1. Corporate Financial Policy
EXP 482
Corporate Financial Policy
Clifford W. Smith, Jr.
Winter Overhead 2
* Covers readings on course outline through Barclay/Smith/Watts (1997)

2. M/M (1958) D E

3. M/M (1958) D E

4. Historical Evidence
From Barclay/Smith/Watts (1997)

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

6. Corporate Tax LiabilitiesTc D E
M/M (1963)

7. Taxes and Bankruptcy CostsBC D E
Kraus/Litzenberger (1973)

8. 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

9. Measuring Bankruptcy Costs
We can measure the bankruptcy costs in relation to firm value at various points in time -5 T
Time
BC = T 
T=0
BCt (BC = $2 million)
0 - Filing date
T - Settlement date
(T = 13 years)
BC BC
V0 V-7
= 5.3%
= 1.0%

10. 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

11. 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.

12. Corporate and Personal TaxesTc Tp D E
Miller (1977)

13. 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

14. 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.

15. 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)

16. 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.

17. 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.

18. 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.

19. 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

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

21. 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

22. 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 =

23. 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

24. 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

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

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

27. 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

28. 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 A
B –

29. 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
A = 100
B – = 25

30. 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
A =
B – =
Bond ?

31. A Simple Example Time NPV Project 0 1 2 A -50 100 50 = 100
B – = 25
Bond

32. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) = 125

33. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) = 125
DIV (A-) – = 150

34. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) = 125
DIV (A-) – =

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

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

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

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

39. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) = 125
DIV (A-) – = 100

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

41. 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.

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

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

44. Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) =

45. Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) =
DIV (A-) – =

46. Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100
Bond
DIV (A&B) =
DIV (A-) – =

47. Which Bond Do I Want to Issue?
High Leverage
Bond
DIV(A -) – = 100
Low Leverage
Bond
DIV(A+B) = 125

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

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

50. From Barclay/Smith/Watts (1997)

51. Economic Significance
From Barclay/Smith/Watts (1997)

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

53. 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

54. From Barclay/Smith/Watts (1997)

55. Regulation
From Barclay/Smith/Watts (1997)

56. 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

57. From Barclay/Smith/Watts (1997)

58. 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

60. From Barclay/Smith/Watts (1997)

61. Signaling
From Barclay/Smith/Watts (1997)

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

63. "Form Ever Follows Function"
Louis Henri Sullivan, 1896

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

65. Articles Handouts for Class 2:
“Incentive and Tax Effects of Executive Compensation Plans” by C. Smith, & R. Watts
Book chapter, pgs
“The Determinants of Corporate Leverage and Dividend Policies” by M. Barclay, C. Smith, and R. Watts, Journal of Applied Corporate Finance, vol. 7, no. 4 (winter 1995), pgs