Download Financing Decisions

Financing Decisions(Allen and Gale)
1. Efficient Markets and Corporate Finance
Efficient Markets Hypothesis:
A firm's stock market value is determined by the discounted value
of its cash flows.
This is based on stock markets being competitive and having many
profit-seeking investors. The following example illustrates the
basic idea.
Example
Consider a firm which for simplicity only lasts for two periods and
that has per share cash flows which are paid out to shareholders as
follows:
The opportunity cost of capital is 10 percent.
What would happen if the stock was selling in the market at 2.00?
How could investors make money? Suppose an investor borrowed
2.00 and bought one share. Since the discounted present value of
the payments on the stock is 2.29 the investor will be able to pay
back the loan and make a profit in term's of today's dollars of 0.29.
To see this another way
In other words the investor is left with 0.355 at date 2 which is
equivalent to
at date 0. Everybody will therefore
try to borrow and buy shares. The price will be bid up to 2.29.
Suppose the price was 2.35 what should somebody who owns the
stock do? The owner should clearly sell since this gives 2.35
whereas if the stock was held onto it would pay off 2.29 in terms
of today's money(real or fundamental value). If everybody who
owns the stock tries to sell the price will fall until it is equal to
2.29.
Whenever prices get out of line with discounted cash flows there
will be profit opportunities. The efficient markets hypothesis is
essentially arguing these can't last for long. In other words
arbitrage ensures that prices reflect discounted cash flows.
If stock market prices reflect discounted cash flows then this
implies the following.
Implication of Efficient Markets Hypothesis:
If a positive NPV project is accepted the value of the firm will
increase by the amount of the project's NPV.
Hence accepting positive NPV projects leads to an increase in
stock price and the creation of shareholder wealth. Rejecting
negative NPV projects avoids a fall in share price and the
destruction of shareholder wealth.
This fundamental view of the stock market is at the heart of most
corporate finance theories. An alternative view is a technical
perspective. What is this? One of the activities that some market
analysts, known as technical analysts, undertake is to plot the
movement of stock prices against time and try to predict future
cycles.
Suppose you discover a cycle, and at the present moment the stock
is at the bottom of a trough. What should you do? You should buy
the stock in anticipation of it going up. But what happens if there
are a lot of technical analysts and many people do this? The price
rises until it offers only a normal rate of return. In other words, any
cycles will self-destruct because many people will be doing this.
People will arbitrage away profit opportunities.
Competition in technical research will tend to ensure that current
prices reflect all information in the past sequence of prices and that
price changes cannot be predicted from past prices. This is called
the weak form of market efficiency: Current prices reflect all the
information contained in the record of past prices. Predictable
cycles are eliminated because otherwise positive NPV transactions
would exist.
If this is the case, why do stock prices change? Efficient markets
theory argues they change because new information is received.
They must change as soon as the information is received and fully
reflect this information, otherwise positive NPV transactions
would again exist. The semi-strong form of market efficiency is that
current prices reflect not only past prices but all other published
information. The strong form of efficiency is when prices reflect
not just public information but all the information such as that
which can be acquired by painstaking fundamental analysis of the
company and the economy.
New information cannot by definition be predicted ahead of time
since otherwise it would not be new information. Therefore, price
changes cannot be predicted ahead of time.
Series of price changes must be random. To put it another way, if
stock prices already reflect all that is predictable, then stock price
changes must reflect only the unpredictable--they must be random.
Prices follow a random walk. In the 1970’s there was an immense
amount of empirical work done by Fama and others to determine
whether the evidence supports market efficiency or a technical
view. The interpretation of the evidence amassed was that it
provided substantial support for weak-form market efficiency.
Semistrong efficiency also had substantial support. The evidence
for strong-form efficiency was more in dispute.
To summarize, we have said that theoretically prices should reflect
available information since otherwise people would be able to
make arbitrage trades and profit from them. The efficient market
hypothesis has a number of implications:
1. Values of stocks depend on cash flows.
We have argued that the value of stocks depends on expectations
of cash flows not on the supply and demand on any particular day.
In other words, you should be able to issue large blocks of stocks
at close to the market price as long as you can convince other
investors that you have no private information.
2. There are no financial illusions.
In an efficient market there are no financial illusions. Investors are
concerned with their entitlement to a firm's cash flow. This implies
that any attempt to mislead investors by, for example, changing
accounting conventions to boost EPS will be unsuccessful.
3. Markets have no memory.
We have argued that there are no true cycles. Hence the notion that
now is a good time or now is a bad time to issue securities is
essentially false. For example, there may just have been a long
series of rises so that you think it is the top of the market and
therefore a good time to issue. However, we know if this was true,
investors would already have sold and the market would not be
where it now is. You cannot outguess the market using information
available to everybody else.
4. Trust market prices.
In an efficient market you can trust prices. They incorporate all the
available information about the value of each security. This means
that in an efficient market firms can issue securities at any time.
The amount that they will receive is a fair value.
2. Types of Security
Common Stock
Long Term Debt and Preferred Stock
Convertible Securities
3. Capital Structure Decisions
The assumption behind most of the analysis we have done so far is
that the firm is all equity financed. In practice, of course, firms use
debt and many other types of security to finance themselves. In this
section we are interested in whether using different types of
security, in particular debt and equity, creates value for
shareholders.
Motivation Example
The Saw Company is reviewing its capital structure. It pays no
taxes and has access to perfect capital markets. The interest rate on
debt is 10 percent. Its current position is as follows:
The company has no leverage and all the operating income is paid
out as dividends to the common stockholders. The expected
earnings and dividends per share are $2.50. This is an average;
actual earnings could turn out to be more or less than $2.50. The
price of each share is $20. Since the firm expects to produce a level
stream of earnings in perpetuity, the expected return is given by:
Mr. Modigliani, a Harvard MBA and the firm's president, has
come to the conclusion that shareholders would be better off if the
company had equal proportions of debt and equity. He therefore
proposes to issue $1000 of debt at the risk free lending and
borrowing rate of 10% and use the proceeds to repurchase 50
shares. To support his proposal Mr. Modigliani has analyzed the
situation under the various different assumptions about operating
income. The results are as follows:
Mr Modigliani argues as follows: "It can be seen from this diagram
that the effect of leverage depends on the company's operating
income. If this is greater than $200, the EPS are increased by
leverage and our shareholders are better off. If it is less than $200,
the EPS are reduced by leverage. Our capital structure decision,
therefore, depends on what we think operating income will be.
Since on average we expect operating income to be $250 which is
above the critical level of $200, the shareholders will be better off
with levered capital structure." Is this argument correct do you
think?
Ms. Miller, who has recently graduated from the Stern School and
is a young executive on the fast track, counters Mr. Modigliani's
argument as follows: "Leverage will help the shareholders as long
as operating income is above $200. But your argument ignores the
fact that shareholders have the alternative of borrowing on their
own account. For example, suppose that a person borrows $20 and
then invests a total of $40 in two unlevered Saw shares. This
person has to put up only $20 of his own money. The payoff on the
investment is as follows:
Possible Outcomes
By buying two shares in the unlevered company and borrowing
$20 the returns are exactly the same as buying 1 share of the
levered firm. "
Modigliani- Miller Proposition I
With perfect capital markets and no taxes, the total value of any
firm is independent of its capital structure.
The expected return on a firm's assets, rA, is equal to the expected
operating income divided by the total value of the firm which must
be equal to the total market value of the firm's securities (otherwise
there would be an arbitrage opportunity) so:
The firm's borrowing decision does not affect its operating income;
that is determined by the markets the firm operates in. It follows
from Proposition I that it does not affect the total market value of
its securities. Therefore rA is independent of its debt decision.
Suppose that somebody were to hold a portfolio consisting of all of
a firm's debt and all of its equity. The interest on the debt would
cancel out and the investor would simply receive the firm's
operating income. It follows from this that the expected return on
the portfolio would be equal to rA. The expected return on a
portfolio of two stocks is equal to a weighted average of the
expected returns on the individual securities. Therefore the
expected return on a portfolio consisting of all the firm's debt and
equity is
where D and E are the amount of the firm's debt and equity
respectively. Rearranging, gives
MM Proposition II
We can see the general implications of MM II graphically as
below.
The figure assumes that the bonds are essentially risk free at low
debt levels. Thus rD is independent of D/E and rE increases linearly
as D/E increases. As the firm borrows more, the probability of
default increases and some of the risk is transferred from
stockholders to bondholders. The firm is required to pay higher
rates of interest on debt.
Proposition II predicts that when this occurs, the slope of the line is
reduced so it flattens out.
The Risk-Return Trade-off
We know from Proposition I that a firm's borrowing does not
affect its value. We also know from Proposition II that the rate of
return on equity increases as leverage increases. At first sight these
results seem rather contradictory. How can they be reconciled?
What is happening is that risk is increasing as leverage increases.
The beta of the firm's assets is a weighted average of the betas of
the individual securities:
Importance of MM propositions
MM's propositions are again a starting point. Earnings per share
and return on equity are not important in determining optimal
capital structure. What are important in determining optimal
capital structure are market imperfections and taxes.
Corporate Taxes
Under the U.S. corporate tax code and in many countries, there is
an important difference in the way in which interest and dividends
are treated. Historically, interest has been regarded as a cost of
doing business and as a result it is tax deductible. In contrast
dividends have been treated as the return to the owners and are
therefore not tax deductible. This difference in treatment causes a
bias toward debt finance.
Corporate and Personal Taxes
So far we have concentrated on the effects of corporate taxes. But
what is it that holders of securities are interested in? They are
interested in the money they can actually spend. Since they must
pay income tax on the receipts from securities, we must also
consider the effects of personal taxes.
If the tax rate on income from equity is the same as the tax rate on
the income from debt, then there is no change in our theory since
personal taxes do not favor debt or equity. It can be shown that
they do not alter present value since they simply "wash out".
The Modigliani-Miller Theorem with Taxes
If interest is deductible for corporations then
The implication of this result is that firms should borrow as much
as possible to gain the maximum possible tax shield. But in fact
they do not borrow very much. On average corporations debt ratio
(i.e. debt/total value) has been around 30-40% in recent decades.
How can we explain why firms do not borrow more? To do this we
must turn to capital market imperfections: the costs of financial
distress such as bankruptcy costs and agency costs.
Costs of Financial Distress
If firms have a capital structure with a high proportion of debt,
they have a high probability of bankruptcy. How did bankruptcy
figure into our Modigliani Miller analysis?
There was nothing in our derivation of the MM propositions that
said that firms could not go bankrupt in some situations. In an ideal
world with perfect capital markets, what happens when a firm
cannot pay its debt obligations? It would go bankrupt in the
evening and during the night it would issue new securities and the
bondholders would receive the proceeds. In the morning, the firm
would continue as normal. Bankruptcy would not be costly at all.
Thus with perfect capital markets the possibility of bankruptcy
does not affect the debt/equity decision at all.
In practice, of course, bankruptcy does not work like this. It is a
lengthy and costly process. In other words capital markets are
imperfect. If a firm goes bankrupt it incurs the costs of bankruptcy
that are discussed in greater detail below. However, even if they
don't go bankrupt they may incur what are known as agency costs.
We will consider what these are below. Together bankruptcy costs
and agency costs are known as costs of financial distress. We can
incorporate these into our analysis as follows.
The Modigliani-Miller Theorem with Taxes and Costs of Financial
Distress
The value of the firm is:
The costs of financial distress depend on the probability of distress
and the magnitude of costs encountered if distress occurs.
Taking the costs as given, the greater the leverage of the firm the
greater the probability of financial distress. Hence there is a
trade-off between the tax advantage of leverage and the
disadvantage of leverage caused by the costs of financial distress.
The figure shows how optimal capital structure is determined. The
PV of the tax shield increases as the firm borrows more. At low
levels of debt, the debt is risk free and there are no costs of
financial distress. As debt levels rise, bankruptcy becomes a real
possibility and the costs of financial distress rise. The optimal
capital structure is when the PV of the firm is maximized.
Another way of thinking about this is in terms of the weighted
average cost of capital. Without taxes and bankruptcy costs we
showed Modigliani and Miller Proposition II. The return on assets
could be found from
From Section 1 we know that we could use rA as the opportunity
cost of capital for projects that had the same risk as the firm.
Graphically we had
With taxes and bankruptcy cost the line representing the cost of
debt is changed. Now the cost of debt is no longer rD. Instead
term represents the fact that interest is tax deductible at
the corporate level.
term differs from rD because it incorporates costs of
financial distress as well as systematic risk. In other words when
the firm is in financial distress or bankrupt the bondholders will
bear costs.
They recognize this when the debt is issued and demand a higher
return to compensate them for these costs. i.e.
The weighted average cost of capital for the firm is then given by
The effect of replacing rD by (1 – Tc)rD is to make the weighted
average cost of capital a u-shaped function of the debt ratio.
The optimal debt ratio is where the weighted average cost of
capital is minimized. This corresponds to the point at which the
total PV of the firm is maximized in our previous diagram. To see
this suppose the firm produces a constant cash flow C in perpetuity
then
4. Payout Policy
How much cash should firms give back to their shareholders? And
what form should payment take? Should corporations pay their
shareholders through dividends or by repurchasing their shares,
which is the least costly form of payout from a tax perspective?
Firms must make these important decisions over and over again
(some must be repeated and some need to be reevaluated each
period), on a regular basis.
Six empirical observations play an important role in discussions of
payout policies:
1. Large, established corporations typically pay out a significant
percentage of their earnings in the form of dividends and
repurchases.
2. Historically, dividends have been the predominant form of
payout. Share repurchases were relatively unimportant until the
mid-1980s, but since then have become an important form of
payment.
3. Among firms traded on organized exchanges in the U.S., the
proportion of dividendpaying firms has been steadily declining.
Since the beginning of the 1980s, most firms have initiated their
cash payment to shareholders in the form of repurchases rather
than dividends.
4. Individuals in high tax brackets receive large amounts in cash
dividends and pay substantial amounts of taxes on these dividends.
5. Corporations smooth dividends relative to earnings.
Repurchases are more volatile than dividends.
6. The market reacts positively to announcements of repurchase
and dividend increases, and negatively to announcements of
dividend decreases.
The challenge to financial economists has been to develop a payout
policy framework where firms maximize shareholders’ wealth and
investors maximize utility. In such a framework payout policy
would function in a way that is consistent with these observations
and is not rejected by empirical tests.
The seminal contribution to research on dividend policy is that of
Miller and Modigliani (1961). Prior to their paper, most
economists believed hat the more dividends a firm paid, the more
valuable the firm would be. This view was derived from an
extension of the discounted dividends approach to firm valuation,
which says that the value V0 of the firm at date 0, if the first
dividends are paid one period from now at date 1, is given by the
formula:
Gordon (1959) argued that investors’ required rate of return rt
would increase with retention of earnings and increased investment.
Although the future dividend stream would presumably be larger
as a result of the increase in investment (i.e., D t would grow faster),
Gordon felt that higher rt would overshadow this effect. The reason
for the increase in rt would be the greater uncertainty associated
with the increased investment relative to the safety of the dividend.
Similarly to their work on capital structure, Miller and Modigliani
pointed out that this view of dividend policy incomplete and they
developed a rigorous framework for analyzing payout policy. They
show that what really counts is the firm’s investment policy.
Dividend irrelevance theorem
As long as investment policy doesn’t change, altering the mix of
retained earnings and payout will not affect firm’s value.
The Miller and Modigliani framework has formed the foundation
of subsequent work on dividends and payout policy in general. It is
important to note that their framework is rich enough to encompass
both dividends and repurchases, as the only determinant of a firm’s
value is its investment policy.
The payout literature that followed the Miller and Modigliani
article attempted to reconcile the indisputable logic of their
dividend irrelevance theorem with the notion that both managers
and markets care about payouts, and dividends in particular. The
theoretical work on this issue suggests five possible imperfections
that management should consider when it determines dividend
policy:
(i)
Taxes If dividends are taxed more heavily than capital
gains, and investors cannot use dynamic trading strategies
to avoid this higher taxation, then minimizing dividends is
optimal.
(ii)
Asymmetric Information If managers know more about the
true worth of their firm, dividends can be used to convey
that information to the market, despite the costs associated
with paying those dividends. (However, we note that with
asymmetric information, dividends can also be viewed as
bad news. Firms that pay dividends are the ones that have
no positive NPV projects in which to invest.)
(ii)
Incomplete Contracts If contracts are incomplete or are
not fully enforceable, equityholders may, under some
circumstances, use dividends to discipline managers or to
expropriate wealth from debtholders.
(iv)
Institutional Constraints. If various institutions avoid
investing in non- or low-dividend-paying stocks because of
legal restrictions, management may find that it is optimal to
pay dividends despite the tax burden it imposes on
individual investors.
(v)
Transaction Costs. If dividend payments minimize
transaction costs to equityholders (either direct transaction
costs or the effort of self control), then positive dividend
payout may be optimal.