VII. Does capital structure really matter? The Modigliani-Miller theorems
1. The Modigliani-Miller Theorem 2. Taxes and Capital Structure 3. The Miller-Modigliani Dividend Irrelevance Theorem 4. The Effect of Taxes and Transaction Costs on Distribution Policy 5. Pecking Order Theory
1. The Modigliani-Miller Theorem o Modigliani-Miller Theorem: Assuming - A firm’s total cash flows to security holders are independent of how it is financed - There are no transaction costs - No arbitrage opportunities exist in the economy then, the total market value of the firm, which is the same as the sum of the market values of items on the right-hand side of the balance sheet (i.e. its debt and equity), is independent of how it is financed.
Proof of Theorem
If two firms are identical except for their capital structure an opportunity to earn arbitrage profits exist if the total values of the two firms are no the same. Proof of theorem
Company U Company L Future Current Future Current Cash Flow Value Cash flow Value Debt 0 0 (1+r D)D D Equity ~ E ~ − + E X U X 1( rD )D L Total ~ V =E ~ V =D+E X U U X L L
2. Taxes and Capital Structure Choice Corporate Taxes o How Debt affect After-Tax Cash Flows:
The firm is financed with a combination of equity and risk-free perpetuity bond , The year t after-tax cash flow is expressed in the following equation: ~ = (~ − )( − )+ Ct X t rD D 1 TC rD D
~ − X t rD D , is taxable income
By rearranging terms, ~ = ~ ( − )+ Ct X t 1 TC rD DT C
o How Debt affect the value of the Firm:
Result 1 : Assume that the pre-tax cash flows of the firm are unaffected by a change in a firm’s capital structure, and that there are no transaction costs or opportunities for arbitrage. If the corporate tax rate
is T c, then the value of a levered firm with static risk-free perpetual debt is the value of an otherwise equivalent unlevered firm plus the product of the corporate tax rate and the market value of the firm’s debt, that is .
VL = V U + T CD
Result 2 : Assume that the pre-tax cash flows of the firm are unaffected buy a change in a firm’s capital structure, and that there are no transaction costs or opportunities for arbitrage. With corporate taxes but no personal taxes, a firm’s optimal capital structure will include enough debt to completely eliminate the firm’s tax liabilities 3. The Miller-Modigliani Dividend Irrelevance Theorem
Preliminary concept related to Dividends : - The Different Types of Dividends
1. Cash dividends
Payment of cash by the firm to its shareholders
2. Stock dividends
Distribution of additional shares to a firm’s stockholders
3. Stock split
Issue of additional shares to firm’s stockholders
4. Share repurchase
Firms buys back stock from its shareholders. - Standard Method of Cash Dividend Payments
Monday Friday Monday Thursday
1/15 1/26 1/30 2/16
Declaration Ex-dividend Record Payment date date date date
1. Declaration date : The board of directors declares a payment of dividends
2. Ex-dividend date: Dates that determines whether a stockholder is entitled to a dividend payment;
anyone holding stock before this date is entitled to a dividend; under NYSE rules, shares are traded
ex-dividend on and after the fourth business day before the record date (Buy before this date if
you want the dividend).
3. Payment date: The dividend checks are mailed to shareholders of record. - Dividends versus Capital Gains
The asset’s value is determined by the present value of its future cash flow.
- The value of a stock will be equal to:
1. The discounted present value of the sum of next period’s dividend plus next period’s stock price
Div p =1 + 1 p0 1+r 1 + r
2 The discounted present value of all future dividends
Div Div Div∞ Div p =+1 2 +3 += t 0 +2 3 L ∑ + t 1r()1+r() 1 + r t=1 (1 r )
- The rate or return ( rE) that investor expect from this share over the next year is
Div p− p r =1 + 1 0 E p0 p 0 The Miller-Modigliani dividend irrelevancy theorem (I)
Consider the choice between paying a dividend and using an equivalent amount of money to
repurchase shares. Assume:
- There are not tax considerations
- There are not transaction costs
- The investment, financing, and operating policies of the firm are held fixed.
Then the choice between paying dividends and repurchasing shares is a matter of indifferent to shareholder.
The sources and uses of a corporation’s after tax cash flows
After-Tax cash flows = Investment – Change in debt + Interest payments – Change in equity + Dividends The Miller-Modigliani dividend irrelevancy theorem (II)
Consider the choice between paying out earnings to shareholders versus retaining the earnings for
investment. Assume:
o There are no tax considerations
o There are no transaction costs
o The choice between paying a dividend and retaining the earnings for reinvestment within the
firm does not convey any information to shareholder
o The firm is financed completely with equity
Then a dividend payout will either increase or decrease firm value, depending on whether there are
positive net present value ( NPV) investments that could be funded by retaining the money within
the firm. If there are no positive NPV investments, the money should be paid out. 4. The effect of Taxes and Transaction Costs on Distribution Policy
• How Taxes Affect Dividend Policy
Taxes favour share repurchase over dividends. The gain associated with a share repurchase over a
cash dividend depends on:
1. The difference between the capital gains rate and the ordinary tax rate
2. The tax basis of the shares, that is, the price at which the shares were purchase
3. The timing of the sale of the shares (if soon, the gain is less)
Can Individual Investors Avoid the Dividend Tax?
o Miller y Scholes (1978): Individuals borrow money that they invest in tax-deferred insurance
annuities.
o Deferring taxes may be more difficult in practice than in theory..
5. Pecking Order of Financing Theory.
1. Firms prefer to finance investments with retained earnings rather than outside sources of funds.
2. Firms adapt their divided policies to reflect their anticipated investment needs.
3. If the firm has excess cash, it will tend to pay off its debt prior to repurchasing shares. If external
financing is required, firms tend to issue the safest security first. They begin with straight debt, next
issue convertible bonds, and issue equity only as a last resort.
Empirical evidence of Pecking Order Theory:
1. Extremely profitable firms tend to use a substantial amount of their excess profits to pay down debt
rather than to repurchase equity.
2. Less profitable firms that need outside capital tend to use debt to fund their investment needs.
3. Firms generally do not issue equity when they are having financial difficulties.
A number of explanations are offered for this pecking order behaviour
1. An explanation Based on Taxes and transaction costs Taxed and transaction costs favour funding
new investment with retained earnings a debt over issuing new equity (as stated above)
2. An explanation Based on Management Incentives This reason is based on the idea that managers
personally benefit from having their firm relatively unleveraged.
3. An explanation Based on Managers Having More Information than Investors (Mayers and Majluf’s
(1984) information-based model). The basic idea is that managers are reluctant to issue stock when
they believe their shares are undervalued.
4. An explanation Based on the Stakeholder Theory . In general, most nonfinancial stakeholders are
pleased to see the firm issue equity for example, employees will find their jobs more secure and their
bargaining power improved if the firm has less leverage.
VIII – Bankruptcy Costs and Debt Holder – Equity Holder Conflicts
1. Debt Holder – Equity Holder Conflicts: an Indirect Bankruptcy Costs
1.1 The debt overhang problem
1.2. The assets substitution problem
1.3 To reluctance to liquidate problem
2. How can Firms Minimize Debt Holder – Equity Holder Incentive Problems?
3. Empirical Implications for Financing Choices.
Preliminary Concepts
- Bankruptcy Legal mechanism for allowing creditors to take over the firm when the decline in the
value of its assets triggers a default on outstanding debt.
- Bankrupcty costs : Courts and lawers The fees involved in a bankruptcy proceeding are paid out of
the remaining value of firm’s assets. Creditors end up with only what is left after paying the
lawyers and other court expenses.
- Types of bankruptcy costs:
o Direct Bankruptcy costs: related to the legal process involved in reorganizing a bankrupt firm
Indirect bankrupcty costs: dificulties of running a company while it is going through
bankrupctcy Conflict of interest between debt holders and equity holders.
1. Debt Holder-Equity Holder Conflicts: An Indirect Bankruptcy Cost
- Indirect costs often arise because of the threat of bankruptcy and are relevant even if the firm never defaults on its obligations ( financial distress costs).
The Equity Holders Incentives
The incentives of equity holders to maximize the value of their shares are not necessarily consistent with the incentive to maximize the total value of the firm’s debt and equity
max E ≠ max V = E+D
Shareholders of a leveraged firm often have an incentive to implement investment strategies that reduce the value of the firm’s outstanding debt. Strategies of Equity Holder:
• Strategies that decrease the value of a firm’s debt without reducing its total value increase the
firm’s share price .
• Strategies that reduce the total value of the firm’s debt and equity claims if these strategies transfer
a sufficient amount from the debt holders to the equity holder
Result:
Firms acting to maximize their stock prices make different decisions when they have debt in their
capital structures than when they are
Who Bears the Cost of the Incentive Problem? The Interest Rate 1.1 The Debt Overhang Problem
Equity holders may underinvest, that is, pass up profitable (positive NPV ) investment because the firm’s existing debt capture most of the project’s benefits (Myers, 1977)
Example:
Year O Year 1 Year 2
Star Spend $100 Million R&D in development costs Sell marketing rights Market looks favorable worth $500 million
π=0.9 Borrow $100 million To fund original Research Market looks unfavorable Sell marketing rights ($110 million 1-π=0.1 worth $150 million due in year 2)
In this example:
- The collective interest of the original lenders is to provide additional funds to the firm, but it is not in the interest of the individual lenders to do the same. ( Free rider problem)
- The debt overhang problem in the Lily example arose because Lily’s existing debt hand protective covenants that prevented the company from issuing new debt senior to the existing debt. Financing the
R&D whit unprotected debt would have allowed the firm to finance the additional investment with new debt that would be senior to the original debt ( Senior Structure of Debt ) 1.2 The Asset Substitution Problem ( Incentive to take large risk )
Debt provides an incentive for firms to take on unnecessary risk, substituting riskier investment projects for less risky projects (Jensen and Meckling, 1976)
Intuition : Equity holders can realize an unlimited upside, but in the event of an unfavorable outcome, they can do no worse than lose their entire investment because they have limited liability .
Other consequences of Asset Substitution Problem
- Asset Substitutions with Government- Insured Debt: The Case of S&Ls :
- Credit Rationing : (Stiglitz and Weiss, 1981).. Example of Asset Substitution Problem:
A Company has to choose between two investment projects with the same cost: $70 million
• The project 2 is riskier than project 1
• Investors are risk neutral and maximize to expected returns
• Risk-free interest rate is zero (the present value of projects are their expected payoffs)
Cash flow if State of the Economy is
Unfavorable (p=0.5) Favorable (p=0.5) Expected Value
Project 1 $50 million $100 million $75 million
Project 2 $25 million $115 million $70 million
Scenario:
• All-Equity Firm:
NPV (project 1) = -70 + 75 = 5 (the best alternative) NPV (project 2) = -70+70 = 0
• Firm Use D= $40 million and Equity (Internal sources) = $ 30 million
Payoffs to Equity Holder When the Debt Obligation is $40 Million
Unfavorable (p=0.5) Favorable (p=0.5) Expected Value
Project 1 $10 million $ 60 million $ 35 million
Project 2 $0 million $ 75 million $ 37.5 million
Result: The equity holder of a leveraged firm may prefer a high-risk, low (or even negative) NPV project to a low-risk, high NPV project ¿How do Lenders Respond to Shareholder Incentives?
• If the equity holders were to able to commit to taking project 1 (for example including loan
covenants that allow it to commit credibly to project 1) they select project 1
• But if the equity holders find it difficult to monitor a firm’s investments and the project cannot
be verified, the equity holders have an incentive to choose project 2.
Result 2 : With sophisticated lenders, equity holders must bear the costs that arise because of their tendency to substitute high-risk, low NPV projects for low-risk, high NPV projects.
The Case of Saving and loans (S & L)
In the 1980s a number of (S&Ls) invested in commercial real estate investments and other risky
ventures that may not have had positive NPVs. These investments were fund with debt that was
raised in the form of insurance deposits.
• Shareholder would have received large gains if the investments turned out well
• When the investments turned out bad, some of the losses were shared by the governments
(deposit insurance fund )
Crisis of S&Ls in US : Sophisticated Lenders would have been unwilling to provide the debt financing that these S&Ls were indirectly receiving from U.S. government in the form of insured deposits. Credit Rationing : Banks ration credit rather than increase borrowing rates
Lenders may choose not to lend to certain firms regardless of the rate of interest the firms are willing to pay.
Intuition: Higher interest obligations Firms will respond choosing riskier investments
Example: A Company has to choose between two investment projects with the same cost: $100 million
Cash flow if State of the Economy is
Good Bad ) Probability o Good Expected Value
Project A $130 million $ 50 million 0.8 $ 114 million
Project B $150 million $50 million 0.2 $ 70 million 1.3 The Reluctance to Liquidate Problem
Firms must decide whether to continue to operate or to dismantle the business and sell its property and equipment for its liquidation value. o Firms must decide continue when V ≥ L . where V is going-concern value and L is liquidation value. o However, the capital structure affects liquidation decision. (Gernet and Scharfstein, 1981; Padilla and
Requejo,1999,)
We suppose that L > V and the firm must liquidate:
- If L < D Equity holders receive nothing in liquidation, therefore they prefer continue operating.
- Manager have a direct interest in keeping the firm operating because they are likely to lose their
job if the firm liquidate How can Firms Minimize Debt Holder – Equity Holder Incentive Problems?
a) Protective Covenants.
b) Bank Debt :
- Solve the free-rider problem ( debt overhang problem )
- Banks and other private providers of debt capital are better able to monitor the investment
decisions of firms (García-Marco and Ocaña, 1999, Zoido, 1998).
- More stringent covenants can be imposed on private debt because it is much easier to renegotiate
and to enforce a covenant with a bank. c) Short-Term Debt
Advantages of Short-Term Debt:
- Mitigating the Debt Overhang Problem (Myers, 1977) noted that it is possible to eliminate the
debt overhang problem if the firm’s existing debt matures prior to the time when it must raise
additional debt to fund a new project.
- Mitigating the Assets Substitution Problem: With short-term financing, the lending rate is
renegotiated after completion of the production process, which largely eliminates a firm’s ability
to gain at the expense of its lenders.
Disadvantages of Short Term Debt:
- If long-term projects are funded with short-term debt, unexpected increases in interest rates
could potentially bankrupt a highly leveraged firm.
d) Management Compensation Contracts.
Managers often have other objectives and align themselves with the interest of debt holders than equity holders:
Managers generally have a much larger portion of their wealth tied up in the firms they manage
and thus are likely to act as though they are more risk averse.
Prestige and power go hand in hand with operating a growing firm, providing an incentive for
managers to overinvest (solving the debt overhang problem)