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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
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