Theory of Capital Structure

• Capital Markets are frictionlesse

• Borrow and lend money at risk free rate

• There are not taxes

• Firms are in the same risk class

• Firms only issue risk free debt or risky equity

1. Cost of Equity is a positive linear function of leverage

1. Leverage, or Debt, does not affect the firms and shareholders wealth

It does not matter how you slice up the pie.

• Value is determined on the left hand site of a balance sheet

• We need a bigger pie if a firm should be more valuable

• Shareholder has to invest in positive NPV to generate Vaule

No, the shareholder are indifferent

No these are just benchmarks, but not results under realistic assumptions.

• Bondholder Wealth Expropriation

• Risk Shifting / Asset Substitution

• Underinvestment Problem

• Free Cash Flow theory

Shareholders issue new debt to finance their own purchases of equity. Current Bondholders are in a risky position -> loss of wealth because there is only a partial claim to the asset of teh firm. The Bondholder are in a risky position because they are unable to charge more.

The Wealth shifted from the Bondholder to the Shareholder.

• If the management dont add convenants and does not issue new debt. Bondholder fear if the management is issuing new debt, but if the dont issue new debt, bondholder would pay a price below the true value.

• In this case, the firm would have to much debt

Higher Variance has a higher probability to leave equity holdes “in the money”. They tend to deviate from the NPV-Rule to pursuit higher varaince projects.

If bonds are issuer before the risky investment, equity-holder can exploit bondholder. They use the debt to finance theier risky projects. Bondholders want to prtoect themself and demand higher interest rate or covenants

• Covenant

  • Firm is restricted to rearrange assets. Bondholdes will price protect

  • But: It is costly, because rearange assets could be beneficial. It could be useful to issue Callable Bonds

• Convertible Bonds

The Uniderinvestment Problem could arise. If a Firm has to much debt, it could lead to a debt overhang problem. This could discourage the management to invest in good projects because most of the benefits would go to the creditors.

It would be not enough if the Investment Project has a NPV>0. Rather the Value of the Invesment has to be positive after the Invesment Costs + Debt Costs

The FCF helps to finance expenditures that lead to agency costs outside of equity.

• A low FCF implies more control of the capital market -> Firms are forced to issue debt or equity to growth

• Managers could announce permanent dividends increase, but this is not really credible because the are in charge of all FCF

A Solution could be to issue more debt.

• Debt forces Managers to increase the FCF to match up with the interest payments

• Can add Value to Cash-Cow firm whom overinvest money. -> Reduces investment in bad projects.

In asymmetric information, changes in capital structure can change the expectation from the market for the return stream of a firm.

Risky capital structure could be a sing for an confident management.

If he would Singal confidenc (D>D*) the firm would go bankrupt

Financial Variables like

• leverage

• dividen policy

Leland and Pyle (1977) state that increase of leverage could be a sign of confidence

If the payoff of telling the truth is greater. than lying.

The Marginal gain from a false signal weighted by the Management Share < Bankruptcy Costs

• Do not give away information when its most valuable to you

• If there is no new project and the market knew it, issuing equity was a signal that the market can use the inside information

• Postive NPV (good news) through issuing equity (bad news) financing is a mixed signal. Market cannot separate information and weather the firm is over or undervalued

No, because:

• Equity is on top and at the bottom of the pecking order

• Leverage. changes when there is an imbalance between internal financing and new investment opportunities

• Financial flexibility is valuable but also too dangerous for missmanagment

• Cross sectional regressions involving accounting data

• Time series regresions involving the flow deficit

• Survey Evidence

1. If the Coporate Tax is higher than the Personal tax, it would be better to go debt (Increase of the debt-equity ratio). If Personal Tax is higher it would be better to hold Shares of the firm (Decrease of debt-equitsy ratio)

2. It influence teh debt to quity ratio, but not the firm value

1. Charge a Rate of Return to compesate theier risk ex ante

2. Restrict the actions of the shareholder

No, if the default probabilty is zero.

1. In a fair market, securites can always be sold at a fair price

2. Regardless which finance tool is being used, accept every NPV > 0

1. If Manager have inside information and behaves in the interst of old shareholder, he will not issue more shares even if its a good investment

2. In a good state, cost to old shareholder for issuing shares will outweight the NPV

3. Decision to not issue new shares is a positive signal (Firm is undervalued), while issuing new shares would signal the firm is overvalued

• Abnormal Returns for Equity are negative, but common stocks are absoulte large than preffered stocks or debt

• Converitable are absolut larger thant straight bonds

• Information asymmetry leads to mispricing (adverse selection)

• Stock decreases prices after announcing an equity issue

• There is a pecking order of corporate finance

• there is no optimal debt equity mix

• Firms prefer internal financing

• Issue cheapest security, then hybrid securities

• Issueing Equity is the last resort

  
  

• if the affect corporate and personal tax obligations

• they affect the probability and the associated costs of financial distress

• affect management incentive to follow the value-maximizing rule

• Subordinbated debt so bonds with a longer run-time are not less important than shorter ones. Therefore the issue of shorter bonds should be restricted

• Bonds puttable, or Increasing the cash-flows if the rating of the Bond is downgraded-

• low debt level, becasue shareholders investment decision is not affected by the underinvestment problem

• As the FV of debt rises, the loss of firm values becomes significant (Debt Overhang Problem)

If D* is the maximum amount of debt an unsuccesful firm can carry without going bankcrupt, D > D* the market will say the firm is peforming well

• Risk free debt -> it is like cash and therfore no underinvestment problem

• Risky debt -> underinvestment problem

• Firms avoid capital market discipline -> issuing equity as a last resort

• Firms wants to finance in reverse order of adverse selection, this means they want to finance themself with at least risk as possible

• Inverse relationshipf of leverage and profitability

• Tangibilty

• Size

• Growth

• Profitability

Higher recovery rate in case of bankruptcy, because their are collateral

• Large frim are better diversified

• Direct cost of issuing equity is lower for large firms

• Size is an indicator for asymmetric information

• Growth frims face higher probability of bankruptcy

• Grwoth companies suffer imbalance between internal financing and investment opportunities, but issuing equity is avoided because pecking order theory

• Prefers internal funds rather than debt

• Debt Obliagates Manager to return free cash flow to its investors

• Low costs of financial distress and use tax shields