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Tradeoff and Pecking Order Theories of Debt by Frank and Goyal (2)
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Transcript of Tradeoff and Pecking Order Theories of Debt by Frank and Goyal (2)
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Tradeoff and Pecking Order
Theories of Debt
By Frank and Goyal
Presented to: Dr. Khurram S. Mughal
Presented on: 15-05-2014
Presented by:
Aneeza YounusZareen Fatima
Sadia Khaliq
Fahd Salman Mirza
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Layout
Conceptual Framework oftheories of debt
M&M Theory
Trade-off Theories
Pecking Order
Evidences
Conclusion
Aneeza Younus
Zareen
Fatima
Sadia Khaliq
Fahd Salman Mirza
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Capital Structure Puzzle
Basic Question?
How do firms choose their capital
structures?
Broadly, capital irrelevance, trade off and
pecking order theories explains capital
structure decisions
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Modigliani Miller Theorem
(Propositions)
FirstUnder some assumptions, the value ofcompany is independent of itsleverage(debt + preferred stock)
SecondMultiple equilibrium is determined wheredebt is issued by different firms keepingin view the personal and corporate taxwhich also affect economy wide leverageratio such as debt to asset ratio, debt toequity ratio etc.
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Assumptions of MM Theorem
1. No consideration of taxes2. No transaction costs
3. No costs of financial distress or bankruptcy
4. No agency costs
5. Lack of separtability between financing andoperations
6. Investors have homogeneous expectations
of company returns or future cash flows7. Individuals investors can borrow at the
same interest rate as that of a company orfirm
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The theory has unrealistic assumptions
Later on by filling the gaps in the theory
(assumptions), various researchershave given their own theories
Empirically, MM theory is difficult to test
Criticism on Theory
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Plus Points
It remained relevant up till 1980
Influenced the early development of
both the trade-off theory and peckingorder theory
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Trade Off TheoryCharacteristics:
Theory that capital structure is based on a trade-offbetween debt and equity
If debt is more, equity would be less and if debt is less,
equity would be more
Firm evaluates the various costs and benefits of leverageplans
Different leverage plans are dependent on taxes
(personal + corporate), bankruptcy costs, tax schedules
and transaction costs
If the actual leverage ratio deviates from the optimal one,
the firm will adapt its financing behavior in a way that
brings the leverage ratio back to the optimal level
Solution
Obtained when equilibrium or balance point is reached 8
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The Static Trade Off Theory
Firms leverage is determined by asingle period trade-off between the tax
benefits of debt and the deadweight
costs of bankruptcy
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The Dynamic Trade Off Theory
Presents a model of dynamic optimalcapital structure choice in the presence
of recapitalization costs such as tax
rates, tax codes, transaction andbankruptcy costs
Capital Structure may not alwayscoincide with their target leverage ratios
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Pecking order theory The pecking order theory suggests that there is an order of
preference for the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:
Internal funds
External funds
Debt
Equity
Firm size and age are important determinants of capital structure
Larger firms use less leverage
Older firms use less leverage
pecking order models can be derived based on adverse
selection consideration and agency cost.
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Pecking Order Theory There are three factors that the pecking order
theory is based on and that must beconsidered by firms when raising capital.
1. Internal funds are cheapest to use (no issuancecosts) and require no private information release.
2. Debt financing is cheaper than equity financing.3. Managers tend to know more about the future
performance of the firm than lenders andinvestors. Because of this asymmetric information,investors may make inferences about the value ofthe firm based on the external source of capital thefirm chooses to raise. Equity financing inferencefirm is currently overvalued
Debt financing inferencefirm is correctly orundervalued
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Asymmetric-Information Costs
Definition:The costs of overcoming two types ofinformation problems:
Adverse selection:separating good from bad risks
before implementation of a financial contract.
Agency theory:insuring that economic agentswith proxy authority live up to the terms of their
contracts.
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Adverse selection
The key idea is that the owner-manager ofthe firm knows the true value of the firms
assets and growth opportunities.
Outside investors can only guess these
values. If the manager offers to sell equity,then the outside investor must ask why the
manager is willing to do so.
manager of an overvalued firm will be happy
to sell equity, while the manager of anundervalued firm will not.
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Adverse selection refers to a market process inwhich undesired results occur when buyersand sellers have asymmetric information(access to different information); the "bad"products or services are more likely to beselected.
Adverse selection make some financing vehicles
much more expensive than others Managers want to issue new stock only when it is
overvalued.
Stock issuance is a bad signal.
Stock issuance causes the price of outstandingstock to fall.
Decline in stock price is part of the cost ofexternal finance.
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Conclusion of adverse selection
Adverse selection models can be alittle mild. It is possible to construct
equilibrium with a pecking order, But
adverse selection does not imply thatpecking order as the general situation.
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Agency theory
Principal-Agent Problem: Principal designates anagent to act on his behalf. But becausemonitoring and disciplining are costly, the agenthas scope to pursue his own interest at theexpense of the principal.
Examples:
1. Separation of ownership from control allows managersto use firm resources to pursue their own interestsrather than maximize shareholder value.
2. Separation of savers and investors allows investors touse surplus funds to pursue their own interests ratherthan accept the capital projects with the highest netpresent value.
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Debt Financing and Agency
Costs One agency problem is that managers
can use corporate funds for non-valuemaximizing purposes.
The use of financial leverage: Bonds free cash flow. Avoid bonuses and non-value adding
acquisition.
A second agency problem is the potential
for underinvestment. Debt increases risk of financial distress.
Therefore, managers may avoid riskyprojects even if they have positive NPVs.
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LEVERAGE DIFFERENCES
BETWEEN FIRMS
Debt ratios vary among firms on thebasis of :
Determining Factors correlated with
leverage
Debt conservatism puzzle
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Leverage Definition & Other
Econometric Issues
Leverage is defined asi. Book leverage (debt/total assets) or
ii. Market leverage (debt/total assets + market value ofequity)
Early studies focused on book leverage
because Debt is better supported by assets in place than growth
opportunities
Market value fluctuates, so gives unreliable figures
Backward looking
Subsequent studies focused on marketleverage because Book value only balance the two sides of balance sheet
Book value can be negative
Market value is forward looking
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Econometric Issues
1. Panel structure of data Can be overcome by using more than one methods
2. Incomplete data in panel
Can be overcome by multiple imputation
3. Outliers
Can overcome by rule of thumb (remove extreme
data), winsorization (most extreme tails of distribution
are replaced by most extreme value that has not been
removed) & robust regressions4. Assumptions about debt market
Use of book debt to study debt market
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LEVERAGE FACTORS
1. Leverage & growth
2. Leverage & Firm size
3. Leverage & Tangibility of assets
4. Leverage & profitability
5. Leverage & industry median debt ratios
6. Leverage & dividends
7. Leverage & expected inflation
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1. Leverage & Growth
i. Static trade-off theory predicts negativecorrelation between these variables because of:
Underinvestment problem
Growth firms lose their value when are in distress
Asset substitution issue In high growth firms, stockholders can easily increase project risk
Agency cost of free cash flow is less severe
ii. Pecking order theory predicts positive relation
between these variables
Different studies conclude negative correlation
between leverage & growth
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2. Leverage & Firm size
i. Static trade-off theory predicts positive correlationbetween variables because
Are more diversified
Low default risk
ii. Pecking order theory predicts negative correlation
between variables because
Adverse selection issue is low so equity issuance is
easy
Studies find positive relationship between leverage
& firm size
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3. Leverage & Tangibility of assets
Tangibility of assets is measured by:
Fixed Assets/ Total assets
i. Static tradeoff theory & Agency theory predicts
positive relation between variables because:
Easily collateralize-able
Difficult to replace high risk assets with low risk
assets
ii. Pecking order theory predicts negative relation
because:
Low information asymmetry makes equity issue less
costly
Studies found positive relation between leverage &
tangibility of assets
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4. Leverage & Profitability
i. Static trade off theory predicts positive relationbetween variables because:
Bankruptcy cost is low
Tax shields are more valuable
ii. Pecking order theory predicts negative relation
because: Profitable firms prefer internal financing
Studies find negative relation between leverage &profitability
5. Leverage & Industry median debt ratios
Different empirical studies find the positive relationbetween variables
Firms adjust their ratios towards industry ratios 26
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6. Leverage & Dividends
Static trade-off theory predicts positive relation ashigh levered firms should pay more dividend to seemless risky
Dynamic trade-off theory predicts negative relation
Pecking order theory predicts positive relation Empirical studies show negative relation between
leverage & dividends
7. Leverage & Expected Inflation Tax code suggests positive relation between
variables
Tax deduction on debt is higher if expected inflation
rate is higher 27
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DEBT CONSERVATISM Debt conservatism puzzle means that many firms are having
lower leverage than would maximize firm value
Miller find that bankruptcy cost is too small to offset large taxsubsidies of debt
He regarded tax gains & bankruptcy cost as horse & rabbitstew recipe
i. Bankruptcy cost
Direct bankruptcy costs are less than indirect ones Molina find that ex-ante cost of financial distress are
comparable to the current estimates of tax benefit of debt
ii. Tax Benefit
Information about tax shield is difficult to obtain
Graham & Tucker find that firms with tax shelters use lessdebt but their results are criticized by different researchers
Ju et al (2004) find that firms have more leverage thanoptimal ratio
Behaviorist approach find out that overconfident managerchooses more debt than rational one 28
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STUDIES OF LEVERAGE
CHANGES
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Tests of Pecking Order
Changes in debt have played an important role in
assessing pecking order theory because financing deficit
is suppose to drive debt
The regression of net debt issues on financing deficit has
slope equal to 1
Shyam-Saunders & Myers find a strong support for the
pecking order theory (0.75 regression slope)
Frank & Goyal (2003) found that equity is used more
than debt for financing deficit This shows that other cross-sectional factors are more
important than financing deficit
Support for pecking order theory is found among large
firms30
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Debt Capacity Lemmon & Zender gave the idea of debt capacity in
understanding rejection of pecking order theory that whenconstrained by debt capacity, firm issues equity otherwisedebt is issued
Firms with debt rating are unconstrained by debt capacity Hhalov & Heider (2004) argues that in case of information
asymmetry, debt has more adverse selection problem(asset volatility), so firms issue equity
Debt ratios donot rise prior to equity issues, suppotrespecking order theory (Korrajczyk et al. 1990)
Less than 40% firms follow pecking order while issuingdebt where as almost half of the firms follow order whileissuing equity
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Tests of Mean Reversion
Static trade-off theory predicts a debt ratio that depends upon
tax benefits & cost of financial distress (target adjustment
process)
But data reveals that leverage is quite stable in American firms
Early studies used long term average as a target assuming
factors causing change are constant Recent studies use two step procedure:
i. Target equation
ii. Adjusted equation
Different studies show that firms adjust towards target debt
ratio
But the speed with which adjustment towards target is made is
not a settled issue
Pattern of leverage changes are due to different adjustment
costs Levera e mean reversion ha ens throu h debt market
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Exit
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Previous literature & theories suggest that
Bankruptcy is the only way of exit
Mergers & acquisitions are more common reason for
exit than bankruptcy & liquidations Exit by merger is different from exit by liquidation
In exit by merger & acquisitions, assets receive more
value than exit by liquidation
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Effect Of Current Market Conditions On
Leverage Adjustment Choices
Factors affect leverage choices are
1. Market to book ratio
2. Inflation rate
But these two do not affect long term leverage ratio
Firms that issue equity in good markets have low
leverage ratio for a decade (Baker & Wurgler, 2002)
Different studies find that market timings have
effects on leverage but disappear after one 1-2years
Effect of shocks on equity are permanent
This idea was rejected because usually good equity
returns are followed by more stock issues 35
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Market Valuation of Leverage Changes
Predictions
What are the Valuation effects on repurchases or
exchanges of one security for another?
Trade-off Theory:
Firms will only take actions if they expect benefits. Market reaction to both equity and debt securities
will be positive
Two pieces of information confounding response to
leverage change:i) The revelation of the fact that the firms conditions
have changed, necessitating financing.
ii) The effect of the financing on security valuations
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Market Valuation of Leverage Changes
Good news if the firm is issuing securities to take
advantage of a promising new opportunity that wasnot previously anticipated.
Bad news if the firm is issuing securities because
the firm actually needs more resources than
anticipated to conduct operations.Agency Perspective:
Equity issues by firms with poor growth prospects
reflect agency problems between managers and
shareholders. If this is the case, then stock prices would react
negatively to news of equity issues.
f C
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Market Valuation of Leverage Changes
Pecking Order Theory:
Predicts that securities with more adverse selection(equity) will result in more negative market reaction.
Securities with less adverse selection (debt) will
result in less negative or no market reaction.
EvidenceEckbo and Masulis (1995)
Announcements of corporate debt issues and debt
repurchases have little if no effect on the market
value of the firm.Announcements of equity issues are generally
associated with a drop in the market value of the
firm.
Announcements of equity repurchases are
generally associated with an increase in the market
Market Valuation of Leverage Changes
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Market Valuation of Leverage ChangesJung et al. (1996)
Firms without valuable investment opportunities
experience a more negative stock price reaction toequity issues than do firms with better investment
opportunities.
Firms with low managerial ownership have worse
stock price reaction to new equity issue
announcements than do firms with high managerial
ownership (Agency view)
Eckbo and Masulis (1992)
Examined stock price reactions to equity issues
conditional on a firms choice of flotation method.Announcements of security issues typically
generate a non-positive stock price reaction.
The valuation effects are the most negative for
common stock issues, slightly less negative for
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Natural Experiments
Blanchard et al. (1994) Examined a sample of 11 firms and found that firms
increased their long-term debt following the cash
windfall.
The pecking order predicts an increase in debt if
firms have attractive investment opportunities andborrow more money.
The increase in debt following cash windfalls is
inconsistent with the pecking order theory.
The agency theories predict that managers expandwhen possible.
Firms are able to increase debt because cash
windfalls increase a firms debt capacity.
Consistent with Agency theory.
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Natural Experiments
Cash can be viewed as negative debt, then, thecash windfall is a reduction in leverage.
If the original leverage was optimal, then the firm
needs to increase its debt (or repurchase equity) in
response to the windfall.
Compatible with the trade-off theory perspective.
Experiments on Tax
Calomiris and Hubbard (1995) show that firms
increased their debt after the introduction of theundistributed profits tax.
Consistent with firms increasing the amount of debt
to reduce taxes on retained profits.
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Natural Experiments
Experiments on Tax In 1986, there was a tax reform that reduced both
corporate and personal marginal tax rates.
Firms with high tax rates prior to the tax reform
reduced their debt the most after the tax reform.
(Consistent with Trade-Off theory) In 2003, there was a large cut in individual dividend
income taxes.
Chetty and Saez (2004) show that there was a
significant increase in dividend payments followingthe tax cut.
Goyal et al. (2002) examine the US defense
industry during the 1980-1995 period.
Examined how the level and structure of corporate
debt changed when growth opportunities declined.
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Natural Experiments
Experiments on Tax New debt issued increased significantly for
weapons manufacturers during the low growth
period.
Dittmar (2004) and Mehrotra et al. (2003) examine
the capital structure choices that firms make whenengaging in spinoffs.
Firms with higher tangibility of assets are allocated
more leverage. Assets with lower liquidation costs
have more leverage.
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Surveys
The most common criticism of survey approach isthat it measures beliefs rather than actions.
The approach implicitly assumes that managers
beliefs reflect reality.
Graham and Harvey (2001) This desire for financial flexibility seems
inconsistent with the pecking order theory since
dividend-paying firms value flexibility the most.
Firms that perceive their stock to be undervalued
are reluctant to issue equity.
CFOs consider the tax advantages of debt to be
moderately important.
Market Valuation of Leverage Changes
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Market Valuation of Leverage Changes
Surveys
Managers show great deal of concern about creditratings and earnings volatility in making debt
decisions.
European managers also rank financial flexibility as
the most important factor in determining their firmsdebt policy.
Tax advantage of interest expense ranked as the
fourth most important factor after financial flexibility,credit rating and earnings volatility.
Conclusion/Stylized facts
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Conclusion/Stylized facts
According to the standard trade-off theory, taxes
and bankruptcy account for the corporate use of
debt.According to the standard pecking order theory,
adverse selection accounts for the corporate use of
debt.
Private firms seem to use retained earnings andbank debt heavily.
Small public firms make active use of equity
financing.
Large public firms primarily use retained earnings
and corporate bonds.
Direct transaction costs and indirect bankruptcy
costs appear to play important roles in a firms
choice of debt.
Over long periods of time, leverage [debt/assets] is
Conclusion/Stylized facts
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Conclusion/Stylized facts
Firms adjust their debt frequently. The financing
deficit plays a role in these decisions.
Aggregate dividends are very smooth and almostflat as a fraction of total assets for all classes of
firms.
After an IPO, equity issues are more important for
small firms than for large firms. Many small firmsissue equity fairly often.
Mergers and acquisitions are more common
reasons for exit than are bankruptcies and
liquidations.
Announcements of corporate debt issues and debt
repurchases have little if any effect on the market
value of the firm.
Announcements of equity issues are generally
associated with a drop in the market value of the
Conclusion/Stylized facts
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Conclusion/Stylized facts
Announcements of equity repurchases are
generally associated with an increase in themarket value of the firm.
The natural experiments papers are generally
easy to understand from the perspective of the
trade-off theory.
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Thank You