Capital Structure in the Modern World

Anton   Miglo

Capital Structure in the Modern World

ISBN 978-3-319-30712-1 ISBN 978-3-319-30713-8 (eBook) DOI 10.1007/978-3-319-30713-8

Library of Congress Control Number: 2016940577

© Th e Editor(s) (if applicable) and Th e Author(s) 2016 Th is work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifi cally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfi lms or in any other physical way, and trans-mission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. Th e use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specifi c statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Th e publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.

Cover illustration: Cover image © CVI Textures / Alamy Stock Photo

Printed on acid-free paper

Th is Palgrave Macmillan imprint is published by Springer Nature Th e registered company is Springer International Publishing AG Switzerland

Anton   Miglo Nipissing University, Ontario , Canada

To my parents Alla and Viktor.

vii

Capital structure is a very interesting and probably one of the most con-troversial areas of fi nance. It is an area of permanent battles between dif-ferent managers defending their favorite approaches, between theorists and practitioners looking at the same problems under diff erent angles, and between professors and students since the area is complicated and requires a superior knowledge of econometrics, microeconomics, accounting, mathematics, game theory etc. Many of the results obtained in capital structure theory over the last 50–60 years have been very infl u-ential and led their authors to great international recognition. Among the researchers who contributed signifi cantly to capital structure theory, note Nobel Prize Award winners Franco Modigliani, Merton Miller, Joseph Stiglitz, and most recently Jean Tirole. Although until recently capital structure theories did not have strong support from practitioners and were too complicated to teach at colleges and business schools, they are quickly gaining recognition at universities and in the real world. Th is fi eld has become extremely intriguing to potential employees and stu-dents. Th e roles of investment banker and corporate treasurer, which require fundamental capital structure education, are very popular.

Th is book focuses on the microeconomic foundations of capital struc-ture theory. Some areas are based on traditional cost-benefi t analyses, but most include analyses of diff erent market imperfections, primarily asymmetric information, moral hazard problems and, more recently

Pref ace

viii Preface

developed, imperfections involving incomplete contracts. Knowledge of game theory and contract theory prior to reading this book is benefi cial but I aim to present the material in the most accessible way possible, with lots of examples for readers with diff erent levels of knowledge. For additional readings in the fi eld of capital structure, I recommend Capital Structure and Corporate Financing Decisions (edited by. Baker and Martin, 2011) and Financing Growth in Canada (edited by Halpern, 1997). Both of these editions have a more applied approach to capital structure, including empirical research and econometrics, and cover a lot of inter-esting topics relating to capital structure and fi nancing decisions. I would also recommend the journalofcapitalstructure.com website dedicated to capital structure discussions.

Th is book attempts to explain the basic concepts of capital structure as well as more advanced topics in a consistent fashion. Th e fi rst part is focused on providing an introduction to the major theories of capi-tal structure: Modigliani and Miller’s irrelevance result, trade-off theory, pecking-order theory, asset substitution, credit rationing, and debt over-hang. I think that the majority of the basic ideas in capital structure compliment each other quite logically although signifi cant disagreement between researchers still exists about which theory is more important in practice. Part II discusses such topics as capital structure and a fi rm’s per-formance, capital structure and corporate governance, capital structure of small and start-up companies, corporate fi nancing versus project fi nanc-ing and examples of optimal capital structure analyses for some compa-nies. Many advanced theories of capital structure discussed in Part II are still growing areas of research. At the same time, the objective of the book is not to cover as many topics of capital structure as possible but rather to review the major theoretical concepts and provide basic tools to under-stand the complicated area of capital structure.

Many of the existing ideas of capital structure were created by “inject-ing” a new type of market imperfection into diff erent capital structure analyses. From my experience, the comprehension of this fact is crucial to understanding the theory of capital structure. At the beginning of my PhD studies I was spending a lot of time explaining to my adviser why debt fi nancing and equity fi nancing create diff erent degrees of risk for a company. At the time, I was surprised not to see an extremely enthusiastic

Preface ix

reaction to my “discoveries” from my PhD adviser who was mostly point-ing to the importance of market imperfections in my research. When teaching capital structure in my classes, I am always primarily concerned with how well students understand the diff erence between perfect and imperfect markets. Th e challenge for me has been to explain the impor-tance of the marginal diff erences in models’ assumptions. Th ese diff er-ences are often responsible for large variations in models’ predictions and their capacities to explain existing empirical evidence. It has been a fasci-nating experience for me to see how much progress students demonstrate in understanding diff erent fi nancial concepts.

Th is book was inspired by over 20 years of my experience in capital structure research. I was also inspired by my experience with teaching fi nance courses at diff erent universities in Europe and North America including courses directly related to capital structure such as Financing Strategies and Corporate Governance, Advanced Corporate Finance, Financial Management II, and Entrepreneurial Finance. It was also inspired by my working experiences in areas of capital structure man-agement including issuing stocks and bonds in commercial banks. Th e fi nancial crisis of 2008 and 2009 also provided extra motivation. It seemed that many companies faced problems that stemmed from their fi nancing policies. Some discussions in this book are devoted to this topic.

Anton Miglo North Bay, Ontario, Canada

References

Baker, H., & Martin, G. (Eds.). (2011). Capital structure and corporate fi nancing decisions , Robert W.  Kolb series in Finance. John Wiley and Sons, Inc.

Halpern, P. (Ed.). (1997). Financing growth in Canada . University of Calgary Press.

xi

For very helpful comments and suggestions regarding some topics I would like to thank Rodrigo González, Finance professor in Pontifi cia Universidad Católica de Chile. I would also like to thank Di An, Victor Bruzon, Sean Coughlin, Benjamin Dilq, Fei Dio, Julian Dove, Sajal Dutta, Athanasios Gouliaras, Shun Jiang, Jianfeng Lin, Ivana Nesterovic, Sabilla Rafi que Le Sheng, Milos Suljagic, Xumei Tan, Shuai Wang, Heran Xing, and Joel Wood, for editorial assistance and comments. Last but not least, I would like to thank Aimee Dibbens, Alexandra Morton, and Ganesh Pawan kumar along with the design and editorial team from Palgrave for their work on the cover design as well as the overall support with the manuscript preparation.

Acknowledgements

xiii

Part I Basic Capital Structure Ideas 1

1 Introduction 3 1.1 Th e Capital Structure Problem 3 1.2 Th e Concept of Perfect Market and Some Stylyzed Facts 6 1.3 Capital Structure Choice Analysis: Th e Beginnings 9 References 17

2 Modigliani-Miller Proposition and Trade-off Th eory 21 2.1 Th ree Ideas 21 2.2 Modigliani–Miller Th eorem 23 2.3 Bankruptcy Costs 27 2.4 Corporate Income Taxes and Capital Structure 30 2.5 Trade-off Th eory 32 2.6 Th eory Predictions and Empirical Evidence 36 References 41

3 Asymmetric Information and Capital Structure 45 3.1 Finance and Asymmetric Information 45 3.2 Insiders and Outsiders 46

Contents

xiv Contents

3.3 Pecking Order Th eory 47 3.4 When Incumbent Shareholders Are Risk-Averse 56 3.5 Is Asymmetric Information Behind the 2007 Crisis? 62 References 66

4 Credit Rationing and Asset Substitution 69 4.1 Shareholders Versus Creditors: Capital Structure Battle 69 4.2 Asset Substitution and Risk-Shifting 71 4.3 Credit Rationing 80 4.4 Other Related Ideas 83 Appendix 1: Stochastic Dominance 90 References 94

5 Debt Overhang 97 5.1 Debt Overhang 97 5.2 How Does the Type and the Level of Debt Aff ect

the Underinvestment Problem 100 5.3 Debt Overhang Implications and Prevention 102 5.4 Flexibility Th eory of Capital Structure 107 5.5 Debt Overhang in Financial Institutions 108 References 111

Part II Diff erent Topics 113

6 Capital Structure Choice and Firm’s “Quality” 115 6.1 Interesting Problem 115 6.2 Th e Role of Asymmetric Information 117 6.3 Capital Structure, Market Timing and Business Cycle 125 References 131

7 Capital Structure and Corporate Governance 135 7.1 Corporate Governance 135 7.2 Financing Strategy and Managerial Incentives:

Free Cash Flow Th eory 137

Contents xv

7.3 Financing Strategy, Incomplete Contracts and Property Rights Allocation 140

7.4 Costly Eff ort, Capital Structure, and Managerial Incentives 144

7.5 Earnings Manipulation 147 7.6 Other Works 153 References 157

8 Capital Structure of Start-Up Firms and Small Firms 163 8.1 Life Cycle Th eory of Capital Structure 163 8.2 Capital Structure of Venture Firms 165 8.3 Debt Financing for Small Businesses 170 References 178

9 Corporate Capital Structure vs. Project Financing 183 9.1 Introduction 183 9.2 Moral Hazard Models 187 9.3 Asymmetric Information Models 194 9.4 Other Models 202 References 207

10 Capital Structure Analysis: Some Examples 211 10.1 Social Media and Airline Industries 211 10.2 Methodology 214 10.3 Capital Structure Analysis 215 References 225

Answers/Solutions to Selected Questions/Exercises 227

Index 251

xvii

Fig. 1.1 Timeline 10 Fig. 1.2 Balance sheet changes and fi nal income statement

under debt fi nancing 11 Fig. 1.3 Balance sheet changes and fi nal income statement

under equity fi nancing 12 Fig. 1.4 Debt payments under limited liability 14 Fig. 1.5 Debt payments under unlimited liability 15 Fig. 2.1 Balance sheets of fi rms U and L 24 Fig. 2.2 Optimal level of debt under trade-off theory 33 Fig. 2.3 Optimal level of debt under trade-off theory

when B increases 35 Fig. 2.4 Optimal level of debt under trade-off theory

when I increases 38 Fig. 3.1 Sequence of events 48 Fig. 3.2 Th e Firm 1 owners’ payoff under imperfect information 49 Fig. 3.3 Th e sequence of events under imperfect information 58 Fig. 4.1 Th e sequence of events 72 Fig. 4.2 Credit rationing 80 Fig. 4.3 Sequence of events 82 Fig. 4.4 First-order stochastic dominance (FOD) 91 Fig. 5.1 Sequence of events 98 Fig. 5.2 Sequence of events 100 Fig. 6.1 Sequence of events 119

List of Figures

xviii List of Figures

Fig. 6.2 Sequence of events 126 Fig. 7.1 Sequence of events 138 Fig. 7.2 Sequence of events 142 Fig. 7.3 Th e rule of marginal revenues under debt fi nancing 143 Fig. 7.4 Optimal eff ort under equity fi nancing 145 Fig. 7.5 Optimal contract under costly state verifi cation 149 Fig. 7.6 Optimal eff ort under debt fi nancing 152 Fig. 8.1 Capital structure ideas across a fi rm’s life cycle 164 Fig. 8.2 Sequence of events 167 Fig. 8.3 Th e choice of fi nancing 174 Fig. 9.1 Sequence of events 188 Fig. 9.2 Sequence of events 195

xix

Table 1.1 Debt ratios for selected industries 7 Table 1.2 Average IPO returns 8 Table 1.3 Average IPO returns in selected countries 8 Table 1.4 Average long run operating underperformance

of fi rms that issue equity 9 Table 1.5 Firms’ access to debt 9 Table 2.1 Investments and earnings from strategies 1 and 2 in

Example 2.1 26 Table 2.2 Largest bankruptcies in US history 28 Table 2.3 Corporate tax rates in selected countries 31 Table 3.1 Expected profi ts and variances in Example 3.2 58 Table 4.1 Projects and earnings in Example 4.1 74 Table 4.2 Shareholders’ payoff in Example 4.1 75 Table 4.3 Projects and earnings in Example 4.2 76 Table 4.4 New and existing project earnings 77 Table 4.5 Projects and earnings 81 Table 4.6 Projects and profi ts in Example 4.3 92 Table 4.7 Stochastic dominance analysis in Example 4.3 92 Table 4.8 Projects, outcomes and probabilities in Example 4.4 93 Table 4.9 Stochastic dominance analysis in Example 4.4 94

List of Tables

xx List of Tables

Table 10.1 Results from Facebook analysis 2011 217 Table 10.2 Results from Facebook analysis 2015 217 Table 10.3 Results from United analysis 2015 222 Table 10.4 Information UHC ownership 223