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What influences capital structure?

M&M Theory (Static Trade-Off)

Agency Theory

Asymmetric Information (Pecking Order)

Business Risk Uncertainty about operating income


Firms tax position Will it benefit from the debt
tax shield?

Financial flexibility Ability to raise capital on


reasonable terms
Managers - Conservative or aggressive?

Uncertainty about future Operating Income (EBIT),


i.e. how well can we predict operating income?
Low risk

Probability

High risk
0

E(EBIT)

EBIT

Note that business risk does not include financing


effects, e.g. debt and interest expense.

Uncertainty about demand (Sales): Q

Uncertainty about output prices: P

Uncertainty about costs (Input P)

Elasticity of Demand Price sensitivity

Currency Risk Exposure Foreign sales?

Product and other types of legal liability

Operating leverage (FC vs. VC)

Firms can control business risk:


Negotiate long-term contracts for labor, supplies, inputs,
leases, etc.
Marketing strategies to stabilize units sales and prices
Hedging with commodity and financial futures to stabilize
revenues and costs

General Rule: The greater the business risk, the lower the
optimal debt ratio.

Operating leverage is the use of fixed costs rather than


variable costs.

If most costs are fixed, and therefore do not decline


when demand falls, then the firm has high operating
leverage.

Examples: Airlines, Motor Plants


General Rule: Higher the operating leverage, the greater
the business risk, lower optimal debt.

Low operating leverage


Probability
High operating leverage

EBITL

EBITH

Typical situation: Can use operating leverage to get


higher E(EBIT), but risk also increases.

Financial leverage is the use of debt and preferred


stock
Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage
(Debt).
Remember: Business Risk is the risk with no debt.

Foundations of capital structure


Originated with Modigliani and Miller (1958)

Impact of capital structure on firm value (DCF)


Increasing cash flows
Decrease WACC

Model developed in three stages


Without taxes and bankruptcy costs
With taxes but without bankruptcy costs
With taxes and bankruptcy costs

Impact on Cash Flows

Capital structure does not affect value of firm.


Financing decision vs. Investment decision

Impact on WACC

WACC constant regardless of capital structure.

If firm increases debt

Risk to shareholders increases


They demand higher returns
Increased RE offsets D/E change and WACC unchanged.

Impact on Cash Flows


Tax gives rise to interest tax shield benefit.
Tax shield benefit increases linearly with debt taken on.
VL = VU + T c x D

Impact on WACC
Cost of debt (RD) is interest payable on debt.
RD reduced due to govt. subsidy on interest payments.
Taking on debt therefore reduces WACC.

Therefore optimal debt is 100%.

Why is 100% debt not observed in practice?


Debt increases risk of bankruptcy
Bankruptcy destroys firm value

As we take on debt we
Increase firm value due to interest tax shield benefit
But also increase cost of bankruptcy.

Optimal capital structure


Occurs where tax shield exactly offset by bankruptcy costs
Beyond this point costs of debt outweigh benefits
Essentially trade-off between tax benefits of debt and costs of bankruptcy
(Static Trade-Off)

Taxes:
Tax benefit from leverage only important to firms in
a tax-paying position (i.e. Profitable)
Firms with substantial tax shields from other
sources (e.g. Depreciation) receive less benefit.

Not all firms have same tax rate. Higher tax rate,
greater incentive to borrow.

Financial Distress:
Firms with greater risk of financial distress will borrow
less than those with less risk.

Typically measure risk through volatility of PBIT.


Financial distress also more costly to some firms than
others depending on assets.

Firms with mostly tangible assets can dispose of them


more easily and cost-effectively than those with
intangibles.

Critics contend M&M flawed once real world issues


introduced.

Perhaps our model needs to be extended?

Previously only considered debt and equity for


determining firm value.

Various stakeholders have claim to cash flow of firms,


however (e.g. government for taxes, potential
bankruptcy costs, environmental groups, etc.)
All of these can only be paid from cash flows of firm.

Marketable versus Non-marketable Claims


Marketable claims can be bought and sold in financial markets
(e.g. Debt and equity)
Non-marketable claims cannot (e.g. Taxes, bankruptcy costs)

Firm value is thus sum of marketable and non-marketable claims


Therefore cannot alter firm value by changing capital structure.
Capital structure is important, however, because it determines
split between marketable and non-marketable claims.
Goal is to maximise marketable claims while minimising nonmarketable claims.

The capital structure (mix of debt, preferred, and common


equity) at which share price (P0) is maximized.

Trades off higher E(ROE) and EPS against higher risk. The
tax-related benefits of leverage are exactly offset by the
debts risk-related costs.
The target capital structure is the mix of debt, preferred
stock, and common equity with which the firm intends to
raise capital.

Managers versus Shareholders


Agency problems arise between shareholders and
management where manager equity stake in firm is low.
More equity management holds, less agency conflicts
likely.
If we hold absolute equity stake of management constant,
taking on debt increases their relative holdings in firm
and reduces conflict between managers and
shareholders.
Debt can therefore be used to mitigate agency problems.

Debt contracts have limited upside

Over-investment by firms near bankruptcy

Selection of high risk projects

Equity captures gains


Debt may bear losses

Debt-holders bear the consequences


High risks can be taken
Even negative NPV projects may be attractive

Shifting risk erodes firm value (& debt value)


Value is transferred from debt holders to equity holders
Known as asset substitution

Problems may be anticipated by lenders


Higher interest charges
Equity holders may counter by offering covenants

Underinvestment by firms near bankruptcy (Myers, 1977)


No incentive for equity holders to invest even in good projects
Likely that benefit of gains will accrue to debtholders

Larger debt levels may lead to rejection of value-adding projects

Diamond (1989)
Firms have incentive to pursue safe projects
Debtholders dislike firms with history of risky investments
Build history of safe investments for best lending terms
May be incentive for small firms to take on risky investments early
in life
If they survive without defaulting, will eventually switch to safe
projects
Therefore likely that younger firms have less debt than older ones

Managers possess private information re


firms opportunities
Capital structure decisions therefore sends
signal to market re private information (Ross,
1977)
Can also be used to limit inefficiencies in
investment decisions due to information
asymmetries (Myers and Majluf, 1984)

An equity issue
Good news (+ve NPV projects)?
Bad news (shares overvalued)?

Discount share price!

A debt issue
Share prices don't fall - convey more positive news
Management feels they can service new debt

Ross (1977)
Managers possess more information on firm than market
Managers benefit if equity value increases
Managers penalized if firm goes bankrupt
Investors take high debt levels as sign of quality
Low quality firms have higher marginal costs of debt and
therefore issue less debt

Ross (1977)
Finds that firm value and D/E ratio positively related
However, greater debt also increases bankruptcy costs
Quality firm able to accommodate costs of debt,
however.

Managers can therefore use debt to signal firm quality


and improve firm value

Myers and Majluf (1984)


If investors less well-informed than insiders about value of firms assets
then equity may be mispriced in market

Assume firm issuing equity to finance new project and severe


underpricing occurs
New shareholders effectively received discount on investment while price
of existing shares drop
Therefore receive greater net return than they should have at expense of
existing shareholders

Existing may have captured more return if debt used instead of equity
Avoid this by issuing security not undervalued by market (e.g. Debt)

Conclusion (Myers and Majluf, 1984):


Possibility of mispricing dictates capital structure
decisions
Firms always issue less undervalued assets first
Typical order is:

Internal funding (retained earnings)


Low-risk debt
Equity

Theory referred to as pecking order

Booth (2001):
Factors influencing capital structure decisions similar
across developing and developed markets regardless of
significant differences in financial environments

Find that firms with good profits tend to have less debt
(pecking order)
Also significant information asymmetries exist making
external financing potentially expensive.
Also support for impact of asset intangibility on debt
levels.

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