Corporate Financing and investment Decisions when Firms Have Information That Investors

Do Not Have

James Song

Jan 30, 2007

Optimal Capital Structure

• In perfect markets, capital structure is irrelevant.

• If markets are perfect (except for tax), then the optimal capital structure is 100% debt.

The market is not perfect at all

• There are costs of debt that we’ve missed. At some point, those costs must outweigh debt’s tax benefits

Total firm value

100% equity 100% debt

Convex curve of cost of capital

• The optimal capital structure is the one that maximizes the value of the firm, is in between the extremes.

• The value of firm is to shareholders.

• Numerous problems are associated with the confusing responsibility.

Bankruptcy Cost

• It is not the event of going bankrupt that matters, it is the costs of going bankrupt that matter.

• If ownership of the firm’s assets was transferred costlessly to its creditors in the event of bankruptcy, optimal capital structure would still be 100% debt.

• When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to using leverage.

Choice for debt

• Balance between tax shelter with bankruptcy cost.

• Later we will discuss more about other trade offs for debt

• lowering monitoring cost vs. cost of debt;

• lowering cost of capital vs. value-destroying project investment;

• Clientele of investors vs. political risks

Cost of bankruptcy

• Costs of bankruptcy-related litigation• Cost of management time diverted to bankruptcy

process• Loss of customers who don’t want to deal with a

distressed firm• Loss of employees who switch to healthier firms• Strained relationships with suppliers• Lost investment opportunities • Reputation and emotional loss

More concerns for bankruptcy cost

• When the firm’s product requires that the firm stay in business (e.g., when warranties or service are important)

• When the firm must make additional investments in product quality to maintain customers

Estimation of Bankruptcy Cost

• Legal, auditing and administrative costs (include court costs) – 1% - 10% of firm value

• Bankruptcy governed by Federal law and filings are made in Federal bankruptcy courts

• Chapter 7 (Liquidation)• Chapter 11 (Reorganization)• In liquidation, a trustee is usually appointed to liquidate

firm’s assets.• In reorganization, firm’s management continues to

operate firm, can propose reorganization plan.• Reputation cost: shareholders refuse to contribute funds;

labor refuse to work for you; etc.

Agency Costs

• Agency costs arise as soon as an entrepreneur sells a fraction a of her firm to outside investors.

• Entrepreneur enjoys private benefits of control (perquisites), but bears only (1- a ) of the cost of “perks.”

• Separation between ownership and control of a firm gives rise to agency costs of outside equity.

Agency Costs Of Outside Debt

• Debt helps mitigate these costs, but debt has its own agency costs

• Expropriate bondholders wealth by paying excessive dividends

• Bait And Switch: Promise to use borrowed money for safe investment, then use to buy high/risk, high/return asset

Agency Cost

• Bondholders protect themselves with positive and negative covenants in lending contracts.

• Agency costs of debt are burdensome, but so are solutions.

Trade-Off Theory

• Agency Cost / Tax Shield Trade-Off Model Of Corporate Leverage

• Companies trade off tax and agency cost benefits of debt against the costs of bankruptcy and agency costs of debt.

• Firm maximized at a unique optimal debt level• Empirical research offers support for the model,

but the model is far from perfect in its predictions.

• Weaknesses lead to development of Pecking Order Theory.

Weakness of Trade-Off Theory

• Trade-off theory cannot explain three empirical capital structure facts:

• Most profitable firms in an industry use least debt.

• Stock market responds to leverage-increasing events strongly positive; negative reaction to leverage-decreasing events.

• Firms issue debt frequently, but rarely issue equity.

Pecking Order Theory

• Myers (1984), Myers & Majluf (1984) propose pecking order theory of corporate leverage.

• Assumptions: There are information asymmetry between managers and investors.

• Manager acts in best interests of existing shareholders.

Managerial Behavior

• Two key predictions about managerial behavior

• Firms hold financial slack so they don’t have to issue securities.

• Firms follow pecking order when issuing securities: sell low-risk debt first, equity only as last resort.

Signaling And Other Asymmetric Information Models

• Third group of models, based on asymmetric information between managers and investors, predict managers will use a costly signal:

• A simple statement of high firm value not credible• Must take action that is too costly for weak firm to mimic• Crude signal: Drive BMW cars; only wealthy can afford • If signaling can differentiate between strong and weak firms based

on signal, a signaling equilibrium results.• Investors identify stronger firms, assign higher market value • If signaling cannot differentiate between strong and weak firms, a

pooling equilibrium results.• Investors assign low average value to all firms.• Models predict high value firms use high leverage as signal.• Makes sense, but empirics show the opposite—most profitable &

highest market/book firms use least leverage.

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Model of Perking Order Theory

• Before we start, we clear couple issues as below• Because we are talking about the probability that

high value projects are not financed through external equity capital, so we assume that these “high value projects” have high return R that always covers initial investment I, so debt financing part is risk-free.

• But because of the concave capital cost, entrepreneur has to issue external equity in our perking order theory model.

Model of Perking Order Theory

• We will first assume that the firm’s type can take only two possible values: it can be either high or low.

• At period 0,

• XL - Low value firm worth $0

• XH - High value firm worth $200

• The new project demands new equity finance of I = 30, R=50

When information is perfect

• Required investment (or the amount in SEO)

• 30=I = a(X+R)=a(200+50), a* = 0.12 or 12%

• After SEO, entrepreneur wealth is

• W = (1-a*)(X+R) = $220 > $200

• Next we will first use discrete model to analyze the imperfect information models, then use continuous model to analyze it.

When information is not perfect – Discrete model

• Assume firm could be low value with probability p, then see next page

Conclusion from discrete model

• The profitable project will not be financed if p>0.5!

When information is not perfect – continuous model

• See next page

Conclusion

• Retained earning, debt is better than external equity capital