Advanced corporate finance
Topic 1 – back to basics
Firms can access finance through
- internal capital
- debt
- equity
Leverage can be seen as the ratio of debt within the company; debt/equity of debt/assets
This can change because debt is issued/paid back or equity is issued/paid back
Under MM, a firm’s financing decision does not affect firm value
Assumptions that need to hold:
1. perfect capital markets → competitive, frictionless, rational agents
2. all agents have same information
3. no bankruptcy costs
4. no taxes
MM propositions:
I – firm’s market value is independent of its capital structure
II – firm’s cost of equity increases with its debt-equity ratio
Dividend irrelevance
Investor indifference
Financial risk is the additional risk placed on the common stockholders as a result of the
decision to finance with debt
MM is not a statement about the real world, but it helps ask right questions
MM’s most basic messages:
- value is created only on left-hand side of the balance sheet
- firm’s financial policy should mostly be a means to support operating policy
Pecking order theory to deal with adverse selection problem
Firms will prefer:
- retained earnings (no asymmetric information)
- debt (less sensitive to asymmetric information, not related to company performance)
- equity
‘Mother of all equations’ in finance:
- tangibility = higher leverage
- size (log sales) = higher leverage (bigger firms are more diversified)
- MTB = lower leverage (take advantage of ‘mispriced’/overvalued stock)
- ROA = both - higher leverage = disciplining effect of debt – lower leverage = pecking
order theory
,Topic 2 – debt covenants
A company’s debt capital structure is typically divided into several constituencies:
- senior debt (usually provided by a bank or other lending institution)
- lowest cost, variable interest rate, secured by all/most assets, yearly
amortization of principal
- subordinated debt (usually high yield bonds)
- higher cost – compensation for lack of protection, fixed interest rates, unsecured
Parts of a typical loan agreement:
- the note; specifies principal, interest and timing of repayment
- collateral; specifies assets assigned and terms under which lender takes possession of
assets
- borrower guarantees; promise by one party to assume debt obligation of a borrower if
that borrower defaults
- events of default; exact conditions under which a loan is considered in default
- covenants
Covenants are agreements between company and its creditors that the company should
operate within certain limits
→ these limits might limit other borrowing, certain level of leverage, interest cover,
working capital and debt service cover
Debt covenants are agreed as a condition of borrowing → might change if debt is
restructured
Debt covenants can impose heavy obligations, a company might be forced to sell assets
in order to stay within a debt covenant
In theory a breach of debt covenants means a lender can demand immediate repayment,
in practice this rarely happens as borrower probably in no position to repay immediately
→ breach of covenants usually leads to renegotiation of the terms of the debt
Negative debt covenants state what the borrower cannot do
Positive debt covenants state what the borrower must do
New development – leveraged loans
→ loans usually arranged by a syndicate of banks and granted to companies with already
high leverage/low rating (tend to be safer than high yield bonds as they are more senior,
are collateralized and are protected by covenants)
The leveraged loan market has exploded since financial crisis
With investors eager for higher returns, companies have been able to borrow money on
increasingly favorable terms, giving them greater flexibility if they run into trouble
Covenant-light loans are loans that do not have the usual protective covenants for the
benefit of the lending party
Leveraged loans can be bundled in securities traded in financial markets called
‘collateralized loan obligations’
CLOs are vehicles which take a group of risky loans (especially leveraged loans) and use
them to back a series of bond of varying degrees of riskiness (essentially a CDO)
,Paper – Roberts and Sufi (2009)
Goal of this study is to examine the response of corporate financial policies to covenant
violations
Descriptive statistics:
- of the firms in the sample, 25.6% of firms reported covenant violation (varying
percentages across industries)
- smaller companies tend to have higher probability of covenant violation
- companies with credit rating are less likely to violate the covenant
They find that after covenant violation, firm’s average net debt issuance goes down
(strongly, by about 120 basis points)
They find that after covenant violation, firm’s average net equity issuance remains steady
They find that after covenant violation, firm’s average leverage ratio becomes
significantly lower
Companies that violated a covenant recently (i.e. 2 quarters ago) still have a higher
leverage ratio compared to other firms → it takes time for them to pay back the debt
Companies that violated a covenant progressively reduced their net debt issuance (issue
less debt) → results in having progressively lower leverage ratios
How quickly to firms adjust? → check
If it is negative, company today issues less debt than 2 quarters ago
The ‘more’ negative, the faster a company adjusts:
- companies with higher leverage ratio adjust faster (more risky=need to adjust faster)
- companies with higher MTB ratio adjust slower (high MTB=large growth in future,
creditors are more lenient)
- companies with credit rating adjust slower
Overall, companies with less alternative capital adjust faster
Whether creditors take action in response to covenant violations depends on firm
characteristics
A creditor is more likely to take action if the firm is:
- a serial offender
- highly levered
- does not have much cash
- not very profitable
- does not have credit rating
, Topic 3 – private and public firms
Studies until now focused mainly on examining capital structure theories with regards to
publicly traded firms, not private firms
Number of fundamental questions concerning private firms unanswered:
- what characterizes capital structure and funding behavior of private firms?
- do existing theories of capital structure provide appropriate description of financing
behavior of private firms?
Private firms have fewer choices for raising equity capital
- owner’s equity (retention and plow back of company’s earnings)
- venture capital/private equity
Public firms have more choices for raising equity capital
- common stock (IPO/SEO)
- preferred stock (characteristics of debt and equity)
- tracking stock (stock issued against specific assets/portions of firm – no voting rights)
- warrants (gives investor option to buy equity at fixed price in future)
Private firms and debt – main problem = private firms generally don’t access public debt
market and are therefore unrated; most debt on the books is bank debt
- trade credit is also important form of credit (paying later)
Public firms and debt = likely to be rated, access to large bond market
- possibility of bank debt
Predictions of differences between public and private firms:
Sensitivity effect – consequences that arise from the fact that private firm’s absolute
cost of accessing external capital markets is higher than public firms (more opaque)
1. private firm’s financial policies are more passive vs public firms → private firms are
less likely to visit external capital markets
2. since it is more costly for private firms to rebalance their debt ratios → leverage will
exhibit larger sensitivity to operating performance
So, public firms are more likely to visit external capital markets
Level effect – consequences that arise from the fact that private firm’s relative cost of
equity to debt capital is higher than that of public firms
1. private firms are more opaque than public firms → debt financing is cheaper than
equity financing since equity is more sensitive to information
2. private firms are usually controlled by large shareholder (family) → equity financing is
expensive as it would dilute their control
In other words, private firms are more likely to choose debt over equity financing and the
debt ratios for private firms expected to be higher than for public counterparts
Under MM → capital structure is irrelevant for firm value!
So what market frictions exist so that private equity is more costly than public equity?
- ownership structure – private more focused (family) → want to keep control
- information asymmetry – private firms more opaque → equity more sensitive to
information asymmetry → cost of equity private higher than cost of equity public
Expect private firms to have higher leverage ratio!
A public firm is a firm listed on an official market – unrestricted rights to issue equity and
debt to the market
A private firm is not listed on an official market
- public non-quoted firms are firms that have unrestricted rights to issue equity
and debt to the market, not listed on an official market
Topic 1 – back to basics
Firms can access finance through
- internal capital
- debt
- equity
Leverage can be seen as the ratio of debt within the company; debt/equity of debt/assets
This can change because debt is issued/paid back or equity is issued/paid back
Under MM, a firm’s financing decision does not affect firm value
Assumptions that need to hold:
1. perfect capital markets → competitive, frictionless, rational agents
2. all agents have same information
3. no bankruptcy costs
4. no taxes
MM propositions:
I – firm’s market value is independent of its capital structure
II – firm’s cost of equity increases with its debt-equity ratio
Dividend irrelevance
Investor indifference
Financial risk is the additional risk placed on the common stockholders as a result of the
decision to finance with debt
MM is not a statement about the real world, but it helps ask right questions
MM’s most basic messages:
- value is created only on left-hand side of the balance sheet
- firm’s financial policy should mostly be a means to support operating policy
Pecking order theory to deal with adverse selection problem
Firms will prefer:
- retained earnings (no asymmetric information)
- debt (less sensitive to asymmetric information, not related to company performance)
- equity
‘Mother of all equations’ in finance:
- tangibility = higher leverage
- size (log sales) = higher leverage (bigger firms are more diversified)
- MTB = lower leverage (take advantage of ‘mispriced’/overvalued stock)
- ROA = both - higher leverage = disciplining effect of debt – lower leverage = pecking
order theory
,Topic 2 – debt covenants
A company’s debt capital structure is typically divided into several constituencies:
- senior debt (usually provided by a bank or other lending institution)
- lowest cost, variable interest rate, secured by all/most assets, yearly
amortization of principal
- subordinated debt (usually high yield bonds)
- higher cost – compensation for lack of protection, fixed interest rates, unsecured
Parts of a typical loan agreement:
- the note; specifies principal, interest and timing of repayment
- collateral; specifies assets assigned and terms under which lender takes possession of
assets
- borrower guarantees; promise by one party to assume debt obligation of a borrower if
that borrower defaults
- events of default; exact conditions under which a loan is considered in default
- covenants
Covenants are agreements between company and its creditors that the company should
operate within certain limits
→ these limits might limit other borrowing, certain level of leverage, interest cover,
working capital and debt service cover
Debt covenants are agreed as a condition of borrowing → might change if debt is
restructured
Debt covenants can impose heavy obligations, a company might be forced to sell assets
in order to stay within a debt covenant
In theory a breach of debt covenants means a lender can demand immediate repayment,
in practice this rarely happens as borrower probably in no position to repay immediately
→ breach of covenants usually leads to renegotiation of the terms of the debt
Negative debt covenants state what the borrower cannot do
Positive debt covenants state what the borrower must do
New development – leveraged loans
→ loans usually arranged by a syndicate of banks and granted to companies with already
high leverage/low rating (tend to be safer than high yield bonds as they are more senior,
are collateralized and are protected by covenants)
The leveraged loan market has exploded since financial crisis
With investors eager for higher returns, companies have been able to borrow money on
increasingly favorable terms, giving them greater flexibility if they run into trouble
Covenant-light loans are loans that do not have the usual protective covenants for the
benefit of the lending party
Leveraged loans can be bundled in securities traded in financial markets called
‘collateralized loan obligations’
CLOs are vehicles which take a group of risky loans (especially leveraged loans) and use
them to back a series of bond of varying degrees of riskiness (essentially a CDO)
,Paper – Roberts and Sufi (2009)
Goal of this study is to examine the response of corporate financial policies to covenant
violations
Descriptive statistics:
- of the firms in the sample, 25.6% of firms reported covenant violation (varying
percentages across industries)
- smaller companies tend to have higher probability of covenant violation
- companies with credit rating are less likely to violate the covenant
They find that after covenant violation, firm’s average net debt issuance goes down
(strongly, by about 120 basis points)
They find that after covenant violation, firm’s average net equity issuance remains steady
They find that after covenant violation, firm’s average leverage ratio becomes
significantly lower
Companies that violated a covenant recently (i.e. 2 quarters ago) still have a higher
leverage ratio compared to other firms → it takes time for them to pay back the debt
Companies that violated a covenant progressively reduced their net debt issuance (issue
less debt) → results in having progressively lower leverage ratios
How quickly to firms adjust? → check
If it is negative, company today issues less debt than 2 quarters ago
The ‘more’ negative, the faster a company adjusts:
- companies with higher leverage ratio adjust faster (more risky=need to adjust faster)
- companies with higher MTB ratio adjust slower (high MTB=large growth in future,
creditors are more lenient)
- companies with credit rating adjust slower
Overall, companies with less alternative capital adjust faster
Whether creditors take action in response to covenant violations depends on firm
characteristics
A creditor is more likely to take action if the firm is:
- a serial offender
- highly levered
- does not have much cash
- not very profitable
- does not have credit rating
, Topic 3 – private and public firms
Studies until now focused mainly on examining capital structure theories with regards to
publicly traded firms, not private firms
Number of fundamental questions concerning private firms unanswered:
- what characterizes capital structure and funding behavior of private firms?
- do existing theories of capital structure provide appropriate description of financing
behavior of private firms?
Private firms have fewer choices for raising equity capital
- owner’s equity (retention and plow back of company’s earnings)
- venture capital/private equity
Public firms have more choices for raising equity capital
- common stock (IPO/SEO)
- preferred stock (characteristics of debt and equity)
- tracking stock (stock issued against specific assets/portions of firm – no voting rights)
- warrants (gives investor option to buy equity at fixed price in future)
Private firms and debt – main problem = private firms generally don’t access public debt
market and are therefore unrated; most debt on the books is bank debt
- trade credit is also important form of credit (paying later)
Public firms and debt = likely to be rated, access to large bond market
- possibility of bank debt
Predictions of differences between public and private firms:
Sensitivity effect – consequences that arise from the fact that private firm’s absolute
cost of accessing external capital markets is higher than public firms (more opaque)
1. private firm’s financial policies are more passive vs public firms → private firms are
less likely to visit external capital markets
2. since it is more costly for private firms to rebalance their debt ratios → leverage will
exhibit larger sensitivity to operating performance
So, public firms are more likely to visit external capital markets
Level effect – consequences that arise from the fact that private firm’s relative cost of
equity to debt capital is higher than that of public firms
1. private firms are more opaque than public firms → debt financing is cheaper than
equity financing since equity is more sensitive to information
2. private firms are usually controlled by large shareholder (family) → equity financing is
expensive as it would dilute their control
In other words, private firms are more likely to choose debt over equity financing and the
debt ratios for private firms expected to be higher than for public counterparts
Under MM → capital structure is irrelevant for firm value!
So what market frictions exist so that private equity is more costly than public equity?
- ownership structure – private more focused (family) → want to keep control
- information asymmetry – private firms more opaque → equity more sensitive to
information asymmetry → cost of equity private higher than cost of equity public
Expect private firms to have higher leverage ratio!
A public firm is a firm listed on an official market – unrestricted rights to issue equity and
debt to the market
A private firm is not listed on an official market
- public non-quoted firms are firms that have unrestricted rights to issue equity
and debt to the market, not listed on an official market
