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    Session 13. Capital Structure Decisions Part II

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    Session 13. Capital Structure Decisions Part II

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    © All Rights Reserved
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    6 views10 pages

    Session 13. Capital Structure Decisions Part II

    Uploaded by

    KAVYA GOYAL PGP 2021-23 Batch

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
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    Session 13.

    Capital Structure Decisions Part


    II
    PGP, IIM INDORE
    Recap
    •Financial Leverage and ROE
    •Does financial leverage affect firm value?
    • Modigliani Miller Theorems
    • World without taxes and other assumptions: Value of levered firm = Value of an unlevered
    firm
    • In the presence of corporate taxes: Value of a levered firm is higher by present value of
    tax shields
    • Does that mean that the optimal level of debt would be 99.99% debt?
    • Costs of Financial Distress and Bankruptcy
    • Value of Levered firm = value if all-equity financed + PV(tax shield) - PV(costs of financial distress)
    • Trade-off theory
    • Capital Structure decisions in the presence of information asymmetry
    Capital Structure Decisions

    Static Trade-off
    Benefit from Tax
    Theory: Bankruptcy Pecking Order
    Deductibility of
    Costs and Costs of Hypothesis
    Interest
    Financial Distress
    Equity and Debt Issues with Information Asymmetries
    •Information asymmetries
    •Managers know more about their firm’s prospects, risks and values, than outside investors
    • That is, there are information asymmetries between managers and outside investors

    •Managers are less likely to issue equity when it is undervalued.


    •In fact, managers are more likely to issue equity when it is overvalued
    — Investors anticipate this, and they watch corporate action to interpret the value of equity
    — Equity issuance often signals overvaluation
    — Therefore, as a step 1: Use internal financing first
    — Step 2: Issue debt next. If you have exhausted your debt capacity – issue new equity as the last
    resort
    The Pecking-Order Hypothesis
    —The pecking-order theory implies:
    —Firms prefer internal finance
    —If external finance is required, firms issue debt first, then hybrid security
    (possibly), then equity as a last resort.
    —There is no target D/E ratio (contrary to Trade-off theory)
    — There are two kinds of equity: one (internal) at the top of the pecking order
    and one (external) at the bottom
    —The theory also implies
    —Profitable firms use less debt
    — They may not need external funding
    —Companies prefer to have financial slack
    The Pecking-Order Hypothesis
    —Financial Slack (cash, near cash, easily saleable real assets, spare debt
    capacity)
    —Positives of having financial slack: It is valuable.
    —If positive NPV opportunities arise, you use internal funding or easily
    access debt markets
    —Negatives of financial slack: Lead to agency problems – misuse of cash
    Is there a Theory of Optimal
    Capital Structure?
    Is there a theory of optimal capital
    structure?
    •There is no ONE theory that captures everything about the Debt-equity
    choice
    •Profitable firms:
    • Have lower debt ratio, because they can rely on internally generated profits for
    funding investments (pecking order hypothesis)
    • This is contrary to the prediction of Trade-off theory that more profitable firms
    could use tax shields, and thus should lever up.
    •Tangible assets: Firms with higher fixed assets (as % of Total assets)
    • They tend to borrow more
    • Assets can serve as collateral and reduce financial distress
    Is there a theory of optimal capital
    structure?
    •Smaller growth company:
    • Less need for interest tax shields
    • Preserving debt capacity / financial slack is more important
    • Costs of financial distress are high
    • They are most likely to use equity financing (confirms to Trade-off theory)
    •Mature public corporation:
    • Often follow pecking order
    • Information asymmetries deter large equity issues
    Reference
    Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2015). Principles of corporate finance. Tata
    McGraw-Hill Education. Referred to as BM hereafter.
    ◦ BM: Ch 17 & 18

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