Corporate Financial Policy BRN482 Corporate Financial Policy Clifford W. Smith, Jr. Summer 2007 Overhead 2 * Covers readings on course outline through Barclay/Smith/Watts (1997)

M/M (1958) D E

M/M (1958) D E

Historical Evidence From Barclay/Smith/Watts (1997)

just wrap my arms around the whole backfield and peel ’em off one by one until I get the ball carrier. Him I keep”. I “ Gene “Big Daddy” Lipscomb

Relaxing the M/M Assumptions Interest payments to bondholders are deductible for tax purposes while payments to equity holders are not.

Corporate Tax Liabilities Tc D E M/M (1963)

Corporate Tax Liabilities Tc D E M/M (1963)

Taxes and Bankruptcy Costs BC Tc D E Kraus/Litzenberger (1973)

Taxes and Bankruptcy Costs BC D E Kraus/Litzenberger (1973)

Bankruptcy Costs Warner examined the bankruptcies of 11 railroads to estimate the costs of bankruptcy. The bankruptcy proceedings typically lasted many years. The average was 13 years, and the longest was 23 years. On average these firms spent approximately $2 million on the bankruptcy proceedings

Measuring Bankruptcy Costs We can measure the bankruptcy costs in relation to firm value at various points in time 0 - Filing date T - Settlement date (T = 13 years) BC BC V0 V-7 = 5.3% = 1.0%

Taxes and Bankruptcy Costs Merton Miller A case of horse and rabbit stew Analysis so far ignores personal taxes and the effect of issuing debt on the equilibrium in the bond market

Miller's Debt and Taxes Both corporations and individuals pay taxes. When corporations pay interest on debt, they reduce their own taxes, but increase the taxes of individuals. Ultimately, the corporation must bear all of the taxes associated with its activities either directly, or indirectly through higher required rates of return on the securities that it issues.

Corporate and Personal Taxes Tp Tc D E Miller (1977)

Corporate and Personal Taxes Tc Tp D E Miller (1977)

DeAngelo and Masulis Debt and Taxes As corporations increase their debt, they reduce the probability that they will pay the highest marginal tax rate and be able to fully utilize all tax credits and deductions. Zero taxes, deductions not fully utilized Positive taxes, tax credits not fully utilized Taxes paid at the highest marginal rate Default Income

DeAngelo and Masulis Debt and Taxes In equilibrium, there is an optimal capital structure for the economy as a whole and for each individual firm.

DeAngelo and Masulis Debt and Taxes In equilibrium, there is an optimal capital structure for the economy as a whole and for each individual firm Optimal leverage - - B/V = B/V(tax credits, non-interest deductions - - + - s2, BC, tc, tp)

What's Wrong With This Story? Large industrial firms with many physical assets typically have many noninterest deductions (like depreciation), large tax credits (the investment tax credit), and also high leverage. Firms with high dividend yields (like regulated utilities) typically have high leverage.

The DeAngelo/Masulis Capital Structure Model with Taxes Holding other things constant, the logic of the model is sound; it provides useful information about optimal capital structure. The problem is that there are important variables that are not included in the model. As we examine firms in the real world, there seems to be important determinants of capital structure that are not captured by this model.

The Effect of Capital Structure on Real Investment Decisions The owner of an all equity firm will take all positive NPV projects to maximize firm value. When a firm has both debt and equity, the debt and equity holders sometimes disagree about the optimal investment policy. Since equity holders have ultimate authority over investment decisions, we have to be concerned about how adding debt to the capital structure affects equity holders' investment incentives.

Agency Theory Jensen and Meckling An agency relationship is a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. Often there is a blurred distinction between the principal and the agent Agent responds to incentives and will not always act in the best interests of the principal

Agency Theory Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:

Agency Theory Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components: = + + Agency Monitoring Bonding Residual Costs Costs Costs Loss

Agency Theory Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components: Agency Monitoring Bonding Residual Costs Costs Costs Loss Out-of-Pocket Costs = + +

Agency Theory Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components: Agency Monitoring Bonding Residual Costs Costs Costs Loss = + + Opportunity Costs Out-of-Pocket Costs

Agency Theory Before Jensen and Meckling, it was common to focus only on the out-of-pocket costs (M/M theory focused on fixed investment policy) Contracts affect incentives for current and future investments Private incentives exist within the contracting process for the firm to maximize its current market value as well as the "welfare" of society

The Nexus of Contracts Theory of the Firm Share- holders Bond- Board of Directors Managers Employees Lessors Lessees Suppliers Customers

The Nexus of Contracts Theory of the Firm Share- holders Bond- Board of Directors Managers Employees Lessors Lessees Suppliers Customers

Conflicts of Interest + - + + + + V = E(V, F, T, σ², r, DIV) + - + + + + V = E(V, F, T, σ², r, DIV) + + - - - - + B(V, F, T, σ², r, DIV) Dividend payout Claim dilution Asset substitution Underinvestment

A Simple Example Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero. There are no taxes or transactions costs. Time NPV Project 0 1 2 A -50 100 50 B – -75 100

A Simple Example Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero. There are no taxes or transactions costs. Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25

A Simple Example Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero. There are no taxes or transactions costs. Dividends can be paid in a period so long as that period's promised payment to the bondholders is made first. Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25 Bond ? -20 -100

A Simple Example Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25 Bond 120 -20 -100

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond ? -20 -100

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75

A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75 DIV (A-) 20 80 – = 100

The Underinvestment Problem Do I want to issue this bond? Who bears the agency costs of increased leverage in this case? In general? Equity holders have strong incentives to structure debt contracts in a way that minimizes the adverse incentive costs.

Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond ? -10 -50

Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50

Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100 = 125

Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100

Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100 = 125 DIV (A-) 10 90 – = 100

Which Bond Do I Want to Issue? High Leverage Bond 70 -20 -100 DIV(A -) 20 80 – = 100 Low Leverage Bond 60 -10 -50 DIV(A+B) 10 15 100 = 125

Investment Opportunity Set Assets in Place Growth Opportunities Cost of Debt Low High (Underinvestment) Predicted Leverage High Low

Benchmarking Corporate Leverage Impact on Leverage Growth Options (Merck) Lower

From Barclay/Smith/Watts (1997)

Economic Significance From Barclay/Smith/Watts (1997)

Regulation From Barclay/Smith/Watts (1997)

Benchmarking Corporate Leverage Impact on Leverage Growth Options (Merck) Lower Credence Goods (Eastern) Lower Product Warranties (Yugo) Lower Future Product Support (Yugo/Wang) Lower

Benchmarking Corporate Leverage Impact on Leverage Growth Options (Merck) Lower Credence Goods (Eastern) Lower Product Warranties (Yugo) Lower Future Product Support (Yugo/Wang) Lower Supplier Financing (Campeau) Lower Closely Held Firm Higher Regulation Higher

From Barclay/Smith/Watts (1997)

Benchmarking Corporate Leverage Impact on Leverage Growth Options (Merck) Lower Credence Goods (Eastern) Lower Product Warranties (Yugo) Lower Future Product Support (Yugo/Wang) Lower Supplier Financing (Campeau) Lower Closely Held Firm Higher Regulation Higher Tax Credits Lower Marginal Corporate Tax Rate Higher Marginal Personal Tax Rate Lower

From Barclay/Smith/Watts (1997)

Benchmarking Corporate Leverage Impact on Leverage Growth Options (Merck) Lower Credence Goods (Eastern) Lower Product Warranties (Yugo) Lower Future Product Support (Yugo/Wang) Lower Supplier Financing (Campeau) Lower Closely Held Firm Higher Regulation Higher Tax Credits Lower Marginal Corporate Tax Rate Higher Marginal Personal Tax Rate Lower Information Costs Higher

From Barclay/Smith/Watts (1997)

Signaling From Barclay/Smith/Watts (1997)

Management Implications Benchmarking Rochester Gas & Electric Eastman Kodak Responding to change Frontier Communications Southern Company

Capital Structure Management Trade Off Hypothesis Pecking Order Hypothesis Market Timing Hypothesis

Don’t let the information age article

Pecking Order Hypothesis There is an important information asymmetry between stockholders and managers “What you don’t know CAN hurt you”. If firm issues securities, those value depends on firm value investors price-protect themselves. This cost is largest for equity, then risky debt; internally generated capital is least expensive.

Pecking Order If there is an “optimal” capital structure, the firm spends a lot of time away from it. Extreme Version: There is no optimal capital structure – observed capital structure is just the result of a sequence of myopic financing choices.

Pecking Order Regression results are strong and robust. Look at tails of distribution.

Market Timing Firm only issues equity when it’s overvalued There is no optimal capital structure

Strategic Capital Structure Management Determine the optimal capital structure for the economic balance sheet. Look at the trajectory of capital structure. Whenever the costs of deviating from target exceed the cost of adjustment - adjust.

Adjustment Costs Firm Value Leverage Target Leverage

Adjustment Costs Leverage Target Leverage Time

Adjustment Costs Differ by transaction ─ Costs of share issues are higher than that for debt ─ Costs of share issues are higher than that of share repurchases Exhibit fixed costs and scale economics ─ Equity offers are rare while bank loans are common ─ Optimal adjustment frequently involves overshooting ─ Most companies spend considerable time away from their target

Strategic Capital Structure Management But investment opportunities are not smooth – they are lumpy and episodic. Suppose you have a large growth option – it will increase firm value by 50% and take three years to exercise. How do you finance this project?

Table 1 All Firms

Table 1 All Firms [cont.]

Strategic Capital Structure Management Pecking Order Hypothesis Market Timing Hypothesis Tradeoff Hypothesis

Table 2 Assets-In-Place Firms (28%) and Growth Firms (72%)

Table 2 Assets-In-Place Firms (28%) and Growth Firms (72%) [cont.]

"Form Ever Follows Function" Louis Henri Sullivan, 1896

Financial Architecture Leverage Public vs. private debt Maturity Priority Conversion rights Call provisions