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Lecture9 - capital structure theory

Investor preference for levered unlevered equity

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Unformatted text preview: of Static Tradeoff Theory The Static Theory of Capital Structure VL = VU + TC × D Firm Value, VL PV(financial distress costs) VL* PV(tax shields on debt) Value of firm with no debt VU VU D* D 44 A More Detailed Summary What doesn’t matter? – Investor preference for levered / unlevered equity: Investor preference This is the essence of MM. Investors don’t need firms to create or undo leverage. Investors can do this themselves. this Advantages to debt – Interest tax shield – Reduces agency costs of equity (Jensen’s free Reduces cash flow hypothesis) 45 A More Detailed Summary Disadvantages to debt – Personal taxes favor equity – In or near bankruptcy, the firm’s resources go to In lawyers and accountants lawyers – Firms in or near bankruptcy may damage relations Firms with employees, suppliers, and customers with – Agency costs of debt Underinvestment Excessive risk taking by management Milking the firm Milking 46 The Pecking Order Hypothesis This is the main alternative to the optimal capital structure This theory (it is more like a story) theory It seems to fit some of the empirical facts better than the It static theory. Key is asymmetric information: the manager must know asymmetric the more about the firm’s prospects than does a typical investor. investor. Investors are aware of the information asymmetry: they Investors try to infer this information from managerial decisions. try 47 The Pecking Order Hypothesis Managers can use their private information to “time” new Managers equity issues: equity – Issue equity when it is overvalued (new sh. -, old sh +) – Do not issue when it is undervalued (new sh +, old -), Do rather issue a low-risk bond easier for investors to price rather If a firm issues equity, investors will infer that it is If overvalued, and would only pay very low prices. If it issues debt, they will infer the stock is undervalued. If Thus, to the extent possible, all firms needing to raise Thus, external capital should issue debt, rather than equity. external 48 The Pecking Order Hypothesis Managers also have some private information about the Managers firm’s debt (e.g., managers know the true probability of default). So it is likely that managers also tend to issue debt when they think it is overvalued. Taking this into account, investors will require higher yields on bond issues. However, investor fear of mispricing is much less for debt than for equity. 49 The Pecking Order Hypothesis The theory says that managers prefer the following The ordering of financing: ordering – Retained earnings (avoid investor skepticism) – Debt (a little bit of information asymmetry) – Equity (large information asymmetry) Other reasons for the pecking order: Other – Higher costs of issuance for equity than for debt – Agency cost...
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