Corporate Finance- Theory and Empirics

8/3/2019 Corporate Finance- Theory and Empirics

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Empirics of Financial Markets

Patrick J. Kelly, Ph.D.

Theory and Empirics of Corporate Finance

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Firms and Project (Investment) Financing

Firms are economically productive organizations whichproduce streams of cash flows.

Coase (1937) firms as the nexus of contracts

How do firms finance the activities of the firm?

2010 Patrick J. Kelly 3

Financing Investment

Firms raise capital for investment by selling rights to theircash flows.

Debt1. Typically fixed payments2. Typically for a fixed amount of time3. Typically debt holders gain control rights

if the firm fails at (1) or (2) Equity

Control rights (ownership) Residual claimant: Get whatever cash is left over after all other

claimants are paid (such as debt holders)


The theory of capital structure

The mix of equity and debt, or rather the fraction of firmvalue attributed to debt and equity is calledthe Capital Structure of the firm

Why do we see that firms have the level of debt that theydo?

They should choose the capital structure that maximizes the valueof the firm!


Modigliani and Miller (1958)

The value of the firm is: Independent of its capital structure

Consider an Unlevered firm (U):

Investment Payoff


UUVS =

Equity Raised through Share Issuance

Value of Unlevered Firm

X

Fraction of Firm value


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Capital Structure Irrelevance

Unlevered firm (U):

Investment Payoff

Levered firm (L):

Investment Payoff


UUVS = X

LLLDSV += ( ) XrDrDX LL =+

Payoff to Equity orShare Holders inLevered Firm

Payoff to DebtHolders inLevered Firm

Same, so the firmvalue must be thesame

ULVV =

Irrelevance Enforced by Arbitrage

if < short sell debt and equity in

levered and buy unlevered

if > short sell equity in unlevered

buy debt and equity in levered


LLLUUDSVVS +===

1. Assumptions Needed for Capital Structure Irrelevance

1. Frictionless markets No taxes: personal or corporate Perfect divisibility of assets Costless information available to all

No bankruptcy

2. Individuals can mimic firms

Equal access to capital markets

Homemade leverage Can issue equity, just like firms


2. Assumptions Needed for Capital Structure Irrelevance

3. Perfect Competition4. Homogeneous expectations

Insiders and outsiders have the same information, i.e. no signalingopportunities.

5. Investors maximize wealth6. No wealth transfers (no agency costs)7. Investment decisions are given (fixed)8. Operating cash flows are unaffected by capital structure


The power of M&M58

Not that capital structure is irrelevant, but rather the assumptions needed to make capital structurerelevant are really strict.

Relaxing these assumptions has lead to a betterunderstanding of the nature of the firm


Miller (1963) Relaxing No Corporate Taxes Assumption

Often interest payments on debt can be deducted fromprofits, lowering the tax bill

Investment Payoff

Invest and Borrow Payoff

Same payoffs Same Price 2010 Patrick J. Kelly 12

( )( )CL

rDX 1~

LS

Homemadeleverage ( )CLU DS 1

Cleverly chosenamount to borrow

( ) ( )CLC

rDX 11~

( )( )CL

rDX = 1~


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Miller (1963)

By No Arbitrage rule: Same payoffs Same Price means

Investment in a Levered Firm = Investing in Unlevered plus borrowing

Implication: Borrow 100% the value of the firm! 2010 Patrick J. Kelly 13

( )CLU

DS 1=L

S

( )CLLU

DSS = 1

( )LCLLU

DDSS +=

LCLUDVV =

LCULDVV += Discounted Present

Value of Tax Shield

Empirical Findings: Gains to Leverage M&M(1966)


Miller and Modigliani, AER June 1966

Electric Utility Industry (63 Firms)

Graham (1996) in a sample of 10,000 firms from 1980-1992, finds thathigh tax rates are associated with higher debt.

Bankruptcy

Borrowing 100% is not real Bankruptcy costs

Warner (1977) 11 railroad bankruptcies 1933-55 Direct cost 5.3% of value 1 month prior to filing (avg. not MC) 1% of value 7 years prior Directed costs are trivial


Indirect Costs of Bankruptcy

Indirect costsTrade CreditValue of warrantiesValidity of contracts Litigation costs Cash flow may drop due to bankruptcy

Altman (1984) Opportunity costs are 8.1% of firm value 3 years prior 10.5% 1 year prior

Opler and Titman (1994) During downturns, high leverage firms from 26% in market value


Bankruptcy costs affect the level of Debt

Cost of Debt

Taxes Paid

FinancialDistress Cost ofDebt

$ PV

D

D+S

Optimal CapitalStructure

17

Implications

Bankruptcy costs reduce the benefits of debt Capital Structure IS relevant

VL

Debt

VU

Miller6

3

MM58

Warner (1977) andothers BankruptcyCosts

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Empirical Findings: Gains to Leverage

Mackie and Mason (1990): the propensity to issue debt is: Negatively related to

existence of other tax shieldsA one standard deviation increase in non-debt tax shields leads to a 10% lower

probability of debt issuance

Probability of distress Positively related to

Level of Free Cash Flow Asset Tangibility

Frank and Goyal (2003) add (+) size, median industry leverage, top corporate tax rate (-) dividends, loss carry forwards, profitability, and interest rates Suggests: Trade-off theory


Relaxing M&M58s Assumptions

If we introduce personal taxes andTaxes on capital gains < tax on interest income

Gains to leverage are less than when the taxes on interest and capital gainsdont exist or are the same

+=

)1(

)1)(1(1

PB

PSC

LULDVV

Gains to Leverage

GL

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Relaxing M&M58s Assumptions

M&M58: c=ps=pb=0 GL=0

Miller (1963): c> 0 but ps=pb=0 GL= cDL

Miller (1977): c> 0 and ps (1 - pb ) or

(1 - c) (1 - ps) < (1 - pb)

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Supply and Demand for Bonds

For simplicity lets assume: ps=0

and corporate tax the same for all corporations.

%

$ amount of all bonds

j

C

S rr

=

1

1

0

r0is the effective, aftertax interest rate thecorporation pays

i

pb

D rr

=

1

1

0

Demand: order individuals by tax rate

+1

0i

pb

i

pb

Tax Exempt Bonds

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Implications

1. High tax individuals buy tax exempt bonds Once those run out low tax individuals supply capital to the

corporate debt market

2. There is an optional economy-wide debt levelBUT each firm is exactly indifferent

Why? Costs the same.

Implies capital structure is irrelevant

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De Angelo and Masulis (1980)

Heterogeneous Corporate TaxesWith different tax rates:

Low tax firms are less interested in debt (and high more) Resulting in a downward sloping supply curve of debt

Currently, in the US, the corporate tax rate is 35% How do corporations get different tax rates?

They substitute, depreciation, investment tax credits Even with the same rate, corporations may have different effective

tax rates

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Debt Market Equilibrium

%


j

C

S rr

=

1

1

0

i

pb

D rr

=

1

1

0

Tax Exempt Bonds

FirmswithHighc

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Differences in Tax Rates

Cordes and Sheffrin (1983) using Treasury Data to calculate effective tax rates

Differences in Effective tax rates ranging from 45% for tobacco 16% for transportation and agriculture

Differences due to:Tax carry-backs and carry-forwards Foreign and domestic tax credits Investment tax credits Difference in taxes on capital gains vs. earnings Minimum tax rules


An Example

Consider a world where return is sufficiently volatile thatsome times the tax shield won

t be valuable.

r0=10% c=50% ps=0% pb=20% Assume all investors have the same tax rate:

Required return on taxable Debt:

125.2.1

1.

1

0=

=

=

pb

D

rr

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Example: Diminishing Value of Tax Shield

S1 S2 S3 S4

Pr . 25 .25 .25 .25

Taxable Income

E[After TaxIncome]

EffectiveTax Rate

Highest RateWilling

Next $

Debt 0 500 1000 1500 2000 625 50% 20%

Debt 40000 500 1000 1500 375 37.5%

.1/(1-.375)

Interest 500 16%

Debt 80000 0 500 1000 187.5 25%

.1/(1-.25)=

Interest 1000 13.3%

Debt 120000 0 0 500 125 12.5%

.1/(1-.125)

Interest 1500 11.4%

Debt 160000 0 0 0 0 0% 10%

Interest 2000

Tax Shield available upto $500 in interestpayments

But, over $500 in interest no taxes are paid inone state of the world: .75 x .50 = .375

=

=

5.1

%10

1

%10

C


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Example: Diminishing Value of Tax Shield

Taxable Income

E[After TaxIncome]

Effective TaxRate

HighestRate

Willing

Debt 0 500 1000 1500 2000 625 50% 20%

Debt 2000250 750 1250 1750

Interest 250

Tax rate 50% 50% 50% 50%500 50%

.1/(1-.50)

After Tax Inc. 125 375 625 875 20%

Debt 60000 250 750 1250

Interest 750

Tax rate 0% 50% 50% 50%312.5 37.5%

.1/(1-.375)

After Tax Inc. 0 125 375 625 16%

Between $0 and $500 indebt payments

Between $500 and$1000 in debt payments

Debt Supply

%


Downward sloping because effective tax rate drops and

Cannot deduct interest in all states of the world

20%

16%

13.3%

11.4%10%

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$4K $8K $12K $16K

Downward Sloping Debt Supply

%


jC

S rr

=

1

1

0

i

pb

D rr

=

1

1

0

r*

( ) ( )*00*

11D

Cpb

rrr

=

=

Effective Tax Rate at givenlevel of debt

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Implications

Many firms use leasing a non-debt tax shield Leasing lowers the value of the debt tax shield

In a recession Debt Supply curve drops Capital Structure IS relevant

VL

Debt

VU

Miller6

3

MM58

DeAngelo and

Masulis (1980)

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Relaxing more M&M58 Assumptions

Relaxing Assumptions of No wealth transfers and Fixed Investments

Agency Problems1. Under investment2. Risk Sharing3. Milking the firm

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Under Investment

Under Investment: when the shareholders in a firm nearbankruptcy instruct management not to invest in a positive

NPV project because it will only benefit bond holders

Consider an example 3 time periods 2 projects r = 0% Risk Neutral investors

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Under Investment Example

Two projects have the following cash flows:

Suppose there is a bond in the capital structure thatmatures at t=2

t=0 t=1 t=2 NPV

A -50 100 50 100

B 0 -75 100 25

Cash Flow

to Equity -50 25 150 125

t=0 t=1 t=2 NPV

Bond 120 -20 -100 0

A+B -50 25 150 25

Cash Flow

to Equity 70 5 50 12537


Consider if the firm takes the bond, but only project A:

If bond holders pay $120 for bonds expectingprojects A & B will be done, the bond holders areripped off.

If they knew theyd only be willing to pay $70 for the bondpaying $120

t=0 t=1 t=2 NPV

CF of Bond 120 -20 -100

CF of A -50 100 50

Cash Flow

to Equity 70 80 0 150

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If they pay $70 for the bond paying $120:

If instead they just commit to the $70 bond:

t=0 t=1 t=2 NPV

CF of Bond 70 -20 -100 -50

CF of A&B -50 25 150

Cash Flow

to Equity 20 5 50 75

t=0 t=1 t=2 NPV

CF of Bond 70 -20 -50 0

Only A -50 100 50 100

Cash Flow

to Equity 20 80 0 100

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Firm has no incentive to do both A & B If the firm cannot credibly commit to A & B then only

A is sustainable.

But this is not optimal: the NPV from taking bothprojects (if they could commit) is 125

t=0 t=1 t=2 NPV

CF of Bond 70 -20 -50 0

Only A -50 100 50 100

Cash Flow

to Equity 20 80 0 100

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2) Risk shifting

Payoffs to bond and equity holders in a firm with debt:$

Vfirm

Payoffs to Equity like a call: = Vequity Payoffs to Bonds like writing a put

Equity PayOffs

Debt PayOffs

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Risk Shifting

With debt, riskier projects are better for equity holders Share holders especially prefer high risk projects near

bankruptcy

Potential bond holders anticipate this and are willing to payless for debt

Who loses out?The equity holders pay the cost of not being able to credibly

commit

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3) Milking the property

In financial distress pay more to shareholders:t=0 t=1

CF Equity $750 0CF to Debt 0 0CF Equity 0 $100CF to Debt 0 $1,000

Take $$and run

Leave Assetsin Place

Bond holders insist on covenants as a part of thecontract to protect their wealth from expropriation byshareholders.

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Bond Holder wealth expropriation

Jensen and Meckling (1976)Agency Cost of Debt

Agency Costof Equity

Agency Cost ofDebt

$Cost

D

D+S


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Jensen and Meckling (1976)

Typical Bond Indenture Provisions1. Restrictions on dividend payouts2. Restrictions on issuance of new debt3. Restrictions on merger activity4. Restrictions on the disposition of firm assets

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Signaling

Firms choose their capital structure to communicate signalsabout the quantity of the projects/firm to the market

Implicit in M&M58 is that the market knows the cash flows.But they dont.

The market values the perceived cash flows

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Ross (1977)

Capital structure may change the perception of risk w/oactual changes in return

Example: Suppose D* is the maximum debt a bad firm can take w/o going

bankrupt

Good firms can take on D* or more without the risk of bankruptcy For equilibrium, signals must be

Unambiguous Managers must have the incentive to tell the truth

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Ackerlof (1970): The market for Lemons

4 types of cars: New/Used Good/Bad

When you buy a newcar you dont know if it is good orbad.

Over time an information asymmetry develops Owners (sellers) know the quality - - Buyers dont

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Ackerlof (1970): The market for Lemons

Buyers cant tell the difference between good and bad cars so they offer the same price for each type good or bad.

Implication: Good cars are not traded only bad cars are. Costly signals can solve the problem.

Idea: find a signal that is too costly for the bad to use, but cheapfor the good.

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Example: Costly Signaling Spence (1973)

Job seeker of one of two types: Productive Unproductive

Suppose education is costly Productive: Cost = x yrs Unproductive: Cost = 1 x yrs

Offer a high wage to those who get at least Y* years ofeducation and a low (or no) wage to those that dont

But employers cannot offer so much that it is valuable forunproductive workers to get an education

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Pooling vs. Separating Equilibrium

If wages, in the example, are too high we have a poolingequilibrium: you cant tell the good from the bad.

If wages are set high enough to entice high productivityworkers, but low enough to not make it worth while for low

productivity, then we have a separating equilibrium: the bad

choose not to get an education and the good do.

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Pooling vs. Separating Equilibrium

Suppose there are two types of firms: Hi & Lo Lo could not maintain a certain level of Debt, D*, because

of Low profits or high volatility (risking bankruptcy)

But High can. Ross(1977) suggested that if E[profit] does not equal actual

profit, then high quality firms can raise their value, by

signaling their quality through choosing a level of Debt D*

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Pecking Order Hypothesis/Conjecture

Myers and Majluf (1984) and Myers (1984)

Managers know the true value of the firm. Outsiders dont Adverse selection costs caused by information asymmetry

If a project comes along managers first use1. Retained earnings

No adverse selection costs2. Debt

Debt is a costly commitment3. External equity financing

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Frank and Goyal (2003)

Pecking Order Hypothesis/Conjecture doesnt hold up sowell

1. Should work best for small high growth firms but in fact itbest explains large low growth firms in the 70s and 80s

2. External financing is prevelant and large3. Equity Capital is often larger than Debt in firms

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Dividends: How dividends are paid

Declaration date: date when the size of the dividend isstated

Ex-dividend date: the first date the stock trades withoutthe declared dividend

Record date: the date, 2 days after the ex-dividend date, onwhich the company sees who owns their shares.

Payable date: is the date the dividend checks are sent out.

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Dividend Policy in Brief

Like M&M 58, Dividend Policy should be irrelevant to the value of thefirm

Given that dividends are tax disadvantaged (taxed as income at higherrates until 2003) they shouldnt be used.

Investors prefer repurchases (because of taxes)

Dividend policy cannot affect the present value of cash flows onlywhen we receive them

Accelerating payments does NOT reduce uncertainty of cash flows and pricedrop on ex-dividend date will be l arger

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Empirical Dividend Policy

Litner (1956) surveyed 28 companies, managers:1. Focus on the change in dividend, not the amount2. Avoid making dividend changes that have to be reversed3. Change dividends if earnings are out of line4. Pay little attention to need for investment

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Empirical Dividend Policy

Brav, Graham, Harvey & Michaely (2003) Cut dividends only under extra ordinary circumstances

Tend to smooth dividends Changes linked to long term changes in profitability

Repurchases are more flexible Used for temporary earnings spikes after investment needs are met

Repurchase when stock prices are low Repurchase to improve EPS

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Optimal Dividend Policy?

Without taxes there is none. If there are taxes choose the cheapest

The Bird in the Hand Fallacy

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The Bird in the Hand Fallacy [Bhattacharya (1979)]

Many have argued that when cash flows are uncertain paying dividends sooner reduces uncertaintyA bird in the hand is worth two in the bush

Bhattacharya (1979) points out that dividend policy cantchange the present value of cash flows received only the

timing.

What is relevant is the riskiness of cash flows

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Optimal Dividend Policy?

Without taxes there is none. If there are taxes choose the cheapest

Marsalis and Truman (1988) model personal taxes ondividends

Implication Cost of Internal capital is lower than external funds (ifdividends are tax disadvantaged)

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Optimal Dividend Policy

Marsalis and Truman (1988): Cost vs. Benefit of internal vs. external financing

Equilibrium is when after tax return is the same to reinvestment and dividends High tax individuals prefer reinvestment Low tax prefer dividends (tax clienteles) Firms with positive NPV projects will use up internally generated

fund first

Firms with fewer growth options will pay dividends Decreases in current earnings should leave investment unchanged in

firms that use external capital and decrease investment in firms usinginternal capital

Shareholder disagreement about investment policy will lead to theuse of internal funds

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Evidence: Clientele Effects

Low tax investors buy high dividend yield stocks Elton and Gruber (1970)

Possible Caveat: Tax Arbitrage [Kalay, 1977, 1982] 2010 Patrick J. Kelly 63

Ex-date pricedecline div

Dividends as Signaling

Ross (1977) Dividends are irrelevant in part becauseM&M61 assume investors know random returns

Capital structure can be used to signal the quality of the firm Bhattacharya (1979)

Dividends can be a costly signal because less successful firmswould have to finance externally

Trade off between signaling benefit and Tax Consequences

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Repurchases

With tax dividends taxed at a higher rate, repurchases are away to distribute cash to share holders at the lower capitalgains tax rate

IRS is not dumb though: frequent repurchases will be taxed likedividends

Open market repurchase Buy back over time

Tender offer: number of shares, tender price, expiration of offer If over subscribed, repurchase on a pro rata basis If undersubscribed, extend or cancel

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Guay and Harford (2000)

When Dividends? When Repurchase? Dividends: permanent cash flows Repurchase: transient cash flows

Hypotheses: Why repurchase?1.Signaling: Signal of increased cash flows OR exhausted investment

opportunities

2.Tax shield: repurchase shares with new debt issue3.Avoiding taxes: Section 302: Substantially disproportionate4.Bond holder wealth expropriation: reduce asset base5.Wealth transfer among share holders

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Guay and Harford (2000): Findings

Evidence most consistent withTax shieldTax avoidance

But signals favorable information about future cash flows.

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Evidence of Dividends as a costly signal is mixed

Information about current dividends does not help forecastearnings [Watts (1973), Gonedes (1978), Penman (1983)]

Earnings changes predict dividend changes, but not the other wayaround [Benartzi, Michaely and Thaler (1997)]. Dividend decreases

precede HIGHER earnings

Market reaction to dividend changes larger when taxes arehigher [Grullon and Michaely (2001)]

Similar reactions in Germany, where dividends are tax favors(they are lessof a signal) [Amihud and Murgia (1997)]

Might signal changes in systematic risk [Grullon, Michaelyand Swaminathan, 2002]


Firm as a Nexus of Contracts

The firm is a set of contracting relationships Where there may exist externalities to the contracting

process

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Externalities

Externalities are the by product of a (productive) processthat imposes harm (or benefits) to other agents

Pollution Cattle Rancher/Farmer Problem

A rancher trying to water his cattle tramples the field of a farmerThe externality is the destroyed crop

One agent maximizing profits imposes costs on another Principle-Agent realm: one agent maximizing utility imposes costson the principle

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Coase (1960)

Property Rights: The socially enforced right to select uses ofgoods

Coase Theorem: In the absence of transactions costs the allocation of resources

does not depend on the initial disposition of property rights.Assuming

No transactions costs Trade-able property rights No income effects

Bottom p4 then p371

Coase Theorem

Efficiency occurs regardless of the structure The Coase Theorem is an Organizational Irrelevance

Theorem

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Firm as the Nexus of Contracts: Coase (1937)

In market economies coordination of activity is doesthrough the pricing mechnism

Why do we have firms which entirely remove prices fromthe production coordination process?

Answer: There are costs to using the price mechanism Discovering Prices NegotiationTaxes

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Boundaries of the Firm

Transactions costs help dictate the boundaries and structure ofthe firm

Activities which are less costly to internalize are made partof the firm otherwise external

The essence of Coase (1937) It is in the interest of individuals to explore gains to trade It is in the interest of individuals to explore contracts to minimize

costs

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If a research paper says

If a research paper says an organizational feature isimportant, you must ask:

What is the ill-defined property right?What is the transaction cost ? that makes this feature important?

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Firm is a set of contracting relationships among individuals Imperfect contracting leads to agency problems

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When owner/manager owns 100% of firm there are noagency costs. The manager maximizes his or her own utility.

Sets Marginal Utility derived from $1 of expenditure of firmresources = Marginal Utility of $1 in purchasing power (fromdividends paid)

Perquisite consumption not a problem

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If a owner/manager owns only 95%:The manager expends effort to the point where the marginal utilityof $1 of expenditure of firm resources equals marginal benefit of

95 cents purchasing power

Partial ownership leads to less vigorous effort Perquisite consumption

Agency costs arise because contracts cannot be written andenforced with no cost

Coase (1960): Contracts define the rights, but There are significant transaction costs.

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Agency Costs are:1. Costs of Structuring a set of contracts2. Costs of Monitoring and Controlling the behavior of agents by

principles

3. Costs of bonding to guarantee that agents make optimal decisions Or that principles are compensated for suboptimal decisions

4. Welfare loss arises from the divergence between agents decisionsand those which maximize the principles welfare.

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Agency costs affect the level of Debt Bankruptcy liquidation is a hard tool against managers

Agency Costof Equity

Agency Cost ofDebt

$Cost

D

D+S


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Corporate Finance- Theory and Empirics

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