What are the two traditional approaches of capital structure? Explain them.
- Modigliani-Miller Trade-off Theory
->focuses on the trade off between debt tax shields and financial distress
-> firms choosing its D/E in order to equate the two effects at the margin
• In principle: Optimal Capital Structure (D/E -> fixed) - Pecking order theory
› In financing new projects, managers prefer the
following order: - Internal funds [“inside” equity from from cash flow]
- Additional debt (go to bank or issue bonds)
- Lastly, “outside” equity
› So, no clear D/E mix prediction (no optimal capital structure)
What are the top 3 factors affecting CFOs on a stock issue?
- EPS dilution
- Equity overvaluation/undervaluation
- “high” stock price
Note: Note: equity issue lowers expected EPS [=dilution]. Because also D/E ratio falls, lower E[EPS] reflects lower financial risk. [Framing issue]
What are “mispricing” financing side effects?
1) Investor Biases [Market Mispricing→ Market Timing]
• Positive [negative] adjustment to ‘rational’ project NPV because equity is issued above [below] fundamental value.
• Generate positive NPV by repurchasing of equity when stock price is undervalued.
• [Note: in the traditional theory mispricing may be explained by information assymetry].
2) Managerial Biases [Perceived Market Mispricing]
• Forgo NPV>0 projects [=underinvestment] because of perceived equity undervaluation [for firms with no cash and debt capacity]. Firms with cash may rather repurchase shares, and forgo the NPV>0 project.
• [Note: in the traditional theory underinvestment may be explained by agency conflicts].
• Overconfidence may lead to the use of debt rather than equity
What is market timing?
Buying low, selling high. Executive will sell high when they issue equity that they perceive as overvalued and buy low when they perceive it to be undervalued. (inside buying/selling in respect to their personal portfolios)
What is financial flexibility and what is associated with it? Explain.
Financial flexibility= having enough internal funds available to pursue new projects when they come along.
-> Convertable debt = a lot of CEOs issue convertible debt as they think it is an inexpensive way to issue “delayed” common stock and because their stock is undervalued
They think:
1) lower interest rates than for fixed debt (embedded short option premium foregone)
2) Converts to equity when the future stock price rises
Framing issue: that does not mean that the debt is cheap, it depends on how the debt is priced in the market
What are the top 4 factors affecting CFOs issuing debt?
- Financial flexibility
- Credit rating
- Earnings and cash volatility
- Insufficient internal funds (pecking order theory)
Interest tax savings & distress costs (trade-off theory) are not mentioned as main reasons
What is sensitivity of capital investment to firm cash flow?
Overconfident and over-optimistic managers overestimate future project cash flows, underestimate project risk, and consider the firm’s equity to be undervalued in the market
• When firm is cash-rich: management tends to invest in projects with perceived-positive NPVs [whereas some/many of them actually have negative NPVs ] → Over-investment Problem
• When firm is cash-poor [and also lacking debt capacity]: management may forego positive-NPV projects → Under-investment Problem
Result depends on: perceived equity undervaluation vs perceived NPV>0
What is behavioural value of a firm with leverage?
VL = VU
+ PV Interest Tax Shield
− PV Financial Distress Costs
+ PV Agency Benefits
− PV (Agency Costs)
+/- PV (Inefficient Prices) ->biased investors
+/- PV (Managerial Biases) ->biased managers
What is the evidence that supports or disapproves the pecking order theory?
- Yes, reluctance to issue equity (information asymmetry and behavioural biases)
- Yes, cash flow sensitivity (->internal funding)
- No, when sentiment, managers exploit overvaluation
- No, large firms prefer debt over cash (for unexpected investment opportunities)
What are market imperfections associated to payout policy?
• Income tax of investors: dividends face a tax disadvantage
• Corporate taxes: payouts lower negative cash tax shield
• Transaction Costs: Weakens ‘Home-made Dividend’ argument
• Information Asymmetry: Dividends serve as information-signaling device
• Agency conflicts: dividends lower cash that may
create adverse incentives
Clientele Effect: firms may cater their payout policies to investor needs & investor classes
Why investors prefer cash dividends?
- Mental Accounting: Mental ‘system’ to organize information & events into manageable & logical pieces
(1) current income -> dividends
(2) investment assets
(3) home equity
(4) future income -> dividends - Limited self-control
• Apply the “Don’t Dip Into Capital” heuristic
• Dividends in the mental “Income Account” are earmarked as consumption money, capital gains not
(Older investors and low-income young investors use dividends as income)
(Older investors buy stock before the dividends payout day and sell stock after) - Hedonic editing (Prospect theory)
- Segregate gains (‘Christmas wrapping ’ effect )
- Integrate losses (‘Big bath’ effect )
- Integrate smaller losses with larger gains [canceling to net gain → offsetting loss aversion]
- Segregate small gains from larger losses (‘Silver lining ’ effect )
- > Remember that in the traditional view, investors only care about their total after-tax return, and not about the form in which arrives
Why would managers prefer cash dividend?
These opinions indicate managers apply the following dividend heuristics:
- Avoid lowering dividends per share
- Target level of dividend per share and dividend growth rate
- Maintain smooth dividend stream over time
- >Main aim: predictability
