FIN 468: Intermediate Corporate Finance

FIN 468: Intermediate Corporate Finance Topic 9–Capital Structure Larry Schrenk, Instructor

Topics • Efficient Markets • Capital Structure

Can Financing Decisions Create Value? • Use NPV to evaluate financing decisions. • How much debt and equity to sell • When to sell debt and equity • When (or if) to pay dividends

Efficient Market Hypothesis (EMH) • An efficient capital market is one in which stock prices fully reflect available information. • The EMH has implications for investors and firms. • Since information is reflected in security prices quickly, knowing information when it is released does an investor little good. • Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.

Foundations of Market Efficiency • Investor Rationality • Independence of events • Arbitrage

The Different Types of Efficiency • Weak Form • Security prices reflect all historical information. • Semistrong Form • Security prices reflect all publicly available information. • Strong Form • Security prices reflect all information—public and private.

Weak Form Market Efficiency • Security prices reflect all information found in past prices and volume. • If the weak form of market efficiency holds, then technical analysis is of no value. • Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.

Semistrong Form Market Efficiency • Security prices reflect all publicly available information. • Publicly available information includes: • Historical price and volume information • Published accounting statements • Information found in annual reports

Strong Form Market Efficiency • Security prices reflect all information—public and private. • Strong form efficiency incorporates weak and semistrong form efficiency. • Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.

All informationrelevant to a stock Information setof publicly availableinformation Informationset ofpast prices Information Sets

What the EMH Does andDoes NOT Say • Investors can throw darts to select stocks. • This is almost, but not quite, true. • An investor must still decide how risky a portfolio he wants based on risk aversion and expected return. • Prices are random or uncaused. • Prices reflect information. • The price CHANGE is driven by new information, which by definition arrives randomly. • Therefore, financial managers cannot “time” stock and bond sales.

The Evidence • The record on the EMH is extensive, and, in large measure, it is reassuring to advocates of the efficiency of markets. • Studies fall into three broad categories: • Are changes in stock prices random? Are there profitable “trading rules?” • Event studies: does the market quickly and accurately respond to new information? • The record of professionally managed investment firms.

Are Changes in Stock Prices Random? • Can we really tell? • Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness. • People claiming to see patterns in stock price movements are probably seeing optical illusions. • A matter of degree • Even if we can spot patterns, we need to have returns that beat our transactions costs. • Random stock price changes support weak form efficiency.

What Pattern Do You See?

Event Studies • Event Studies are one type of test of the semistrong form of market efficiency. • Recall, this form of the EMH implies that prices should reflect all publicly available information. • To test this, event studies examine prices and returns over time—particularly around the arrival of new information. • Test for evidence of underreaction, overreaction, early reaction, or delayed reaction around the event.

Event Study Results • Over the years, event study methodology has been applied to a large number of events including: • Dividend increases and decreases • Earnings announcements • Mergers • Capital Spending • New Issues of Stock • The studies generally support the view that the market is semistrong form efficient. • Studies suggest that markets may even have some foresight into the future, i.e., news tends to leak out in advance of public announcements.

The Record of Mutual Funds • If the market is semistrong form efficient, then no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole. • We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index.

The Record of Mutual Funds Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).

The Strong Form of the EMH • One group of studies of strong form market efficiency investigates insider trading. • A number of studies support the view that insider trading is abnormally profitable. • Thus, strong form efficiency does not seem to be substantiated by the evidence.

Empirical Challenges • Limits to Arbitrage • “Markets can stay irrational longer than you can stay insolvent.” John Maynard Keynes • Earnings Surprises • Stock prices adjust slowly to earnings announcements. • Size • Small cap stocks seem to outperform large cap stocks. • Value versus Growth • High book value-to-stock price stocks and/or high E/P stocks outperform growth stocks.

Empirical Challenges • Crashes • On October 19, 1987, the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released. • A drop of this magnitude for no apparent reason is inconsistent with market efficiency. • Bubbles • Consider the tech stock bubble of the late 1990s.

Implications for Corporate Finance • Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return. • Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it. • Firms should expect to receive the fair value for securities that they sell. • Fair means that the price they receive for the securities they issue is the present value. • Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets.

Implications for Corporate Finance • The EMH has three implications for corporate finance: • The price of a company’s stock cannot be affected by a change in accounting. • Financial managers cannot “time” issues of stocks and bonds using publicly available information. • A firm can sell as many shares of stocks or bonds as it desires without depressing prices. • There is conflicting empirical evidence on all three points.

S S B B Capital Structure and the Pie • The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V =B + S • If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. S S B B Value of the Firm

Stockholder Interests There are two important questions: • Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. • What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50

EPS and ROE Under Current Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3.0% 11.3% 19.7% Proposed Shares Outstanding = 240 shares

Assumptions of the Miller-Modigliani (MM) Model • Homogeneous Expectations • Homogeneous Business Risk Classes • Perpetual Cash Flows • Perfect Capital Markets: • Perfect competition • Firms and investors can borrow/lend at the same rate • Equal access to all relevant information • No transaction costs • No taxes

MM Proposition I (No Taxes) • We can create a levered or unlevered position by adjusting the trading in our own account. • This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm: VL = VU

MM Proposition II (No Taxes) • Proposition II • Leverage increases the risk and return to stockholders Rs = R0 + (B / SL) (R0 - RB) RB is the interest rate (cost of debt) Rs is the return on (levered) equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity

MM Proposition II (No Taxes) The derivation is straightforward:

MM Proposition II (No Taxes) Cost of capital: R (%) R0 RB RB Debt-to-equity Ratio

MM Propositions I & II (With Taxes) • Proposition I (with Corporate Taxes) • Firm value increases with leverage VL = VU + TC B • Proposition II (with Corporate Taxes) • Some of the increase in equity risk and return is offset by the interest tax shield RS = R0 + (B/S)×(1-TC)×(R0 - RB) RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity

MM Proposition II (With Taxes) Start with M&M Proposition I with taxes: Since The cash flows from each side of the balance sheet must equal: Divide both sides by S Which quickly reduces to

The Effect of Financial Leverage Cost of capital: R(%) R0 RB Debt-to-equityratio (B/S)

Total Cash Flow to Investors All-equity firm Levered firm S G S G B The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. This is how cutting the pie differently can make the pie “larger.”–the government takes a smaller slice of the pie!

Summary: No Taxes • In a world of no taxes, the value of the firm is unaffected by capital structure. • This is M&M Proposition I: VL = VU • Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. • In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

Summary: Taxes • In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. • This is M&M Proposition I: VL = VU + TC B • Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. • In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.

Costs of Financial Distress • Direct Costs • Legal and administrative costs • Indirect Costs • Impaired ability to conduct business (e.g., lost sales) • Agency Costs • Selfish Strategy 1: Incentive to take large risks • Selfish Strategy 2: Incentive toward underinvestment • Selfish Strategy 3: Milking the property

Example: Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? $200 $0 The bondholders get $200; the shareholders get nothing.

$100 NPV = –$200 + (1.50) Selfish Strategy 1: Take Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 NPV = –$133

PV of Bonds With the Gamble: $30 $70 $20 = $47 = (1.50) (1.50) • PV of Stocks With the Gamble: Selfish Strategy 1: Take Risks • Expected CF from the Gamble • To Bondholders = $300 × 0.10 + $0 = $30 • To Stockholders = ($1000 – $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0

$350 NPV = –$300 + (1.10) Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period. • Cost of investment is $300 (the firm only has $200 now), so the stockholders will have to supply an additional $100 to finance the project. • Required return is 10%. NPV = $18.18 • Should we accept or reject?

PV of Bonds With the Project: PV of Stocks With the Project: $300 $50 –$54.55 = $272.73 = (1.10) (1.10) Selfish Strategy 2: Underinvestment Expected CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 – $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 – $100

Selfish Strategy 3: Milking the Property • Liquidating dividends • Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. • Such tactics often violate bond indentures. • Increase perquisites to shareholders and/or management

Can Costs of Debt Be Reduced? • Protective Covenants • Debt Consolidation: • If we minimize the number of parties, contracting costs fall.

Tax Effects and Financial Distress • There is a trade-off between the tax advantage of debt and the costs of financial distress. • It is difficult to express this with a precise and rigorous formula.

Tax Effects and Financial Distress Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Maximumfirm value Present value offinancial distress costs V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt

Signaling • The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. • Investors view debt as a signal of firm value. • Firms with low anticipated profits will take on a low level of debt. • Firms with high anticipated profits will take on a high level of debt. • A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.

FIN 468: Intermediate Corporate Finance