Post on 16-Dec-2015
EXP 482EXP 482Corporate Financial Corporate Financial PolicyPolicy
Clifford W. Smith, Jr. Winter 2007 Overhead 2 * Covers readings on course outline through Barclay/Smith/Watts (1997)
Relaxing the M/M Assumptions
Interest payments to bondholders are deductible for tax purposes
while payments to equity holders are not.
Bankruptcy Costs
Warner examined the bankruptcies of 11 railroads to estimate the costs of bankruptcy.
The bankruptcy proceedings typically lasted many years. The average was 13 years, and the longest was 23 years.
On average these firms spent approximately $2 million on the bankruptcy proceedings
We can measure the bankruptcy costs in relation to firm value at various points in time
Measuring Bankruptcy Costs
0 Filing dateT Settlement date (T 13 years)
5 T0 Time
BC BCV0 V-7
= 5.3% = 1.0%
BC =
T
T=0
BCt (BC = $2 million)
Taxes and Bankruptcy Costs
Merton Miller
– A case of horse and rabbit stew
– Analysis so far ignores personal taxes and the effect of issuing debt on the equilibrium in the bond market
Miller's Debt and Taxes
Both corporations and individuals pay taxes.
When corporations pay interest on debt, they reduce their own taxes, but increase the taxes of individuals.
Ultimately, the corporation must bear all of the taxes associated with its activities either directly, or indirectly through higher required rates of return on the securities that it issues.
DeAngelo and MasulisDebt and Taxes
DefaultZero taxes,deductions notfully utilized
Positive taxes,tax credits notfully utilized
Taxes paidat the highestmarginal rate
Income
As corporations increase their debt, they reduce the probability that they will pay the highest marginal tax rate and be able to fully utilize all tax credits and deductions.
In equilibrium, there is an
optimal capital structure for the
economy as a whole and for
each individual firm.
DeAngelo and MasulisDebt and Taxes
In equilibrium, there is an optimal capital structure for the economy as a whole and for each individual firm
Optimal leverage B/V B/V(tax credits, non-interest
deductions 2, BC, c, p)
DeAngelo and MasulisDebt and Taxes
What's Wrong With This Story?
Large industrial firms with many physical assets typically have many noninterest deductions (like depreciation), large tax credits (the investment tax credit), and also high leverage.
Firms with high dividend yields (like regulated utilities) typically have high leverage.
The DeAngelo/Masulis Capital Structure Model with Taxes
Holding other things constant, the logic of the model is sound; it provides useful information about optimal capital structure.
The problem is that there are important variables that are not included in the model. As we examine firms in the real world, there seems to be important determinants of capital structure that are not captured by this model.
The Effect of Capital Structure on Real Investment Decisions
The owner of an all equity firm will take all positive NPV projects to maximize firm value.
When a firm has both debt and equity, the debt and equity holders sometimes disagree about the optimal investment policy.
Since equity holders have ultimate authority over investment decisions, we have to be concerned about how adding debt to the capital structure affects equity holders' investment incentives.
Agency Theory
Jensen and Meckling
― An agency relationship is a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.
― Often there is a blurred distinction between the principal and the agent
― Agent responds to incentives and will not always act in the best interests of the principal
Agency Theory
Jensen and Meckling provide a
definition of agency costs that
divides these costs into their
individual components:
Agency Theory
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
= + +
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
Agency Theory
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
= + +
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
Out-of-PocketCosts
Agency Theory
Agency Monitoring Bonding ResidualCosts Costs Costs Loss
= + +
Out-of-PocketCosts
Opportunity
Costs
Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:
Agency Theory
Before Jensen and Meckling, it was common to focus only on the out-of-pocket costs (M/M theory focused on fixed investment policy)
Contracts affect incentives for current and future investments
Private incentives exist within the contracting process for the firm to maximize its current market value as well as the "welfare" of society
The Nexus of ContractsTheory of the Firm
Firm
Share-holders
Bond-holders
Board ofDirectors
Managers
Employees
LessorsLessees
Suppliers
Customers
The Nexus of ContractsTheory of the Firm
Firm
Share-holders
Bond-holders
Board ofDirectors
Managers
Employees
LessorsLessees
Suppliers
Customers
Dividend payout
Claim dilution
Asset substitution
Underinvestment
Conflicts of Interest
+ - + + + +V = E(V, F, T, σ², r, DIV) + + - - - - + B(V, F, T, σ², r, DIV)
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs.
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 = 100 B – -75 100 = 25
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs.
A Simple Example
Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25Bond ? -20 -100
Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero.
There are no taxes or transactions costs. Dividends can be paid in a period so
long as that period's promised payment to the bondholders is made first.
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75 DIV (A-) 20 80 – = 100
A Simple Example
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 20 80 – = 100
The Underinvestment Problem
Do I want to issue this bond?
Who bears the agency costs of increased leverage in this case? In general?
Equity holders have strong incentives to structure debt contracts in a way that minimizes the adverse incentive costs.
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100
Less Leverage
Time NPVProject 0 1 2 A -50 100 50 B – -75 100
Bond 60 -10 -50
DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100
High Leverage
Bond 70 -20 -100
DIV(A -) 20 80 – =
100
Low Leverage
Bond 60 -10 -50
DIV(A+B) 10 15 100 = 125
Which Bond Do I Want to Issue?
Investment Opportunity Set
Assets inPlace
GrowthOpportuniti
es
Cost of Debt Low High (Underinvestment)
Predicted Leverage High Low
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
Tax Credits Lower
Marginal Corporate Tax Rate Higher
Marginal Personal Tax Rate Lower
BenchmarkingCorporate Leverage
Impact on Leverage
Growth Options (Merck) Lower
Credence Goods (Eastern) Lower
Product Warranties (Yugo) Lower
Future Product Support (Yugo/Wang) Lower
Supplier Financing (Campeau) Lower
Closely Held Firm Higher
Regulation Higher
Tax Credits Lower
Marginal Corporate Tax Rate Higher
Marginal Personal Tax Rate Lower
Information Costs Higher
Management Implications
Benchmarking
– Rochester Gas & Electric
– Eastman Kodak
Responding to change
– Frontier Communications
– Southern Company
Financial Architecture
Leverage
Public vs. private
debt
Maturity
Priority
Conversion rights
Call provisions
Articles Handouts for Class 2:
“Incentive and Tax Effects of Executive Compensation Plans” by C. Smith, & R. WattsBook chapter, pgs. 139-157.
“The Determinants of Corporate Leverage and Dividend Policies” by M. Barclay, C. Smith, and R. Watts, Journal of Applied Corporate Finance, vol. 7, no. 4 (winter 1995), pgs. 4-19.