Lecture 1,3 & 4:
Assumptions neo-classical finance theory:
Company is regarded as a black box.
o One goal: no conflicts of interest
o Business cash flows are given
Perfect market:
o Capital will flow to business opportunities with optimal risk-return
relationship
o No tax, transaction or information costs
o No distress
o Market efficiency
Asymmetric Information: homogeneous perception and expectations (results in no
agency costs)
Investors are risk-averse
MM1: In the neo-classic framework the company value is independent to the financing
decision. Only the asset value determines the value of the company.
MM2: In the neo-classic framework the total costs of capital are independent to the
financing decision.
Assumptions MM Propositions:
Strict separation between business (assets) and financing decisions (liabilities)
Always financing available, given the business cash flows
Insolvency costs show up in:
Direct costs: settlement costs, loss of tax credit due to net operating losses.
o =p(bankruptcy) * (costs settlement + tax credit)
Indirect costs:
o Suppliers or clients are less willing to do business (strict separation between
business and financing disappears)
o Conflicts of interest between shareholders (option value) and
bondholders/banks (timing bankruptcy)
o Bad reputation for investors, etc.
Direct- and indirect costs results in lower (expected) cash flows
An increase in business risk and financing risk, resulting in higher financing costs.
Mostly an extra credit risk premium (plus an extra equity risk premium)
Insolvency costs = Directs costs, indirect costs, and an increase in business risk and financing
risk in turn to a lower company value
Concept on leverage decision:
Static Trade Off theory:
o Tradeoff between tax advantages ad bankruptcy costs
o Optimum is somewhere within an interval, given by the business risk
Pecking Order theory:
o Complete different perspective on capital structure decisions.
1
, o Information asymmetry between equity issuer and investor
o Does not seek for an optimal capital structure
Option theory for Equity and Debt: two concepts to describe the debt-equity holder conflict
(hold especially for distressed companies): Asset substitution and Debt overhang
Empirical studies:
No difference in characteristics between the Static Trade Off and Pecking Order firms
First order drivers of capital structure: Log (assets), EBIT, Tangibility, Market-to-book
(not significant)
Observations empirical studies (Zingales):
Capital structures show distinct national patterns, and have pronounced industry
patterns
Within industries, leverage inversely related to profitability
Taxes clearly influence capital structure (not alone decisive)
Leverage ratios appear inversely related to perceived costs of financial distress.
Existing shareholders consider leverage increasing events as good news and leverage
decreasing events as bad news
Differences in transaction costs of issuing new securities has little impact on observed
capital structures
Ownership structure clearly influences capital structures (true relationship
ambiguous)
Corporations that are force away from a preferred capital structure tend to return to
that capital structure over time
Asset risk vs. Financing risk:
Asset risk and financing risk must be somewhat balanced in such a way that
insolvency costs are at a reasonable/acceptable level for most investors
First order estimate of what a capital structure should be is determined by: life cycle,
size, and sector (first order indicators of asset risk)
Target capital structure strongly related to the sector (business characteristics)
Example proxies for business risk: salary costs/sales (fixed/variable costs) applicable to
service or profit (cash flow level) applicable to con. and industry
Example proxies for financing risk: collateral applicable to trade sector and industry
Views/concepts on capital structure decisions:
Balance between business risk and financing risk (insolvency costs)
Possible classification of views/concepts on capital structure decisions along the
prime objective in the leverage decision:
o Reduction of financing costs (lower financing cost)
o Reduction of financing risk (availability of financing sources)
o Governance perspective (impact governance issues on capital structure)
Static Trade Off theory/ Target debt ratio
o Corporate tax/ personal tax vs. distress
2
Assumptions neo-classical finance theory:
Company is regarded as a black box.
o One goal: no conflicts of interest
o Business cash flows are given
Perfect market:
o Capital will flow to business opportunities with optimal risk-return
relationship
o No tax, transaction or information costs
o No distress
o Market efficiency
Asymmetric Information: homogeneous perception and expectations (results in no
agency costs)
Investors are risk-averse
MM1: In the neo-classic framework the company value is independent to the financing
decision. Only the asset value determines the value of the company.
MM2: In the neo-classic framework the total costs of capital are independent to the
financing decision.
Assumptions MM Propositions:
Strict separation between business (assets) and financing decisions (liabilities)
Always financing available, given the business cash flows
Insolvency costs show up in:
Direct costs: settlement costs, loss of tax credit due to net operating losses.
o =p(bankruptcy) * (costs settlement + tax credit)
Indirect costs:
o Suppliers or clients are less willing to do business (strict separation between
business and financing disappears)
o Conflicts of interest between shareholders (option value) and
bondholders/banks (timing bankruptcy)
o Bad reputation for investors, etc.
Direct- and indirect costs results in lower (expected) cash flows
An increase in business risk and financing risk, resulting in higher financing costs.
Mostly an extra credit risk premium (plus an extra equity risk premium)
Insolvency costs = Directs costs, indirect costs, and an increase in business risk and financing
risk in turn to a lower company value
Concept on leverage decision:
Static Trade Off theory:
o Tradeoff between tax advantages ad bankruptcy costs
o Optimum is somewhere within an interval, given by the business risk
Pecking Order theory:
o Complete different perspective on capital structure decisions.
1
, o Information asymmetry between equity issuer and investor
o Does not seek for an optimal capital structure
Option theory for Equity and Debt: two concepts to describe the debt-equity holder conflict
(hold especially for distressed companies): Asset substitution and Debt overhang
Empirical studies:
No difference in characteristics between the Static Trade Off and Pecking Order firms
First order drivers of capital structure: Log (assets), EBIT, Tangibility, Market-to-book
(not significant)
Observations empirical studies (Zingales):
Capital structures show distinct national patterns, and have pronounced industry
patterns
Within industries, leverage inversely related to profitability
Taxes clearly influence capital structure (not alone decisive)
Leverage ratios appear inversely related to perceived costs of financial distress.
Existing shareholders consider leverage increasing events as good news and leverage
decreasing events as bad news
Differences in transaction costs of issuing new securities has little impact on observed
capital structures
Ownership structure clearly influences capital structures (true relationship
ambiguous)
Corporations that are force away from a preferred capital structure tend to return to
that capital structure over time
Asset risk vs. Financing risk:
Asset risk and financing risk must be somewhat balanced in such a way that
insolvency costs are at a reasonable/acceptable level for most investors
First order estimate of what a capital structure should be is determined by: life cycle,
size, and sector (first order indicators of asset risk)
Target capital structure strongly related to the sector (business characteristics)
Example proxies for business risk: salary costs/sales (fixed/variable costs) applicable to
service or profit (cash flow level) applicable to con. and industry
Example proxies for financing risk: collateral applicable to trade sector and industry
Views/concepts on capital structure decisions:
Balance between business risk and financing risk (insolvency costs)
Possible classification of views/concepts on capital structure decisions along the
prime objective in the leverage decision:
o Reduction of financing costs (lower financing cost)
o Reduction of financing risk (availability of financing sources)
o Governance perspective (impact governance issues on capital structure)
Static Trade Off theory/ Target debt ratio
o Corporate tax/ personal tax vs. distress
2
