Post on 05-Jan-2016
FIN 413FIN 413Corporate Financial Corporate Financial PolicyPolicy
Clifford W. Smith, Jr. Spring 2007 Overhead 2 * Covers readings on course outline through Barclay/Smith/Watts (1997)
D E
M/M (1958)
D E
M/M (1958)
Historical Evidence
From Barclay/Smith/Watts (1997)
Relaxing the M/M Assumptions
Interest payments to bondholders are deductible for tax purposes
while payments to equity holders are not.
Corporate Tax Liabilities
M/M (1963)
D
Tc
E
Corporate Tax Liabilities
M/M (1963)
D
Tc
E
Taxes and Bankruptcy Costs
Kraus/Litzenberger (1973)
E
BC Tc
D
Taxes and Bankruptcy Costs
Kraus/Litzenberger (1973)
E
BCTc
D
Bankruptcy Costs
Warner examined the bankruptcies of 11 railroads to estimate the costs of bankruptcy.
The bankruptcy proceedings typically lasted many years. The average was 13 years, and the longest was 23 years.
On average these firms spent approximately $2 million on the bankruptcy proceedings
We can measure the bankruptcy costs in relation to firm value at various points in time
Measuring Bankruptcy Costs
0 Filing dateT Settlement date (T 13 years)
5 T0 Time
BC BCV0 V-7
= 5.3% = 1.0%
Taxes and Bankruptcy Costs
Merton Miller
– A case of horse and rabbit stew
– Analysis so far ignores personal taxes and the effect of issuing debt on the equilibrium in the bond market
Miller's Debt and Taxes
Both corporations and individuals pay taxes.
When corporations pay interest on debt, they reduce their own taxes, but increase the taxes of individuals.
Ultimately, the corporation must bear all of the taxes associated with its activities either directly, or indirectly through higher required rates of return on the securities that it issues.
Corporate and Personal Taxes
D E
Tp Tc
Miller (1977)
Corporate and Personal Taxes
D E
Tp
Tc
Miller (1977)
DeAngelo and MasulisDebt and Taxes
DefaultZero taxes,deductions notfully utilized
Positive taxes,tax credits notfully utilized
Taxes paidat the highestmarginal rate
Income
As corporations increase their debt, they reduce the probability that they will pay the highest marginal tax rate and be able to fully utilize all tax credits and deductions.
In equilibrium, there is an
optimal capital structure for the
economy as a whole and for
each individual firm.
DeAngelo and MasulisDebt and Taxes
In equilibrium, there is an optimal capital structure for the economy as a whole and for each individual firm
Optimal leverage B/V B/V(tax credits, non-interest
deductions 2, BC, c, p)
DeAngelo and MasulisDebt and Taxes
What's Wrong With This Story?
Large industrial firms with many physical assets typically have many noninterest deductions (like depreciation), large tax credits (the investment tax credit), and also high leverage.
Firms with high dividend yields (like regulated utilities) typically have high leverage.
The DeAngelo/Masulis Capital Structure Model with Taxes
Holding other things constant, the logic of the model is sound; it provides useful information about optimal capital structure.
The problem is that there are important variables that are not included in the model. As we examine firms in the real world, there seems to be important determinants of capital structure that are not captured by this model.
The Effect of Capital Structure on Real Investment Decisions
The owner of an all equity firm will take all positive NPV projects to maximize firm value.
When a firm has both debt and equity, the debt and equity holders sometimes disagree about the optimal investment policy.
Since equity holders have ultimate authority over investment decisions, we have to be concerned about how adding debt to the capital structure affects equity holders' investment incentives.
Agency Theory
Jensen and Meckling
― An agency relationship is a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.
― Often there is a blurred distinction between the principal and the agent
― Agent responds to incentives and will not always act in the best interests of the principal
Agency Theory
Jensen and Meckling provide a
definition of agency costs that
divides these costs into their
individual components:
Agency Theory
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
= + +
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
Agency Theory
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
= + +
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
Out-of-PocketCosts
Agency Theory
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
= + +
Out-of-PocketCosts
Opportunity
Costs
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
Agency Theory
Before Jensen and Meckling, it was common to focus only on the out-of-pocket costs (M/M theory focused on fixed investment policy)
Contracts affect incentives for current and future investments
Private incentives exist within the contracting process for the firm to maximize its current market value as well as the "welfare" of society
The Nexus of ContractsTheory of the Firm
Firm
Share-holders
Bond-holders
Board ofDirectors
Managers
Employees
LessorsLessees
Suppliers
Customers
The Nexus of ContractsTheory of the Firm
Firm
Share-holders
Bond-holders
Board ofDirectors
Managers
Employees
LessorsLessees
Suppliers
Customers
Dividend payout
Claim dilution
Asset substitution
Underinvestment
Conflicts of Interest
+ - + + + +V = E(V, F, T, σ², r, DIV) + + - - - - + B(V, F, T, σ², r, DIV)
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs.
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 = 100 B – -75 100 = 25
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs.
A Simple Example
Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25Bond ? -20 -100
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs. Dividends can be paid in a period so
long as that period's promised payment to the bondholders is made first.
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 = 100 B – -75 100 = 25
Bond 120 -20 -100
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond ? -20 -100
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 70 -20 -100
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75 DIV (A-) 20 80 – = 100
The Underinvestment Problem
Do I want to issue this bond?
Who bears the agency costs of increased leverage in this case? In general?
Equity holders have strong incentives to structure debt contracts in a way that minimizes the adverse incentive costs.
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond ? -10 -50
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
Less Leverage
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100
High Leverage
Bond 70 -20 -100
DIV(A -) 20 80 – =
100
Low Leverage
Bond 60 -10 -50
DIV(A+B) 10 15 100 = 125
Which Bond Do I Want to Issue?
Investment Opportunity Set
Assets inPlace
GrowthOpportuniti
es
Cost of Debt Low High (Underinvestment)
Predicted Leverage High Low
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
From Barclay/Smith/Watts (1997)
Economic Significance
From Barclay/Smith/Watts (1997)
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
From Barclay/Smith/Watts (1997)
Regulation
From Barclay/Smith/Watts (1997)
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
Tax Credits Lower
Marginal Corporate Tax Rate Higher
Marginal Personal Tax Rate Lower
From Barclay/Smith/Watts (1997)
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
Tax Credits Lower
Marginal Corporate Tax Rate Higher
Marginal Personal Tax Rate Lower
Information Costs Higher
From Barclay/Smith/Watts (1997)
Signaling
From Barclay/Smith/Watts (1997)
Management Implications
Benchmarking
– Rochester Gas & Electric
– Eastman Kodak
Responding to change
– Frontier Communications
– Southern Company
"Form Ever Follows Function"
Louis Henri Sullivan, 1896
Financial Architecture
Leverage
Public vs. private
debt
Maturity
Priority
Conversion rights
Call provisions
Capital Structure Management
Trade Off Hypothesis
Pecking Order
Hypothesis
Market Timing
Hypothesis
Pecking Order Hypothesis
There is an important information asymmetry between stockholders and managers
“What you don’t know CAN hurt you”.
If firm issues securities, those value depends on firm value investors price-protect themselves.
This cost is largest for equity, then risky debt; internally generated capital is least expensive.
If there is an “optimal” capital structure, the firm spends a lot of time away from it.
Extreme Version: There is no optimal capital structure – observed capital structure is just the result of a sequence of myopic financing choices.
Pecking Order
Regression results are strong and robust.
Look at tails of distribution.
Pecking Order
Market Timing
Firm only issues equity when it’s overvalued
There is no optimal capital structure
Determine the optimal capital structure for the economic balance sheet.
Look at the trajectory of capital structure.
Whenever the costs of deviating from target exceed the cost of adjustment - adjust.
Strategic Capital Structure Management
Adjustment Costs
Firm Value
LeverageTarget Leverag
e
Adjustment Costs
Leverage
Time
Target Leverag
e
Differ by transaction─ Costs of share issues are higher than that for debt
─ Costs of share issues are higher than that of share repurchases
Exhibit fixed costs and scale economics─ Equity offers are rare while bank loans are common
─ Optimal adjustment frequently involves overshooting
─ Most companies spend considerable time away from their target
Adjustment Costs
Strategic Capital Structure Management
But investment opportunities are not smooth – they are lumpy and episodic.
Suppose you have a large growth option – it will increase firm value by 50% and take three years to exercise.
How do you finance this project?
Pecking Order Hypothesis
Market Timing Hypothesis
Tradeoff Hypothesis
Strategic Capital Structure Management