Guiding Seminar 6

Question 1

Explain how asymmetric information between managers and investors may affect the capital structure of a firm.
(Capital structure)

Answer 1

If firms issue stock, investors believe that managers have some private information about poor future prospects → that means that equity is overvalued → stock price drops after the announcement of an equity issue.

Question 2

Give an explanation of what are sticky dividends and how they are considered when choosing capital structure (Capital structure)

Answer 2

Dividends are “sticky” - if, in need of cash, firms use external financing rather than cut dividends.
If external funds are required, firms will issue the safest security first → debt before equity (debt suffers
from adverse selection much less than equity).

Question 3

List the main reasons which can cause companies to deviate from their target debt ratios.
(Empirical capital structure: a review)

Answer 3

1. Profitability
   • Higher profitability → less debt (pecking order theory)
2. Market Timing
   • When a firm’s management thinks that its stock is cheap (market values are high relative to book values), it may choose to take advantage of this mispricing.
3. Stock Returns (Past stock returns ↑ → Debt ↓)
   • Rather mechanical effect → an increase in a firm’s stock prices will increase the denominator of the debt ratio, thereby lowering the ratio
   • High growth opportunities → equity highly-priced → fund growth opportunities with equity
4. Managerial Preferences and Entrenchment
   • Agency problems → managers may make a decision to take on less debt than shareholders would prefer
   • Powerful CEO → capital structure may reflect managerial preferences (management “style” )
   • If managers own equity & stock options → increased willingness to take risk → more debt

Question 4

Explain what is the effect of leverage on non-financial stakeholders of a company.(Empirical capital structure: a review)

Answer 4

1) Employees
• High leverage → lower wages, lower funding of pensions
• High leverage → less job security during downturn (more frequent layoffs)
• High leverage → labor unions less aggressive (labor union faces the choice of either accepting a lower
wage or forcing the firm into bankruptcy and then negotiating with creditors)
2) Customers
• High leverage in firms producing unique products → customers anticipate high liquidation costs during
downturn (think about claiming a warranty from a bankrupt manufacturer) à firm loses sales.
• In case of deregulations that ease new entry → competitions rises → firms with high leverage are less
likely to survive
3) Suppliers
• Suppliers require lower rates of debt (protection against financial distress), especially in industries with
high R&D costs (& unique products)

Question 5

According to De Angelo, what are the main factors that cause companies to pay out dividends? What are the reasons to retain cash flows?
(Corporate payout policy)

Answer 5

Factors stimulating payouts ↑
• investors pressure managers to accelerate cash payouts (avoid wasteful investment &
managers’ personal benefits)
• managers have incentives to build a reputation for treating investors fairly in their payout
decisions to be able to sell future equity at higher prices
• firms generating large amounts of FCF are “sitting ducks” for takeovers by activist investors (if
investor demand for dividends not fulfilled à company valuation decreases).
Factors retaining payouts ↓
• agency problems – managers make decision to keep cash
• Servicing different tax clienteles: some investors face high tax rate on dividends à they
prefer deferred payouts à firms with such investors specialize in retention

Question 6

Provide argumentation of why companies may choose to pay out low/high levels of dividends. (Corporate payout policy)

Answer 6

High dividends:
Lower agency costs
Low growth
Signaling future performance
Clientele
Low dividends:
Financial distress
Good growth
Minimize taxes

Question 7

Provide the main arguments for why more capital is raised by firms, which are overvalued. (Overvalued equity and financing decisions)

Answer 7

Arguments for raising more capital when overvalued:
1) Catering investors’ expectations
• The pressure on managers to take actions such as raising capital to finance ambitious projects
is especially strong among overvalued firms
2) Low costs
• Overvalued firms should be eager to raise inexpensive capital
3) Project scale economies
• If some investment projects have a minimum efficient scale, then overvalued firms will tend
to find it more attractive than undervalued firms to raise capital for purposes of investment
4) Investor short-termism
• Managers are more heavily focused on short-run stock prices

Question 8

Describe how fiduciary duties worked in the case of (in)solvency before the Credit Lyonnais ruling. (Fiduciary duties and equity-debtholder conflicts)

Answer 8

When a firm is not insolvent but in the “zone of
insolvency”, duties are already owed to creditors → when a company is in serious trouble, the
director’s responsibilities shift somewhat in the direction of the creditors

Question 9

Discuss the structure of a private equity fund, state the role of a private equity firm in the structure.
(Leveraged buyouts and private equity)

Answer 9

PE funds organized as limited partnerships → general
partners (PE firm) manage the fund, limited partners
(institutional investors and wealthy individuals) provide
most of the capital.
The private equity firm typically has up to five years to
invest the capital committed to the fund into companies and then has an additional 5 -8 years to return the capital to its investors

Question 10

Discuss the development of the PE industry over the last three decades. (Leveraged buyouts and private equity)

Answer 10

Until 1990 – large transactions in mature industries
1990-1994 - buyouts of non-publicly traded firms.
Lower aggregate transaction value, but twice as
many deals as in 1985-1989
1995-2004 - New industries: information
technology, media, telecommunications, financial
services, healthcare.
2005-2006 - Public-to-private and secondary
buyouts grow rapidly in number and size.

Question 11

Explain how operational engineering can create economic value for companies as a result of an LBO. (Leveraged buyouts and private equity)

Answer 11

• PE firms → highly industry focused
• Use industry and operating knowledge to identify attractive investments, to develop value creation plans
for those investments, and to implement the value creation plans
• Cost-cutting and productivity improvements, strategic changes or repositioning, acquisition opportunities