lOMoARcPSD|1277595

Lecture 1 - Capital Structure

Corporate Finance (Brunel University)

StuDocu is not sponsored or endorsed by any college or university

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)
 lOMoARcPSD|1277595

Capital structure lecture 1

Lets assume that transacions costs are small and assume at the same ime, companies are
close to their opimal strucuture. If we ind companies have diferent d/e raios this can
mean two things. It could relect that dif companies have diferent risk factors or in any
other variable which could afect capital structure. But more simply it could be that
managers don’t know what the opimal capital strucuture is. They may not know what their
target is. Even if they are aware of the target, they might not be bothered to move towards
the raio even if it is easy to move towards it.

Miller 1977 is discussed in the myers paper. Miller brings personal taxes into the equaion.
He results that debt policies sill do not mater. Personal taxes have no impact on a
companies capital strucuture so there’s no tax advantage to debt. The problem with this
assumpion is that all companies pay the marginal tax rate, which is not the case in reality.
The marginal tax rate depends on various factors such as capital allowances. Myers then
goes on to discuss inancial distress costs. There are direct and indirect costs of bankruptcy.
Direct is legal and admin costs. We also need to consider the indirect costs which could
include erosion of company value even if the company managers to avoid formal default
ater recovery. One of the key indirect costs is the loss of sales, where customers are weary
of purchasing goods from customers, especially with those of longer warrenty. Customers
are scared.

Generally, we would expect risky companies to borrow less with high d/e raios. Companies
with higher betas. In contast, companies with lots of tangible assets should borrow more. It
makes sense as companies with tangible assets can use tan assets as collateral.

The pecking order theory has no target debt to equity raio and companies follow the path
of least resistance. We use internal funds, debt and then equity as a last resort. Myers states
quite clearly that according to PET each companies observed debt raio relects its
cumutlaive requirements for external inance. It takes into account its previous
requiremenets for inance. One of the things he also states is that Pet can be explained by
managerial capitalism where managers wish to avoid the disciplining rule of the market.
They want to avoid the disiciplining rule of capital markets so they follow the PET. Rather
than bororow debt and equity, they use internally generated funds. Why? If a company
issues equity, it signals to the market that the shares are currently over valued. The eyes of
the capital market is on that market as the companies believe the shares are overvalued, so
the SP will fall. It is a negaive signal to the market. The pecking order theory is based upon
assymetric informaion. If a project becomes available, irm value will increase by the NPV of
the project, assuming the NPV is posiive.

However, if they don’t have internally generated funds, they will need to borrow from
external markets to invest in these projects. We ind companies will have to issue securiies
for less than they’re worth. There are issues associated with issuing securiies for less than
they’re worth. This cost is not an investment cost.
We need to consider that this cost is risk. The cost is that managers are acing in the
interests of shareholders so they exploit new shareholders to beneit exising shareholders.

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

Myers and Magluf have developed a model.

It ASSUMES two things. N = Value of the shares when they’re issued. This is the market
esimate of the value of the shares. N is the market share price.
N1 in contrast the managers esimate of the value of the shares. Therefore N1 – N is the
equivielent of the under or over valuaion of the shares by the management.
If n1 – N is posiive then it means that the companies shares are undervalued and the
managers esimate of the shareprice is higher than that of the market. When N1 – N is
posiive, the company is undervalued and the managers esimate of the shareprice is higher
than that of the markets esimate of the share price. This implies that managers know good
informaion about the company which hasn’t been taken into consideraion by the market.
The market hasn’t responded to the news that they hold.

Scenario two is where N1-N is negaive. This means that the company is over valued. The
managers esimate of the share price is lower than that of what the market has said for the
shares. This implies that managers know unfavourable informaion about the company
which the market has not yet responded to. We ind in pracice that managers in overvalued
companies will always issue and invest where managers in undervalued irms may not issue
and invest. This depends on the extent of undervaluaion.

Implicaion of the model: There are two main implicaion. The irst main one is that the cost
of forgoing a posiive nopv investment can be avoided by retaining enough internally
generated cash. The cost relying reliynig on external inance. If COMPANIES keep enough
internally generated funds, they wont have to give up posiive npv projects.

Implicaion two – The advantage of debt over equity issues. The idea is that if a company
does have to issue external funds, it should issue debt irst as it’s the safest security and has
the lowest informaion costs.

Over valued irms have an incenive to issue equity as the market value is higher than that of
the managers esimate of the share price. When companies issue equity, it signals to the
market that the market share price of a company is over valued, so it pulls the share price
down.
At the end of the paper myers asks quesions. What we know about corporate inance
behaviour about**. We states that we know ive main facts about corporate inance
behaviour.

1- Investments are predominantly inanced by debt and retained earnings. Internal

funds and debt. This is consistent with the PET.
2- Companies ime the stock market by issuing equity when share price is over
valued and risen. They WONT issue debt when managers percvice share prices to
be undervalued on the market. This is inconsistent with the staic trade of and
PET theory.
3- Companies with intangible assets or growth opportuniies borrow less. This
makes sense as these companies do not have securiies they can use as collateral.

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

4- Share prices rise when they increase debt but decrease when they issue equity.
An example of companies issuing equity is slogan et al. They ind a negaive
market response of equity issues. James 1987 inds a posiive one.
5- Share prices fall when irms announce a share issue and rise on annoumncement
of a share repurchase. This signals to the market that the share is undervalued
and they’re being bought because they’re cheap to do so.
These are points in relaion to corporate inance behaviour. Now we look at three
observaions.

These three do not link to corp inance behaviour but have been found.
1- Myners found there are taget debt raios
2- Risky companies borrow less
3- Tax is a second order concern.

Financing decisions: who issues stock? Fama & French (2005)

Follows on from the Myers paper we looked at. In the Myers paper, PET performs just as well
as the trade of theory. However, the paper by Fama and French refutes the PET theory. In
this paper, they test the PET predicions and decisions about inancing decisions. What they
do is, they examine and under what circumstances companies issue equity. The results of
what fama and French ind are diferent from myers in 84. They uncover what seems to be
pervasive contradicions of the PET. Diferent results.

The PET order theory predicts :

- Share and equity issues are rare as they’re at the botom of the pecking order. Only
issued as a last result. Myers states this as a fact. The problem is that Myers is only
talking about SEO’s. In the PET myers does not take into account diferent ways in
which companies can issue equity. He didn’t consider equity issues in other ways.
Other ways include – merger transacion, rights isuse, converible bonds, engage in
employee stock opion plans.
- Share REPURCHASES are limited to companies with few investment opps and low
gearing. So companies which are mature as they have few investment opps and low
d/e raios.
- Net issues of equity are not material. They are small amounts of inance being raised
not lots.
- Share issue would be done by irms under duress.

Fama and French ind major diferences.

- Most companies issue equity and engage in repurchase programms or do both each
year.
- Share issues are not as rare as myers suggests. Companies in general purchase and
repurchase and issue shares each year.
- FF also do consider companies can issue shares in various ways.
- Many companies that repurchase shares have inancing deicits. Equity issues are
large on average compared to what Myers said. They also ind that share issues are
not done by companies under duress.

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

PET is centralised around how informaion issues are what leads to managers to follow
the PET. But what FF suggest is that there are other ways to issue equity which avoid the
assymetric informaion problem to reduce infmroaion costs and transacions costs.

- Firstly we have mergers where companies can issue in a share for share exchange.
We ind that when they pay using shares, they’re typically negoiated deals between
the buyer and the seller. This reduces informaion costs according to the theory.
- Employee stock opion plans – employees will know more about the company than
what outsiders will. Because of this, they are more likely to realise the true value of
the shares. But UNLESS you’re in high management, you probably won’t know much.
- Warrants are securiies which enitle the holder the opion to buy the shares of a
company at a ixed price unil a certain date. So even if the market price is 200 and
the warrant says 150, they pay 150.
- Rights issues, shares go to exising share holders. This should reduce informaion
problems.
- Converible bonds which are hybrid securiies, issued as debt but can be converted
into equity.
- Direct purchase plans. Rarther than take your dividends in cash, share holders reduce
the value of the dividends and purchase more shares in the company. As the shares
are being sold the exising share holders, this should lower informaion costs.
- Private placements of equity. Equity is placed with speicifc groups of share holders.
This should lower informaion costs.
Given that companies can issue equity in these ways, FF conclude that the Myers PET doesnt
take into account that other ways can be used to issue equity not just SEO’s. The premise of
the paper is that equity issues are not as rare as what the PET predicts. There are other
explanaions which look at why equity might be preferred over debt.

The irst main reason comes down to agency problems. Managerial beneits are linked with
investments. There is a posiive relaionship between the two. The more that companies
invest, the higher the managerial beneit. But it might be that equity issues have beneits
that outweigh the costs.

First case is that – assume that we are doing a merger transacion which is inanced by
shares. A share for share exchange. With a S4S we might ind that capital gains tax is
postponed for the shareholders. This is good as shareholders own’t want to pay tax. But in
addiion it might just be that equity issues have moivaional beneits, so when companies
issue shares to employees, employees become more moivated. The idea is that if
companies issue shares to employees, they own the company, the employees working hard,
increases company share price. Employees will beneit. But it depends on the company and
the amount of shares you hold.

FF look at growth and gearing. According to them, companies issue equity by ways.
SEOS account for a large fracion of the equity issues of a small companies. The issues are
rare, but they account for a large fracion.

Stock inance mergers account for large fracions of the equity issues of small and big net
issuers. This is because large companies have lower assymetrical informaion asymmetry, s

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

they’ll be less likely to follow the PET as the PET is based on the presumpion that
infmroaion asymmetry leads managers to follow the theoy itself.

Stock issues to employees are probably the most consistent source of important amounts of
new equity for big and small irms. This is important evidence against the PET.

Conclusions; FF show emplirical evidence contradicing the PET. They show argue and
suggest that equity issues are not as rare as what the PET suggests. They also show other
ways of issuing equity. Companies can issue via various means, not just by an SEO.

The theory and pracice of corporate inance: evidence from the ield – Graham & Harvey
2001

A comprehensive study of corporate inance 1999 publiseed in 2001. 16 years ater, it is

widely cited.
Methodology: They sent out surveys to American companies CEO’s 4400. They received 392
back. The SURVEY asked quesions in three main areas. They looked at cost of capital.
Quesions on capital budgeing and on the companies capital strucuture in general. They
realised that the responses they received will difer depending on the company. They looked
at the age of the company, the size of the company, its growth potenial and its gearing. In
adiion to looking at company characterisics, they looked at the CEO’s personal
characterisics too. The use of survey analysis to look at current pracice is good as its an
easy methodology. There is a however a problem with this approach that surveys measure
the least and not necessarily the acions. They do note this themselves in the paper. The
survey included 15 quesions. Each quesion had a sub quesion. In total it was 3 pages long.
Generally, they used a ick the box approach. 5 opions, ranging from 0 to 4 never to always
not important very important. In addiion there were one or two quesions where managers
were able to give their own opinions. Any further explanaion was supplementary.

Graham and Harvey took into consideraion diferent companies had diferent
characterisics. They looked at the dif characterisics such as the size of the company
measured by sales. They could have used the total assets igure but they didn’t.
They measured the growth potenial by the p/e raio. Anything greater than 15 were growth
companies.
Gearing was measured by the debt to asset raio.

Personal data also was gathered such as age, experience in the post, educaion and share
ownership. Younger people may be more risk averse than olders. Backgrounds help too.
Look at secion 5 of the paper, the data too.

Trade of theory -> Graham and Harvey found the tax advantage of debt is moderately
important. (2.07/4) Cruciially they found that the corporate tax advantage of debt is
important to large companies, regulated companies and dividend paying companies as
they’re likely to have the highest tax bill. So there is some support for a trade of theory.

Personal tax consideraions are not important according to the study. 0.68/4

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

Surprising as we’d expect companies to take into account persona tax consideraions but
apparently not.

They also found that inancial distress costs are not very important either 1.24/4
But they did ind that companies are concerned with credit raings 2.46/4 which probably
ies into inancial distress. Credit raings impact cash lows and liquidity. Companies are
concerned about earnings volaility 2.32/4 which is consistant with the STO theory.

According to the TO theory, companies have a target to work towards, but graham and
Harvey found that only 10% of companies surveyed have a strict raio that they work
towards. What they ind is that 37% of companies have a lexible d/e raio.
Companies which have strict target debt to equity raios are larger companies not the
smaller. Despite inding that companies have lexible or strict raios, GH ind that there is no
evidence of rebalancing. This is interesing.

Rebalancing - Assume company has a strict raio. If that companies market value increases,
they would have to issue debt to get back to the opimum. If the market value decreases,
companies would have to reire debt to get back to the opimum, but we don’t ind any
evidence of rebalancing. Finding that this doesn’t happen in pracice is consistent with the
ixed transacion cost explanaion by Fisher ET AL IN 1989. They argued that if there are ixed
transacion consts inherent with issuing or reiring debt or equity, companies will only adjust
towards the opimum capital strucuture, when the actual raio is too far away. So if they
have a target of 50%, as long as the actual raio is between 45-55 they’re ine to have it that
way. Only when theres a large variance, will the companies rebalance towards the opimum.

The pecking order theory – According to this theory, maintaining inancial slack would
support the PET. Maintaining inancial slack is the most important factor afecing a
companies debt decision is what was found. 2.59/4
Although they found this was the most important, some of the results are weird. The PET is
based on assymetric informaion, hwoever the results of GH ind that the importance of
inancial lexiblility is not related to informaion asymmetry. What GH ind is that inancial
lexibility (slack) is more important for dividend paying companies. This goes against
theoreical explanaions. Dividended paying companies have low slack and vice versa.

Insuicient internal funds is moderately important. Having insuicient funds is moderately

important factor to issuing debt. This is generally consistent with the PET. If companies don’t
have enough retained earnings, you have to move down the pecking order and issue debt.
It’s found that its most important for small companies as they have higher informaion
asymmetry problems.

Managerial opimism could explain the pecking order theory. The idea is that companies are
reluctant to issue equity when they perceive the market esimate of the share price is lower
than their own esimate of the share price. This means that it could lead to a situaion where
managers ime the market. They issue equity is over valued. Companies ind a window of
opportunity where the share price is higher than their own esimate and they will issue
shares when the opportunity arises.

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)

 lOMoARcPSD|1277595

Capital structure lecture 1

Finding a window of opportunity is important for companies with higher informaion

asymmetry problems. Finding the companies are reluctant to issue equity when
undervalued, this is generally consistant with the pecking order theory.

They looked at other assymetric theory explanaions

- Market iming theory; managers ime the market by issuing shares when the equity
is over valued. They ind a window of opportunity. This is most important for
companies with higher informaion problems.
- There is no evidence that signalling theory has impact on a companies debt policies.
- Converible bonds are viewed as backdoor equity. Converibles are used to atract
investors who might be concerned with the riskiness of the issuing company. The
idea is if the companies going to go bust, they can lose their investment. So they can
change their debt to equity and sell the shares. The survey found that companies see
converible bonds provides lower inancial distress costs and smaller undervaluaion
than equity. This general inding is consistent with stein 1992.
- There is no evidence consistent with the fact that companies will delaying issues of
debt due to their credit raing improving in the future. There is weak evidence in
support.
- There is evidence that companies iem market interest rates. Companies will issue
debt when the interest rate is low and not when the rate is high.

Agency cost theories: We might ind that agency conlicts between share holders and debt
holders might have an efect on the capital structure decision of companies.
Debt holders are bondholders so for example, share holders want high risk projects is
basically because they beneit from these high risk projects. If it is successful they have the
most to gain and lose the least. Debt holders however want ixed returns. They low risk as
they have the same returns regardless of whether the project is high risk or low risk.
Problems of bondholders and shareholders:
The under investment problem is where companies will forgo posiive NPV projects and wait
for another rproject with hghier returns. There is no evidence for this.
Weak evidence for the asset subsiiion problem. This is where companies will borrow for
project a. a IS LOW risk. The lender lend son the basis of low risk project. Instead they invest
that money into a more risky project. The shareholders win as if the project is successful it
will increase their wealth. The debtholders however are not compensated for the extra risk.
There IS only weak evidence for this. But we need to remember that managers could have
lied here.

We can look at conlicts of interest between managers and shareholders – Jensen 1986
Free cash low theory – litle evidence to support it. The theory suggests thtat managers do
not waste money on perks. They don’t waste money on ineicient investment projects and
clearly state they do not need to issue debt as they do not need to be disciplined by debt.
But again they could have lied. They may be unlikely to admit, they need to be disciplined
and controlled by debt.

Downloaded by Aurangzeb Chaudhary (zebch_61@hotmail.com)