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8Capital Structure in Practice2

8Capital Structure in Practice2 - Capital Structure in...

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Capital Structure in Practice
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Firm Objective Maximize Value Capital Budgeting Decision Invest in projects that add value to the firm Financing Decision Maximize firm  value through optimal capital structure Payout Decision Return excess cash to investors to maximize shareholder wealth
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Financing Decision Maximize firm value through optimal capital structure Implement a capital structure with the optimal mix of equity and debt Issue the right kind of debt and equity securities to match assets
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What do firms actually do? We spent a lot of time looking at capital structure theories Tradeoff theory Pecking order theory Market timing theory What do firms actually do? How do firms choose leverage targets, if they do at all? How do firms decide between alternative financing actions? What other factors appear to be influencing firm financing behavior?
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Example Leverage Ratios Ticker Company Company D/E Industry D/ E MO Altria Group 0.47 1.12 GE General Electric 3.85 2.62 JNJ Johnson & Johnson 0.17 0.35 MSFT Microsoft 0.00 0.40 IBM International Business Machines 0.80 0.49 BA Boeing 2.01 1.59 PG Procter & Gamble 0.55 0.91 KO Coca-Cola 0.27 0.62 NKE Nike 0.07 0.09 XOM Exxon Mobil 0.07 0.24 Firm leverage seems to be related to industry leverage, but there seem to be some idiosyncratic differences.
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Firms with Target D/E Ratios No Target Ratio/Range 19% Somewhat Tight Target/Range 34% Very Strict Target 10% Flexible Target 37% Survey of 392 CFOs by Graham and Harvey (2001, JFE) More likely  to be using  Pecking- Order or  Market  Timing… or  nothing at  all More likely to be  using tradeoff  theory or some  variation  Targets are more  common in large firms  and investment grade  firms
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Testing Pecking Order Shyam-Sunder and Myers Find significant evidence in favor of pecking order model Reject tradeoff model (M&M) based on their data and method Chirinko and Singha Show that Shyam-Sunder and Myers tests were bad, biased toward finding results in favor of pecking order Frank and Goyal Reject pecking order theory Find that financing deficit is less important in explaining net debt issues over time for firms of all sizes. They show that net equity issues track financial deficit more closely than net debt issues
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Testing Tradeoff Theory Difficult thing about testing Tradeoff Theory is that the optimal capital structure target is unobservable Leary and Roberts Incorporate capital structure adjustment costs Find evidence in favor of target capital structures Flannery and Rangan Incorporate partial adjustment toward capital structure target Find significant evidence in favor of the tradeoff theory of capital structure Problem: can replicate the results of these studies with randomly generated data as long as actual firm financial deficits are used… oops… not much evidence here, either
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Factors Affecting Debt Policy 0% 10% 20% 30% 40% 50% 60% 70% Customer/Supplier Bankruptcy Costs Peer Firm D/E Level
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