Advanced Corporate Finance

Video Conference 2: Hating Modigliani & Miller

The Elusive Optimal Capital Structure

Things people say… This firm is in trouble, it owes too much Equity is expensive Retained earnings are cheap If I can borrow at 5% and invest at 7% I should

borrow a lot Fights over dividends and retained cash Firm A has to borrow so it is in trouble Keep reserves, just in case

Choosing a capital structure Many stakeholders’ point of view to take into

account Possibility for differences in valuation and

gains from trade Go back to intrinsic valuation paradigm Separate LHS arguments from RHS arguments Compare with market values Careful analysis of this thorny issue

There is a lot of misinformation, sophistic arguments and hidden agendas

List of actors Equity Holders

Insiders Concentrated Institutions Individuals

Debt Holders Markets Banks

Economic v. Institutional Exposure Derivatives Protection buyers

Types of financing: dimensions Maturity Seniority Security Issuer Control

Dynamic Capital Structure Adjustment and/or issuance costs of different

forms of financing

The probability of these costs binding in the future means there is a need for “precautionary” savings today

Affects more: More uncertain arrival of “great” investment

opportunities Higher Q of investment opportunities

Market Value of Equity

Unlevered Taxes

“Creating” Value Through Leverage

Fixed Assets

Working Capital

Market Value of

Debt

Value of Equity

Taxes after Interest

Pre-Tax IC

Tax Shields

Debt Holders

Equity Holders

IRS

Fixed Assets

Working Capital

Tax Shields

Debt Holders

Equity Holders

Pre-Tax CE Post-Tax IC Post-Tax CE

Destroying Value Through Leverage

Fixed Assets

Working Capital

Market Value of

Debt

Value of Equity

Taxes after Interest

Pre-Tax IC

Tax Shields

Debt Holders

Equity Holders

IRS

Pre-Tax CE

Fixed Assets

Working Capital

Debt Holders

Equity Holders

IRS

CFD

WACC and Leverage

What to do with risk?1. Reduce it2. Contract it to the party better suited to bear

it3. Diversify it away4. Price it

Bundling and unbundling can help with the first 3!

The art of weaving different risk threads Underlying correlation between structural

sources of risk

Exposure to shifts in structural source of risk (leverage, i.e. relative volatility)

“Vertical” splitting of risk Seniority

Debt only cares about Downside

0 20 40 60 80 100

0.000.020.040.060.080.100.120.140.160.180.20

Probability of Firm CF

0 10 20 30 40 50-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

Probability of €50 CFD

Equity only cares about Upside

0.000.020.040.060.080.100.120.140.160.180.20

Probability of Firm CF

0 10 20 30 40 50-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

Probability of €50 CFE

Optimal Leverage

Modigliani & Miller

VL = VU + PV(TS) – PV(CFD) +/- Agency

We hate Modigliani & Miller: Capital Structure can affect

Expected Cash Flows of the Assets Unlevered Risk Assets are Subject to

Other important effects “Co – Insurance” Effect Monitoring

Cost of information acquisition and processing Career concerns of intermediaries

Investor size Ease of renegotiation – commitment v. flexibility

“Free-riding”

AGENCY COSTS:Seductive, the Dark Side can be

Stealing from Banks and other assorted thieves

Exploiting Debt Holders: The Agency Costs of Leverage Agency Costs

Conflicts of interest between the firm’s stakeholders

Management make decisions that increase the value of equity.

May make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. The share price benefits from equity holders’ ability to

exploit debt holders in times of distress.

The debt holders recognize this possibility and pay less for the debt when it is issued, reducing the amount the firm can distribute to shareholders.

Debt Maturity and Covenants The magnitude of agency costs often depends

on the maturity of debt. Agency costs are highest for long-term debt and

smallest for short-term debt

Covenants may help to reduce agency costs, however, because covenants hinder management flexibility, they have the potential to prevent investment in positive NPV opportunities and can have costs of their own

The good, the bad and the ugly

• “Gambling for resurrection” • Loss of potential customers• Loss of management

efficiency/focus• Restrictive contractual terms in

day-to-day operations

• Agency costs• shareholders v. managers• shareholders v. debt-holders

• Equity as an option on the assets• Managers as empire-builders

• Stop managers as empire-builders• Focus attention of managers• Commitment value v. competitors

Optimal Leverage with Taxes, Financial Distress, and Agency Costs

TheFedExStory

FedEx early days: What would you do?

Monday: $27,000 bill due

Friday: $5,000 cash at hand

Of course, we would all do this!

Excessive Risk-Taking and Over-investment Shareholders have an incentive to invest in

negative-NPV projects that are risky, even though a negative-NPV project destroys value for the firm overall.

“Gambling for resurrection” Anticipating this bad behavior, security holders

will pay less for the firm initially.

TheWhat’s In It

For Me?

Debt Overhang and Under-investment Under-investment Problem

Equity holders choose not to invest in a positive NPV project

Because the firm is in financial distress

The value generated will accrue to bondholders rather than themselves

Debt Overhang and Under-investment Baxter is considering an investment

opportunity that requires an initial investment of $100,000 and will generate a risk-free return of 50%.

If the current risk-free rate is 5%, this investment clearly has a positive NPV. What if Baxter does not have the cash on hand to

make the investment?

Could Baxter raise $100,000 in new equity to make the investment?

Outcomes for Baxter’s Debt and Equity with and without the New Project ($ thousands)

Debt Overhang and Under-investment If equity holders contribute $100,000 to fund

the project, they get back only $50,000. The other $100,000 from the project goes to the

debt holders, whose payoff increases from $900,000 to $1 million.

The debt holders receive most of the benefit, thus this project is a negative-NPV investment opportunity for equity holders, even though it offers a positive NPV for the firm.

Estimating the Debt Overhang How much leverage must a firm have for there to

be a significant debt overhang problem? Suppose equity holders invest an amount I in a

new investment with similar risk to the rest of the firm.

Equity holders will benefit from the new investment only if:

D

E

NPV β D>

I β E

TheTake the Money

And Run

Cashing Out When a firm faces financial distress,

shareholders have an incentive to withdraw money from the firm, if possible. If it is likely the company will default, the firm may

sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders

TheGordon Gecko

The Agency Benefits of Leverage Management Entrenchment

Separation of ownership and control may lead managers tomake decisions that benefit themselves at investors’ expenses

Entrenchment may allow managers to run the firm in their own best interests, rather than in the best interests of the shareholders.

Concentration of Ownership One advantage of using leverage is that it

allows the original owners of the firm to maintain their equity stake. As major shareholders, they will have a strong interest in doing what is best for the firm.

Concentration of Ownership Assume Ross is the owner of a firm and he plans

to expand. He can either borrow the funds needed for expansion or raise the money by selling shares in the firm. If he issues equity, he will need to sell 40% of the firm to raise the necessary funds

With leverage, Ross retains 100% ownership and will bear the full cost of any “perks,” like country club memberships or private jets.

By selling equity, Ross bears only 60% of the cost; the other 40% will be paid for by the new equity holders. Thus, with equity financing, it is more likely that Ross

will overspend on these luxuries.

Reduction of Wasteful Investment Managers may engage in empire building.

Managers often prefer to run larger firms rather than smaller ones, so they will take on investments that increase the size, but not necessarily the profitability, of the firm. Managers of large firms tend to earn higher salaries,

and they may also have more prestige and garner greater publicity than managers of small firms. Thus, managers may expand unprofitable divisions, pay too

much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

Reduction of Wasteful Investment Managers may over-invest because they

are overconfident. Even when managers attempt to act in

shareholders’ interests, they may make mistakes. Managers tend to be bullish on the firm’s prospects and

may believe that new opportunities are better than they actually are.

Free Cash Flow Hypothesis The view that wasteful spending is more likely to

occur when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders

Reduction of Wasteful Investment When cash is tight, managers will be

motivated to run the firm as efficiently as possible. According to the free cash flow hypothesis,

leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

Reduction of Wasteful Investment Leverage can reduce the degree of managerial

entrenchment because managers are more likely to be fired when a firm faces financial distress. Managers who are less entrenched may be more

concerned about their performance and less likely to engage in wasteful investment.

In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight.

TheCrazy Ivan

Leverage and Commitment Leverage may also tie managers’ hands and

commit them to pursue strategies with greater vigor than they would without the threat of financial distress

A firm with greater leverage may also become a fiercer competitor and act more aggressively in protecting its markets because it cannot risk the possibility of bankruptcy