CORPORATE FINANCING DECISIONS èThrough its financing decisions, a firm provides “financial services” to investors èI.e., the firm packages its operating cash flows as interest, dividends, capital gains, offering different risk-return profiles to investors, depending on the mix of stock and bonds èThe securities the firm issues also provide clues (“signals”) to investors about what is happening inside the firm

CAN WE CREATE VALUE THROUGH FINANCING DECISIONS? èCompetition is heavy in financial services èfinancial institutions èother nonfinancial corporations èinvestors themselves èOpportunities for value creation will be limited èThese opportunities arise primarily from market “frictions”

CAPITAL MARKET FRICTIONS èTaxes èCan financing reduce taxes? For whom? èBankruptcy Costs èIs anything lost when the firm goes broke? èAgency Costs èWhat conflicts of interest arise between shareholders, managers and bondholders? èCosts of imperfect information

FINANCING AND THE COST OF CAPITAL Cost of capital concepts: WACC = weighted average cost of capital r E = cost of equity r D = cost of debt r = unlevered cost of capital (i.e., cost of capital the firm would have if it didn’t have any debt)

COMPANY VALUATION

VALUATION: A DIFFERENT APPROACH Total cash flows to bondholders and shareholders: r D D + ATOCF - r D (1-T)D = ATOCF + Tr D D We should be able to value the firm by valuing these two pieces. Discount ATOCF at r and Tr D D at r D.

ADJUSTED PRESENT VALUE

ANOTHER EXPRESSION FOR WACC

EFFECTS OF PERSONAL TAXES Debt has a tax advantage to the firm BUT: for investors, cash received as interest is more heavily taxed than equity income Net tax advantage of debt = T* < T

FINANCING DECISION TRADEOFFS èTax considerations favor debt over equity but debt financing has its costs: èFinancial distress costs èTrouble with suppliers and other disruptions èLoss of tax shields èAgency Costs èThe Asset Substitution Problem èClaim Dilution èThe underinvestment problem

ASSET SUBSTITUTION PROBLEM Firm has 50% chance of earning $415 before interest 50% chance of earning $215 r f = 5% Debt has $150 face value, 5% coupon

ASSET SUBSTITUTION (cont.) Now firm switches suddenly to riskier assets 50% chance of earning $515 50% chance of earning $115

ASSET SUBSTITUTION (cont.) èShareholders have gained at bondholders’ expense, because of the fixed nature of the bond contract èHad the bondholders known about this in advance, they would have demanded a higher coupon rate èThey will protect themselves by adding restrictive covenants or refusing credit

CLAIM DILUTION èIn the same way shareholders can undermine bondholders by: èIssuing more debt of same priority èGiving new bondholders a secured claim on specific assets èSelling assets and leasing back èPaying dividends èRepurchasing shares

UNDERINVESTMENT PROBLEM Consider same firm, earning either $515 or $115 New project costs $90 and returns $105 in one period no matter what

UNDERINVESTMENT (cont.) èFor firm as a whole, new project has positive NPV NPV= 105/ = 10 èBut for shareholders, NPV negative: Shareholder gain = = Cost = 90; NPV = = èShareholders will not be willing to fund project

WHO SHOULD ISSUE DEBT? èFavorable to debt: Stable cash flows Mature industry Few investment opportunities Assets suitable for use as collateral Good reputation for treatment of bondholders èUnfavorable to debt Lots of uncertainty Rapid technological change Large future investment opportunities Intangible assets Unknown to bondholders