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Lecture9 - capital structure theory

Low issue thus the main empirical implication is that

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Unformatted text preview: s (managers don’t like monitoring) 50 Implications of the Pecking Order Implications Hypothesis Hypothesis There is no target debt ratio or optimal capital There no structure D/E depends on financing needs: when firms accumulate cash from profits they retire debt; they issue debt when cash flows are low issue Thus, the main empirical implication is that more Thus, profitable firms use less debt (more internal cash, don’t need debt) don’t Companies like financial slack. Having cash available Companies for projects avoids the need to issue undervalued equity. equity. 51 The Market Timing Theory Firms try to time the market by issuing debt when it is Firms cheap and equity when it is cheap cheap Managers look at current conditions in both debt and Managers equity markets. If they need financing, they will use whichever market looks more favorable. If neither market looks favorable, then fund raising may be deferred then If conditions look unusually favorable, then funds may be If raised even if they are not currently required raised 52 The Market Timing Theory When the firm’s market-to-book ratio is higher, as when When the firm’s equity has increased in price, then it will tend to issue more equity to If interest rates are high (e.g., high Treasury Bill rates), If then firms will tend to rely less on debt financing then If inflation is expected, then a manager timing the market If will increase debt since he can pay off its nominal debt in devalued dollars devalued 53 Empirical Facts About Capital Structure Low debt/asset ratios: < 50% in general. Firms don’t use up all available tax shelters. Prices rise in response to debt increases, fall for Prices equity increases: This probably has more to do with signaling than anything. We will talk about these issues in Lecture 13. issues 54 Empirical Facts About Capital Structure Empirical Persistent inter-industry differences – Low debt in growth industries (higher expected Low bankruptcy costs) bankruptcy – Significant tangible assets go with high debt Significant (tangible assets reduce costs of financial distress) (tangible – Very risky enterprises have lower debt levels – Profitable firms issue less debt Profitable This fits best with pecking order hypothesis – managers like to keep their free cash flow managers Contradicts optimal capital structure theory: Contradicts profitable firms need tax shelter from debt more 55 Selected Empirical Findings From Frank&Goyal Variable Trade-off Pecking Order Market Timing Finding Accounting profits + - NA - Market-to-book ratio - NA - - Firm size + NA NA + Growth - NA NA Industry leverage + NA NA R&D expenses - + NA Asset tangibility + NA NA Tax rate + NA NA Depreciation - NA NA Dividends NA + NA Investment grade NA - NA Cash-flow volatility - + NA Interest rates NA NA - Expected inflation NA NA + 56 + + - + How to Determine OPTIMAL Capital How Structure in Practice? Structure Tough question We know that important things are: – Taxes (marginal rate to be more precise) – Asset risk – Asset tangibility – Free cash flow and agency costs of equity – Agency costs of debt Talk to your investment banker about various rS and rB numbers at different debt levels. at Compare with other firms in your industry (a little bit circular Compare reasoning though). 57 How to Determine OPTIMAL Capital How Structure in Practice? Seems like managers work incrementally, by a process involving experience and intuition. process Type of technology: for example, more capital Type intensive firms require external financing to purchase equipment equipment Maybe managerial preferences are just as important Maybe as shareholder wealth maximization? Can managers bypass governance mechanisms? Important issue! More about this on Lecture 12 More Macroeconomic uncertainty 58...
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