of funds.

24. Graham-Harvey (2001): Theory-Practice of Corporate Finance • 5.1. Tradeoff theory of capital structure choice: Firms have optimal debt-equity ratios which they determine by trading off the benefits of debt (tax advantage of interest deductibility), with the costs of debt (financial distress costs, and tax expense incurred by bondholders). • Fig 5: Corporate tax advantage of debt only moderately important. • Fig 5: Financial distress moderately important. But credit rating may be a proxy for financial distress costs. • Fig 5: Personal tax considerations appears to be not important.

25. Graham-Harvey (2001): Theory-Practice of Corporate Finance • 5.2. Asymmetric information explanations of capital structure choice: • 5.2.1 Pecking-order theory: Firms do not target a specific debt ratio, but instead use external financing only when internal funds are insufficient: External funds are less desirable because informational asymmetries between management and investors imply that external funds are undervalued. Hence, if firms use external funds, they prefer to use debt, convertible securities, and, as a last resort, equity. • Table 9: Consistent with the pecking-order theory : Having insufficient internal funds is a moderately important influence on the decision to issue debt, especially for smaller firms (that are likely to suffer from greater asymmetric-information-related equity undervaluation).

26. Graham-Harvey (2001): Theory-Practice of Corporate Finance • 5.2. Asymmetric information explanations of capital structure choice: • 5.2.2 Recent increase in stock price: A surge in share price increase can correct an undervaluation or lead to an overvaluation. • Table 8: Recent stock price increase third most important factor in equity-issuance decision. • 5.2.4 Convertible debt issuance: Conversion feature makes convertible debt relatively insensitive to asymmetric information (between management and investors) about the risk of the firm. • Table 10: Firms use convertible debt to attract investors unsure about the riskiness of the firm (more relevant for smaller firms).

27. Graham-Harvey (2001): Theory-Practice of Corporate Finance • 5.3. Underinvestment problem • Table 6: Consistent with theory underinvestment more of a concern for growth firms compared to non-growth firms. • Table 6: Overall, underinvestment does not appear to be a major concern.