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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.