1. 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)

2. M/M (1958) D E

3. M/M (1958) D E

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

5. 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

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

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

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

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

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

11. 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

12. 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%

13. 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

14. 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.

15. Corporate and Personal TaxesTp Tc D E
Miller (1977)

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

17. 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

18. 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.

19. 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)

20. 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.

21. 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.

22. 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.

23. 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

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

25. 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

26. 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 =

27. 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

28. 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

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

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

31. 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

32. 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 –

33. 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

34. 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 ?

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

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

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

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

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

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

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

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

43. 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.

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

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

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

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

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

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

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

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

52. From Barclay/Smith/Watts (1997)

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

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

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

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

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

59. From Barclay/Smith/Watts (1997)

60. 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

62. From Barclay/Smith/Watts (1997)

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

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

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

66. Don’t let the information age article

67. 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.

68. 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.

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

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

71. 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.

72. Adjustment Costs
Firm Value
Leverage
Target Leverage

73. Adjustment Costs
Leverage
Target Leverage
Time

74. 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

75. 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?

76. Table 1 All Firms

77. Table 1 All Firms [cont.]

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

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

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

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

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