Principles of Corporate Finance Chapter 19. How much should a firm borrow? Ciclo Profissional 2 o Semestre / 2009 Graduacão em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 1 / 70
Topics covered 1 Costs of financial distress 2 Description of financial distress costs 3 Can cost of debt be reduced? 4 Integration of tax effects and financial distress costs 5 Signaling 6 Agency cost of equity 7 The pecking-order theory 8 Growth and the debt-equity ratio 9 Personal taxes 10 How firms establish capital structure V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 2 / 70
Costs of financial distress Debt provides tax benefits to the firm However, debt puts pressure on the firm Stockholders are not legally entitled to dividends Interest and principal payments are obligations If these obligations are not met, the firm may risk some sort of financial distress the ultimate distress is bankruptcy Bankruptcy corresponds to the situation where ownership of the firm s assets is legally transferred from the stockholders to the bondholders Financial distress costs tend to offset the advantages to debt V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 3 / 70
Costs of financial distress: An example The Knight Corporation plans to be in business for one more year It forecasts a cash flow of either $100 or $50 in the coming year, each occurring with 50% probability The firm has no other asset Previously issued debt requires payments of $49 of interest and principal The Day Corporation has identical cash flow prospects but has $60 of interest and principal obligations V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 4 / 70
Costs of financial distress: An example Day Corp. in recession: bondholders cannot be satisfied in full If bankruptcy occurs Bondholders will receive all of the firm s cash Stockholders will receive nothing and don t have to come up with the additional $10: limited liability V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 5 / 70
Costs of financial distress: An example We assume that Both bondholders and stockholders are risk-neutral The interest rate is 10% Due to risk-neutrality, cash flows of bondholders and stockholders are discounted at 10% For Knight we have The value of equity The value of debt The value of the firm S knight = $23.64 = $51 1 2 + $1 1 2 1.10 B knight = $44.54 = $49 1.10 V knight = $68.18 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 6 / 70
Costs of financial distress: An example For Day we have The value of equity S day = $18.18 = $40 1 2 + $0 1 2 1.10 The value of debt B day = $50 = $60 1 2 + $50 1 2 1.10 The value of the firm V day = $68.18 The two firms have the same value Bondholders of Day Corp. are valuing bonds with their eyes open Thought the promised payment of interest and principal is $60, bondholders only expect $50 in case of recession They required a higher return or yield $60 $50 1 = 20% V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 7 / 70
Costs of financial distress: An example Day s debt can be viewed as a junk bond because the probability of default is high Day s forecasted cash flows are not realistic because it ignores costs due to financial distress Bondholders are likely to hire lawyers to negotiate or even to sue the company The firm is likely to hire lawyers to defend itself Further costs will be incurred if the case gets to a bankruptcy court The fees are always paid before bondholders get paid Assume that bankruptcy costs total $15 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 8 / 70
Costs of financial distress: An example The value of Day Corp. is now $61.36, an amount below the $68.18 The possibility of bankruptcy has a negative effect on the value of the firm However, it is not the risk of bankruptcy itself that lowers value Rather it is the costs associated with bankruptcy that lower value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 9 / 70
Costs of financial distress: An example Bondholders are aware that they would receive little in a recession Therefore they pay a low price for the debt: in this case the promised return is $60 $43.18 1 = 39.0% Bondholders pay a fair price and stockholders bear the future bankruptcy costs Assume Day Corp. was originally all equity Stockholders want the firm to issue debt with a promised payment of $60 and use the proceeds to pay a dividend Without bankruptcy costs, bondholders would pay $50 to purchase debt and a dividend of $50 could be paid to the stockholders When bankruptcy costs exist, bondholders would only pay $43.18 for debt In that case, only a dividend of $43.18 could be paid to the stockholders V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 10 / 70
Description of financial distress costs 1 Direct costs: legal and administrative costs of liquidation or reorganization 2 Indirect costs: impaired ability to conduct business 3 Agency costs V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 11 / 70
Direct costs: legal and administrative costs of liquidation or reorganization Lawyers are involved throughout all the stages before and during bankruptcy Fees are often in the hundreds of dollars an hour In addition, administrative and accounting fees can substantially add to the total bill If trial takes place, each side may hire a number of expert witness to testify about the fairness of a proposed settlement V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 12 / 70
Direct costs: legal and administrative costs of liquidation or reorganization While large in absolute amount, bankruptcy costs are actually small as a percentage of the firm value Empirical estimates: White, JoF (1983), Altman, JoF (1984) and Weiss, JFE (1990). About 3% of the market value of the firm Warner, JoF (1977). Direct financial distress costs of 20 railroad bankruptcies: on average 1% of the market value 7 years before bankruptcy and 2.5% of the market value of the firm 3 years before bankruptcy Example: the municipality of Orange County in California lost $1.69 billion in its financial portfolio and sank into bankruptcy The total costs amount to more than $29 million: Accountants: $325 an hour Lawyers: $385 an hour Financial advisors: $150,000 a month V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 13 / 70
Direct costs: legal and administrative costs of liquidation or reorganization Few firms end up in bankruptcy The preceding costs estimates must be multiplied by the probability of bankruptcy to yield the expected cost of bankruptcy Suppose, for example, that a given railroad picks a level of debt such that bankruptcy would occur on average once every 20 years the probability of going bankrupt is 5% in any given year Assume that when bankruptcy occurs, the firm would pay a lump sum penalty equal to 3% of its now current market value Then the firm s expected cost of bankruptcy is equal to 15/100 of one percent of its now current market value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 14 / 70
Indirect costs: impaired ability to conduct business Sales are frequently lost because of both fear of impaired service and loss of trust: In the 1970s, Chrysler skirted insolvency: many loyal customers switched to other manufacturers Gamblers avoided Atlantis casino in Atlantic City after it became technically insolvent Suppliers modify their behavior when a firm enters in financial distress: they require cash payment or simply cancel delivery These costs are difficult to measure Andrade and Kalman, JoF (1998): estimate total distress costs to be between 10% and 20% of firm value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 15 / 70
Agency costs When a firm has debt, conflicts of interest arise between stockholders and bondholders: stockholders are tempted to pursue selfish strategies These conflicts of interest are magnified when financial distress is incurred We identify three types of agency costs: 1 Incentive to take large risks 2 Incentive toward underinvestment 3 Milking the property V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 16 / 70
Agency costs: Incentive to take large risks Firms near bankruptcy oftentimes take great chances They believe that they are playing with someone else s money To see this Imagine a levered firm considering two mutually exclusive projects, a low-risk one and a high-risk one There are two equally likely outcomes: recession and boom The firm is in such dire straits that should a recession hit, it will come near to bankruptcy with one project and fall into bankruptcy with the other The firm has promised to pay bondholders $100 Bondholders have the prior claim on the payoffs, and the shareholders have the residual claim V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 17 / 70
Agency costs: Incentive to take large risks The cash flows for the entire firm if the low-risk project is taken is described by The expected value of the firm is $150 = $100 1 2 + $200 1 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 18 / 70
Agency costs: Incentive to take large risks Now suppose that another, riskier project can be substituted The expected value of the firm is $145 = $50 1 2 + $240 1 2 Thus, the low-risk project would be accepted if the firm were all equity V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 19 / 70
Agency costs: Incentive to take large risks However, The expected value of the stock is $70 = $0 1 2 + $140 1 2 for the high-risk project For the low-risk project it is only $50 = $0 1 2 + $100 1 2 Stockholders will select the high-risk project, even though the high-risk project has a lower NPV Stockholders expropriate value from the bondholders V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 20 / 70
Agency costs: Incentive toward underinvestment Stockholders of a firm with a significant probability of bankruptcy often find that new investment helps the bondholders at the stockholders expense Consider a firm with $4,000 of principal and interest payments due at the end of the year The firm will be pulled into bankruptcy by a recession because its cash flows will be only $2,400 in that state The firm could avoid bankruptcy in a recession by raising new equity to invest in a new project The project costs $1,000 and brings in $1,700 in either state: positive NPV Such project would be accepted in an all-equity firm V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 21 / 70
Agency costs: Incentive toward underinvestment The project hurts the stockholders of the levered firm To see this, imagine the old stockholders contribute the $1,000 themselves The expected value of the stockholders interest without the project is $500 = $1, 000 1 2 + $0 1 2 The expected value of the stockholders interest with the project is $1, 400 = $2, 700 1 2 + $100 1 2 The stockholders wealth rises by only $900 while costing $1,000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 22 / 70
Agency costs: Incentive toward underinvestment Stockholders contribute the full $1,000 investment But both stockholders and shareholders share the benefits The stockholders take the entire gain if boom times occur Conversely, the bondholders reap most of the cash flow from the project in a recession V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 23 / 70
Agency costs: leverage distorts investment policy For both agency costs: Incentive to take large risks Incentive toward underinvestment an investment policy (accept or not a project) for the levered firm is different from the one for the unlevered firm Leverage results in distorted investment policy Whereas the unlevered corporation always chooses projects with positive net present value, the levered firm may deviate from this policy V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 24 / 70
Agency costs: Milking the property Another strategy is to pay out extra dividends in times of financial distress Leaving less in the firm for the bondholders This is similar to the previous strategy of not raising new equity to invest in lucrative projects V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 25 / 70
Agency costs: summary Who pays for the cost of selfish investment strategies? Ultimately, it is the stockholders Rational bondholders know that, when financial distress is imminent, they cannot expect help from stockholders They know that stockholders are likely to choose investment strategies that reduce the value of bonds Bondholders protect themselves accordingly by raising the interest rate that they require on bonds Because stockholders must pay these high rates, they bear the costs of selfish strategies V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 26 / 70
Can costs of debt be reduced? Each of the costs of financial distress we mentioned above is substantial in its own right The sum of them may well affect debt financing severely Managers have an incentive to reduce these costs There exist several methods to below these costs but they cannot be entirely eliminated V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 27 / 70
Protective covenants Stockholders must pay higher interest rates as insurance against their own selfish strategies Therefore, they frequently make agreements with bondholders in hopes of lower rates These agreements are called protective covenants and are incorporated as part of the loan document (or indenture) A broken covenant can lead to default Protective covenants can be classified into two types: negative covenant positive covenant V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 28 / 70
Negative covenants A negative covenant limits or prohibits actions that the company may take Here are some typical negative covenants: 1 Limitations are placed on the amount of dividends a company may pay 2 The firm may not pledge any of its assets to other lenders 3 The firm may not merge with another firm 4 The firm may not sell or lease its major assets without approval by the lender 5 The firm may not issue additional long-term debt V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 29 / 70
Positive covenants A positive covenant specifies an action that the company agrees to take Here are two examples 1 The company agrees to maintain its working capital at a minimum level 2 The company must furnish periodic financial statements to the lender Some loan agreements may have more than 30 covenants V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 30 / 70
Protective covenants Smith and Warner, JFE (1979) examined public issues of debt: 91% of the bond indentures included covenants that restricted the issuance of additional debt 23% restricted dividends 39% restricted mergers 36% limited the sale of assets Protective covenants should reduce the costs of bankruptcy, ultimately increasing the value of the firm Thus, stockholders are likely to favor all reasonable covenants V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 31 / 70
Protective covenants Consider the following three choices by stockholders to reduce bankruptcy costs 1 Issue no debt: Because of the tax advantages to debt, this is a very costly way of avoiding conflicts 2 Issue debt with no restrictive and protective covenants: In this case, bondholders will demand high interest rates to compensate for the unprotected status of their debt 3 Write protective and restrictive covenants into the loan contracts: If the covenants are clearly written, the creditors may receive protection without large costs being imposed on the shareholders. The creditors will gladly accept a lower interest rate Bond covenants, even if they reduce flexibility, can increase the value of the firm They can be the lowest-cost solution to the stockholder-bondholder conflict V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 32 / 70
Consolidation of debt One reason bankruptcy costs are so high is that different creditors (and their lawyers) contend with each other This problem can be alleviated by proper arrangement of bondholders and stockholders: If one, or at most a few, lenders can shoulder the entire debt Bondholders can purchase stock as well In Japan, large banks generally take significant stock positions in the firms to which they lend money Debt-to-equity rations in Japan are far higher than those in the United States Legal limitations prevent this practice in the United States V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 33 / 70
Integration of tax effects and financial distress costs MM argue that the firm s value rises with leverage in the presence of corporate taxes This implies that all firms should choose maximum debt The theory (of MM) does not predict the behavior of firms in the real world We suggested that bankruptcy and related costs reduce the value of the levered firm V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 34 / 70
Integration of tax effects and financial distress costs One may combine the two aspects: The value of the firm rises linearly as the firm moves from all-equity to a small amount of debt This is because the present value of distress costs is minimal since the probability of distress is so small However, as more and more debt is added, the present value of these costs rises at an increasing rate At some point, the two following factors have offset 1 Increase in the present value of the distress costs from an additional dollar of debt 2 Increase in the present value of the tax shield This point is the optimal amount of debt After this point, bankruptcy costs increase faster than the tax shield, implying a reduction in firm value from further leverage V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 35 / 70
Integration of tax effects and financial distress costs V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 36 / 70
Integration of tax effects and financial distress costs The Weighted Average Cost of Capital (r wacc ) goes down as debt is added to the capital structure After reaching B the WACC goes up The optimal debt also produces the lowest weighted average cost of capital V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 37 / 70
The static trade-off theory Following our discussion, a firm s capital structure decisions involve a trade-off between the tax benefits of debt and the costs of financial distress This approach is frequently called the trade-off or static trade-off theory of capital structure The implication is that there is an optimum amount of debt for any individual firm This amount of debt becomes the firm s target debt level: in the real world of finance, this optimum is frequently referred to as the firm s debt capacity Because financial distress costs cannot be expressed in a precise way, no formula has yet been developed to determine a firm s optimal debt level exactly V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 38 / 70
Pie theory Taxes are just another claim on the cash flows of the firm Let G (for government and taxes) stand for the value of the firm s taxes Bankruptcy costs are also another claim on the cash flows Let us label their value with an L (for lawyers) The pie theory says that these claims are paid from only one source V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 39 / 70
Pie theory CF Cash Flows = Payments to stockholders + Payments to bondholders + Payments to the government + Payments to the lawyers + Payments to any and all other claimants to the cash flows of the firm V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 40 / 70
Pie theory Ignoring taxes and bankruptcy costs, we defined the value of the firm as E + D We should be broader in our definition of the firm s value V T E + D + G + L V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 41 / 70
Pie theory The essence of MM intuition and theory is: The value V T of the firm depends only on the total cash flow of the firm The capital structure cuts it into slices There is an important difference between claims Claims to stockholders and bondholders are marketed claims Claims to government or potential litigants in lawsuits are nonmarketed claims Marketed claims can be bought and sold on financial markets, while nonmarketed claims cannot V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 42 / 70
Pie theory V T = E }{{ + D } + G }{{ + L } V M V N According to the Pie theory, the value of the firm V T does not depend on the capital structure (how the pie is sliced) A rational financial manager (with correct incentives) will choose a capital structure to maximize the value V M of marketed claims to minimize the value V N of nonmarketed claims V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 43 / 70
Signaling We saw that the firm s capital structure is optimized where the marginal subsidy to debt the marginal cost of financial distress are equals What is the relationship between a company s profitability and its debt level? A firm with low anticipated profits will likely take on a low level of debt A small interest deduction is all that is needed to offset all of this firm s pretax profits Too much debt would raise the firm s expected distress costs A more successful firm would probably take on more debt The firm could use the extra interest to reduce taxes from its greater earnings Being more financially secure, this firm would find its extra debt increasing the risk of bankruptcy only slightly V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 44 / 70
Signaling Rational managers raise debt levels (and the interest payments) when profits are expected to increase Rational investors are likely to infer a higher firm value from a higher debt level Investors are likely to bid up a firm s stock price after the firm issued debt in order to buy back equity (or pay dividend) We say that investors view debt as a signal of firm value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 45 / 70
Signal A manager can fool investors by taking on some additional leverage Consider a firm whose level of debt is optimal the marginal tax benefit of debt exactly equals the marginal distress cost of debt The manager might want to increase the level of debt just to make investors think that the firm is more valuable than it really is If the strategy works, investors will push up the price of the stock What are the incentives of the manager to fool investors He may know that many of his stockholders want to sell their stock soon V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 46 / 70
Signal Imagine that a firm has issued extra debt just to fool the public At some point the market will learn that the company is not that valuable after all At this time, the stock price should actually fall below what it would have been had the debt never been increased Why? Because now every investor is aware that the debt level is now above the optimal level If current stockholders plan to sell half of their shares now retain the other half to sell later on An increase in debt above the optimal level will help them on immediate sales but likely hurt them on later ones V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 47 / 70
Signal In a world where managers do not attempt to fool investors, valuable firms issue more debt than less valuable ones Even when managers attempt to fool investors, the more valuable firms will want to issue more debt than the less valuable firms The costs of extra debt prevents the less valuable firms from issuing more debt than the more valuable firms issue Investors can still view an announcement of debt as a positive sign for the firm V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 48 / 70
Signal Empirical evidences validate the signaling theory We take evidence from Exchange offers There are two types of exchange offers The first type of offer allows stockholders to exchange some of their stock for debt, increasing leverage The second type of offer allows bondholders to exchange some of their debt for stock, decreasing leverage V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 49 / 70
Signal The market infers from an increase in debt that the firm is better off, leading to a stock price rise The market infers the reverse from a decrease in debt, implying a stock-price fall V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 50 / 70
Agency cost of equity An individual will work harder for a firm if he is one of its owner than if he is just an employee The individual will work harder if he owns a large percentage of the company than if he owns a small percentage This idea has an important implication for capital structure that we illustrate by the following example Mr. Pagel is an owner-entrepreneur running a computer-services firm worth $1 million He currently owns 100% of the firm To expand he must raise another $2 million V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 51 / 70
Agency cost of equity Mr. Pagel can either issue $2 million of debt at 12% interest, or issue $2 million in stock Mr. Pagel can choose the degree of intensity with which he works 6-hour days leading to $300,000 of earnings 10-hour days leading to $400,000 of earnings V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 52 / 70
Agency cost of equity With the debt issue, the extra work brings him $100,000 more income With the stock issue, the extra work brings him merely $33,333 more income Mr. Pagel is likely to work harder if he issues debt, in other words, he has more incentives to shirk if he issues equity In addition, he is likely to obtain more perquisites a big office, a company car, more expense-account meals if he issues stock. If he is a 1/3 stockholder, 2/3 of these costs are paid by the other stockholders V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 53 / 70
Agency cost of equity If he issues stocks, Mr. Pagel is more likely to take on capital-budgeting projects with negative NPV It may be surprising since Mr. Pagel has an equity interest and the stock price would fall in that case However, managerial salaries generally rise with firm size Managers have incentives to accept some unprofitable projects after all the profitable ones have been taken on The loss of stock value to a manager with only a small equity interest may be less than the increase in salary As the firm issues more equity, the manager will likely 1 increase leisure time 2 increase work-related perquisites 3 increase unprofitable investments V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 54 / 70
Agency cost of equity This example is applicable to a small company considering a large stock offering The manager-owner will greatly dilute his share in the total equity However, the example may be less applicable for a large corporation with many stockholders Consider a large company like General Motors going public for the umpteenth time The typical manager there already has such a small percentage stake that any temptation for negligence has probably been experienced before An additional offering cannot be expected to increase this temptation Who bears the burden of these agency costs? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 55 / 70
Agency cost of equity If the new stockholders invest with their eyes open, they do not Knowing that the manager may work shorter hours, they will pay a low price for the stock Thus, it is the owner-manager who is hurt by agency costs The owner-manager can protect himself to some extent The owner may allow monitoring by new stockholders Proper reporting and surveillance may reduce the agency costs of equity but these techniques are unlikely to eliminate them V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 56 / 70
Effect of agency costs of equity on debt-equity financing We can now extend the static trade-off model by including the agency costs of equity Now Change in value of the firm = The tax shied on debt + The reduction in the agency costs of equity The increase in the costs of financial distress (including agency costs of debt) Because costs of financial distress are so significant, the costs of equity do not imply 100% debt financing V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 57 / 70
Free cash flow We identified motives for a wasteful behavior of the manager: Managers with a small ownership interest bear only a small portion of the costs of perks and reap all the benefits We propose to analyze the opportunity We might expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to generate only small flows: this is the free cash flow hypothesis Since dividends leave the firm, they reduce free cash flow Therefore, an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities Interest and principal also leave the firm: debt reduces free cash flow as well V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 58 / 70
Free cash flow Interest and principal should have a greater effect than dividends have on free-spending ways of managers This is because bankruptcy will occur if the firm is unable to make future debt payments By contrast, a future dividend reduction will cause fewer problems to the managers In conclusion, the free cash flow hypothesis argues that a shift from equity to debt will boost firm value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 59 / 70
The pecking-order theory The trade-off theory has dominated corporate finance circles for a long time Now, attention is also being paid to the pecking-order theory Consider the attitude of a financial whose firm needs new capital The manager faces a choice between issuing debt and issuing equity The trade-off theory claims that the choice is evaluated in terms of 1 tax benefits 2 distress costs 3 agency costs There is one consideration that we have so far neglected: timing V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 60 / 70
The pecking-order theory A manager may want to issue stock in one situation only when it is overvalued If the stock of the firm is selling at $50 per share But the manager think it is actually worth $60 The manager will not issue stock: current stockholders would be upset Indeed, the firm would be receiving $50 in cash, but giving away something worth $60 If the manager believes the stock is undervalued, he would issue bonds Bonds, particularly those with little or no risk of default, are likely to be priced correctly V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 61 / 70
The pecking-order theory Suppose that the stock of the firm is selling at $70 The manager would like to issue stock If he can get some fool to buy stocks for $70 while is really only worth $60 Then the manager (or the firm) will be making $10 for the current shareholders In this example the firm makes immediately $10 by properly timing the issuance of equity $10 worth of agency costs and bankruptcy cost reduction might take many years to realize V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 62 / 70
The pecking-order theory The key assumption of the timing is asymmetric information The manager must know more about his firm s prospects than does the typical investor This assumption is quite plausible Managers should know more about their company than do outsiders, because they work at the company every day However, some managers are perpetually optimistic about their firm, blurring good judgement V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 63 / 70
The pecking-order theory Investors watch what the managers do if a firm issues stock, investors may infer that the firm wa likely overvalued If a firm issues debt, investors may infer that the firm was likely undervalued There is a poker game between managers and investors When the stock is undervalued, the firm should issue debt Actually even if the firm is overvalued, it should issue debt If a firm issues equity, investors will infer that the stock is overvalued They will not buy it until the stock has fallen enough to eliminate any advantage from equity issuance Only the most overvalued firms have any incentive to issue equity V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 64 / 70
The pecking-order theory This theory seems to rule out any issue of equity Asymmetric information is not always important and there are other forces at work If the firm has already borrowed heavily, and would risk financial distress by borrowing more Then it would have a good reason to issue common stock The announcement would still depress the stock price since it would highlight the manager s concerns about financial distress But the fall in price would not necessarily make the issue infeasible High-tech, high-growth companies can also be credible issuers of stock Such companies assets are mostly intangible, and bankruptcy or financial distress would be especially costly V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 65 / 70
Rules of the pecking order 1 Use internal financing 2 Issue safe securities first V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 66 / 70
Use internal financing We have oversimplified by assuming that debt was riskless and fairly priced In reality, corporate debt has the possibility of default Managers may have tendency to issue debt when they think it is overvalued The public may think that the firm s prospects are rosy, but the manager sees trouble ahead The public see the debt as nearly risk-free, whereas the manager see a strong possibility of default The manager will view the firm s debt as being overvalued Investors are likely to price a debt issue with the same skepticism that they have when pricing an equity issue Investors can preclude this by financing projects out of retained earnings V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 67 / 70
Issue safe securities first Investors fear mispricing of both debt and equity The fear is much greater for equity If financial distress is avoided, investors receive a fixed return for debt The pecking-order theory implies that, if outside financing is required, debt should be issued before equity There are many types of debt Convertible debt is more risky than straight debt The pecking-order theory implies that the manager should issue straight debt before issuing convertibles V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 68 / 70
Implications There is no target amount of leverage Each firm chooses its leverage ratio based on financing needs This contrasts with the trade-off theory Profitable firms use less debt Profitable firms generate cash internally, implying less need for outside financing The trade-off model does not have this implication The greater cash flow of more profitable firms creates greater debt capacity These firms will use debt capacity to capture the tax shield benefit Two recent papers find that in the real world, more profitable firms are less levered, a result consistent with the pecking-order theory: Sunder and Myers, JFE (1999) and Fama and French, RFS (2002) V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 69 / 70
Implications Companies like financial slack The pecking-order theory is based on the difficulties of obtaining financing at a reasonable cost A skeptical investing public thinks a stock is overvalued if the managers try to issue more of it, therefore leading to a stock-price decline This happens with bonds only to a lesser extent: however firms can only issue debt before encountering the potential costs of financial distress Because firms know that they will have to fund profitable projects at various times in the future They accumulate cash today and they are not forced to go to the capital markets when a project comes up There is a limit to the amount of cash a firm will want to accumulate Too much cash free may tempt managers to pursue wasteful activities V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance November, 2009 70 / 70