1. Advanced Corporate Finance
Lecture 08.1
Capital Structure and Bond Valuation (Continued)

2. Underinvestment Problem
Given risky debt in the capital structure there is a tendency to
Reject positive NPV projects
Incentive to pay high dividends
May simply be impossible to Finance new investment because of debt overhang.

3. Example of Underinvestment
UHFX International (million)
For simplicity assume all securities earn 10%
and the probability of each state occurring is 50%
Good State Bad State
Total
Debt
Equity
B = 50
S = 20
V = 70

4. Example of Underinvestment
New investment Option
I = 60
Pays off: 77 in good state, 66 in bad state
NPV = $? million
Finance with junior debt or equity

5. If adopt, financed with Junior Debt
UHFX International (million)
Good State Bad State
Total
Debt
Junior Debt
Equity
B = 60
JB = 60
S = 15 ( A LOSS in value of $ 5 million)
V = 135, and NPV is positive but hurts stockholders

6. Risk Shifting
The Risk shifting problem occurs when it is in the interest of the stockholders to take on a very risky investment even though it has a negative NPV
Example:
Investment = 30
-33

7. Risk Shifting Cash Flow Before Investment Good State Bad State MV
Total
Debt
Equity
CF from Investment
Total Cash Flow
Senior Debt
Junior Debt
Equity

8. Values Before After Firm 70 60 Snr Debt 50 35 Jnr Debt -- 30
Equity

9. Firm Value
Costs of
Financial
Distress
V = V(u) + PV of Tax Shield
Debt Level
Optimal Debt Level

10. Pecking Order Hypothesis
Costly Information
Managers know more about the future of the firm than do outsiders
Conclusion
Firm has an ordering under which they will Finance
First, use internal funds
Next least risky security

11. A Problem XYZ Corporation $10 B $5 B Current Value Value of Equity
Good State Bad State
$10 B $5 B
Current Value
Value of Equity
Return on Equity

12. Announcement Effect of Capital Raising Choices
Common Stock %
Straight Debt %*
Internally Financed %
Means not statistically significant
What is the rationale (theory)?

13. So the announcement effect
If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm.
Therefore the firm will never issue equity if it can avoid it to finance in projects.
Thus pecking order.

14. Empirical Evidence We tend to see that firms:
1. Use internal funds to invest in projects if available
2. Use least risky securities as possible if it has to finance these projects externally.
3. Announcement of a new Debt issue has a small negative impact on stockprice
4. Announcement of a new Equity issue has a strong negative impact on stockprice

15. Empirical Evidence
Schwartz & Aronson: Leverage tends to decline as the proportion of total value of the firm consists of Growth Opportunities.
Information costs: Very strong relationship between type of capital structure change and price change It is difficult to distinguish between tradeoff theory and Pecking Order
Taxes: Leverage increases associated with high taxes

16. Generalizing
When we look at established Capital Structures we tend to find evidence that supports a static tradeoff theory of capital structure
When we consider changes in capital structure (issuing debt or equity, repurchases, calls, etc.) there tends to be a significant pecking order component