Advanced Corporate Finance & Governance
1
,Advanced Corporate Finance and Governance Summary
Week 1, no class
Week 2 slides
Why do we care about capital structure?
o People with money and people with ideas are not the same people, interests are not aligned
Optimize capital structure to reduce the weighted average cost of capital
o If no taxes
r e∗E r d∗D
WACC = +
D+ E D+ E
o Interest rate on debt usually lower than the required
return on shares
When there is more debt in a firm, it is riskier for equity holders,
so they demand a higher return
Share= part of ownership
The value of the firm is the discounted value of the future
cashflows
o The capital structure has a direct influence on the
discount factor, so the present value of the future
cashflows
Modigliani & Miller state that the capital structure of a firm is not relevant
o The Pie-theory
You cannot change the size of a pie by cutting it into different sized slices
M&M Proposition 1
o The value of an asset remains the same, regardless of how the net operating cash flows
generated by the asset are divided between different classes of investors
Pie theory
Cash flows matter, but how you divide the cash flows doesn’t matter
M&M Proposition 2
o The cost of equity of a levered firm is equal to the cost of an unlevered firm plus a financial
risk premium, which depends on the degree of financial leverage
In a formula
D
r e =r 0+ (r −r )
E 0 d
The more debt there is, the more return the equity holders will demand
o The more debt there is, the higher Re becomes
Interest rate on debt generally lower than required return on shares
The firm value of a levered firm should have the same firm value as an unlevered firm
o Firm value levered and unlevered should be the same
Key assumptions by M&M
o Individuals borrow at the same rate as corporations
o Perfect capital market (no information asymmetry or transaction costs)
o No taxes
o No costs for financial distress
o Fixed investment policy
Personal taxes matter as well, since this determines how easily the firm can raise money through debt
or equity financers
Classical system
o Leverage will increase a firm’s value because interest on debt is a tax deductible expense
resulting in an increase in the after-tax net cash flows to investors
Proposition 1, with taxes
o Value of a levered firm is equal to the value of an unlevered firm of the same risk class plus
the present value of the tax saving
2
, Debt seems to be the best choice for the financing of a firm, why use equity?
o The main benefit of increased debt is the increased benefit from the interest expense as it
reduces taxable income
o With an increased debt load, the following occurs:
Interest expense rises and the cash flow that needs to cover the interest expense
also rise
Debt issuers become nervous that the company will not be able to cover its financial
responsibilities with respect to the debt they are issuing
Stock holders become nervous too
If interest increases, EPS decreases, and a lower stock price is valued.
If a company goes bankrupt, stockholders are the last to be paid retribution
o Overall, tax gives an advantage to debt, the personal tax rate reduces this advantage a little
Why not 100% debt financing for firms?
o This decreases the company’s rating, increases chances for bankruptcy
o Smaller chance to pay all the interest every year
In M&M going bankrupt was costless, unlike in the real world
o Direct costs: lawyers, accountants
o Indirect costs, are more important: even before going bankrupt, rumours for example, could
already hurt a lot suppliers are scared, employees might leave
Costs for financial distress
o Are the highest for the banking industry, bank run
o Are not easy to measure
o The average costs are about 10-20% of the firm value
Bankruptcy provides a good reason to not having too much debt
The reasons described above are an answer to the assumptions of M&M, so
o Individuals don’t borrow at the same rate as corporations (personal tax vs. corporate tax)
o There are transaction costs
o There are taxes, even double taxation shareholders pay tax through the corporate tax,
and have to pay tax on the dividends themselves
o Costs of financial distress are really high in the real world
o Do firms have investment policies independent of leverage?
Agency costs
Risk shifting (disadvantage of debt)
o Which is also known as asset substitution, occurs if managers
make overly risky investment decisions that maximize shareholder
value at the expense of debtholders' interests. A stockholder's
claim on a levered company can be viewed as a call option on the
group's asset value.
Risky projects are started by equity holders, when there
are substantial amounts of debt, and equity holders start
gambling on really risky decisions, just to get every
money out of the firm. Bondholders know this will
happen, so they demand a higher return
Shareholders have more upside potential
Bondholders have more downside risk
o Asset substitution and risk shifting is especially relevant if the risk
of default is substantial
Over-investment (empire building) (advantage of debt)
o A conflict of interest between shareholders and managers
When there is just too much money lying around, so
managers overinvest, and just use it for personal use,
such as private planes, which is not in line with the
interests of the shareholders agency cost
3
, Taking on more debt is a form of discipline with regard to management
o Higher interest payments reduce the free cash flows, so managers can invest less into risky
projects
Static trade-off theory
o Between tax shields and the costs of financial distress, agency problems
o The static version says, there is an optimal capital structure
o Agency costs are included
Debt is good, because it reduces overinvestment, but at some point it becomes bad
because you het asset substitution
There is always an optimum
Dynamic trade-off theory
o Wherever you are, you try to move to the optimum
Relation between firm characteristics and optimal debt ratios
o Theoretical predictions Reality
Firm size + +
Fixed assets (tangibility) + + Firms with fixed assets use debt financing the most
Growth opportunities - -
Profitability + - Profitable firms should have a lot of debt, prediction
Firm risk - -
Notes on theoretical predictions
o Profitability
Firms that are profitable can benefit more from a tax shield since they are paying
more taxes due to their profitability
Most predictions of the static trade-off theory are consistent with patterns in the data
o However some, like the relation between profitability and leverage, are not
Findings of Graham (2000)
o A significant number of firms are surprisingly conservative in their use of debt
o Even firms with low expected costs of financial distress (large, profitable firms)
Static trade-off theory
o The theory is one of the main capital structure theories and poses that firms have a target
debt ratio based on the advantages and disadvantages of debt
One advantage of debt is the tax treatment of interest (tax shield)
One disadvantage is the cost of financial distress
The propositions of M&M
o 1
The value of an asset remains the same, regardless of how the net operating cash
flows generated by the assets are divided between the different classes of investors
(debt vs equity investors)
o 2
The cost of equity of a levered firm is equal to the cost of equity of an unlevered
firm plus a financial risk premium, which depends on the degree of financial
leverage
4
1
,Advanced Corporate Finance and Governance Summary
Week 1, no class
Week 2 slides
Why do we care about capital structure?
o People with money and people with ideas are not the same people, interests are not aligned
Optimize capital structure to reduce the weighted average cost of capital
o If no taxes
r e∗E r d∗D
WACC = +
D+ E D+ E
o Interest rate on debt usually lower than the required
return on shares
When there is more debt in a firm, it is riskier for equity holders,
so they demand a higher return
Share= part of ownership
The value of the firm is the discounted value of the future
cashflows
o The capital structure has a direct influence on the
discount factor, so the present value of the future
cashflows
Modigliani & Miller state that the capital structure of a firm is not relevant
o The Pie-theory
You cannot change the size of a pie by cutting it into different sized slices
M&M Proposition 1
o The value of an asset remains the same, regardless of how the net operating cash flows
generated by the asset are divided between different classes of investors
Pie theory
Cash flows matter, but how you divide the cash flows doesn’t matter
M&M Proposition 2
o The cost of equity of a levered firm is equal to the cost of an unlevered firm plus a financial
risk premium, which depends on the degree of financial leverage
In a formula
D
r e =r 0+ (r −r )
E 0 d
The more debt there is, the more return the equity holders will demand
o The more debt there is, the higher Re becomes
Interest rate on debt generally lower than required return on shares
The firm value of a levered firm should have the same firm value as an unlevered firm
o Firm value levered and unlevered should be the same
Key assumptions by M&M
o Individuals borrow at the same rate as corporations
o Perfect capital market (no information asymmetry or transaction costs)
o No taxes
o No costs for financial distress
o Fixed investment policy
Personal taxes matter as well, since this determines how easily the firm can raise money through debt
or equity financers
Classical system
o Leverage will increase a firm’s value because interest on debt is a tax deductible expense
resulting in an increase in the after-tax net cash flows to investors
Proposition 1, with taxes
o Value of a levered firm is equal to the value of an unlevered firm of the same risk class plus
the present value of the tax saving
2
, Debt seems to be the best choice for the financing of a firm, why use equity?
o The main benefit of increased debt is the increased benefit from the interest expense as it
reduces taxable income
o With an increased debt load, the following occurs:
Interest expense rises and the cash flow that needs to cover the interest expense
also rise
Debt issuers become nervous that the company will not be able to cover its financial
responsibilities with respect to the debt they are issuing
Stock holders become nervous too
If interest increases, EPS decreases, and a lower stock price is valued.
If a company goes bankrupt, stockholders are the last to be paid retribution
o Overall, tax gives an advantage to debt, the personal tax rate reduces this advantage a little
Why not 100% debt financing for firms?
o This decreases the company’s rating, increases chances for bankruptcy
o Smaller chance to pay all the interest every year
In M&M going bankrupt was costless, unlike in the real world
o Direct costs: lawyers, accountants
o Indirect costs, are more important: even before going bankrupt, rumours for example, could
already hurt a lot suppliers are scared, employees might leave
Costs for financial distress
o Are the highest for the banking industry, bank run
o Are not easy to measure
o The average costs are about 10-20% of the firm value
Bankruptcy provides a good reason to not having too much debt
The reasons described above are an answer to the assumptions of M&M, so
o Individuals don’t borrow at the same rate as corporations (personal tax vs. corporate tax)
o There are transaction costs
o There are taxes, even double taxation shareholders pay tax through the corporate tax,
and have to pay tax on the dividends themselves
o Costs of financial distress are really high in the real world
o Do firms have investment policies independent of leverage?
Agency costs
Risk shifting (disadvantage of debt)
o Which is also known as asset substitution, occurs if managers
make overly risky investment decisions that maximize shareholder
value at the expense of debtholders' interests. A stockholder's
claim on a levered company can be viewed as a call option on the
group's asset value.
Risky projects are started by equity holders, when there
are substantial amounts of debt, and equity holders start
gambling on really risky decisions, just to get every
money out of the firm. Bondholders know this will
happen, so they demand a higher return
Shareholders have more upside potential
Bondholders have more downside risk
o Asset substitution and risk shifting is especially relevant if the risk
of default is substantial
Over-investment (empire building) (advantage of debt)
o A conflict of interest between shareholders and managers
When there is just too much money lying around, so
managers overinvest, and just use it for personal use,
such as private planes, which is not in line with the
interests of the shareholders agency cost
3
, Taking on more debt is a form of discipline with regard to management
o Higher interest payments reduce the free cash flows, so managers can invest less into risky
projects
Static trade-off theory
o Between tax shields and the costs of financial distress, agency problems
o The static version says, there is an optimal capital structure
o Agency costs are included
Debt is good, because it reduces overinvestment, but at some point it becomes bad
because you het asset substitution
There is always an optimum
Dynamic trade-off theory
o Wherever you are, you try to move to the optimum
Relation between firm characteristics and optimal debt ratios
o Theoretical predictions Reality
Firm size + +
Fixed assets (tangibility) + + Firms with fixed assets use debt financing the most
Growth opportunities - -
Profitability + - Profitable firms should have a lot of debt, prediction
Firm risk - -
Notes on theoretical predictions
o Profitability
Firms that are profitable can benefit more from a tax shield since they are paying
more taxes due to their profitability
Most predictions of the static trade-off theory are consistent with patterns in the data
o However some, like the relation between profitability and leverage, are not
Findings of Graham (2000)
o A significant number of firms are surprisingly conservative in their use of debt
o Even firms with low expected costs of financial distress (large, profitable firms)
Static trade-off theory
o The theory is one of the main capital structure theories and poses that firms have a target
debt ratio based on the advantages and disadvantages of debt
One advantage of debt is the tax treatment of interest (tax shield)
One disadvantage is the cost of financial distress
The propositions of M&M
o 1
The value of an asset remains the same, regardless of how the net operating cash
flows generated by the assets are divided between the different classes of investors
(debt vs equity investors)
o 2
The cost of equity of a levered firm is equal to the cost of equity of an unlevered
firm plus a financial risk premium, which depends on the degree of financial
leverage
4
