1. FIN 413 Corporate Financial Policy Clifford W. Smith, Jr. Spring 2007 Overhead 2 * Covers readings on course outline through Barclay/Smith/Watts (1997)

2. D E M/M (1958)

3. 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 Liabilities M/M (1963) D TcTc E

7. Corporate Tax Liabilities M/M (1963) D TcTc E

8. Taxes and Bankruptcy Costs Kraus/Litzenberger (1973) E BC TcTc D

9. Taxes and Bankruptcy Costs Kraus/Litzenberger (1973) E BC TcTc D

10. 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

11. We can measure the bankruptcy costs in relation to firm value at various points in time Measuring Bankruptcy Costs 0  Filing date T  Settlement date (T  13 years) 55 T0Time BC V 0 V -7 = 5.3% = 1.0%

12. 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

13. 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.

14. Corporate and Personal Taxes D E TpTp TcTc Miller (1977)

15. Corporate and Personal Taxes D E TpTp TcTc Miller (1977)

16. DeAngelo and Masulis Debt and Taxes Default Zero taxes, deductions not fully utilized Positive taxes, tax credits not fully utilized Taxes paid at the highest marginal rate Income 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.

17. In equilibrium, there is an optimal capital structure for the economy as a whole and for each individual firm. DeAngelo and Masulis Debt and Taxes

18.  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   2, BC,  c,  p ) DeAngelo and Masulis Debt and Taxes

19. 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.

20. 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.

21. 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.

22. 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

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

24. 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

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 Out-of-Pocket Costs

26. Agency Theory Agency Monitoring Bonding Residual Costs Costs Costs Loss = + + Out-of-Pocket Costs Opportunity Costs Jensen and Meckling provide a definition of agency costs that divides these costs into their individual components:

27. 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

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

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

30. Dividend payout Claim dilution Asset substitution Underinvestment Conflicts of Interest + - + + + + V = E(V, F, T, σ², r, DIV) + + - - - - +B(V, F, T, σ², r, DIV)

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

32. A Simple Example Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25  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.

33. A Simple Example Time NPV Project 0 1 2 A -50 100 50= 100 B – -75 100 = 25 Bond ? -20 -100  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.

34. A Simple Example Time NPV Project 0 1 2 A -50 100 50 = 100 B – -75 100 = 25 Bond 120 -20 -100

35. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125

36. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150

37. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 120 -20 -100 DIV (A&B) 70 5 50 = 125 DIV (A-) 70 80 – = 150

38. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond ? -20 -100

39. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100

40. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75

41. A Simple Example Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 70 -20 -100 DIV (A&B) 20 5 50 = 75 DIV (A-) 20 80 – = 100

42. 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.

43. Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond ? -10 -50 Less Leverage

44. Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 Less Leverage

45. Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100= 125

46. Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100= 125 DIV (A-) 10 90 – = 100

47. Less Leverage Time NPV Project 0 1 2 A -50 100 50 B – -75 100 Bond 60 -10 -50 DIV (A&B) 10 15 100= 125 DIV (A-) 10 90 – = 100

48.  High Leverage Bond 70-20 -100 DIV (A -) 20 80 – = 100  Low Leverage Bond60 -10 -50 DIV (A+B) 10 15 100 = 125 Which Bond Do I Want to Issue?

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

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

51. From Barclay/Smith/Watts (1997)

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

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

54. 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

55. From Barclay/Smith/Watts (1997)

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

57. 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

58. From Barclay/Smith/Watts (1997)

59. 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

61. From Barclay/Smith/Watts (1997)

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

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

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

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

66. Capital Structure Management  Trade Off Hypothesis  Pecking Order Hypothesis  Market Timing Hypothesis

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.  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. Pecking Order

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

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

71.  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. Strategic Capital Structure Management

72. Adjustment Costs Firm Value Leverage Target Leverage

73. Adjustment Costs Leverage Time Target Leverage

74.  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 Adjustment Costs

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?

78.  Pecking Order Hypothesis  Market Timing Hypothesis  Tradeoff Hypothesis Strategic Capital Structure Management