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Advanced Corporate Finance

Advanced Corporate Finance. Lecture 08.1 and 09 Capital Structure and Bond Valuation (Continued) Fall, 2010. Underinvestment Problem. Given risky debt in the capital structure there is a tendency to Reject positive NPV projects Incentive to pay high dividends

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Advanced Corporate Finance

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  1. Advanced Corporate Finance Lecture 08.1 and 09 Capital Structure and Bond Valuation (Continued) Fall, 2010

  2. Underinvestment Problem • Given risky debt in the capital structure there is a tendency to • Reject positive NPV projects • Incentive to pay high dividends • May simply be impossible to Finance new investment because of debt overhang.

  3. Example of Underinvestment • UHFX International (million) • For simplicity assume all security’s required return is 10% • Risk Neutrality and the probability of each state occurring is 50% • Good State Bad State • Total 110 44 • Debt 66 44 • Equity 44 0 • B = 50 • S = 20 • V = 70

  4. Example of Underinvestment • New investment Option I = 60 Pays off: 77 in good state, 66 in bad state NPV = $? million Finance with junior debt or equity

  5. If adopt, financed with Junior Debt • UHFX International (million) • Good State Bad State • Total 187 110 • Debt 66 66 • Junior Debt 88 44 • Equity 33 0 • B = 60 • JB = 60 • S = 15 ( A LOSS in value of $ 5 million) • V = 135, and NPV is positive but hurts stockholders

  6. Risk Shifting • The Risk shifting problem occurs when it is in the interest of the stockholders to take on a very risky investment even though it has a negative NPV • Example: 77 Investment = 30 • -33

  7. Risk Shifting • Cash Flow Before Investment • Good State Bad State MV • Total 110 44 • Debt 66 44 • Equity 44 0 • CF from Investment 77 -33 • Total Cash Flow 187 11 • Senior Debt 66 11 • Junior Debt 66 0 • Equity 55 0

  8. Risk Shifting • Cash Flow Before Investment • Good State Bad State MV • Total 110 44 70 • Debt 66 44 50 • Equity 44 0 20 • CF from Investment 77 -33 20 • Total Cash Flow 187 11 90 • Senior Debt 66 11 35 • Junior Debt 66 0 30 • Equity 55 0 25

  9. Values • Before After • Firm 70 90 • Snr Debt 50 35 • Jnr Debt -- 30 • Equity 20 25

  10. Firm Value Costs of Financial Distress V = V(u) + PV of Tax Shield Debt Level Static Tradeoff Optimal Debt Level

  11. Pecking Order Hypothesis • Costly Information • Managers know more about the future of the firm than do outsiders • Conclusion • Firm has an ordering under which they will Finance • First, use internal funds • Next least risky security

  12. Announcement Effect of Capital Raising Choices • Common Stock -3.14% • Straight Debt -0.26%* • Internally Financed +1.00% • * Means not statistically significant • What is the rationale (theory)?

  13. So the announcement effect • If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm. • Therefore the firm will never issue equity if it can avoid it to finance in projects. • Thus pecking order.

  14. Empirical Evidence • We tend to see that firms: 1. Use internal funds to invest in projects if available 2. Use least risky securities as possible if it has to finance these projects externally. 3. Announcement of a new Debt issue has a small negative impact on stockprice 4. Announcement of a new Equity issue has a strong negative impact on stockprice

  15. Empirical Evidence • Schwartz & Aronson: Leverage tends to decline as the proportion of total value of the firm consists of Growth Opportunities. • Information costs: Very strong relationship between type of capital structure change and price change It is difficult to distinguish between tradeoff theory and Pecking Order • Taxes: Leverage increases associated with high taxes

  16. Generalizing • When we look at established Capital Structures we tend to find evidence that supports a static tradeoff theory of capital structure • When we consider changes in capital structure (issuing debt or equity, repurchases, calls, etc.) there tends to be a significant pecking order component

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