FIN 413 Corporate Financial Policy Clifford W. Smith, Jr. Spring 2007 Overhead 2 * Covers readings...

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)

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

Taxes and Bankruptcy Costs

Kraus/Litzenberger (1973)

E

BC Tc

D


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%


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.


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)


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


= + +


Out-of-PocketCosts

Agency Theory


= + +

Out-of-PocketCosts

Opportunity

Costs


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

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


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


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


Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125

A Simple Example


Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150

A Simple Example


Bond ? -20 -100

A Simple Example


Bond 70 -20 -100

A Simple Example


Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75

A Simple Example


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.


Bond ? -10 -50

Less Leverage


Bond 60 -10 -50

Less Leverage

Less Leverage


Bond 60 -10 -50

DIV (A&B) 10 15 100 = 125

Less Leverage


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

Economic Significance



Impact on Leverage


Credence Goods (Eastern) Lower

Product Warranties (Yugo) Lower

Future Product Support (Yugo/Wang) Lower


Impact on Leverage





Supplier Financing (Campeau) Lower

Closely Held Firm Higher

Regulation Higher

Regulation



Impact on Leverage







Regulation Higher

Tax Credits Lower

Marginal Corporate Tax Rate Higher

Marginal Personal Tax Rate Lower


Impact on Leverage







Regulation Higher

Tax Credits Lower

Marginal Corporate Tax Rate Higher

Marginal Personal Tax Rate Lower

Information Costs Higher

Signaling


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


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


FIN 413 Corporate Financial Policy Clifford W. Smith, Jr. Spring 2007 Overhead 2 * Covers readings...

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Transcript of FIN 413 Corporate Financial Policy Clifford W. Smith, Jr. Spring 2007 Overhead 2 * Covers readings...