Debt Overhang Problem

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 ~ VU=E U ~ VL=D+E L X X 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

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