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Financing 1.

Financing 1.

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Financing 1.

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  1. Financing 1. In the absence of any frictions (or market imperfections), arbitrage arguments may be used to show that capital structure and dividend policy cannot affect value. Anything that the firm could do could be undone by any investor - and vice-versa. (This is an example of catsup economics.)

  2. M & M When Corporate Taxes are introduced to a frictionless economy: • Total (Societal) Value is not affected by capital structure. • The value of taxes shrinks as leverage increases. • Optimal Capital Structure: Virtually All Debt.

  3. Dividends & Taxes • Absent Frictions, with Personal Taxes, Optimal Dividend Policy: Nodividends. • They originated in old days: • No Income Tax • No GAAP / Disclosure Requirements • Tax Liability from dividends: High -- This is a puzzle. • Paid from “Permanent Income.”

  4. Barclay, Smith & Watts 1 They start by noting: Large dispersion across companies “Remarkable Stability” of averages over 1963 -- 1993.

  5. The first friction that we appeal to is usually bankruptcy costs. Direct - Easy to overstate. Transfer of ownership. Indirect - Varied! -- Who wants to tie-up value in a failing company? Workers? Suppliers? BSW 2

  6. BSW 3 Underinvestment: Consider a company with most of its value in the form of growth options (Real Options), and few assets in place. We imagine a circumstance where company’s long-term prospects are bright, but has a need for cash. If this company has a lot of debt, then it will not be able to raise new capital. Anticipating this, it will not use debt.

  7. BSW 4 On the other hand, consider a company in a mature industry, with profitable assets in place. For such a company, debt may help to align managerial and shareholder interests: Will management add negative NPV projects (Growth for Empire Building). Reduces Shareholder Base. Presumably more concentrated ownership reduces agency costs.

  8. Review BSW Table 2

  9. BSW 5 Theories that focus on Bankruptcy Costs (both direct and indirect) do not consider the dynamics of raising new capital. Dynamics shifts attention to signaling. Pecking Order: Internal Capital Debt Equity

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