Summary Advanced Corporate
Finance
Lecture 1 Capital Structure Basics
Financial sources: Internal capital: retained earnings, within a firm | External capital: debt & equity
Does finance matter for firm value? The answer is NO when we take the easiest framework:
The Modigliani-Miller irrelevance theorem
We assume perfect markets, no taxes, no bankruptcy costs and all agents have the same information
MM- Proposition I (MM 1958): a firm’s total market value is independent of its capital structure
the value of a firm consists of the PV of future CFs and CFs are split when a firm issues debt and
equity; safe stream to bondholders and risky stream to stockholders.
MMI: the firm value is determined by the real assets (ability of company to generate CF); the CF does
not depend on the amount of debt/equity so the capital structure is irrelevant.
Example: it does not matter whether a firm is financed by debt or equity because the CFs are based
on EBIT. However, when a firm is financed by debt we see interest payments have to be done but this
is not taken into account by EBIT.
MM states the value of a levered company = unlevered company
The capital structure is irrelevant without corporate taxes
MM-Proposition II (MM 1958): a firm’s cost of equity increases with its debt-equity ratio
Increasing the amount of debt(D/E ^) in a firm makes equity riskier, this increases the expected
return investors demand.
Debt is senior to equity (in case of bankruptcy, debtholders receive their money first)
Leverage increases shareholder risk and increases the return on equity > to compensate for the
higher risk D^ means higher beta for leveraged firms.
Investor indifference (Stiglitz 1969): individual investors are indifferent to all firms’ financial
policies
MM: companies should not care about investors’ preferences for financial assets, they care about
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,consumption. According to MM, the investor can undertake the same transactions the firms can do,
so they will not pay a premium.
The firm’s leverage does not affect investors’ returns > whether you invest in a leveraged (D+E) firm
or unleveraged (Only E), it gives the same return.
MM is not a literal statement about the real world, but it helps us to ask the right question:
“how does finance change the size of the pie? (the size of CF to be generated)”
Win-win fallacy: debt is better because some investors prefer debt to equity.
Clientèles theory different investors prefer different consumption streams. All-equity firms might
fail to exploit investors’ demands for safe assets (debt is saver than equity). Better to issue both debt
and equity to allow investors to focus on their preferred asset mix
We remove the MM’s assumptions one-by-one
assump.: perfect markets, no taxes, no bankruptcy costs and all agents have the same information
Assumption 1: Taxes
Usually corporations pay less taxes on debt than equity, so debt is cheaper and companies tend to
issue too much debt – putting pressure on the banking system.
Corporate taxes decreased while personal taxes increased.
MM fails when you look at the example with only equity and both E & D
Only equity: EBIT: $1000 – 40% tax = $600
Both E&D: EBIT: $1000- $50 interest over debt = $950 - 40% tax = $570 + $50 = $620
So, a company with both E&D has a higher CF because the $50 interest paid is tax free.
Conclusion: firms favor debt financing due to tax reasons.
What happens if we subsidize equity (make it tax free)?
This is called NID: notional interest deduction 5% we treat equity the same as debt, equity * 5% =
$250 for example, this will be subtracted from EBIT so lower amount of tax to be paid.
The NID is an explicit equity deduction introduced in Belgium in 2006.
As expected: the subsidy to equity induced Belgian companies to increase their use of equity and
decrease the use of debt. Starting in 2006: equity ratios increase, leverage ratios decrease
However, this effect is not very strong for small companies.
Conclusion: Tax plays an important role in defining capital structure.
Assumption 2: Bankruptcy costs
The market value: value if all equity finance – PV costs of financial distress
Costs of financial distress
- Direct costs: legal and administrative costs
- Indirect costs: impaired ability to conduct business (lost sales, people are less likely to buy
your computer because they want guarantee)
o Selfish strategies: incentive to take large risks, toward underinvestment and “milking
the propery
Selfish strategies
- Take large risks: selfish stockholders accept negative NPV projects because the bondholders
get 300$ back for sure and the shareholders 0 but with this project they might get 700 or
even more back with a small chance > they are willing to take the risk: nothing to lose.
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, - Underinvestment: the cost of investment for a project is higher than what the firm has so
the stockholders will have to supply the extra money this decreases their CF so they are
not willing to do this even though the NPV of the project is positive
- Milking the property: shareholders know there is $200 cash left in the company and they
want this to be paid out as dividend – violated bonds covenants! There is an optimal amount
of debt in a company (tax advantage) and after exceeding this amount, the costs of financial
distress increase more. > There is a trade-off between the tax advantage of debt and the
costs of financial distress
Assumption 3: Agents do not have the same information asymmetric information
Adverse selection: lemon car problem, seller knows more than borrower – fear of getting a lemon
reduces amount willing to pay for car > good cars leave and only bad cars are supplied.
Pecking order theory: asym. info is a problem and a company can deal with this:
Use retained earnings; this is internal money so no asym info problems
Borrow from debt market: less sensitive than equity because this is independent of the
performance of a company
Issue equity (last resort); very expensive and sensitive
So, asym info between firms & markets makes external finance more expensive than internal funds
and debt less costly than equity because it is less sensitive (point 2 above)
Leverage: debt / total assets (debt, equity, RE)
+ Tangibility: fixed assets / total assets. These assets are easier to seize in case of default. So, these
assets should be associated with higher leverage. This reduces bankruptcy costs.
+ Firm’s size (log sales); bigger firms are more diversified so should be more leveraged.
Return on assets (profitability): ambiguous!
- (-)Pecking order: high profits = lower leverage; they use more retained earnings than debt
(noemer wordt groter dus leverage lager)
- Jensen, 1986: high profits = higher leverage, company with a lot of debt cannot make
mistakes and have to work hard to pay back the debt – perform better than other firms.
Positive relation between profitability and debt.
Market to book ratio – negative relation with leverage
when the company is overpriced (the shares) – the manager issues equity instead of debt so the
leverage is lower because market value ^
So: Tangibility and Size are positively associated with leverage; Return over Assets are negatively
associated with leverage (consistent with Pecking Order) & Market to book negatively associated
Lecture 2 Debt covenants
The debt structure of a company:
- Senior debt; credit agreement between bank / other lending institution. Senior debt is paid
first, later subordinated.
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, - Subordinated debt; high yield risky bonds.
Debt covenants: condition of borrowing. May be changed if debt is restructured. It can impose quite
heavy obligations — a company may well be forced to sell assets in order to stay within a debt
covenant.
When a company violates the debt covenant; creditors may demand immediate repayment, but this
rarely happens since the debtor is often not able to repay immediately renegotiation follows
Negative debt covenants state what the borrower cannot do: sell certain assets, incur additional
long-term debt, pay cash dividends exceeding a threshold.
Positive debt covenants state what the borrower must to: maintain accounting reports & certain
minimum financial ratios, provide audited financial statements etc.
New developments in debt market: leverage loans; granted by banks to companies with high
leverage ratio or low rating. It is kind of a senior debt for higher risk companies. LL are safer than high
yield bonds because they are protected by collateral and debt covenants. This gained popularity
because investors demand higher returns, so risky companies can borrow money on favorable terms.
Leveraged loans could be bundled in securities sold/trade in financial markets called “Collateralized
Loan Obligations” CLOs are vehicles which take a group of risky loans (and especially leveraged
loans) and then use them to back a series of bonds of varying degrees of riskiness
Investors in the lowest rated tranches get higher returns, but they are the first one to hit when the
underlying loans begin to default.
Roberts and Sufi (2009); Goal is to examine the response of corporate financial polices to covenant
violations. The better the credit rating (AAA), the lower the chance on covenant violation
Covenant violation has:
- A strong effect on net debt issuance, a fall of almost 120 basis points in the two quarters
following the violation.
- Not a very strong effect on equity issuance
- Leverage ratio becomes significantly lower following a covenant violation. The ratio was
increasing in the quarters prior to the violation, after the violation is takes a while but
eventually decreases (because it takes a while to repay the debt) -> making the company less
risky than before
Net debt issuance decreases and have (gradually) lower leverage ratios.
Net Debt Issuance
The smaller ∆ the faster a firm adjusts the net debt issuance after a covenant
Total Assets
violation. Negative delta; issue less debt today than yesterday etc. positive: adjusts, but slow
Companies with a:
- High leverage ratio; negative delta because they are riskier so they act more quick after
renegotiations.
- High market-to-book ratio (so high opportunities to become profitable); positive delta
because creditors give them more space because the company might become profitable
- S&P credit rating: positive delta; lower prob of default so the creditor is less worried
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