Ch11 Corporate Financing Flashcards
(28 cards)
Lifecycle Financing of Corporations
- Start-up
- High Growth
- Rapid Expansion
- Mature Growth
- Decline
Start-up Financing
- Low revenues/earnings
- high external funding needs
- relies on Owner’s Equity and Bank Debt
High Growth Financing
- Negative or low earnings
- high external funding needs relative to firm value
- uses Venture Capital and Common Stock
Rapid Expansion Financing
- Moderate earnings
- moderate external funding needs relative to firm value,
- uses Common Stock (SEO), Warrants, Convertibles, and Debt
Mature Growth Financing
- High earnings constrained by infrastructure
- low external funding needs relative to firm value, accesses private equity
- IPOs, and Bond issues
Decline Financing
More internal funds than funding needs, retires debt, repurchases stock
Equity vs. Debt: Key differences
Equity: Residual claim, lowest cash-flow priority, not tax-deductible, infinite maturity, involves management control. Includes various types: private vs. listed, voting vs. participating, restricted vs. non-restricted, registered vs. bearer, preferred vs. common shares
Debt: Fixed payoff, highest cash-flow priority, tax-deductible, limited maturity, generally no management functions. Includes many types: public vs. private, senior vs. junior, syndicated vs. bilateral, secured vs. unsecured, fixed vs. floating rate, domestic vs. international, coupon-bearing vs. zero-coupon, long-term vs. short-term, callable vs. non-callable, putable vs. non-putable
Private Equity / Venture Capital
Equity not quoted on stock exchange. VC provides capital and management support (“smart money”) to young/growing firms. VC firms earn profit from capital gains (e.g., IPO exit). Information asymmetries are extreme in VC; solutions include staged financing, preferred stock, and contingent control rights based on performance
Initial Public Offering (IPO)
A private firm sells shares to the public
Benefits: Tap new finance sources, foster growth, allows owners to diversify/exit, provides objective value measure, helps discipline managers via takeovers
Costs: Direct (printing, fees, underwriting spread typically 3-7%, consulting) and Indirect (management time, underpricing). IPO underpricing varies significantly by country (e.g., USA 18.3%, China 256.9%)
Seasoned Equity Offerings (SEO)
Public companies issue new shares
▪ Forms: General cash offer (similar to IPO), Rights issue (existing shareholders get priority, common in Europe), Private placement (to small investors).
▪ General cash offers can dilute existing shareholders if new shares are sold below market price. Stock prices generally fall on SEO announcement day
Debt Covenants
Protect investors’ interests.
◦ Negative/Restrictive/Passive: Limit dividends, restrict new debt or asset sales.
◦ Positive/Active: Force company to inform creditors (e.g., quarterly reports, balance sheets, ratings)
◦ Examples of Financial Covenants: Debt Service Coverage Ratio, EBIT(DA) Interest Cover, CAPEX Limit, Leverage Ratio, Debt/Equity Ratio, Net Worth Requirement, Equity/Assets Ratio, Return on Assets
Recovery Rates of debts
Vary by seniority and security
◦ Bank debt has the highest recovery rate (77.5%).
◦ Senior secured bonds have high recovery (62.0%).
◦ Recovery rates decline with less security and lower seniority (Senior unsecured 42.6%, Senior subordinated 30.3%, Subordinated 29.2%, Junior subordinated 19.1%)
Mezzanine/Hybrid Financing and recovery
Treated as quasi-equity in bankruptcy, ranking below debt but above pure equity.
◦ Generally for a limited time.
◦ Types: Preferred stock (convertible), employee stock options, convertible bonds, contingent convertible bonds (CoCos).
◦ Convertible Bond: Allows exchange for a fixed number of shares. Protects debtholders against excessive risk-taking (risk shifting).
◦ Contingent Convertibles (CoCos): Debt that converts to equity or is written off upon a trigger event (e.g., bank financial distress). Debt in good states, converts to equity in bad states.
◦ CoCo Objectives: Capital buffer in distress, reduce systemic risk, bankruptcy avoidance, mitigate “too-big-to-fail” issues, shareholder accountability for mismanagement, potential change of control rights without changing cash-flow rights
Why Capital Costs Matter
Lower cost of capital (discount rate) makes existing projects more valuable (intensive margin) and new projects potentially valuable (extensive margin). The discount rate is the market-value-weighted average cost of equity and debt
Modigliani & Miller (M&M) Indifference Theorem (MM1) (1958)
◦ Assumptions: No arbitrage, frictionless capital markets (no transaction costs, no taxes, no information asymmetries), no bankruptcy costs.
◦ Theorem: The value of a firm is independent of its financing structure.
◦ Homemade Leverage: Investors can replicate any firm’s leverage decision in their own portfolio if capital markets are frictionless.
◦ Setup: One-period model in a complete market with uniquely defined state prices. Firm value at maturity is the sum of debt and equity payoffs in each state. The present value of the levered firm (S+B) equals the present value of the unlevered firm (VU) under these assumptions
MM1 with Taxes
◦ Corporate taxes are introduced, applied to equity payoffs. In case of default, no taxes are paid.
◦ Debt payments are typically tax-deductible, creating a tax shield.
◦ Result: The value of a levered firm with taxes (VL,τ) is equal to the value of an unlevered firm with taxes (VU,τ) plus the present value of the tax shield (τ · B). VL,τ = VU,τ + τ · B.
◦ According to this, firm value increases linearly with higher leverage. This suggests an optimal debt level tends to be high
MM1 with Bankruptcy Costs
◦ Introducing bankruptcy costs (e.g., legal costs, court fees).
◦ Trade-Off Theory: The value of a levered firm with taxes and bankruptcy costs is VL,τ = VU + τ · B - PV(bankruptcy costs).
◦ This theory suggests an optimal leverage ratio where the tax shield benefits are balanced against the costs of bankruptcy.
◦ Warner (1977) estimated direct distress costs around 5%. Evidence shows leverage is often lower than predicted by the tax shield benefit alone, indicating other factors matter (“zero-debt puzzle”)
Agency Gains of Leverage (Jensen’s Free-Cash-Flow Theory)
Leverage forces managers to use cash flow to service debt rather than investing in negative NPV projects or wasting it. Debt acts as a monitoring mechanism, mitigating managers’ tendency to pursue bad projects
Risk Shifting
Shareholders take on excessively risky negative NPV projects at debtholders’ expense
Underinvestment Problem
Shareholders avoid positive NPV low-risk projects if gains primarily accrue to bondholders
Other games in agency problems
Playing for time, Cash-In-and-Run (excessive dividends), Bait-and-Switch (issuing more debt to harm existing lenders)
Bondholder Response to games
- Demand higher rates, impose restrictive covenants.
- Covenants have direct monitoring costs and indirect costs (lost investments, reduced managerial flexibility)
- Agency costs are most relevant in financial distress and can be seen as part of bankruptcy costs
Signaling of Financing Decisions
▪ If managers know the project is good (high payoff state), they prefer debt financing (higher equity value).
▪ If managers know the project is bad (low payoff state), they prefer equity financing (higher equity value).
◦ Conclusion: Debt financing is a signal of good news, and equity financing is a signal of bad news.
Pecking Order Theory (Myers & Majluf, 1984)
Based on this signaling, firms have a financing preference hierarchy.
- Prefer Internal Finance (no asymmetric information costs).
- If external funds are needed, issue cheapest security first (least sensitive to asymmetric information).
- Start with Debt, then hybrids, and only issue Equity as a last resort.
◦ Result: No optimal debt-equity mix. Leverage results from the availability of internal funds and credit capacity.
