Capital Structure. Finance 100

Transcription

1 Capital Structure Finance 100 Prof. Michael R. Roberts 1 Topic Overview Capital structure in perfect capital markets» M&M I and II Capital structure with imperfect capital markets» Taxes Optimal Capital Structure» Bankruptcy costs Optimal Capital Structure» Agency costs (benefits) APV» Asymmetric information APV 2 1 1

2 The Intuition Behind M&M Buy a house today for $100,000 and sell one year later Assume mortgage rate is 10% House Price Size of Mortgage Prob Change 0% 50% 90% 1/3-10% -10% -30% -190% 1/3 10% 10% 10% 10% 1/3 45% 45% 80% 360% Avg. 15% 15% 20% 60% SD 23% 23% 45% 227% E.g., [145,000 (50, ,000)]/50,000-1 = 80% (New Price) (What we owe) (What we paid) 3 Questions Does the value of the house depend on the size of the mortgage? What does change with the size of the mortgage? 4 2 2

3 Financing Investment Example All equity firm considers a project:» Invest $800 today, date 0» Payoff next period, date 1: $1400 if strong economy w.p. 50% $900 if weak economy w.p. 50%» Risk-Free Rate (R f ) = 5%» Project Risk Premium (R p -R f ) = 10% Date 0 Date 1 Strong Economy Weak Economy Debt (D) Equity (E)? Firm All Equity Financing Example (Cont.) What is the project NPV? How much equity can we raise? What are the entrepreneur s profits? What are returns to shareholders (in both states and expectation)? 6 3 3

4 Debt and Equity Financing Example (Cont.) Now suppose borrow $500, in addition to selling equity» Note: Project Cash Flows > Debt Owed in each state? Payoffs to Debt and Equity Date 0 Date 1 Strong Economy Weak Economy Debt (D) Equity (E)? Firm M&M I Value of firm is independent of capital structure in perfect capital markets E = 500» Cash flows of D and E sum to Project cash flows D and E must sum to value of firm (Law of One Price)» M&M I says that V = D + E, regardless of what D and E are! 7 Effect of Leverage on Risk and Return Example (Cont.) Why isn t the value of equity 1 ( ) = Look at the returns to shareholders now Date 0 Date 1 Returns Strong Economy Weak Economy Strong Economy Weak Economy Expected Return Debt (D) % 5% 5% Equity (E) % -25% 25% Firm % -10% 15% Levered equity carries a higher risk premium than unlevered equity r E 15% anymore Levered equity = higher risk = higher return (25%)» This is not due to default risk! (Debt is risk-free)» Project risk is the same 15% 8 4 4

5 Homemade Leverage Replicating Levered Equity Imagine entrepreneur creates all-equity firm, but investor wants levered equity» Investor just needs to borrow to replicate cash flows to levered equity Date 0 Date 1 Strong Economy Weak Economy Unlevered E Margin Loan Levered Equity Loan is risk-free (R f = 5%) since cash flows on equity serve as collateral We just replicated the payoffs to the levered equity & law of one price value of levered equity = $500 9 Homemade Leverage Replicating Unlevered Equity Imagine entrepreneur creates levered firm, but investor wants unlevered equity» Investor just has to buy both debt and equity in the firm Date 0 Date 1 Strong Economy Weak Economy Debt Levered Equity Levered Equity We just replicated the payoffs to the unlevered equity & law of one price value of unlevered equity = $1000 ** With perfect capital markets, different capital structures don t benefit investors don t affect firm value

6 M&M I: Synopsis In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure» Value of Firm (V) = Value of Debt (D) + Value of Equity (E) (No matter what D and E are since investors can undo anything the firm does with perfect capital markets, so capital structure doesn t matter.)» Only thing that matters for value (size of the pie) is the PV of the cash flows doesn t matter how you divide them up (slice the pie) Debt Equity Equity Equity Debt 11 The Cost of Capital Recall (from the last slide!) M&M I implies: V l = E + D = V u ( = V a )» All values are market as opposed to book or accounting» V l =V u comes from homemade leverage Return on a portfolio equals weighted average of returns to the securities in the portfolio: E D RE + RD = RU = RA E+ D E+ D But this implies: R = R + D ( R R ) E U U D E Risk without leverage Additional risk due to leverage

7 M&M II Leverage, Risk, and the Cost of Capital M&M Proposition II says:» The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio re = ra + D ( ra rd) E The WACC, E D rwacc = ra = re + rd = ru E + D E+ D is a constant function of leverage in perfect capital markets because as D/E changes, r E changes to compensate» For really high leverage, r D will change as well (r D =r A in limit) 13 WACC & Leverage in Perfect Capital Markets V U =1000; r A = 15%; r D =5% Shape of r E and r D dictated by response of cash flows to leverage

8 Reducing Leverage and the Cost of Capital Example El Paso s initial WACC =? After the Debt for Equity Swap:» What is the WACC (r A )?» What is the firms leverage ratio (D/D+E) =?» What is r E =? 15 Levered and Unlevered Betas Everything we did with returns (r D, r E, r A ), we can do with betas (β D, β E, β A ): β E D WACC = β A = E D U E D β + E D β = + + β D β E = βa + βa βd E ( ) Unlevering beta refers to the process of removing the effects of financial leverage from β E to obtain a beta that captures only asset risk, β A

9 Levered and Unlevered Betas Examples from the Airline Industry 17 Leverage and EPS A fallacy:» Leverage can increase stock prices via its affect on EPS» Rationale: Leverage leads to higher earnings per share, which in turn lead to higher stock prices» Error: Ignores the impact of leverage on risk Example: Levitron Industries (LVI)» Currently: All equity with 10mil shares with $7.50/share Next year: EBIT = $10mil» Considering: borrowing 8% and use proceeds to repurchase 2mil $7.50/share» What are the consequences of this transaction assuming perfect capital markets?

10 Implications of Leverage for EPS Example (Cont.) Initial EPS:» LVI s earnings (EBIT) =?» LVI has no debt?» Perfect markets?» Initial EPS =? EPS after debt issuance & share repurchase:» Creates Annual Interest Payments =?» Earnings after interest =?» Share Repurchase: # of shares after repurchase =?? EPS after debt issue & repurchase = 19 Leverage and EPS: A Closer Look Example (Cont.) M&M tells us that there can be no benefit so something must give...? Imagine that EBIT was only $4mil (instead of $10mil)» Before debt issuance EPS =?» After debt issuance and share repurchase EPS =?

11 Leverage and EPS: A Picture Average EPS is higher for levered firm Risk is higher (steeper line) for levered firm 21 Leverage and Stock Price Example (Cont.) Assume:» LVI s EBIT is constant in the future (10mil)» All earnings are paid out in dividends» If we increase EPS, what will happen to the share price? Unlevered:» Recall: Earnings = $10mil & Shares = 10mil EPS = $1» Dividends/Share (DPS) =?» Value the company as a perpetuity to get the WACC Recall: Price/Share = $7.50 =? Market Cap =?

12 Leverage and Stock Price (Cont.) Example (Cont.) Levered:» Recall: Issue $15mil debt to repo $15mil of $7.50/shr buyback $15mil/$7.50/shr = 2mil shr 10mil 2mil = 8mil shares remaining after buyback» M&M I New Market Cap =? New D/E ratio =?» M&M II: New r E =?» Earnings Interest =? New EPS =?» New Share Price = Intuition:? 23 Equity Issuances and According to CFOs in the US, what is the most important consideration when issuing equity? Fallacy:» Issuing equity will dilute existing shareholders ownership» Rationale: more shares mean the firm must be divided among a larger # of shares, thereby reducing the value of each individual share» Error: Ignores the fact that cash raised by issuance increases the firm s assets. Example: Jet Sky Airlines (JSA)» Currently: No debt 500mil shares $16/shr Market cap = $8bil» Considering: Expanding operations by buying $1bil new planes with new current price $16/share» What are the implications for the stock price?

13 Effect of Equity Issuances on Stock Prices The firm issues 62.5mil new $16/share to get $1bil Firm grows by $1bil, which offsets increase in shares Any gain or loss from issuance comes from project NPV Key assumption:» Sell the shares at a fair price! 25 Capital Structure in Perfect Capital Markets Summing it Up Conservation of Value Principle for Financial Markets» With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return). This implies that any financial transaction that appears to be a good deal may be exploiting some type of market imperfection. M&M I: V = E + D» Value of the firm is just the sum of E & D, regardless of what they are M&M II: r E = r A + D/E(r A -r D )» Leverage increases risk of equity (not value according to M&M I)

14 What are Perfect Capital Markets What are the assumptions behind M&M? That is, when are the M&M propositions true? 1. no taxes, 2. no bankruptcy costs, 3. no agency costs/benefits, 4. no information asymmetry, and 5. no transaction costs What What s the point of this?» If financial policy is to matter, it must be that it mitigates (or takes advantage of) one or more of these frictions» Devise financial strategies around minimizing (maximizing) the adverse (beneficial) effects of these frictions 27 Debt and Taxes Corporations pay taxes on their profits after interest payments are deducted interest expense reduces taxes Example: Safeway, Inc.: Safeway s 2005 net income is lower with leverage than without and

15 Debt and Taxes (Cont.) equity is lower with leverage than without But, Safeway has greater value with leverage! What s going on?» With leverage, Safeway is worth an additional $140mil» This difference is just the value of the interest tax shield Interest Tax Shield = Corporate Tax Rate Interest Payments = 35% $400 mil = $140mil 29 Interest Tax Shield The interest tax shield is:» Corporate Tax Rate x Interest Payments What is the benefit for firm value?» Present value of the interest tax shield! In a perfect market, we had: V L = V U. M&M I with Taxes:» V L = V U + PV(Interest Tax Shield). To get at PV(Interest Tax Shield) we need:» Forecast of firm s debt forecast of interest payments» With forecasted interested payments interest tax shield» Discount the interest tax shield at the appropriate risk-adjusted rate

16 Present Value of Interest Tax Shield Example Annual Interest tax shield =? PV(Interest Tax Shield) = (Hint: The stream of interest tax shields looks like an? 31 Permanent Debt In practice, future tax savings is uncertain:» Debt usage, interest rates, default risk, and marginal tax rates will vary A special case:» Keep debt amount constant forever Perpetuity or roll over short term debt indefinitely» Then ( r D) τ C Interest τ C D PV(Interest Tax Shield) = = = τ C D r r» Implication: For every $1 of debt issues, firm value τ C D D

17 Leverage Recapitalization Revisited Example Midco Industries:» Currently: 20mil shares $15/share Stable earnings 35% tax rate»plan: Borrow $100mil (on permanent basis) Use proceeds to repurchase shares What happens after the share repurchase? 33 Leverage Recapitalization Revisited Example (Cont.) Before Recap:»V A = V U = E =? After Recap:» PV(interest tax shield) = τ C D =?»V L = V U + τ C D =?»E = V L D =?

18 Leverage Recapitalization Revisited Example (Cont.) Assume Midco repurchases current price $15/share» Repurchase $100mil $15/share = 6.67mil shares After repurchase» New # of shares outstanding =?» New share price after repo =?» Shareholders that keep their shares gain? Total gain =? 35 Leverage Recapitalization Revisited A Problem Why would anyone tender their shares for $15 if they know that after the recap their shares will be worth $17.63?» I would buy $15 before the repo, and then sell after the $17.63 for an arbitrage profit? It is precisely this arbitrage activity that will drive up the price before the recap!» The announcement of the recap will drive up the stock price to incorporate the PV (interest tax shield) ex ante» So Midco s equity will rise from $300mil to $335mil before the repo» Price per share will increase to $335mil / 20mil = $16.75» Tax shield surplus will be split evenly between those who tender their shares and those who keep their shares Original shareholders capture all of the surplus: $1.75 x 20mil = $35mil

19 The WACC with Taxes Tax deductibility of interest effectively lowers the cost of debt, r D, to r D (1-τ C ) Example:» Firm with 35% MTR borrower 10% pa» Interest expense = r D x $100,000 = $10,000» Tax savings = - τ C x r D x $100,000 = -$3,500» After-tax cost of debt = r D (1-τ C ) x $100,000 = $6,500 WACC with taxes: ra = E re + D rd( 1 τ C) = E r D D E + rd rdτ C E+ D E+ D E+ D E+ D E+ D Pre-tax WACC Reduction due to Interest Tax Shield 37 The WACC with and Without Corporate Taxes

20 Personal Taxes Double taxation of equity income:» Cash flows to firm taxed at τ C and then again at the personal rate τ P when distributed to investors Debt holders pay taxes on interest payments (as ordinary income) Equity holders pay taxes on dividends and capital gains The amount of money an investor will pay for a security depends on the cash flows the investor will receive after all taxes have been paid. Personal taxes reduce the cash flows to investors and can offset some of the corporate tax benefits of leverage. The actual interest tax shield depends on both corporate and personal taxes that are paid.» To determine the true tax benefit of leverage, the combined effect of both corporate and personal taxes needs to be evaluated. 39 Top Federal Tax Rates in the US

21 After-Tax Investor Cash Flows Resulting from $1 of EBIT 41 Including Personal Taxes in the Interest Tax Shield Every $1 received after taxes by debt holders from interest payments costs equity holders $(1-τ*) on an after tax basis After-Tax Cash Flows Using 2005 Tax Rates To Debt Holders To Equity Holders (1-τ I ) (1-τ C )(1-τ E ) (1-0.35)=0.65 (1-0.35)(1-0.15)= Equity holders get 15% less than debt holders after taxes (( )/0.5525) Effective tax advantage of debt: ( ) ( )( ) ( τ ) ( )( ) ( τ ) * 1 τ i 1 τc 1 τe 1 τc 1 τe τ = = i i

22 Value of Interest Tax Shield with Personal Taxes Value of levered firm (with personal taxes & permanent debt):» V L = V U +τ*d» Because of the personal tax disadvantage of debt, τ*< τ C» This means that the benefit of leverage is reduced! Personal taxes have a similar effect on the firm s weighted average cost of capital.» While we still compute the WACC as E D rwacc = re + rd (1 τ c) E + D E + D with personal taxes the firm s equity and debt costs of capital will adjust to compensate investors for their respective tax burdens. 43 Value of Interest Tax Shield Practical Considerations Practical Considerations» We assumed capital gains taxes are paid every year E.g., hold asset for 10 years with cap 15% and r f = 6% Effective tax rate for this year is (15%)/ =8.4% Accrued losses can also offset capital gains» We used an (equal-weighted) average of capital gains and dividend tax rates Reasonable for firms that pay 50% of earnings out in dividends (rest is buried in capital gains) Not reasonable for other payout ratios (need to reweight)» We assumed top marginal income tax rates for investors

23 So, Do Firms Prefer Debt? In aggregate, firms prefer debt to equity for external financing 45 Corporate Debt Usage Average Leverage Ratios

24 Average Debt to Value Ratios By Industry 47 Optimal Capital Structure with Taxes To receive the full tax benefits of debt, a firm need not use 100% debt financing!» Firms must first have taxable earnings

25 Optimal Capital Structure with Taxes (Cont.) With: 1. no leverage, the firm receives no tax benefit. 2. high leverage, the firm saves $350 in taxes. 3. excess leverage, the firm has a net operating loss and there is no increase in the tax savings. Because firm is not paying taxes, no immediate tax shield from the excess leverage (ignoring carry-back and carry-forward) No corp tax benefit from incurring interest payments that regularly exceed EBIT» Because interest payments constitute a tax disadvantage at the investor level, investors will pay higher personal taxes with excess leverage 49 Limits of Tax Benefit of Debt We can quantify the tax disadvantage for excess interest payments (Assuming there s no reduction in corporate tax for excess interest payments & investors will pay higher personal taxes with excess leverage): (1 τ e ) τe τi τ ex = 1 = < 0 (1 τi ) (1 τi ) This is < 0 because equity is taxed less heavily than interest for investors (τ e < τ i ) Optimal level of leverage from a tax perspective is such that interest equals EBIT» The firm shields all taxable income and no tax-disadvantaged excess interest

26 Limits of Tax Benefit of Debt Practical Considerations However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely.» If there is uncertainty regarding EBIT, then there is a risk that interest will exceed EBIT. As a result, the tax savings for high levels of interest falls, possibly reducing the optimal level of the interest payment. In general, as a firm s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt declines, limiting the amount of debt the firm should use. 51 Debt and Growth Growth will affect the optimal leverage ratio.» To avoid excess interest, a firm with positive earnings should have a level of debt such that interest payments are below its expected taxable earnings. Interest = r Debt EBIT or Debt EBIT / r D From a tax perspective, the firm s optimal level of debt is proportional to its current earnings. However, the value of the firm s equity will depend on the growth rate of earnings:» The higher the growth rate, the higher the value of equity The optimal proportion of debt in the firm s capital structure [D / (E + D)] will be lower, the higher the firm s growth rate. D

27 Other Tax Shields There are numerous provisions in the tax laws for deductions and tax credits:»r&d,» depreciation,» investment tax credits,» carry forwards of past operating losses, etc. To the extent that a firm has other tax shields, its taxable earnings will be reduced and it will rely less heavily on the interest tax shield. 53 Are Firms Underlevered? Interest as a % of EBIT for S&P500 Firms

28 Are Firms Underlevered? Notice:» Ratio of interest to EBIT is increasing consistent with the increase in the tax advantage of debt» Ratio of interest is far below 1, near which would be optimal according to our analysis What s missing? Why is leverage so low if there is such a big benefit to minimizing taxes?» One possibility =? 55 Capital Structure with Taxes Summing it Up Taxes generate a role for capital structure in shaping firm value Must consider all taxes:» Corporate» Personal Optimal debt shields all taxable income Firms appear very conservative if taxes are the only consideration There must be something more than just taxes

29 Financial Distress, Default, and Bankruptcy Financial Distress occurs when a firm has difficulty meeting its debt obligations Default» Technical Default is the violation of a covenant other than one requiring the payment of interest or principal» Payment Default is the violation of a covenant requiring the payment of interest or principal» Defaults entitle debt holders certain rights, typically the ability to accelerate all payments and terminate any unutilized commitments. Bankruptcy» Ch 11 Reorganization» Ch. 7 Liquidation Without debt, there is no risk of any of these events 57 Default in a Perfect Capital Market Armin Industries Armin is considering a new product:» if successful worth $150mil» if unsuccessful worth $80mil Two capital structure choices:» All equity financing» 1-year debt with face value of $100mil What are the consequences under these two scenarios?

30 Comparing the Two Scenarios Scenario 1: New Product Succeeds» Armin is worth $150mil No leverage E = $150 Leverage D = $100mil, E = $50mil» Note that even if Armin doesn t have the $100mil in cash at the end of the year, it can always roll over debt in perfect market 59 Comparing the Two Scenarios Scenario 2: New Product Fails» Armin is worth $80mil No leverage E = $80 (loss of $70mil) Leverage D = $80mil, E = 0 (loss of $20mil + $50mil = $70mil)» Loss is the same regardless of leverage Product failure leads to economic distress

31 Bankruptcy and Capital Structure in Perfect Capital Markets With perfect capital markets, M&M I applies:» The total value to all investors does not depend on the firm s capital structure. No disadvantage to debt financing. All of the firms cash flows are split among the claimants and no one else no value loss. 61 Bankruptcy Risk and Firm Value Example Without leverage:»e =?» Project risk is diversifiable discount with risk-free rate With leverage:»e =?»D =?

32 The Costs of Bankruptcy and Financial Distress Direct Costs» Legal, accounting, consultants, appraisers, auctioneers, investment bankers, workout experts, etc. grab pieces of the pie» Enron reorganization costs ~10% of assets, typically 3-4% of prebankruptcy assets Indirect Costs» Loss of customers suppliers Employees Receivables» Asset fire sales» Distinct from Economic Distress costs 63 Financial Distress and Firm Value Armin Industries Revisited Same setup as before but now assume:» Debt holders receive only $60mil if product fails due to financial distress costs Financial distress costs lower the value of the firm and M&M I no longer holds» Recall V U = $109.52mil (from before)» V L =?» Costs of financial distress =?

33 Who Pays for Financial Distress Costs? If new product fails, shareholders lose their investment but don t care about bankruptcy costs (limited liability) Debt holders know about loss of value in bankruptcy and therefore pay less for debt initially» The present value of the distress costs This means the firm receives less money from debt offering» This difference comes out of shareholders pockets (so they have incentive to minimize these costs!) 65 Financial Distress and the Stock Price Example Recall V U = $109.52mil Price/Shr =? Recall V L = $100mil Price/Shr =?» Share price declines in anticipation of this value loss after debt issuance After Repurchase:» D =?» # of shares repurchased =?» # of shares remaining after repo =?» E =?» Price per Share =?

34 Optimal Capital Structure The Tradeoff Theory Firms choose their capital structure by trading off the benefits of the tax shield against the costs of financial distress L U V = V + PV (Interest Tax Shield) PV (Financial Distress Costs) Two key factors determine costs of financial distress» Probability of entering distress» Magnitude of the costs after entering distress Helps explain why firms don t fully exploit interest tax shield (because of financial distress costs) 67 Optimal Capital Structure The Tradeoff Theory

35 Agency Costs Agency Costs are costs that arise when there are conflicts of interest between the firm s stakeholders Different claimants have different incentives, which can lead firms to undertake actions that hurt one groups to benefit another» Overinvestment and Asset Substitution» Underinvestment and Debt Overhang Agency costs are another cost of increasing leverage, just like bankruptcy costs 69 Asset Substitution or Overinvestment Baxter Inc. Owes $1mil due at end of year Without a change in strategy, assets will be worth only $0.9mil Baxter will default if they take no action Baxter s considering a new strategy:» No upfront investment» Success will increase firm s assets to $1.3mil w.p. 50%» Failure will decrease firm s assets to $0.3mil w.p. 50% This is a negative NPV project since expected value of firm s assets decline from $0.9mil to $0.8mil» Cash Flow from Strategy Success = $0.4mil» Cash Flow from Strategy Failure = -$0.6mil» E(Cash Flow from Strategy) = -$0.1mil But, does this mean Baxter won t undertake the investment?

36 Asset Substitution or Overinvestment Baxter Inc. (Cont.) Note:» Equityholders gain $0.150mil from investment (0 to $0.150mil)» Debtholders lose $0.250mil from investment ($0.900mil to $0.650mil)» Net gain (loss) in firm value of -$0.100mil = NPV of strategy = 0.5( ) + 0.5( ) = mi Equity holders have incentive to gamble with debt holder s money but debt holders will anticipate this and pay less ex ante 71 Debt Overhang and Underinvestment Baxter Inc. Owes $1mil at end of year but without a change in strategy, assets will be worth only $0.9mil default Considering alternative strategy:» Requires initial investment of $0.1mil» Generates risk-free return of 50%» Clearly a positive NPV investment Problem (?): Baxter doesn t have the cash on hand» Can they raise the money in the equity market?

37 Debt Overhang and Underinvestment Baxter Inc. (Cont.) If equity holders contribute $0.1mil, they only get back $0.05mil» $0.1mil goes to debt holders, whose payoff goes from $0.9mil to $1mil Even though project is positive NPV, equity holders won t undertake it because most of the benefit goes to debt holders Underinvestment or Debt Overhang 73 Agency Costs and the Value of Leverage Leverage can encourage managers and shareholders to act in ways that reduce firm value.» It appears that equity holders benefit at expense of debt holders.» But, ultimately the shareholders bear these agency costs. When a firm adds leverage to its capital structure, the decision has two effects on the share price.» The share price benefits from equity holders ability to exploit debt holders in times of distress.» But, debt holders recognize this possibility and pay less for the debt when it s issued reduces amount firm can distribute to shareholders. Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm

38 Agency Costs and the Amount of Leverage Example Scenario 1: Do nothing» Firm will be worth? E =? D =? Scenario 2: Risky strategy Assets Debt Equity Old Strategy New Risky Strategy Success Failure Expected » Equity worth only $0.45mil under risky strategy, $0.5mil under existing so shareholders will reject it 75 Agency Costs and the Amount of Leverage Example (Cont.) Scenario 3: Conservative strategy Existing Assets New Project Firm Value Debt Equity Without New Project With New Project » Shareholders value increase by $0.15mil for a $0.1mil investment so they re willing to invest in the project

39 Mitigating Agency Costs Shorter maturity debt can offset agency costs by limiting scope of expropriation Covenants can mitigate agency costs by forcing managers to commit not to expropriate debtholders 77 Agency Benefits of Leverage Managerial Entrenchment occurs from the separation of ownership and control in which managers make decisions to benefit themselves at the expense of investors Leverage can preserve ownership concentration and mitigate agency costs» Issuing debt can maintain the original shareholders stake, while issuing equity can dilute original shareholders incentives because any agency costs are shared with others Leverage can mitigate empire building tendencies arising from incentives to run large firms (e.g., salary structure, perquisites)» Leverage imposes discipline by pre-committing the cash flows and by creditor monitoring

40 Agency Costs and the Tradeoff Theory The value of the levered firm can now be shown to be L U V = V + PV (Interest Tax Shield) PV (Financial Distress Costs) PV (Agency Costs of Debt)+ PV (Agency Benefits of Debt) 79 Capital Structure and Asymmetric Information Asymmetric information refers to a situation where parties have different information» E.g., Managers often have better information relative to investors regarding their firm Leverage can act as a signal to investors to convey nonverifiable information» Issuing debt suggests that the firm really will grow since I ve pre-committed to pay back the debt» Or, I promise not to waste money on inefficient investment since I ve pre-committed to pay back the debt

41 Adverse Selection Adverse selection refers to the idea that with asymmetric information, the average quality of assets in the market will differ from the average overall quality Lemons principle: when seller has private information about the value of a good, buyers will discount the price they will pay because of adverse selection Think used cars:» The desire to sell the car suggest it sucks so buyers won t pay much» Owners of good cars don t want to sell because buyers will think they re selling a lemon and offer a low price» The quality and prices of cars sold in the used-care market are both low 81 Equity Issuance and Adverse Selection Same idea can be applied to equity markets» Firms that issue equity have private information about the quality of the future projects.» Lemon principle suggests that buyers are reluctant to believe management s assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.» Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity.» Only those managers who know their firms have poor prospects (and whose securities will have low value) are willing to sell new equity. The lemons principle implies:» The stock price declines on the announcement of an equity issue.» The stock price rises prior to the announcement of an equity issue.» Equity issues occur when information asymmetries are minimized (e.g., immediately after earnings announcements)

42 Stock Returns Around Equity Issuances 83 Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations

43 Summary Optimal capital structure depends on a variety of imperfections» Taxes» Financial distress» Agency costs» Asymmetric information We are currently figuring out why firms do what they do Next we can figure out what they should do