Financing Investment
Firms raise capital for investment by selling rights to their cash flows. Debt
1. Typically fixed payments 2. Typically for a fixed amount of time 3. Typically debt holders gain control rights if the firm fails at (1) or (2)
Equity
Control rights (ownership) Residual claimant: Get whatever cash is left over after all other claimants are paid (such as debt holders)
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SU = VU
Equity Raised through Share Issuance Value of Unlevered Firm
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SU = VU = VL = S L + DL
X
Same, so the firm value must be the same
SU = VU
Levered firm (L):
Investment
if
<
short sell debt and equity in levered and buy unlevered short sell equity in unlevered buy debt and equity in levered
Payoff
if
>
VL = S L + DL
(X rDL ) + rDL = X
Payoff to Equity or Share Holders in Levered Firm Payoff to Debt Holders in Levered Firm
VL = VU
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5. Investors maximize wealth 6. No wealth transfers (no agency costs) 7. Investment decisions are given (fixed) 8. Operating cash flows are unaffected by capital structure
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S L
Relaxing these assumptions has lead to a better understanding of the nature of the firm
Invest and Borrow
Homemade leverage
~ X rDL (1 C )
SU DL (1 C )
Cleverly chosen amount to borrow
X (1 C ) rDL (1 C )
~ = X rDL (1 C )
Payoff
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Miller (1963)
By No Arbitrage rule:
Same payoffs Same Price means Investment in a Levered Firm = Investing in Unlevered plus borrowing
SL =
SU DL (1 C )
SU = S L DL (1 C )
SU = (S L + DL ) CDL
VU = VL CDL VL = VU + CDL
Discounted Present Value of Tax Shield
Graham (1996) in a sample of 10,000 firms from 1980-1992, finds that high tax rates are associated with higher debt.
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Bankruptcy
Borrowing 100% is not real
Bankruptcy costs
Warner (1977)
11 railroad bankruptcies 1933-55 Direct cost 5.3% of value 1 month prior to filing (avg. not MC) 1% of value 7 years prior Directed costs are trivial
Altman (1984)
Opportunity costs are 8.1% of firm value 3 years prior 10.5% 1 year prior
Implications
Bankruptcy costs reduce the benefits of debt Capital Structure IS relevant
VL
Mille
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Warner (1977) and others Bankruptcy Costs MM58
Debt
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Probability of distress
Positively related to
Level of Free Cash Flow Asset Tangibility
(1 C )(1 PS ) VL = VU + DL 1 (1 PB )
Gains to Leverage GL
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M&M58:
c= ps= pb=0
Miller (1963):
c > 0 c > 0 but and
= < >
(1 - pb )
GL= cDL
Miller (1977):
(1 C )(1 PS ) GL = DL 1 (1 PB )
In equilibrium
In equilibrium it must be that for the marginal investor: (1 - c ) (1 - ps ) = (1 - pb ) Why? What would happen if ?
(1 - c ) (1 - ps ) > (1 - pb ) (1 - c ) (1 - ps ) < (1 - pb ) or
rD = r0
1 1 ipb 1 rS = r0 1 Cj
r0 is the effective, after
tax interest rate the corporation pays
$
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Implications
1. High tax individuals buy tax exempt bonds
Once those run out low tax individuals supply capital to the corporate debt market
2. There is an optional economy-wide debt level BUT each firm is exactly indifferent
Why?
Costs the same.
Currently, in the US, the corporate tax rate is 35% How do corporations get different tax rates?
They substitute, depreciation, investment tax credits Even with the same rate, corporations may have different effective tax rates
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%
Firm s with High
rD = r0
1 1 ipb
1 j 1 C
$
amount of all bonds
Tax carry-backs and carry-forwards Foreign and domestic tax credits Investment tax credits Difference in taxes on capital gains vs. earnings Minimum tax rules
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An Example
Consider a world where return is sufficiently volatile that some times the tax shield won t be valuable. r0=10%
S1 .25
S2 .25
S3 .25
Pr
10% 10% = = 1 C 1 .5
Effective Tax Rate Highest Rate Willing Next $
c =50%
ps =0%
pb =20%
Debt Debt Interest Debt Interest Debt
But, over $500 in interest no taxes are paid in one state of the world: .75 x .50 = .375
Taxable Income
0 4000 500 8000 1000 12000 1500 16000 2000 500 0 0 0 0 1000 500 0 0 0 1500 1000 500 0 0 2000 1500 1000 500 0
20%
.1/(1-.375)
16%
.1/(1-.25)=
13.3%
.1/(1-.125)
rD =
r0 .1 = = .125 1 pb 1 .2
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11.4% 10%
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Debt Supply
Downward sloping because effective tax rate drops and Cannot deduct interest in all states of the world %
Taxable Income
500 250 50%
125
0 2000 250
625
50%
20%
.1/(1-.50)
500
50%
20%
0 0%
0
250 50%
125
750 50%
375
1250 50%
625
.1/(1-.375)
312.5
37.5%
16%
$4K
$8K
$12K $16K
Implications
Many firms use leasing a non-debt tax shield
Leasing lowers the value of the debt tax shield
rD = r0 1 1 ipb
r*
1 rS = r0 j 1 C
$
amount of all bonds
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DeAngelo and Masulis (1980) MM58
VU
r* =
(1 ) = (1 )
pb D* C
r0
r0
Debt
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Under Investment
Agency Problems
1. Under investment 2. Risk Sharing 3. Milking the firm
Under Investment: when the shareholders in a firm near bankruptcy instruct management not to invest in a positive NPV project because it will only benefit bond holders Consider an example
3 time periods 2 projects r = 0% Risk Neutral investors
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150
If bond holders pay $120 for bonds expecting projects A & B will be done, the bond holders are ripped off.
If they knew they d only be willing to pay $70 for the bond paying $120
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Firm has no incentive to do both A & B If the firm cannot credibly commit to A & B then only A is sustainable. But this is not optimal: the NPV from taking both projects (if they could commit) is 125
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2) Risk shifting
Risk Shifting
With debt, riskier projects are better for equity holders Share holders especially prefer high risk projects near bankruptcy Potential bond holders anticipate this and are willing to pay less for debt Who loses out?
Vfirm
Payoffs to Equity like a call: = Vequity Payoffs to Bonds like writing a put
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The equity holders pay the cost of not being able to credibly commit
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Bond holders insist on covenants as a part of the contract to protect their wealth from expropriation by shareholders.
Optimal Capital Structure
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Signaling
Firms choose their capital structure to communicate signals about the quantity of the projects/firm to the market Implicit in M&M58 is that the market knows the cash flows. But they don t.
The market values the perceived cash flows
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Ross (1977)
Capital structure may change the perception of risk w/o actual changes in return Example:
Suppose D* is the maximum debt a bad firm can take w/o going bankrupt Good firms can take on D* or more without the risk of bankruptcy
4 types of cars:
New/Used Good/Bad
When you buy a new car you don t know if it is good or bad. Over time an information asymmetry develops
Owners (sellers) know the quality - - Buyers don t
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Buyers can t tell the difference between good and bad cars
so they offer the same price for each type good or bad.
Productive Unproductive
Implication: Good cars are not traded only bad cars are. Costly signals can solve the problem.
Idea: find a signal that is too costly for the bad to use, but cheap for the good.
Offer a high wage to those who get at least Y* years of education and a low (or no) wage to those that don t
But employers cannot offer so much that it is valuable for unproductive workers to get an education
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If wages, in the example, are too high we have a pooling equilibrium: you can t tell the good from the bad. If wages are set high enough to entice high productivity workers, but low enough to not make it worth while for low productivity, then we have a separating equilibrium: the bad choose not to get an education and the good do.
But High can. Ross(1977) suggested that if E[profit] does not equal actual profit, then high quality firms can raise their value, by signaling their quality through choosing a level of Debt D*
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Myers and Majluf (1984) and Myers (1984) Managers know the true value of the firm. Outsiders don t
Adverse selection costs caused by information asymmetry
1. Should work best for small high growth firms but in fact it best explains large low growth firms in the 70 s and 80 s 2. External financing is prevelant and large 3. Equity Capital is often larger than Debt in firms
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Dividend policy cannot affect the present value of cash flows only when we receive them
Accelerating payments does NOT reduce uncertainty of cash flows and price drop on ex-dividend date will be larger
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Bhattacharya (1979) points out that dividend policy can t change the present value of cash flows received only the timing.
What is relevant is the riskiness of cash flows
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High tax individuals prefer reinvestment Low tax prefer dividends (tax clienteles) Firms with positive NPV projects will use up internally generated fund first Firms with fewer growth options will pay dividends Decreases in current earnings should leave investment unchanged in firms that use external capital and decrease investment in firms using internal capital Shareholder disagreement about investment policy will lead to the use of internal funds
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Dividends as Signaling
Ross (1977) Dividends are irrelevant in part because M&M61 assume investors know random returns
Capital structure can be used to signal the quality of the firm
Bhattacharya (1979)
Dividends can be a costly signal because less successful firms would have to finance externally Trade off between signaling benefit and Tax Consequences
Repurchases
With tax dividends taxed at a higher rate, repurchases are a way to distribute cash to share holders at the lower capital gains tax rate
IRS is not dumb though: frequent repurchases will be taxed like dividends
Tender offer:
number of shares, tender price, expiration of offer If over subscribed, repurchase on a pro rata basis If undersubscribed, extend or cancel
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Market reaction to dividend changes larger when taxes are higher [Grullon and Michaely (2001)] Similar reactions in Germany, where dividends are tax favors (they are less of a signal) [Amihud and Murgia (1997)] Might signal changes in systematic risk [Grullon, Michaely and Swaminathan, 2002]
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Externalities
Externalities are the by product of a (productive) process that imposes harm (or benefits) to other agents
Pollution Cattle Rancher/Farmer Problem
A rancher trying to water his cattle tramples the field of a farmer
The externality is the destroyed crop
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Coase (1960)
Coase Theorem
Efficiency occurs regardless of the structure
Property Rights: The socially enforced right to select uses of goods Coase Theorem:
In the absence of transactions costs the allocation of resources does not depend on the initial disposition of property rights. Assuming
No transactions costs Trade-able property rights No income effects
Bottom p4 then p3
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In market economies coordination of activity is does through the pricing mechnism Why do we have firms which entirely remove prices from the production coordination process? Answer: There are costs to using the price mechanism
Discovering Prices Negotiation Taxes
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When owner/manager owns 100% of firm there are no agency costs. The manager maximizes his or her own utility.
Sets Marginal Utility derived from $1 of expenditure of firm resources = Marginal Utility of $1 in purchasing power (from dividends paid) Perquisite consumption not a problem
Agency costs arise because contracts cannot be written and enforced with no cost
Coase (1960):
Contracts define the rights, but There are significant transaction costs.
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4. Welfare loss arises from the divergence between agent s decisions and those which maximize the principle s welfare.
D D+S
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