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BF Notes Session 7 - Session 7 Capital Structure(Ch 6 O...

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Session 7 - Capital Structure (Ch. 6) Overview Chapter 6 discusses the behavioral issues associated with capital structure. In practice, decisions about capital structure reflect a mix of traditional and behavioral considerations. Although many managers do at times target their firms’ debt-to-equity ratios, and do engage in behaviors that reflect pecking order thinking, these are not the primary considerations driving decisions about capital structure. The primary considerations driving decisions about capital structure are dilution , market timing , and financial flexibility . The behavioral approach to capital structure emphasizes that managers might be subject to behavioral biases, investors might be subject to behavioral biases, or both might be subject to behavioral biases. When a firm is financially constrained, but its equity is undervalued, managers of constrained firms have to adjust project hurdle rates to reflect the opportunity cost of repurchasing shares. When managers exhibit excessive optimism and overconfidence , but the market is efficient, then managers of cash rich firms typically adopt negative net present value projects, while managers of cash poor firms typically reject positive NPV projects, unless NPV is very large. In this respect, varying financial flexibility causes firms’ investment policies to be overly sensitive to cash flows , and on average to overinvest . There are two proxies that are correlated with CEO excessive optimism and overconfidence. One is a press coverage indicator, and the second is a longholder property that pertains to the late exercise of executive stock options. When a firm’s equity is mispriced, managers might find that they face a conflict between the short-term interests of shareholders and the long-term interests of shareholders. In this case, managers strive for some kind of balance.
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Traditional Approach to Capital Structure The traditional approach to capital structure focuses on two approaches, tradeoff theory and pecking order theory. Tradeoff theory centers on the choice of a debt-to-equity ratio that optimally balances the benefit of tax shields against the expected costs of financial distress. Pecking order theory centers on a pecking order for financing where internal equity dominates debt, which in turn dominates external equity. Notably, pecking order theory does not feature an optimal debt-to-equity ratio. How Do Managers Choose Capital Structure in Practice? Chief financial officers indicate that the top two considerations that drive their decisions about issuing new equity are dilution and market timing. The top consideration driving their decision about how much debt to issue is financial flexibility. Some aspects of tradeoff theory and pecking order theory are reflected in their thinking. However, these considerations are ranked well down the list.
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