Statistics Assignment
Statistics Assignment
Capital structure decisions are basic part of doing business yet often misunderstood. In terms of modern financial theory and EMH it should not matter what we issue as there is a zero NPV. Managers, however, spend much time worrying about what to issue and when.
Why?
Partially because some of the assumptions we use in developing EMH do not hold, partially because of transaction costs, partially for agency cost reasons, and partially because the Investment banking community is convinced that what firms issue does matter.
Know Advantages/disadvantages of issuing various types of securities.
Costs of issuing securities
APV = adjusted Net Present value
if no costs APV=NPV
if APV
thus firms try to find ways to minimize impact:
Rights offers
Shareholders can buy at a discount. Always exercise (or sell) rights or you will suffer dilution and a loss of wealth.
Similar to poison pills
DRIPS-issuing small amounts in lieu of cash dividend payments (investors are still taxed)
If we ignore costs of issuing securities and if no transaction costs, then what we issue does not matter….reason? Investors can undo anything we do.
Modigliani and Miller (MM) Prop 1:
pizza analogy…size of pie is what matters!
Suppose you own 1% equity in an Unleveraged firm, the firm then leverages up…(suppose stock buyback financed with Debt)…what can you do to get back to original position?)
Thus, if there are no costs then any capital structure is as good as any other. But we know there are costs
So what does capital structure decision depend on?
to answer this we have to take a step back and look at WACC
CETERIS PARIBUS:capital structure that minimizes WACC will maximize value of the firm. (why? advantage of deducting interest expense)
so would have mainly debt.
But in reality we don't hold everything else constant.
For example:
what happens to the equity?
it becomes riskier
why?
MM prop 2
so value of a firm = value of unlevered firm + tax benefits -Fin Distress costs
thus we have to look at where this risk (cost of financial distress)
is great....for these firms, they will be worth more with less debt
What are financial distress costs?
Cost of fighting between stakeholder groups, cost of passing up positive NPV projects, expected costs of bankruptcy
Lost revenues
Increased expenses
Where is the cost of financial distress greatest?
Credence goods
Specialized assets
High information asymmetries
Intangible assets
Bankruptcy Costs
A subset of Financial distress costs
Those costs stemming from Bankruptcy
Direct and Indirect
Warner (1977) suggests the Direct Costs are low
Generally direct costs are not high enough to explain low debt levels
Indirect Bankruptcy costs are higher
Miller 1976 proposed that the 1963 paper overstated benefits of debt. Why?
Equity returns are preferred by shareholders on a tax basis.
Why? Investors can "time" returns to avoid taxes, capital gains rate lower, etc.
Thus debt while having tax advantages to the firm, has tax disadvantages to the investor. This lowers the benefit of debt.
Relative advantage of debt)
Assets in place vs. growth options
We expect more debt for firms with assets in place. (Smith-Barclay)
Why? Assets make better collateral, less opportunity for taking advantage of BH, less risk of passing up positive growth opportunities, ...