1. Behavioral Corporate Finance
Chapter 6
CAPITAL STRUCTURE
Behavioral Corporate Finance
by Hersh Shefrin

2. Traditional Approach to Capital Structure
There are two main approaches to capital structure:
Modigiliani Miller tradeoff theory
Myers- Majluf packing order theory

3. Cont..
Tradeoff theory focuses on the tradeoff between debt tax shields and financial distress.
Interest paid is tax deductible, capital structure affects the after tax cash flows to the firm’s investors.

4. Cont..
Pecking order theory suggests that a firm does not have an optimal debt to equity ratio.
Instead, the firm follows a pecking order. If it needs additional financing the firm first uses internally generated equity(cash). Once it exhausts its cash, it resorts to debt financing. If it exhausts its debt capacity, than it moves to new equity as a last resort.

5. How do managers choose Capital Structure In Practice
Survey evidence indicates that dilution and market timing are the top factors that influence managers’ decisions about issuing new equity.
The top factor influencing financial executives’ decisions about new debt is financial flexibility.
As a group, managers report that they attempt to target values for their firms’ debt-to-equity ratios.
However, this factor is rated fifth in importance.

6. New Equity: Market Timing
Market timing is a prominent consideration driving capital structure decisions, at least in the short term.
Firms tend to issue new equity, and therefore achieve lower debt to equity ratios, when their market to book ratios are high.
Managers issue equity when the equity is most likely to be overvalued.

7. Earnings dilution
An equity issue would lower the debt to equity ratio thereby driving down expected EPS.
Executives might interpret lower EPS as dilution.
Dilution is associated with market timing.

8. New debt: Financial Flexibility
The FEI survey tells that the top factor is financial flexibility: having enough internal funds available to pursue new projects when they come along.
Convertible debt is an inexpensive way to issue delayed common stock.

9. Cont.. Convertible debt exhibits atleast two behavioral features:
Interest rate on convertible debt tends to be less than the interest rate on fixed debt.
Convertible debt tends to convert to equity only when the future stock prices rises.

10. Target debt to equity ratio
Executives decisions about capital structure reflect traditional tradeoff considerations as well as market timing.
Executives assign tradeoff considerations a lower priority than other competing concern.
Traditional theory predicts that firms with lower costs of debt will choose to hold more debt than firm with higher costs of debt.

11. Cont..
Firms with low expected costs of financial distress use debt conservatively.
Large liquid firms in non-cyclical industries use debt conservatuvely.

12. Traditional Pecking order
Investors concern about being informationally disadvantaged relative to managers will lead managers to prefer internal equity to debt financing, and debt financing to external equity financing.
When large firms engage in substantial investments, they tend to rely on debt financing, they do not exhaust their cash reserves before debt financing.
Managers do not behave in strict accordance with the predictions of pecking order theory.

13. Behavioral APV
Behavioral APV reflects errors and biases by managers, the market, or both.
Behavioral APV calculation indicates whether managers of financially constrained firms with positive NPV projects, but whose equity is undervalued, should invest or repurchase.

14. Financial flexibility and Project Hurdle Rate
Three key variables determine the appropriate adjustment to project hurdle rate.
the firm’s financing constraints
degree of mispricing
the impact of the firm’s repurchase activity on the price of its shares

15. Repurchasing
Average market response to announcement of an open market repurchase is 3.5%.
Investors appear to underreact to repurchases, in that stock prices drift upwards when firms repurchase shares.
Stocks of firms who repurchase shares earn four-year abnormal returns of 12.1%.
45.3% for firms with high book-to-market equity.
Example: AutoNation.

16. Sensitivity of Investment to Cash Flow
Firms’ acquisition activity increases when they are the recipients of large cash windfalls coming from legal settlements unrelated to their ongoing lines of business.
Reinsurance companies reduce the supply of earthquake insurance after their capital positions have been impaired by large hurricanes.
When cash flow increases or leverage decreases in one division of a firm, investments in other divisions of the firm increase significantly.

17. Behavioral Explanation
Excessively optimistic, overconfident managers of cash poor firms reject positive NPV projects because they overvalue the equity of their firms, and won't issue new shares to fund the project.
Excessively optimistic, overconfident managers of cash rich firms adopt negative NPV projects because they overvalue the cash flows from those projects and adopt them.
Example: Adaptec.

18. Excessive Optimism, Overconfidence, and Cash
The press often describes some CEOs as “optimistic” and “confident.”
Longholders hold stock options too long.
Example: Scott McNealy of Sun Microsystems.
Empirical evidence that firms with longholder CEOs have investment policies that are excessively sensitive to cash flows.

19. Conflict Between Short-term and Long-term Horizons
Consider a firm whose book-to-market equity ratio is low, and whose stock price has increased rapidly.
Such a firm might earn low returns long-term because its stock is overpriced.
Managers who adopt projects for short-term gain effectively act as if they use low discount rates in their capital budgeting analysis.
Challenge is balancing interests of short-term and long-term investors.

20. The End