Advanced Corporate Finance and Control (MANMEC053)
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Topic 1: Capital structure decision & Cost of debt and equity
Journal quality: high reputation in research community expected to deliver high quality research.
However, you still have to judge quality of each research.
Critically assess how financial decisions (capital structure) can affect the value of a firm.
Capital structure theories: try to explain why capital structure of firm is the way it is.
- 2 options: debt or equity continuum: every combination is possible.
Modigliani-Miller theorem: capital structure is affected by costs of debt/equity how taxes +
financial distress affect company’s capital structure decision.
weighted average cost of capital (WACC): marginal cost of raising additional capital, affected by
costs of capital and proportion of each source of capital.
E D
WACC = ∗r e + + r e∗( 1−t ) where V =D+ E
V V
Based on unrealistic assumptions, but model does help explain real world phenomenon.
1. Investors have homogeneous expectations regarding future cash flows.
2. Bonds and stocks trade in perfect markets. Bond = debt; equity = stock perfect markets.
3. Investors can borrow and lend at the same rate very unrealistic.
4. There are no agency costs.
5. Investment and financing decisions are independent of one another (no taxes).
Assumptions lead to following propositions:
1. Market value of company is not affected by its capital structure capital structure
irrelevance proposition.
- Investors would value firms with same CF the same don’t care how it financed.
Because no benefit of borrowing no interest deductibility.
- Unrealistic model helps explain real world when there are differences in valuation
company maybe assumptions are violated? Important to know when capital structure
matters.
2. Cost of equity is linear function of company’s debt/equity ratio.
- Seniority of debt over equity creditors get money first when company goes bankrupt
cost equity linear function of debt/equity ratio: equity costs increase when there are
more creditors.
- WACC is constant: more cheaper source of capital used (debt), cost of equity increases.
Irrelevance of capital structure for value of firm.
Now introducing taxes + expected cost of financial distress:
- Now choosing debt value firm better due to interest deduction.
- However, debt financing risk financial distress decreases value of firm.
So, there is optimal point of debt financing optimal capital structure: value of firm
maximized + costs are minimized.
Model helps identifying drives of capital structure, even though model is not realistic
many theories have developed on basis of this.
,1a. Lemmon & Zender (2010) – Debt capacity and test of capital
structure theories
RQ: Examine impact of explicitly incorporating a measure of debt capacity in recent tests of
competing theories of capital structure.
Test whether pecking order theory works in real life + add 1 factor: debt capacity.
Tradeoff theory: optimal mix between debt + equity to balance benefits of each.
- Tax benefits + control of free cash flow problems pushes firms to use more debt.
- Bankruptcy + other agency costs incentives to use less debt.
Pecking order: no trade-off/optimal capital structure, but firms follow pecking order of
incremental financing choice.
- Basic assumption is that there is a specific order/sequence in funds/financing.
- Internally generated funds > debt > (external) equity.
- When firm reaches its debt capacity, than external equity.
Debt capacity: indicator whether firm has (based on underlying characteristics) high
likelihood of being able to access further funding via debt.
Authors argue that pecking order is good theory to view capital structure, but debt capacity should be
added.
Model: authors adjust original model by Shyam-Sunder & Myers in 2 ways:
1. Separately analyze firms that are not expected to be constrained by debt capacity concerns.
2. Add independent variable: square of the financing deficit look at financing hierarchy.
- Dependent variable: capital structure 1 debt 0 otherwise (dummy logit regression).
- Debt capacity: likelihood that firm can access public markets
bond rating.
Results: when firms must seek external funding: firms not constrained by
debt capacity (high bond rating) more likely to use debt, firms with
limited debt capacity more reliance on equity for financing deficits.
- Given level of debt capacity: firm reliance on external equity
increases with size of deficit.
Conclusions: pecking order good predictor of capital structure, but should include debt capacity.
Firms least likely to be constrained by debt capacity debt
primary security to finance deficit, even for large deficits.
Small high-growth firms (limited debt-capacity) not that negative
signal equity issue (despite more asymmetric information about
value firm), because investors realize that firm is not flexible in
financing ways.
__________________________________________________
Theoretical relevance: not ‘breaking’, but they address research gap on opposing findings on
literature about pecking order theory, by adding debt capacity.
Practical relevance: dataset 1971-2001 trends past 20 years not considered (crisis + ↓ IPOs).
Societal relevance: low no insights which improve society.
Model: could model be applied to countries with different institutional framework? Whole paper
rests on bond rating/market sentiments model not applicable in bank-based system?
- Paper needed to proxy debt capacity, so chooses bond rating as proxy for difference between
firms. However, paper only uses one measure for this, while whole paper rests on this.
Conclusion: agree that pecking order is good describer, but equity not last resource there are
even cheaper ways.
, Discussion: other factors which could drive capital structure (not incorporated in pecking-order): tax
rates, equity signaling (debt signals you can carry costs, equity signals that stocks are overvalued).
1b. Robb & Robinson (2014) – The capital structure decisions of new
firms
Link to previous paper: capital structure decisions might be different for startupfirms.
RQ: study capital structure choices that entrepreneurs make in their firms’ initial year of operation.
Literature:
Stiglitz/Weiss: friction + information asymmetry in capital markets prevent startups from
accessing formal debt markets financing through informal channels or rely on trade
credit.
Berger & Udell life-cycle: non-transparent firms rely more on informal capital due to
information asymmetry.
However, still in many cases startup is (partially) financed by formal credit channels.
Distinction risk-bearing vs. liquidity provision: entrepreneur uses home levered equity line
to finance startup: entrepreneur bears risk of failure through levered equity stake, but bank
provides liquidity through debt instrument.
Model: use restricted-access data from Kauffman Firm Survey (longitudinal survey of new business in
US). Use six categories to classify funding (owner/insider/outsider debt/equity).
Use 2 potential strategies for decoupling supply & demand:
- Use housing prices as exogeneous source of variations in collateral drives availability of
credit.
Elastic housing supply more reliance on outside debt, since underlying home equity is
pledgable (verpandbaar).
Perfectly inelastic housing supply demand shock would directly effect home equity
values poor collateral, less reliance on outside debt.
- High state-level bankruptcy exemptions receive less outside bank debt, since bankruptcy
protection impairs collateral value.
Results: formal credit channels (business + personal bank loans) most important in their sample,
these startup business rely to surprising degree on bank debt: bank debt > personal equity > trade
credit.
- Housing prices expected sign + significant; state-level bankruptcy exemptions expected sign,
but not significant.
Conclusions: authors no advocate of using this new entrepreneurial pecking other, because it reflects
equilibrium supply/demand rather than entrepreneurial preferences.
Liquid credit markets (+ bank lending conditions) important for functioning young firms,
because reliance on outside debt
__________________________________________________
Relevance: why did it end up in such high-end journal? No hypotheses were tested:
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