Long Questions Flashcards
Explain the tradeoff theory of capital structure
The Tradeoff theory States that firms should increase their leverage until it reaches the level for which the firm value is maximized.
– The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.
- That is: total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs
VL = VU + PV(Interest Tax Shield) - PV(Financial Distress Costs)
Three key factors determine the present value of financial distress costs:
- The probability of financial distress
* The probability of financial distress increases with the amount of a firm’s liabilities (relative to its assets).
* The probability of financial distress increases with the volatility of a firm’s cash flows and asset values. - The magnitude of the costs after a firm is in distress
* Financial distress costs will vary by industry. - The appropriate discount rate for the distress costs
* Depends on the firm’s market risk (beta)
* The present value of distress costs will be higher for high beta firms.
The Tradeoff theory can help explain
* – Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the presence of financial distress costs).
* – Differences in the use of leverage across industries (due to differences in the magnitude of financial distress costs and the volatility of cash flows).
The Bottom Line
The optimal capital structure depends on market imperfections such as
* Taxes
* financial distress costs
* Agency costs, and
* Asymmetric information
(asymmetric information can allow a firm to communicate credible signals for a good project when people have different information)
What information does a share repurchase convey to investors?
An alternative to dividend payments is through share repurchasing
The firm uses cash to buy shares of its own outstanding stock.
Firm can pay cash to shareholders through a share repurchase as it decreases no. of shares outstanding
If new information comes out that the stocks are undervalued after the repurchase, long-term shareholders will reap benefits
A share repurchase generally signals to the market the company management’s firm belief that the price of the stock is going to appreciate in the short term
- Share repurchases are a credible signal that the shares are underpriced, because if they are overpriced a share repurchase is costly for current shareholders.
– If investors believe that managers have better information regarding the firm’s prospects and act on behalf of current shareholders, then investors will react favorably to share repurchase announcements.
Analyse MM proposition I
Analyses leverage, arbitrage and firm value
- Modigliani and Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.
– They reasoned that the firm’s total cash flows still equal the cash flows of the project and, therefore, have the same present value.
- The first proposition essentially claims that the company’s capital structure does not impact its value
- The Law of One Price implies that leverage will not affect the total value of the firm.
– Instead, it merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.
– “In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.”
- Modigliani and Miller (M M ) showed that this result holds more generally under a set of conditions referred to as perfect capital markets: The conditions are:
1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
– In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s security holders is equal to the total cash flow generated by the firm’s assets.
– Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total market value.
An implication of MM1
* Homemade Leverage
– When investors use leverage in their own portfolios to adjust the leverage choice made by the firm
* M M demonstrated that if investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.
– M M Proposition I states that
E+D=U=A
The total market value of the firm’s securities is equal to the market value of its assets, whether the firm is unlevered or levered.
– The cash flows from holding unlevered equity can be replicated using homemade leverage by holding a portfolio of the firm’s equity and debt.
- MM proposition I states that the total value of each firm should equal the value of its assets. Because these firms hold identical assets, their total values should be the same.
If this is not the case, an arbitrage opportunity exists when assets are trading for different prices
Note that the action of arbitrageurs buying the unlevered firm and selling the levered firm will cause price of the unlevered firm’s stock to rise and the price of the levered firm’s stock to fall until the firms’ values are equal and M M proposition I holds.
Analyse MM proposition II
Analyses leverage, risk and the cost of capital
The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt to equity ratio
Re = Ru + D/E(Ru-Rd)
- If a firm is unlevered, all of its free cash flows generated by its assets are paid out to its equity holders
– The market value, risk, and cost of capital for the firm’s assets and its equity coincide and therefore Ru = Ra - But, if a firm is levered, the appropriate cost of capital for the firm’s asset rA equals the firm’s weighted average cost of capital.
- With perfect capital markets, a firm’s W A C C is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.
Leverage amplifies the market risk of a firm’s assets, raising the market risk of its equity
MM Proposition I (With Taxes)
If we now allow for taxes, the firm can increase its value by financing with debt. This is because debt allows the firm to pay less in taxes
he second proposition for the real-world condition states that the cost of equity has a directly proportional relationship with the leverage level. Nonetheless, the presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage level.
The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt:
VL = VU + PV (Interest Tax Shield)
Discuss the agency problems associated with capital budgeting
Agency Costs
– Costs that arise when there are conflicts of interest between the firm’s stakeholders
* Management will generally make decisions that increase the value of the firm’s equity.
– However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.
Common agency costs of leverage include:
- Excessive risk-taking and asset substitution
- Debt Overhang and Under-Investment
- Cashing Out and the Leverage Ratchet Effect
A negative expected payoff if new strategy is implemented.
Equity holders have nothing to lose if EMPIC embarks on the risky strategy.
* If EMPIC does not embark on this strategy, it will default, and shareholders gets nothing
* If it embarks and the new strategy fails, it will default, and shareholders gets nothing. Debt holders suffers additional loss
* If it embarks and the new strategy succeeds, both equity and debt holders’ benefits.
The Asset Substitution problem
When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a negative-NPV project, if it is sufficiently risky
Debt Overhang Problem: When a firm faces financial distress, it may choose not to finance new, positive-NPV projects
* Because bond holders will benefit from the value of such project rather than equity holders
(recall equation)
A negative-NPV investment opportunity for equity holders,
Though, it offers a positive NPV for the firm.
Cashing out and the Leverage Ratchet Effect
* When a firm is in financial distress, shareholders have an incentive to withdraw money from firm.
This maybe through assets sales below market value to fund cash dividends
Leverage ratchet effect refers to the observation that once an existing debt is in place:
* Shareholders may have an incentive to increase leverage even if it decreases the firm’s value
Shareholders will not have an incentive to decrease leverage by buying back shares even if it increases firm’s value
In conclusion:
* The agency costs of debt represent another cost of increasing leverage that affects a firm’s capital structure.
Solutions?
- Debt Maturity
- Agency costs are highest for long-term debt and smallest for short-term debt
- Debt Covenants
- Conditions of making loans where creditors place restrictions on actions firms can take
- Capital structure now becomes a trade-off of all these benefits and costs
The value of levered firm can now be expressed as:
V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs) −PV (Agency costs) + PV (Agency benefit of debt)
Analyse the capital structure fallacies in a perfect capital market
- Fallacy I: Leverage can increase a firm’s expected earnings per share. An argument sometimes made in that by doing so, leverage should also increase the firm’s stock price.
– Analyse this fallacy using the example below:
§ LVI is currently an all−equity firm. It expects to generate earnings before interest and taxes (E B I T) of $10 million over the next year. Currently, LVI has 10 million shares outstanding, and its stock is trading for a price of $7.50 per share. L V I is considering changing its capital structure by borrowing $15 million at an interest rate of 8% and using the proceeds to repurchase 2 million shares at $7.50 per share.
Although L V I’ s expected E P S rises with leverage, the risk of its E P S also increases.
– While E P S increases on average, this increase is necessary to compensate shareholders for the additional risk they are taking, so L V I ’ s share price does not increase as a result of the transaction
- Fallacy II: It is sometimes (incorrectly) argued that issuing equity will dilute existing shareholders’ ownership, so debt financing should be used instead.
- By dilution, the fallacy means that if a firm issues new shares, the cash flow generated by the firm must be divided among a larger number of shares, thereby reducing the value of each individual share.
- The problem here is that it ignores the fact that the cash raised by issuing new shares will increase the firm’s assets
Evaluation
- Suppose Jet Sky Airlines (J S A) currently has no debt and 500 million shares of stock outstanding, which is currently trading at a price of $16.
- Last month the firm announced that it would expand and the expansion will require the purchase of $1 billion of new planes, which will be financed by issuing new equity.
The current (prior to the issue) value of the equity and the assets of the firm is $8 billion.
Agency benefits of debt
Concentration of ownership
Leverage allows 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
Suppose the value of the firm depends largely on Elizabeth’s personal effort (As CEO)
* If she uses borrowed funds
* Elizabeth is more likely to work harder because she will retain 100% of an ↑ in firm’s value
More likely to cut “perks”, like private jets, country club memberships, luxuries etc. Why?
However, if she sells new shares (45% equity) receives 55% of an ↑ in firm value
More likely to overspend on luxuries because she bears only 55% of the cost
Using leverage can lead to a reduction in wasteful spending and reduced efforts
Leverage =⇒ preservation of ownership concentration and avoiding these agency costs
Managers may engage in empire building
* Managers often prefer to run larger firms rather than smaller ones
Take on investments that increase the size, rather profitability
Managers may over-invest because they are overconfident
* Wasteful spending more likely when firms have high cash flows after taking on all +ve NPV projects with no payment commitments
Leverage ↑ firm’s value because firms are committed to future interest payments, =⇒ ↓ excess cash and wasteful investments
- When cash is tight, managers will be motivated to run the firm as efficiently as possible
- In highly levered firms, creditors closely monitor the actions of managers. An additional layer of management oversight.
Signalling with payout policy
Dividend Signalling Hypothesis
– The idea that dividend changes reflect managers’ views about a firm’s future earnings prospects
§ If firms’ smooth dividends, the firm’s dividend choice will contain information regarding management’s expectations of future earnings.
- When a firm increases its dividend, it sends a positive signal to investors that management expects to be able to afford the higher dividend for the foreseeable future.
- When a firm decreases its dividend, it may signal that management has given up hope that earnings will rebound in the near term and so need to reduce the dividend to save cash.
Dividend Signaling (Exceptions)
* Although an increase of a firm’s dividend may signal management’s optimism regarding its future cash flows, it might also signal a lack of investment opportunities.
* Conversely, a firm might cut its dividend to exploit new positive-NPV investment opportunities.
– In this case, the dividend decrease might lead to a positive, rather than negative, stock price reaction.
