CHAPTER 2 LITERATURE REVIEW

CHAPTER 2 LITERATURE REVIEW

CHAPTER П REVIEW OF LITERATURE 2.1. Firm valuation models Some of the most important contributions to financial economics are models of the valuation of securities and their implications for corporate financing decisions developed under assumptions that characterize an ideal capital market (also called a perfect capital market). Researchers developed theoretical models of the valuation of financial assets. Each model has distinct characteristics based on distinct approaches to the problem of valuation, yet all have been developed under ideal capital market assumption. Remarkably, all of the models are discussed are jointly reconcilable. These valuation models have two important implications. (a) They provide explicit valuation models for a firm and its debt and equity securities; and (b) they specify the effects of the firm s choice of capital structure (i.e., mix of debt and equity financing) on the risk and required expected returns of its securities. The first and third models that is discussed, the Modigliani-Miller (1958) capital structure irrelevance theorems and Black-Scholes (1973) option pricing model, yield conditional specifications of the values, risk, and required expected returns on corporate securities based on arbitrage arguments. The second model, the capital asset pricing model (Sharpe 1964; Lintner 1965; Mossion 1966), provides general equilibrium specifications of the values, risk, and expected returns on assets based on jointly reconcilable, that are under specified conditions, the three models yield the same results with respect to the values, risk and expected returns on a levered firm s debt and equity securities. The reconcilability of these theoretical models constitutes an important unification theory as it relates to both valuation and corporate financing decisions under ideal market conditions. Defining an ideal capital market An ideal capital market is defined by a set of five assumptions. Assumption 1: capital markets are frictionless. Market participants face no transaction costs or taxes. Investors face no brokerage commissions or fees on 50

trades, and short selling is unrestricted. Firms face no transaction costs in issuing or retiring securities, and there are no costs associated with bankruptcy. Assumption 2: All market participants share homogenous expectation, valuerelevant information is costlessly available to all market participants, and all participants rationally process such information to determine the value of any security. Thus, all participants share common expectations about the prospects of investments. Assumption 3: All market participants are atomistic. No single market participant can affect the market price of a security via trades. Assumption 4: The firm s investment program is fixed and known. The firm s capital investment program, and therefore its assets, operations, and strategies, are fixed and known to all investors. Assumption 5: The firm s financing is fixed. Once chosen, the firm s capital structure is fixed. In establishing these assumptions, it is recognized that they may conflict with activities actually observed in the real world (i.e., in actual capital market). The purpose of studying theory under ideal capital is twofold. First, insights into the effects of a firm s decisions on the values and risk of its securities is gained (i.e. such decisions may yet have the predicted effects even if real-world conditions only approximate the ideal). Second, armed with an understanding of the effects of corporate financial decisions under ideal conditions, it is a better position to understand the incremental effects (where the increments may be large) of certain real-world factors (which constitute violations of one or more of the ideal capital market assumptions). Modigliani and Miller s Original propositions In 1958, Franco Modigliani and Merton Miller (henceforth, M&M) published a land mark paper in the American Economic Review: The cost of capital, corporation finance and the theory of investment. In this paper they defined the assumptions of an ideal capital market, and developed two important (and 51

controversial) propositions concerning the effects of corporate financing decisions on the values and risk of a firm s debt and equity securities. M&M Proposition I: the market value of a firm is constant regardless of the amount of leverage. (i.e., debt relative to equity) that the firm uses to finance its assets. Proposition I implies that firm s management cannot change the market value of the firm merely by altering its capital structure. This proposition is also referred to as the leverage Irrelevance Theorem or the capital structure Irrelevance theorem. M&M proposition II: the expected return on a firm s equity is an increasing function of the firm s leverage. As it will be observable, proposition II follows directly from proposition I. It is important because it shows that leverage does have effects_ specifically, on the risk and expected return of a firm s equity_ despite the conclusion from proposition I that leverage has no effect on the overall value of the firm. Analysis of M & M proposition I Market Value of a Firm The market value of a firm is, by definition, equal to the sum of the market values of all claims on its cash flows (i.e., all of the firm s outstanding securities). Consequently, the market value of an unlevered firm is defined as the total market value of the firm s equity shares. Whereas the market value of a levered firm is defined as the sum of the total market values of its debt and equity securities. In addition, because investors can derive value from holding the firm s securities only because the firm holds assets that have value and produce income, against which the security holders have a claim, we can interchangeably refer to the value of the firm or the value of the firm s assets. Thus, equation 2.1 and 2.2 can be stated in definition form: For an unlevered firm: V U E U (2.1) And 52

For a levered firm: V L D + E L (2.2) In equation 2.1, V U denotes the market value of (the assets of) an unlevered firm and E U denotes the total market value of its equity shares. In equation 2.2, V L denotes the market value of (the assets of) a levered firm, and D and E L denote the total market value of its debt and equity securities, respectively. Proof of M&M Proposition І via Arbitrage Argument Given definitional equation 2.1 and 2.2, M&M proposition І states that market value of a firm (defined by a fixed set of assets) is constant regardless of the amount of leverage it employs. Proposition І is expressed in equation 2.3, which holds that, for all possible levels of leverage V U = V L (2.3) Arbitrage is the basis for M&M proposition І. To explain the arbitrage involved, consider two scenarios in which equation 2.3 does not hold. In the first scenario, a firm s assets are currently financed entirely with equity that has a total market value of E U V U. But suppose the firm s assets could instead be financed with specified proportions of both debt and equity, and that the resulting market value of the levered version of the firm is V L D + E L, where V L > V U. Under these circumstances, any investor, acting as a arbitrageur, could simply (a) purchases the fraction α of the existing firm s equity at a cost of αv U, (b) place these equity shares in a trust, and then (c) sell securities that present debt and equity claims against the shares in a trust. The total proceeds that the investor would receive for these debt and equity claims would be α (D+E L ), or equivalently, αv L, given the inequality specified above the investor would realize an instant arbitrage profit of α(v L V U ). In the second scenario, the firm s assets are currently financed with specific proportions of both debt and equity such that the market value of the firm is V L D + E L. however, let us assume that V L < V U, where V U E U is the market value of the firm if it were instead financed entirely with equity. Under these circumstances, an arbitrageur could simply (a) purchase equal proportions, α, of the debt and equity of the firm at a cost of αv L = α(d +E L ); (b) place these securities in a trust; and (c) sell shares of a new security that represents equity ownership of the securities in the 53

trust. The arbitrageur can sell these shares at a total price of αv U > αv L, and thereby realize an instant arbitrage profit of α (V U - V L ). Note that, in either of these scenarios, all investors would attempt to perform the indicated arbitrage, and their collective trading activity would alter market values until any such arbitrage is eliminated. Analysis of M&M Proposition ІІ Modigliani and Miller s Proposition ІІ, which relies on the result of proposition І, states that the expected return on a firm s equity increases with the firm s leverage. To explain proposition ІІ, a firm s weighted average cost of capital, or WACC, is defined. A firm s WACC is a value-weighted average of the required expected returns on, or costs of, the firm s debt and equity denoted as r and r respectively. The formula for WACC is given in equation 2.4. WACC = r [ ] + r [ ] (2.4) A firm s WACC can be interpreted as the implicit discount rate used by the market on the firm s future cash flows to determine the value of the firm s assets under a specified capital structure. As such, a firm s WACC can be alternatively denoted as r, the required expected return on the firm s assets under a specified capital structure. Therefore, r can be substituted for WACC in equation 2.4, yielding equation 2.5. r = r [ ] + r [ ] (2.5) However, via proposition 1 the value of the firm s assets does not vary with change in the firm s capital structure. Therefore, proposition І implies that r must also be constant regardless of the firm s leverage. This is important because it implies that the expected return on the firm s assets (specifically the riskiness of the 54

assets) and not on the firm s capital structure. By extension, it implies that a firm s capital budgeting decisions (i.e., the firm s choice of projects to pursue) should be made by discounting the expected future cash flows of any proposed project (using a discount rate based on the riskiness of the project, regardless of how it will be financed and then comparing the present value of the expected future cash flows to the initial cost of the project. With this background, it can be now expressed proposition ІІ in equation form. Solving equation 2.5 for r yield equation 2.6: r = (r r ) (2.6) That is, the required expected return on a firm s equity is equal to the required expected return on the firm s assets, r, plus an adjustment that is the product of a measure of the firm s leverage ( ) and the difference between the required expected returns on the firm s assets and the firm s debt (r r ) So does equation 2.6 automatically imply that proposition ІІ is true? Two considerations can be combined to suggest that proposition ІІ is indeed correct. First, we know from proposition І that r is constant regardless of. Second assuming that the firm s assets are risky and investors require a premium on the expected returns on risky assets (including securities), then r will be greater than r, and thus (r r ) > 0. This will be so because the firm s earnings (i.e., they get paid first), and thus the risk they face is generally less than the risk of the firm s overall earnings. Therefore, if r is constant and (r r ) > 0 it appears that r will increase with. However, to address this question properly we must examine the behavior of the terms on the right side of equation 2.6 more closely. We can do this best by taking the derivative of r in equation 2.6 with respect to, recalling in doing so that r A is constant via proposition І. The result is given in equation 2.7 55

= (r r ) (2.7) In essence, proposition ІІ states that the derivative in equation 2.7 will be positive for all levels of leverage. However, whether r increases with depends on the values of the two expressions on the right side of equation 2.7. To assess the possible values of these expressions, it is needed more information about how the market determines the required expected returns on the firm s assets and its securities. Specifically, more information on r and r is needed. Suppose initially that investors are neutral with respect to the risk of the firm s assets that is they do not demand a premium for risk of the firm s assets. Then r = r where r is the return on a risk-free security such as a Government treasury bill. Furthermore, the risk of both the firm s debt and equity are strictly functions of the risk of the firm s debt and equity securities; therefore, r = r = r will hold as well, regardless of the firm s leverage. Note that, in this case, the values of r, r, and r are consistent with equation 2.6. However, the results are inconsistent with proposition ІІ because r does not vary with A more realistic assumption is that r contains a risk premium. In this case, the expected return on the firm s equity will also contain a risk premium, as will the firm s debt, if the debt is risky. But for the moment, it will be assumed that the firm s debt is risk-free for all possible values of. In this case r D will be equal to r. The derivative on the right side of equation 2.7 will be equal to zero, and r will be an increasing linear function of (r r ), as can be seen from either equation 2.6 or 2.7., with a slope coefficient of (r r ) = However, although debt may be virtually default-free for a few firm, this is not the case in general, a more general scenario is specified with assumption A and B. 56

Assumption A: Investors demand a premium for the risk of a firm s securities. Assumption B: The firm s debt is risky and its risk increases with the firm s leverage. It follows that (a) r must also increases with leverage; (b) the derivative term in brackets in the right side of equation 2.7 is positive; and thus (c) the entire expression ( ) [σ r / σ ( )] is positive therefore, it is not clear from inspection of equation 2.7 that σ r / σ ( ) is positive as proposition ІІ asserts, because the right side of equation 2.7 is the difference of two expressions, both of which are positive and the size of either of these expressions for any given level of leverage cannot be determined. In the end, the present model structure is insufficient to prove that proposition ІІ is true. It can be only argued that proposition ІІ has merit because equity holders, who have only a residual claim to the firm s assets, bear more risk than debt holders, who have a priority claim: therefore, r should be greater than r for any given level of leverage. Moreover, it seems likely that, when leverage increases in risk per dollar of investment than do debt holders, in which case r must increase at a faster rate with than does r D, in which case proposition ІІ will be true. However, to address the issue formally, greater specification of the nature of the firm s risk and that of its debt and equity securities, as well as the market s required compensation for risk in the form of an expected return premium are required. Fortunately, as it is visible, the Capital Assets Pricing Model and the Black- Scholes option pricing model combine to provide such specification (although, too, are only models). As a final comment on the M&M model structure, note that the firm s assets are fixed, so the total amount of firm risk is constant and must be born in its entirely the firm s claimants debt holders and equity holders for any level of leverage. By extension, a change in the firm s leverage simply involves a redistribution of the 57

firm s total risk among the claimants. If it is also assumed that the market provides compensation (in the form of expected return premium) that is linearly related to the risk borne by a given claimant, additional insight into the behavior of r and r as specific is gained. For instant, when it is assumed that r > r and that the firm s debt is riskfree for all levels of leverage (which implies that debtholders bear none of the firm s risk while equityholders bear all of the firm s risk), it was found that the expected return on the equity increases linearly with leverage-specifically, at the rate of r r per unit change in. However, when it is allowed to the risk of the firm s debt to be positive and to increase with leverage, the required expected return on the debt also increases with leverage (i.e., σ r / σ ( ) > 0 in equation 2.7); then it is found that the required expected return on the firm s equity increases at a slower rate with leverage, (r r ) ( ) [σ r / σ ( )] < (r r ). This is logical because debtholders are bearing an increasing share of the firm s risk as leverage increases. Capital Asset Pricing Model Modern Portfolio Theory (MPT) involves two basic constructs: the statistical effects of diversification on the expected return and risk of a portfolio; and the attitudes of investors toward risk; specifically, it is assumed that investors are averse to risk, but are sufficiently tolerant of risk to bear it if sufficient compensation (i.e., higher expected return), is provided. MPT assumes that investors are concerned only with the expected return and standard deviation of their overall portfolio. MPT addresses the task of identifying the portfolio that maximizes an investor s expected utility given the investor s willingness to trade-off risk and expected return. Statistics for a Portfolio of Two Securities To begin a brief review of the statistical effects of diversification on portfolio s expected return and risk, consider two securities, A and B. The expected returns on these securities are denoted as r and r, respectively, and their return 58

standard deviation are denoted as σ and σ, respectively. The correlation between the returns on securities A and B is denoted as ρ, where of course, 1 ρ 1. The expected return on a portfolio of securities A and B, denoted as r is: r = w r + w r (2.8) Where w and w are the portfolio weights, the proportions of the investor s wealth invested in securities A and B, respectively. (w + w = 1) The standard deviation of portfolio, denoted as σ, is σ = [w σ + w σ + 2w w σ σ ρ ] 1/2 (2.9) Statistics for an N-Security Portfolio For the general case in which the investor s portfolio contains N securities, r and σ are calculated using Equation 2.10 and 2.11, respectively. r = w r (2.10) σ = [ w w σ ] / (2.11) Where σij = σiσjρ if i j and σij = σi, if i = j. That is, if i j, σij is the covariance between returns on securities i and j, whereas if i = j, variance of security i is obtained. In the special case in which the investor places equal amounts of money into each of N securities, r and σ are calculated using Equation 2.12 and 2.13, respectively. 59

r = r (2.12) σ = [ σ + 1 σ ] / (2.13) Where σ is the average variance of the individual securities in the portfolio, and σ is the average of all pairwise covariances. Note that as N, the first term in brackets in Equation 2.13 approaches zero, while the second term converges to σ. It is in this sense that the variance of a well-diversified portfolio is determined entirely by covariances and not at all by the variances of the individual securities. The average covariance of a diversified portfolio is somewhat difficult to interpret, so the following alternative formula can be offered. In most practical circumstances, σ can be approximated by the product of the average of all pairwise correlations among the securities, denoted as ρ and σ ; that is σ ρ σ. Therefore, as N, σ ρ σ / (2.13a) Risk Aversion and the Investor s Optimal Portfolio in the Absence of a Risk- Free Security Many securities are available in Indian financial markets today with varying expected return, standard deviation and correlations with other securities. Moreover, a virtually infinite number of portfolios can be developed by varying the number of securities in the portfolio, the specific securities included, and the portfolio weights applied to each security. Among all portfolios of risky securities, the choices can be narrowed considerably by eliminating all portfolios that are dominated. A portfolio is dominated if another portfolio provides both a higher expected return and lower risk 60

(i.e., lower return standard deviation). In other words, a dominated security or portfolio is relatively inefficient in terms of providing compensation for risk. After eliminating all dominated portfolios, only efficient portfolios are remained, which it is represented in Figure 2 in Appendix A, a continuous, concave curve in r σ space known as the efficient frontier. The figure also shows indifference curves and optimal portfolios for two investors; Mr. Moreaverse and Mr. Lessaverse, whose respective tolerances for risk are indicated by their names. Market Equilibrium: The Capital Market Line (CML) In the equilibrium derived in the CAPM, investors collectively hold all risky securities, and all individual investors hold the same portfolio of risky securities, and all individual investors hold the same portfolio of risky securities. In this market portfolio, denoted as M, the portfolio weight for each risky security is equal to the ratio of the total market value of the security to the total market value of all risky securities. As in the (nonequilibrium) depiction of portfolio choice shown in 3 in Appendix A, each and every investor chooses a complete portfolio, C, consisting of weighted investments in the risk-free security and the market portfolio that is consistent with their risk tolerance. Therefore, the choices available to investors create a line in r σ space that is formed by the points representing the risk-free security and M. this line is called the capital market line, or CML: r = r + (r r ) (2.14) The Security Market Line The CAPM also specifies the market equilibrium expected return on any individual security as a function of its relative contribution to the risk of the market portfolio. For any security, r is a function of the security s beta, denoted as β and defined in equation 2.15: β = (2.15) 61

Where σ is the covariance of returns on security i and the market portfolio, and σ is the variance of returns on the market portfolio. Formally, the relationship between the equilibrium expected return on any asset i, r and β is given in equation 2.16: r = r + β (r r ) (2.16) The Binomial Pricing Model The Binomial Pricing Model is a simple model both to provide an alternative proof of M&M Proposition І and to explore firm-specific return relationships that depend on the firm s capital structure. Assumptions of Binomial Pricing Model The assumptions required for the Binomial Pricing Model include all of those associated with the ideal capital market, plus an additional assumption about the distribution of the future value of a firm s assets. With this additional assumption, discussed next, the model uses arbitrage arguments to determine the values of a levered firm s debt and equity securities. The Distribution of a Firm s Future Value in the Binomial Pricing Model The binomial distribution provides the simplest model of risk. Applied to a firm s assets, values of the assets are modeled over a single period, which extends from date 0, the current date, to date T, a future date. The future value of the assets can take on only two possible values, which are defined relative to the assets current value. Denoting the current value of the firm s assets as V, the future value of the firm s assets can take on only one of two possible values, V or V, where V > V and V < V. That is, over the single period involved, the value of the firm s assets can either rise to V or fall to V. Choices of values for V and V define the riskiness of the firm s assets. Appropriate values for V and V depend on three factors: (a) the value of V, (b) the actual riskiness of the value of the firm s assets that it is attempting to model, and 62

(c) the span of time involved in the model s single period. To address (a), it is generally assumed that V and V represent proportional up and down jumps relative to V. The up jump is denoted as u, where u >1, and the down jump is denoted as d, where d = 1/u <1. Thus, V = uv (2.17) And V = dv (2.18) Regarding factors (b) and (c), it is generally wished to model risk as a function of time, where risk increases with the length of the period. To do so, factors (b) and (c) simultaneously must be addressed. For instance, to model the riskiness of the assets of a particular firm, if the length of the period is a year, a particular value of the risk parameter u would be choosed, whereas if the period is five years, another larger value of u should be specified Cox, Ross, and Rubinstein (1379) provided a formula for the parameter u that produces an approximation for the riskiness of the firm in terms of the per-annum return standard deviation, as if the returns were normally distributed. The formula is u = e (2.19) Where σ is the per-annum return standard deviation of the firm s assets, and T is the length of the model s period in years. This formula allows us to specify reasonable values of u. The Expected Return on the Firm s Assets To complete the specification of the binomial distribution of a firm s assets, the probabilities of the up and down jumps must be specified. p is denoted as the probability of an up jump, so the probability of a down jump is (1-p). Consequently, the expected value of the firm s assets at date T, E(V ),is E(V ) = p V + (1 p)v (2.20) 63

And the expected return on the firm s assets is r = p + (1 p)[ ] (2.21) The Binomial Pricing Model and the Valuation of the Debt and Equity of a Levered Firm If the future value of a levered firm s assets follows the binomial distribution, the values of the firm s debt and equity can be determined. It is assumed that the firm has pure-discount debt consisting of a promise to pay debt holders the amount X at date T Case 1: Default-Free Debt D = ( ) if X < V (2.22) And the value of the firm s levered equity is, as before, E V D (2.23) The actual payoff on levered equity at date T depends on the value of the firm s assets at date T. Denoting the equity payoffs in the up and down states as E and E, E = V X And E = V X The formula for the expected return on the firm s levered equity, r, is r = p + (1 p) (2.24) 64

Case 2: Default-Risky Debt If the firm s debt is default-risky (i.e., V > X > V ), in the up state, bondholders will receive the promised amount of X, so D = Xand equityholders will receive E = V X. In the down state, the firm defaults; bondholders receive D = V < X and equityholders receive nothing E = 0. We can value the firm s equity and debt by creating a risk-free hedge portfolio with a long position in the levered firm s assets and a short position in δ units of the firm s levered equity. The value of δ must be chosen so that the portfolio has the same payoff in both the up and down states: [V δe ] = [V δe ] (2.25) Given hedge ratio: δ = (2.26) The cost of this portfolio is V δe where E is the unknown that we wish to determine. The portfolio is riskless, so its present value, or cost, must be equal to the discounted value of the date T payoff, discounting at the risk-free rate. The expressions on both the left side and the right side of Equation 2.25 represent the common date T payoff on the portfolio, so we can choose either. We arbitrarily select the left side expression; the cost of the portfolio must be equal to the present value of this expression: V δe = (2.27) ( ) The value of the levered equity is: E = V V E /(1 + r ) (2.28) 65

The Black-Scholes Option Pricing Model (BSOPM) Fisher Black and Myron Scholes developed a formula to value European options written non-dividend paying stocks. This model, which is now known as the Black-Scholes Option Pricing Model (BSOPM), was instrumental in the development of U.S. option markets, which began trading in the same year in Chicago. Their model can be applied to the pricing of (a) the debt and equity of a levered firm, (b) various options embedded in stock-related securities such as warrants (c) options embedded in corporate bonds such as call and put provisions (d) the conversion option in convertible bonds and (e) stock option grants in executive compensation contracts. As with the other models it has been already discussed, the BSOPM is developed under the assumptions of an ideal capital market. Black and Scholes also assumed that (a) the risk-free interest rate is constant and (b) the future value of the underlying asset against which the option is written is log-normally distributed, or equivalently, the instantaneous returns on the underlying asset are normally distributed with a constant mean (μ) and variance (σ ). The derivation of the BSOPM involves the construction of a risk-free hedge portfolio involving the underlying asset and the option, as was the case for the Binomial Pricing Model. For their model, however, Black and Scholes must assume that risk-free portfolio will be continuously rebalanced. Nevertheless, a risk-free portfolio can be constructed at each instant of time because instantaneously the returns on the asset and the option are perfectly correlated. By continually rebalancing the hedge portfolio so that it remains risk free, Black and Scholes were able to derive a closed form solution for the price of the option using continuoustime mathematics. The BSOPM equation for the price, C, of a European call option is given in equation (2.29) C = V[N(d)] e X[Nd σ T] (2.29) 66

d = V is the current value of the underlying asset; X is the exercise price of the option; σ is the annual standard deviation of returns on the underlying asset T is the time to expiration of the option in years, r is the annual risk-free rate, N(d) is the cumulative standard normal probability density function evaluated at d, and ln (x) is the natural log function. 2.2. Modified Modigliani-Miller propositions Modigliani & Miller (1963) recognized the benefits of personal tax and introduced a model of capital structure incorporating this. Miller and Modigliani provide a general specification the effect of interest deductibility on the value of a firm by (a) using variables to represent the various parameters involved, and (b) making two simplifying assumptions. The first assumption is that the firm s debt consists of a single issue of perpetual debt, which provides an annual cash coupon at a rate of c = r where r is the required return. The value of the debt is denoted as D. the second assumption is that the corporate tax rate, τ, and the deductibility of interest, are fixed into perpetuity. Using the above notion, a firm s annual tax shield can be expressed as the product of the tax rate and the annual coupon interest, or Annual tax shield = τ cd (2.30) It is assumed that both the debt and the tax shield carry into perpetuity, so we can calculate the present value (PV) of the tax shield using the constant perpetuity formula, with r D as the discount rate: PV(tax shield) = {source: (Ogden, et al., 2003)} = = τ D (2.31) As a consequence of this tax effect, M&M original І must be modified. 67

V = V + PV (tax shield) = V + τ D (2.32) {source: (Ogden, et al., 2003)} Equation 2.32 illustrates the point that, when M&M Proposition І is modified for corporate taxes, the value of firm is no longer constant across leverage, but instead increase monotonically with leverage. Thus, it can be concluded from equation 2.32 that, for management to maximize the market value of the firm, the firm should be virtually 100 percent debt financed. Taxes, Arbitrage, and a Firm s Market Value under Alternative Capital Structures If investors can purchase a firm s unlevered equity at a total price that is less than the total value of debt and equity after a leverage-increasing recap, they would realize an immediate riskless arbitrage profit. Such arbitrage profit opportunities will be eliminated in a competitive market, so the seller should reap the same total proceeds whether he sells the firm by issuing equity shares or any combination of debt and equity; and these proceeds should be equal to the maximum market value that can be realized across all possible capital structures, regardless of the capital structure that the seller presents to the market. The levered firm s tax-adjusted WACC would be calculated as follows: Traditional formula: r = r (1 τ ) + r (2.33) Correct formula: r = r + r (2.34) Where: 68

r = r + r (2.35) Indeed many firms have no debt the big question for modified MM hypothesis is why do firms fail to take greater advantage of the deductibility of corporate interest to increase the value of their equity? 2.3. Is There an Optimal Capital Structure? (Traditional Trade-off theory) The Traditional Trade-off theory provides one answer to the question that why do firms fail to take greater advantage of the deductibility of corporate interest to increase the value of their equity? According to this theory, as a firm increases debt relative to equity in its capital structure, expected costs of future financial distress and bankruptcy also raise, eventually enough to fully offset the benefit of the tax shield, at the margin. At this point, firm value is maximized, and beyond this point firm value actually falls. However, the interest tax shield is an observable factor but the costs of financial distress are not. Beattie, Goodacre, & Thomson (2006) asserted the importance of interest tax shield on financing behavior of UK firms. 2.3.1. Costs of Financial Distress According to Myers, (1984) costs which even with preventing formal default, can decrease firm value. Such as judicial and executive costs of bankruptcy, agency costs, moral jeopardy, controlling and contracting costs. Myers, (1984) stated that the previous researches on costs of financial distress props two qualitative statements about financing behavior. A- Firms with higher risk must borrow less rather than firms with lower risk with same conditions. The definition of risk is variance of the share price of the firm in market. With increasing in risk of the firm, the probability of default on debt will be increased. Such default is cause of financial distress; to be on the safer side, firms must be able to increase debt before interest tax shield is offset by the expected costs of financial distress. 69

B- Firms with more tangible assets and powerful secondary market will borrow less than firms with intangible assets or growth opportunities. Apart from the probability of difficulty, the expected costs of future financial distress depend upon value lost in difficulty. Intangible assets or growth opportunities will lose value more likely in financial distress. (p. 581). Myers, (1984) compares the Traditional Trade-off theory with a competing famous story based on the Pecking Order theory: Firms rely on internal finance. They considered target dividend payout ratios relative to investment opportunities although target dividend ratios are gradually adjusted rather than changes in the extent of valorous investment opportunities. Unexpected volatilities in investment opportunity and profitability moreover adhesive dividend policies mean that cash flow generated internally may be more or less than needs for valuable investment opportunities. At the presence of need for external finance, first, firms issue debt as the safest source of external financing, then probably hybrid securities like convertible bonds and ultimately equity as a last asylum. There is no a target debt ratio because there are two types of equity one is retained earnings (internal) and another one is initial public offering (external). Debt ratio for each firm indicates its cumulative needs for external source of finance. De Miguel & Pindado (2001) found an inverse relationship between financial distress costs and debt, due to the higher premium demanded by debt underwriters. According to Beattie, et al.(2006) financial distress is important on financing behavior of UK firms. The Traditional Trade-off theory proposes that all firms have an optimal leverage (debt ratio). This theory predicts moderate borrowing by tax-paying firms (Myers, 2001).Myers (1984) conceptualized that optimal debt ratio of a firm is generally determined by a trade-off between the benefits and costs of debt, if firm s investment plans and assets are held constant. Myers pointed out that the firm is characterized by balancing the costs of financial distress and the value of interest tax shields. He also supposed that the firm substitutes equity for debt, or debt for equity, 70

until arriving to maximum value of the firm. Thus the debt-equity trade-off is illustrated in Figure 1 in the appendix A The firm's optimal capital structure will require the trade-off between the tax advantage of debt and different costs of leverage (Bradley, Jarrell, & Kim, 1984). Bhaduri (2002) presented evidence from India as proxy for less developed countries (LDCs) that the optimal capital structure choice apart from factors such as growth, cash flow and size can be influenced by product and factors related to industry. The results also corroborate the existence of recapitalization costs in obtaining an optimal capital structure. According to Booth, et al.(2001) profitable firms have less demand for external financing. This result does not sit well with the Traditional Trade-off theory, under which it would be expect that highly profitable firms would use more debt to lower their tax bill. Fama & French (2002) confirmed predictions shared by Traditional Trade-off theory, those are as follows Firms with more profitability and fewer investments are expected to have greater dividend payouts. It is expected that the higher the firms investment, the smaller market leverage, which is consistent with the Traditional Trade-off theory and a complex version of the Pecking Order theory. Fama & French (2002) found that more profitable firms are less levered that is contradicting with the Traditional Trade-off theory 71

Figure 2.1: The Traditional Trade-off theory of capital structure. (Source: Myers, 1984, p.577) According to Drobetz & Fix (2003) the more investment opportunities for the firm is along with applying the less leverage, which props both the Traditional Trade-off theory and a complex version of the Pecking Order theory. They also found that more profitable firms use less leverage that is contradicting the Traditional Trade-off theory. Lemmon & Zender (2004) found that, on average, large, profitable, low leverage firms use internally generated funds to finance their growth and allow their leverage ratios to drop over an extended period that is not consistent with the Traditional Trade-off theory. According to Huang & Song (2006) the Traditional Trade-off theory is better in explaining the feature of capital structure for Chinese listed companies. Beattie, et al.(2006) discovered that about half of UK firms seek to maintain a target debt level that is consistent with the Traditional Trade-off theory. Delcoure (2007) also discovered that tangibility has a positive regression coefficient and statistically significant with leverage in Central and Eastern European (CEE) countries. These results are consistent with the Traditional Trade-off and the Pecking Order theory of capital structure. Frank & Goyal (2009) found empirical 72

evidence consistent with some versions of the Traditional Trade-off theory of capital structure. On the existence of optimal capital structure and reducing cost of capital by optimal capital structure, Ezra Solomon as cited in (Schwartz & Aronson, 1967) states that One proof in favor of the Traditional Trade-off theory is that companies in the different industry classification use debt at the presence of some optimum range suitable to each classification. Despite significant difference between firms in debt ratio exist within each classification; the mean of debt by wide industrial classification tends to pursue a stable pattern over time. (p. 10). 2.3.2. Target Debt Level Capital structure is a key issue for financial decision makers. Empirical evidence as well as evidence from surveys indicates that firms look for a target capital structure. The relationship between leverage ratio of firm and well-defined firm characteristics generally has been interpreted in favor of one of these two majors theories of capital structure namely; the Traditional Trade-off and the Pecking Order theory. The concept of target capital structure plays an important role in many models of corporate financing. However, empirical evidence on target leverage has been mixed (Hovakimian, 2004). It is important to note that this target is not discoverable but it may be computed from firm s variables such as debt-to-equity, firm s size, growth options and non-debt tax shields etc.(fama & French, 2002). Marsh, (1982) discovered that target debt ratios are depended on firm size, risk of bankruptcy, and asset combination. He also provided evidence that companies choose financing instrument as if they have target levels of debt in mind. Mayer & Sussman (2004) found evidence consistence with the Traditional Trade-off theory that firms show a strong tendency to revert back to their initial leverage. Kayhan & Titman (2003) found that over long periods of time firms make financing choices that tend to move them towards their target debt ratios. Titman & Tsyplakov (2007) also discovered that firms move relatively slowly towards their 73

target debt ratios. The results of Antoniou, Guney, & Paudyal (2008) confirmed that firms have target leverage ratios. Hovakimian, Hovakimian, & Tehranian (2004) concluded that the significance of stock returns in corporate finance literature is unrelated to target(optimal) leverage and is probably because of Pecking Order market timing behavior. They also found that there is no relationship between profitability and target leverage. To offset the excess leverage due to deadweight losses, firms with no profitability proceed to issue equity. On the flip side, profitable firms do not seem to be offsetting the accumulated leverage deficit by issuing debt. Generally they support the hypothesis that firms have target capital structure. Hovakimian, et al. (2004) ultimately suggested that the priority of internal financing and the temptation to time the market by issue equity when the market price of equity is relatively high admix with the tendency to keep the firm s debt ratio close to its target. Hovakimian (2004) suggested that the conflicting results aroused partially vary across different types of corporate financing transactions because the importance and the role played by target leverage. He also found that firms do not initiate equity transactions to offset the accumulated deviation from the target leverage ratio. 2.3.2.1. Target Adjustment Model Because of random events or other changes, firms may temporarily deviate from their target capital structure and then only gradually work back to the optimal one. However, firms may not adjust fully towards target leverage because it might be less expensive for them even if they come out with that their current debt ratios are not optimum. Nevertheless, there are some empirical evidence that macroeconomic factors are affecting on the process and speed of adjustment towards optimal debt ratio. De Miguel & Pindado (2001) have developed a target adjustment model to explain firm characteristics that determine capital structure and how institutional features affect capital structure. Drobetz & Fix (2003) Used a simple target adjustment model, they reported evidence that firms adjust to long-term financial 74

targets. As shown by Shyam-Sunder and Myers (1999), this can well be consistent with a Pecking Order of financing activities. Leary & Roberts (2005) corroborated that financing behavior is consistent with the presence of adjustment costs, they discovered that firms dynamically rebalance their leverages to maintain an optimal range. Their evidence asserts that the chronic effect of shocks on leverage observed in previous researches is more probably because of adjustment costs than indifference toward capital structure. 2.3.2.2. Speed of Adjustment towards Target Debt-Ratio Nivorozhkin (2005) adopted dynamic adjustment model and found that the large adjustments of leverage tend to be less costly relative to smaller ones, indicating the presence of fixed costs in changing the capital structure of a firm. Drobetz & Wanzenried (2006) documented that faster growing firms and those that are further away from their target capital structure adjust more readily. Their results also reveal interesting interrelations between the speed of adjustment and famous variables of business cycle. Particularly, it is observed that the adjustment speed is more when the spread between current and target debt ratio is more and when economic perspectives are good. Taggart, (1977) concluded that movements in the market values of long-term debt and equity are important determinants of corporate security issues. He also provides some evidence that timing strategies may speed up or postpone firm s adjustment to their targets. According to Jalilvand & Harris, (1984) companies size, interest rate, and levels of market value of firms equity affect adjustment speeds to target debt ratio. Antoniou, Guney, & Paudyal (2002) used panel data to investigate the determinants of leverage ratio of firms operating in France, Germany and England. The estimates reveal that the firms in all three countries adjust their debt ratios to attain their target capital structure but at different speed, French firms were the swiftest and the Japanese are the slowest. According to Nivorozhkin (2005) the speed of leverage adjustment tend to decrease with an increase in firm size, indicating potential supply-side imperfections 75

from the exposure control of providers of debt financing. Titman & Tsyplakov (2007) discovered that firms that are subject to financial distress costs as well as those without conflicts of interest between debt-holders and equity-holders should adjust more quickly towards their target debt ratios. Despite with controlling for the traditional determinants of capital structure and firm fixed effects, Huang & Ritter (2009) found that firms moderately move to target leverage. Half-life of adjustment for book leverage is 3.7 years. Booth, et al (2001) analyzed ten developing nations and found that firms having leverage less than their optimal leverage and adjusted faster towards it, were specified by less growth opportunities, more intangible assets, less non debt tax shields, more financing slack, less share prices and more deviation from their target leverage. Conversely, firms having more leverage than their target leverage and adjusted faster were specified by more growth opportunities, less intangible assets, more non debt tax shields, less financing slack, more share prices and more deviations from their target leverage. Fischer, Heinkel, & Zechner, (1989) developed a model of dynamic capital structure choice at the presence of adjustment costs. The theory provides the optimum dynamic adjustment policy that is a function of firm-specific characteristics. They found that even slight recapitalization costs result in broad deviations in a firm's leverage over time. In a dynamic setting, the results of empirical tests relating firms' leverage ranges to firm-specific characteristics that forcefully prop the theoretical model of relevant capital structure choice. 2.4. Agency Theories of Capital Structure Long & Malitz (1985) stated that a firm must seek an outside source of funds, its choice between debt and equity will depend in part on the magnitude of potential agency costs of debt. According to Auerbach, (1985) The effects of firm growth rates on the level of borrowing is inconsistent with the predictions of "agency" models of leverage. Hovakimian, et al. (2001) found the negative relation between returns on equity in the past and leverage increasing choices is also in accordance with agency models where managers are motivated to increase leverage when market value of equity are low. These results are also confirming this notion that managers are unwilling to issue equity when their market value of equity is underpriced. According to Titman 76

& Tsyplakov (2007) conflict of interest between equity-holders and debt-holders is less pronounced for firms that are more subject to financial distress costs, since such firms have a greater incentive to issue equity and pay down debt when they are doing poorly. According to Beattie, et al. (2006) agency costs are important determinant of financing behavior of UK firms. According to Booth, et al. (2001) demand for external financing in profitable firms is less. This implication supports the notion that there are agency costs of managerial discretion. 2.4.1. Information Asymmetry According to Booth, et al. (2001) more profitable firms had lower debt ratio in 10 developing countries. This finding supports the existence of significant information asymmetries within developing countries. This result suggests that external financing is costly and therefore avoided by firms. Beattie, et al. (2006) asserted that information asymmetry is an important determinant of financing behavior of UK firms. 2.4.2. Ownership Structure De Miguel & Pindado (2001) took into account level of ownership concentration because a high level mitigates the free cash flow problem, and therefore firms with highly concentrated ownership need to issue less debt. According to Huang & Song (2006) ownership structure affects leverage. 77

2.5. The Pecking Order Theory Shyam-Sunder & Myers, (1999) tested the Pecking Order for sample of mature corporations and found that it is an excellent first-order descriptor of corporate financing behavior. The Pecking Order theory predicts lower growth firms with high free cash flow will have relatively low debt ratios (Barclay, et al., 1995). According to the Pecking Order theory, when internal source of finance is not sufficient to fund capital expenditures, the firm will issue debt rather than issuing equity. Hence, the amount of debt in the capital structure of the firm shows the firm s cumulative requirement for external funds (Myers, 2001). Kayhan & Titman (2003) found that financial deficits (the amount of capital raised externally) generally have a positive effect on changes in debt ratios; however, their results indicate that this effect does not hold for firms with high market to book ratios. Booth, et al. (2001) discovered that more profitable have the lower debt ratio, regardless of definition of debt ratio. This finding is in accordance with the Pecking Order theory. Fama & French (2002) confirmed predictions shared by the Pecking Order theory as follows: Firms with fewer investments and more profitability pay higher dividend. Firms with more profitability have less leverage. Firms which have more investments pay lower long-term dividend and dividends do not vary to accommodate short-term changes in investment and earnings is mostly absorbed by debt. Frank & Goyal (2003) tested the Pecking Order theory of capital structure on a wide cross-section of publicly traded US companies for 1971 to 1998. Conflicting with the Pecking Order theory, net issues of equity follow the financing slack more nearly than do net debt issues. While large firms show some aspects of the Pecking Order behavior, the proof is not strong to the inclusion of traditional leverage variables or to the analysis of evidence from the 1990s. They found that financing slack is less significant in describing net issues of debt over time for firms of all sizes. 78