Finance Lecture 3. Keating F&A 3-2 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases

Finance Lecture 3

Keating F&A 3-2 Spring 2008

Outline Lecture 3

• A Target Capital Structure and What It Implies

• New Stock Issuances, Stock Repurchases

• Principal-Agent Problems in Corporations


Last Lecture, We Talked AboutOptions For Raising Money

• Retained earnings are easiest

• Debt is tax-advantaged, but it comes with bankruptcy risk

• New equity dilutes existing equity, may send a negative signal


Many Firms Have A“Target Capital

Structure”• A pre-determined ratio of debt to equity finance that management is to follow, e.g., 40% debt, 60% equity

• As earnings are retained (profits not paid out as dividends), equity investment grows

A moderate amount of new debt can be taken on in proportion to growth in retained earnings, preserving target capital structure


A Target Capital Structure ImpliesHiggins’ Sustainable Growth Rate

• Profits generate new retained earnings

• New retained earnings allow new borrowing in accord with target capital structure

• Sales can grow “sustainably” in parallel to the “natural” increase in equity and debt levels

“Sustainability,” in this context, means growth without need for new equity finance (beyond new retained earnings)


Suppose You Want A Sales Growth Rate

Greater Than The “Sustainable” Rate• You can cut the dividend rate, increasing retained earnings

• You can change the target capital structure to tilt more toward debt

• You can issue new equity (along with commensurate new debt)


Empirical Evidence On “Target Capital Structure”Is Less Overwhelming Than The Theory Is Elegant

• Most firms, in fact, use both equity and debt

• Firms with tangible assets, e.g., factories, do borrow more

Tangible assets can be put up as collateral, reducing borrowing costs

• Actual debt levels vary widely across apparently similar firms


Modigliani And Miller Wrote A FamousNihilistic Paper On Capital Structure

• A firm’s value is unaffected by its capital structure

It doesn’t matter how a firm finances itself in equilibrium“A pizza is still a pizza no matter how you slice it”

• Perturbations of MM tend to lead to corner solutions

The corporate income tax code favors debt financing so firms should take on as much debt as possible

• More on MM in Higgins’ Chapter 6


As A Practical Matter, Debt PastA Certain Level Is Impossible

• Real world bankruptcy costs discourage 100% debt financing

Legal costs of bankruptcy Employees quit Suppliers want cash up-front

• Most bonds have covenants limitingfuture bond issuances

• Bondholders don’t want to lend to asafe firm today that transforms into arisky firm


Outline Lecture 3





A Stock Issuance StartsWith Some Preliminary Steps

• Existing stockholders’ preemptiverights must be honored

Existing stockholders have the first chance to buy any new shares issue Prevents fraudulent dilution, e.g., management sells under-valued shares to cronies to maintain control

• Choice must be made between privateplacement and public offering


A Private Placement DirectlySells Stock To A Large Investor

• Can reduce flotation costs

• Can be done quietly

• But have you obtained a fair price?


If You Do A Public Offering,SEC Paperwork Is Considerable

• Registration Statement

• Prospectus

• Must report on insider trading activities

• Must follow proxy rules

• Goal is to make markets fair, open


You Probably Need An InvestmentBroker To Do Public Offering

• Are market conditions favorable?

• Best efforts assistance or underwriting?

• Investment banker owns then re-sellsstock in underwriting (often leading asyndicate)


Even Without Underwriting Trading Profits,

Investment Banking Costs Are Non-Trivial

Source: Higgins, p. 171

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One Wants Issuing Price To BeFairly Close To Market Price

• Underwriter loses if issue is overpriced

• Firm forfeits possible funds if issueunderpriced

• Investment bank doesn’t wantreputation for gross underpricing(though it is tempting!)


Allegedly Chronic IPOUnderpricing Is Controversial

• Underpricing, if it occurs, takes money away from the issuing firm

• Do investment bankers use underpriced IPOs to reward important insiders?

• Do issuing firms underprice as a form of advertising?

• Does underpricing help firm’s future issuances?


The Magnitude Of Stock PriceDecrease From New Issuance Is Unclear

• New issuance thought to be a negativesignal

• How profitably are you investing extra funds?

• How horizontal is demand curve forfirm’s stock?


Some Firms Pay DividendsWhile Issuing New Stock

• Seems wasteful: New stock issuanceis costly, dividend recipients payincome taxes

• Clientele effect: Existing stockholdersmay have come to count on dividends

• Stockholders may not trust managersso may welcome scrutiny accompanyingnew stock issuance


From A Tax Perspective, A StockRepurchase May Be Preferred To Dividends

• Corporation buys up some existingshares

• Smaller pool of remaining stockholdersto share future flows

• (Hopefully) Resultant stock price increase a capital gain, not ordinary income


Stock Repurchases Have Other Advantages

• Sale of stock is up to investor;receipt of taxable dividend is involuntary

• Allows use of short-term excess cashwithout commitment of dividend increase

• A mechanism for large scale reductionin equity share in capital structure, if so desired


The IRS Can Get ConcernedAbout Repurchases, However

• Not supposed to take actions solelyto reduce income taxation of stockholders

• Management needs a “businessjustification”

• Probably not a problem if done inmoderation


In Contrast To Repurchases, Splits AndStock Dividends Are Fairly Meaningless

• Split of stock gives everyone more shares, but of lower value

• Stock dividend similar

• Want to keep price in “optimal” range?

• Perhaps a favorable signal

• Much ado about very little?


Outline Lecture 3





There Is A Motif Of StockholdersNot Trusting Managers

• One rationale presented, for instance, for new stock issuances concurrent with dividend payments is that stockholders welcome the scrutiny accompanying new stock issuances

• Another example is that stockholders may not want managers to have an open line of credit

Credit access allows quick action if opportunities arise But will managers just buy private jets for themselves?

→ This is a Principal-Agent problem


Principal-Agent Problems AreHeavily Studied In Economics

• Principal: Stockholders

• Agent: Corporate management

• How do stockholders (the principal) make sure managers (the agent) behave in a way that maximizes stockholder wealth?

Effort is not directly observable Observed outcomes include randomness and external factors not within managers’ control


It Is Widely SuspectedManagers Want To Build Empires

• Compensation believed to be related to the size, not the profitability, of an enterprise

• The same theory has been presented for managers/bureaucrats in government agencies


One Incentive Correction Is To TieCompensation To The Stock’s Price

• You want managers to “think like stockholders”

Risk averse managers probably don’t want too high a percentage of their wealth in the firm’s stock

• Call options provide especially strong incentives

A call option is only valuable if the stock price is above the option exercise price upon expiration of the option Some executive have made gargantuan amounts from options There are issues about how options are handled from a tax perspective


Takeover Threat Is AMajor Check On Managers

• If a company is poorly run, an outsider could take on debt to buy out its stockholders and replace management

“Takeover artists,” “Corporate raiders” Leveraged buyout

• While negatively depicted (by hardly disinterested managers), even the threat of takeover benefits stockholders by improving manager motivation

• “Poison pills” that discourage takeovers are not in shareholders’ best interests

Documents

Finance Lecture 3. Keating F&A 3-2 Spring 2008 Outline Lecture 3 A Target Capital Structure and What It Implies New Stock Issuances, Stock Repurchases