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Lecture 1
Dr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD
Meditation for the week:If you are willing to do all that is asked of you, seldom
will you be asked to do all that you are willing to do.
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Topic Objectives
The Irrelevance of Corporate Financing
and Risk Management Decisions
Corporate Hedging and Insurance
Hedging and the Modigliani & Miller Theorem
Agency Costs and Dysfunctional Investment
Comparative advantage in risk bearing
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What is Risk and Risk
Management
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What is Risk
Risk exists if there is something you don’t
want to happen – having a chance to happen!!!
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What is Risk – Take 2
The probability that some event will cause an undesirable outcome on the financial health
of your business and/or other business/family
goals
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Components of Risk
Probability
of 5%
Probability
of 15%
Probability
of 60%
Probability
of 15%
Probability
of 5%
EVENT
Cause/Source Odor lawsuit
Potential
Outcome
#1
Potential
Outcome
#2
Potential
Outcome
#3
Potential
Outcome
#4
Potential
Outcome
#5 [minor nuisance] [catastrophic]
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Components of Risk – Undesirable Outcome
Put simply, the UndesirableOutcome is what hurts!
- lower than expected production- catastrophically lower production
- inability to meet cash flow- loss of income- catastrophic loss of income- loss of life
- loss of buildings & other resources- loss of health- inability to get a permit or loan
X
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Components of Risk – Event (Cause /
Source of Risk)
The Event is what caused thehurt:
- weather event
- injury/death of an employee- neighbors action against you- surplus production of milk- widespread poor grain production- low quality inputs- divorce or disagreement- downward slide in generaleconomy- and countless more!!!
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Components of Risk – Probability
0
20
40
60
80
100
6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8
P e r c e n t
B AC
Probability is a measure of the likelihood that the Risk
Event will occur, e.g., 30% chance of rain
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Back to the Beginning Exercise
Probability Distribution
0
2
4
6
8
10
8 . 5 9
9 . 5 1 0
1 0 . 5 1 1
1 1 . 5 1 2
1 2 . 5 1 3
1 3 . 5 1 4
1 4 . 5 1 5
1 5 . 5 1 6
1 6 . 5 1 7
1 7 . 5
25 Cent Range, Midpoints Are Shown (based on 1988-Dec. 2002
P
e r c e n t O c c u r e n c e
11.62-11.87(11.75 midpoint)
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Back to the Beginning Exercise
Probability Distribution
0
2
4
6
8
10
8 . 5 9
9 . 5 1 0
1 0 . 5 1 1
1 1 . 5 1 2
1 2 . 5 1 3
1 3 . 5 1 4
1 4 . 5 1 5
1 5 . 5 1 6
1 6 . 5 1 7
1 7 . 5
25 Cent Range, Midpoints Are Shown
P e r c e n t O c c u
r e n c e
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Family Goals
& Objectives
Overall Categories of Risk
Legal Risk Price Risk
Environmental
Risk
5 D’s Risk - Death- Disability
- Disagreement- Divorce- Disaster
ProductionRisk
HumanResource
s Risk
FinancialRisk
Relationship/Public
RelationsRisk
11
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Risk Increases the More You Don’t Know
All The Potential Outcomes
The Probability of Occurrence
Cost of a Undesirable Outcome
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All The Potential Outcomes
The Probability of Each Outcome Occurring
Cost of Undesirable Outcomes
Said Another Way:The more you do know and understand
about
the better long term risk manager you willbe.
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What is Risk Management?
Assuring An Outcome
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Risk Management is Assuring An
Outcome
0
20
40
60
80
100
6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8
P e r c e n t
Assuring anOutcome
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Five Primary Means of Risk Management
Reduce1. Reduce the probability that the event will occur
2. Reduce the impact if the event does occur
Transfer
3. Transfer the cost of an undesirable outcome to someoneelse
Avoid 4. Completely avoid potential events thus providing a zero
probability that they will occurDo Nothing
5. Let the risk happen and be ready to bear theconsequences.
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Price RiskWhat Happens to the Distribution When You Have a
Floor Price at $10.51?
12.05 13.58 10.51
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What Happens to the Distribution When You
Establish a Short Fence from $12.05 to 13.58?
12.05 13.58 10.51
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Level of Production
Employee Performance Interest Rates
Personal Injury/Death (you, employee,spouse)
Divorce
Disagreement
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Production RiskRisk: Poor weather event causing the undesirable
outcome of lower than expected yields.Risk Management???
160 19595
Corn Yields
Transfer thecost of the
risk via cropinsurance
P d ti Ri k
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Production Risk:Risk: of a poor weather event causing the undesirable
outcome of lower than expected yields
Risk Management???
160 19595
Corn Yields
Reduce the cost of the risk via spatial location, multiplevariety selection, and other cropping practices.
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Financial RiskRisk: higher interest rates causing the undesirable
outcome of lower than expected income/cash flow
Risk Management???
Do Nothing
Cash Flow
Fi i l Ri k
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Financial RiskRisk: higher interest rates causing the undesirable
outcome of lower than expected income/cash flow
Risk Management???
Cash Flow Transfer therisk via fixed
rate loans Do Nothing
Financial Risk
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Financial RiskRisk: higher interest rates causing the undesirable
outcome of lower than expected income/cash flow
Risk Management???
Transfer the riskvia fixed rate
loans
Reduce the costof the negative
impact via lowerdebt financing
Do Nothing
Cash Flow
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Human ResourcesRisk: Cost of hired labor not showing up or making a mistake
causing lower production, injury, or death
Risk Management???
Reduce the Risk via:-Regular employee meetings-Training programs-Well written position descriptions-Incentive plans
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Transfer the riskvia disability andother insurance
Human ResourcesRisk: Cost of hired labor not showing up or making a
mistake causing lower production, injury, or death
Risk Management???
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Avoid the risk bynot hiring any
employees
Human ResourcesRisk: Cost of hired labor not showing up or making a
mistake causing lower production, injury, or death
Risk Management???
l k
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Environmental RiskRisk: manure spill causing the undesirable outcome of fines,
lawsuits, and loss of income
Risk Management???
Reduce the risk via:-Education-Facilities-Monitoring checks and systems-Field and manure trt. practices
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Transfer the risk vialiability insurance
Environmental RiskRisk: manure spill causing the undesirable outcome of
fines, lawsuits, and loss of income
Risk Management???
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Disability RiskRisk: poor health causing loss of income
Risk Management???
Incapacitated Avg. Health
Reduce incidence or impact of risk via:-Annual health exam - Quit smoking-Exercise -Disability Insurance
-Co-Manager
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So, I now know What Risk
Management is,
but How do I do it???
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How??? Step 1: Be aware, identify the risks you face.
Step 2: Evaluate: the likelihood that the risk will occur, and
how bad the hurt will be if it does occur
Step 3: Decide on how you will address the risk reduce, transfer, avoid, nothing, or some combination
Step 4: Implement What is the most frustrating words used in management??
Answer: “If I had only ……”
Step 5: Control Monitor to assure that what you said you would do, you did,
and that you are getting what you want out of your your riskmanagement strategies.
P i iti i Whi h Ri k t
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Prioritizing Which Risks to
Address First
Probabilityof
Happening
Potential Impact
Act if cost effective
No action required
Immediate action
Action required
Small Catastrophic
High
Low
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Risk Management Is An
Individual Decision
No one "right" decision
The "right" decision depends on the
characteristics of theoperation and
individual decision-maker
Risk
Revenue
1
2
3
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Risk vs. Profitability
Risk
Revenue
1
2
3
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Risk is Pervasive
Risk : uncertainty about occurrence of a loss Importance of Uncertainty: if probability of loss is
zero or 1, there is no risk.
Impossible to totally avoid risk; risk faced by every entity.
Risk can be managed but there are tradeoffs
involved.
Your conscious and unconscious choices affect your
risk and others’ risk; positive and negative externalities
exist.
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Categories of Risk Pure Risk : possibilities of loss or no loss, nochance of gain, e.g. fire.
Speculative Risk : both profit or loss are possible,e.g. gambling.
Fundamental Risk : affects everyone or large
number of persons.
Particular Risk : affects only one person
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Methods of Handling Risk
Avoidance- do not engage in
activity thatincurs risk
Loss Control - prevention- reduction
Retention- active- passive
Transfer - insurance- other
- contract- hedging- incorporation
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Retention and Insurance
Benefits of Increased RetentionSavings on premium loadingsReducing exposure to insurance market volatility Reducing moral hazard Avoiding high premiums caused by
asymmetric information & price regulationMaintaining use of funds
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Costs of Increased Retention
Closely held versus publicly tradedfirms with widely held stock
Firm size and correlation amonglosses
Correlation of losses with other cash
flows and with investmentopportunitiesFinancial leverage
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Modigliani-Miller Theorem
A financial theory stating that the market value of afirm is determined by its earning power and the risk of its underlying assets, and is independent of the way itchooses to finance its investments or distribute
dividends. A firm can choose between three methods of financing: issuing shares, borrowing or spending profits(as opposed to dispersing them to shareholders in
dividends). The basic idea is that, under certain assumptions, itmakes no difference whether a firm finances itself withdebt or equity.
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Hedging is irrelevant under the Modigliani &
Miller (M&M) assumptions
Perfect capital markets No taxes, no transaction cost, no institutional
frictions and no costs of bankruptcy.
Systematic information All investors, firms, and firm managers have the
same information and have perceptionsconcerning the impact of new information on
security prices that are both true and identicalacross investors.
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Hedging is irrelevant under the Modigliani &
Miller (M&M) assumptions
Given investment strategies Investment decisions by the firms are taken as a
given and as independent from financingdecisions.
Equal Access Firms and individuals can issue the same
securities in the capital markets on exactly thesame terms.
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Modigliani-Miller Theorem
Assume Efficient markets and no asymmetricinformation, No taxes, No transaction orbankruptcy costs, Investment decisions don’tchange ; ThenThe value of the firm is independent of itscapital structure.Financing choices are irrelevant! Value is created on the left-hand side of thebalance sheet, not the right-hand side.
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Why is M&M useful?
It tells us what is important … Does debt affect investment decisions? Does debt affect taxes?
Can equity be issued at fair value? Are transaction costs or bankruptcy costs
important?
And what isn’t … Impact of debt on ROE and risk Cost of debt
relative to the cost of equity (rD vs. rE)
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Capital Structure Irrelevance
The value of a company is independent of its capitalstructure. Consider Corporation Superior with £100 of assetsand no debt,
V(t)S = A(t)S = E(t)S = £100
Also consider Corporation Wasu faced with the same
probability distribution as Superior, but with a debt of £50,
V(t) W = E(t) W + D(t) W
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Capital Structure Irrelevance
In the absence of arbitrage the value of Superiorshould equal that of Wasu. To see this, consider an investment strategy in whichan arbitrageur buys 10% of the shares of Corp. Wasu, which will cost him,
0.10E(t) W = 0.10[V(t) W – D(t) W ]
He earns the following per year;
0.10[Profits –R(t)DD(t) W ]
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Capital Structure Irrelevance Now consider a second investment strategy, in whichhe borrows (D(t) W ) on his own in order to invest in Corp.Superior. His net investment outlay is
-0.10D(t) W + 0.10E(t)S = 0.10[V(t)S – D(t) W ] He earns gross profits on his investment:
0.10(Profits) Since he must service his debt, his net profits per year
are 0.10[Profits – R(t)DD(t) W ]
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Debt and the Leverage Irrelevance
M&M proposition II holds that leverage does notbenefit either investors or the corporation no matter who does it. A firm’s cost of capital is the return it must pay to
investors in order to induce them to hold its securities. We can define Wasu’s weighted average cost of capital(WACC) as follows:
E DWACC R
E D
E R
E D
D R
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Debt and the Leverage Irrelevance To illustrate M&M Proposition II, we rearrange the
firm’s WACC in terms of its equity cost of capital:
This equation tells us that the expected returnon equity increases as the leverage of the firmincreases.But issuing debt increases the risk of holding
equity, leading investors to demand a higherexpected return on equity, leaving the overallcost of capital unchanged.
DWACC WACC E R R
E
D R R
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S i ld diff
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Security Holder Indifference At any given time t, the firm cannot do anything with
its financial policy to affect the value of stocks andbonds in that period, but the same is not true at time t-1.
Let the current value of the firm be
V(t) = Et-1(t) + Dt-1(t) At time t, the firm can issue new securities [debt &
equity], then the value of the firm is
V(t) = Et-1(t) + Dt-1(t) + e(t) +d(t)
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Security Holder Indifference
At time t, the firm earns a total net cashinflow of X(t) and invests a total of I(t) in newinvestment projects, where I(t) is assumedunder M&M to be given exogenously.
The sum of dividends (t) and interest (t)paid at time t must equal the net cash flow of
the firm plus the proceeds from any newsecurity issues.
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Security Holder Indifference The firm’s cash flow constraint
(t) + (t) = X(t) – I(t) + e(t) + d(t) Substituting the firm’s cash flow constraint into the value of the firm allows us to express the total wealth of
all security holders: [Et-1(t) + (t)] + [Dt-1(t) + (t)]=X(t) - I(t) + V(t)
Because X(t) is determined by previous investment
decisions and I(t) is assumed given, X(t), I(t) and V(t) areall independent of the firm’s financing decisions.
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Security Holder Indifference
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Security Holder Indifference Combined security holder welfare is independent of
financing decisions made by the firm, but this is notso for individuals. If existing debt is riskless, then new debt will exposethe firm to the risk of default, which will impact both
bondholders. Since the combined value of the securities cannot beaffected by financing decisions, the decline in Dt-1(t)that accompanies the issuance of new, risky debtresults in an increase in E
t-1
(t). A rise in Dt-1(t) is funded by a decline in Et-1(t)
Given Fama and Miller (1972)’s priority rules.
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The Irrelevance of Hedging and
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The Irrelevance of Hedging and
InsuranceThe value of the firm is also independent of any deliberate actions taken by management tocontrol risks through hedging or insurance.
Whether or not investors are holding perfectly diversified portfolios, shareholders should beindifferent to the risk management decisionsmade by corporate managers,
Provided the assumptions underlying theM&M propositions hold.
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Corporate Hedging and Insurance
Does this mean that hedging doesnot increase firm value?
If risk management increases firm value, it must increase expected net
cash flows.
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Hedging and the M&M Theorem
If hedging affects the current firm value, then it must
Change expected tax liabilitiesChange contracting costsChange future investment decisions.
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In view of M&M Theorem
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Does Capital Structure affect value?
Empirical patterns Across Industries Across Firms Across Years Who has lower debt?
High intangible assets/specialized assets High growth firms High cash flow volatility High information asymmetry Industry leaders
Is capital structure managed? If so much time is spent on capital structure then there
must be some value to it (or managers/investors areirrational)
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Debt and Equity Only?
Typically thought of and measured this way Much more complex
Investment opportunities and strategy (needs)
Financing (sources) Cash balance
Distribution: Dividend and repurchases
Debt capacity
Equity capacity Existing debt and equity
Other financial policies: Financial Hedging, CashFlow Volatility, Forms of Compensation
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How does capital structure affect value?
To prove this we start in the “perfect world”
Based on the work of Miller and Modigliani
Shows that capital structure is irrelevant
Value is derived from market imperfections
Example: What if a firm is considering issuingdebt and retiring equal amounts of equity?
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Capital Structure is IrrelevantMiller and Modigliani assume perfect
capital markets
Proposition #1: The market value of any firm is independent of its capital structure.
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Market Imperfections: Taxes T
axes US Tax Code: Deductibility of interest leads to
lower cost of debt (Rd(1-t))
Simple specification overvalues benefit
Ignores personal taxes which
Decreases investors debt return
Increases investors preference for equity Capital gains: Defer and rate difference
Dividend: Some portion is deductible
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Market Imperfections: Contracting Costs
In imperfect markets, alternative ways to contractoptimal behavior are necessary
Costs of financial distress
Underinvestment (rejecting NPV>0 projects), direct,indirect costs, etc.
Benefits of debt
Monitoring function, manages free cash flow problem(Accepting NPV<0 projects), etc.
Contracting costs and taxes are primary motives forstatic trade off theory debt
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Can we quantify the value of market
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Can we quantify the value of market
imperfections?
Debt adds value to the firm due to the interestdeductibility (assume taxes only)
Assume the simple case:
)(TaxShield PV V V U L
C
D
C D D
r
Dr TaxShield PV
)(
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More Complex Tax Shields
Uneven and/or limited time payments
Discount all flows back to time 0
What r do you use? Certain the tax shield can be used: rD
Uncertain? Higher r
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Financial Distress
As leverage increases, the probability therefore PV of financial distress increases
)()( t istressCosFinancialDPV TaxShield PV V V U L
• How do we estimate the cost of distress?
– Probability(Distress)*Cost of Distress
• Probability can be estimated in several ways
– Logit / Probit regressions
– Debt ratings
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Financial Distress: Bankruptcy Costs
Direct Costs Legal, accounting and other professional fees
Re-organization losses
Estimated btw 4-10% of firm value (t-3)
Indirect Costs Reputation costs
Market share
Operating losses Estimated as 7.8% of firm value (t-2)
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Financial Distress: Agency Costs
Risk shifting and asset substitution Shareholders invest in high risk projects and
shift risk to the debt holders
Shareholders issue more debt, diminishing olddebt holders protection
Underinvestment
Expropriating funds
Difficult to estimate
Oth Ad t f D bt
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Other Advantages of Debt
Agency cost of Equity (motive) Shirking is less likely when issuing debt
Perquisites are less likely with debt
Over-investment is less likely with debt
Agency cost of Free Cash Flow (opportunity) Retained earnings versus dividends?
Growth and investment opportunities
Debt serves as a monitoring device, decreasingmanagerial discretion
Bankruptcy as a strategic move???
F l M d l f C it l St t
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Formal Models of Capital Structure Pecking Order
Firms prefer to raise capital Internally generated funds
Debt
Equity Implies capital structure is derived from Financing needs and capital availability
Dynamic rather than static
Asymmetric information and signaling Static Trade Off
I li ti f St ti T d Off
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Implications of Static Trade Off Static rather than dynamic
Taxes and Contracting Cost drive value
Readjustment may be sticky
Optimal trade off between cost of issuances and benefit
of capital structure Insights
Large, stable profit firms will have more debt
Higher the costs of distress lower debt
Lower taxes, lower debt
Less (more) favorable tax treatment of debt (equity),lower debt
E id T
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Evidence: Taxes
This method usually overestimates the taxconsequence
Magnitude of leverage differences acrosscountries and tax regimes is not that big
Equity taxes (personal taxes) are overestimated(Miller)
Timing of capital gains
Higher effective marginal tax rate, higher theleverage (Graham, 2001)
Evidence
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Evidence Contracting Costs: Consistent evidence
Higher (lower) the growth opportunities, higher (lower) thepotential underinvestment problem, lower (higher) theleverage
Higher growth opportunities would prefer Shorter maturity debt (or call provisions)
Less restrictive covenants More convertibility provisions
More concentrated investors (private)
Information costs
Consistent with market timing (SEO’s lead to -3% return) Inconsistent with signaling and pecking order
Taxes: Higher effective marginal tax rate, higher theleverage
MM: Proposition II
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MM: Proposition II
How does leverage affect rE
Start with the WACC
Solve for rE
The rate of return on the equity of a firmincreases in proportion to the debt to equityratio (D/E).
D E ar
V
Dr
V
E r
)( Daa E r r
E
Dr r
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MM: Proposition II (with taxes)
Dc E ar
V
Dr
V
E r )1(
))(1( Daca E r r E
Dr r
Wh Ab Fi i l Fl ibili ?
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What About Financial Flexibility? The ability to quickly change the level and type of
financing
Value increasing if Growth opportunities exist
Company is willing to exercise and extinguish futureflexibility
New investments are unpredictable and large
Precautionary debt ratings cushion is valuable
Value destroying if the opposite is true
What do we do?
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What do we do? Choosing a target capital structure
Minimize taxes and contracting costs (while payingattention to information costs)
Target ratio should reflect the company’s Expected investment requirements
Level and stability of cash flows
Tax status
Expected cost of financial distress
Value of financial flexibility
Dynamic management Financing is typically a lumpy process
Find optimal point where cost of adjusting capital structurei l f d i i f