Advanced Corporate Finance
Lecture 08.1 and 09
Capital Structure and Bond
Valuation (Continued)
Fall, 2010
Underinvestment Problem
•
Given risky debt in the capital structure
there is a tendency to
1. Reject positive NPV projects
2. Incentive to pay high dividends
3. May simply be impossible to Finance new
investment because of debt overhang.
Example of Underinvestment
• UHFX International (million)
• For simplicity assume all security’s required return is 10%
– Risk Neutrality
and the probability of each state occurring is 50%
•
– Total
– Debt
– Equity
• B = 50
• S = 20
• V = 70
Good State
110
66
44
Bad State
44
44
0
Example of Underinvestment
• New investment Option
I = 60
Pays off: 77 in good state, 66 in bad state
NPV = $? million
Finance with junior debt or equity
If adopt, financed with Junior Debt
• UHFX International (million)
•
Good State
–
–
–
–
•
•
•
•
Total
Debt
Junior Debt
Equity
187
66
88
33
Bad State
110
66
44
0
B = 60
JB = 60
S = 15 ( A LOSS in value of $ 5 million)
V = 135, and NPV is positive but hurts
stockholders
Risk Shifting
• The Risk shifting problem occurs when it is
in the interest of the stockholders to take
on a very risky investment even though it
has a negative NPV
• Example:
77
Investment = 30
»
-33
Risk Shifting
• Cash Flow Before Investment
•
Good State Bad State
– Total
– Debt
– Equity
110
66
44
• CF from Investment 77
• Total Cash Flow
187
– Senior Debt
– Junior Debt
– Equity
66
66
55
44
44
0
-33
11
11
0
0
MV
Risk Shifting
• Cash Flow Before Investment
•
Good State Bad State
– Total
– Debt
– Equity
110
66
44
• CF from Investment 77
• Total Cash Flow
187
– Senior Debt
– Junior Debt
– Equity
66
66
55
MV
44
44
0
70
50
20
-33
11
20
90
11
0
0
35
30
25
Values
•
•
•
•
•
Firm
Snr Debt
Jnr Debt
Equity
Before
70
50
-20
After
90
35
30
25
Firm Value
Costs of
Financial
Distress
Debt Level
Static Tradeoff
Optimal Debt Level
Pecking Order Hypothesis
• Costly Information
– Managers know more about the future of the
firm than do outsiders
• Conclusion
– Firm has an ordering under which they will
Finance
• First, use internal funds
• Next least risky security
Announcement Effect of
Capital Raising Choices
•
•
•
•
Common Stock
-3.14%
Straight Debt
-0.26%*
Internally Financed
+1.00%
* Means not statistically significant
• What is the rationale (theory)?
So the announcement effect
• If the firm announces it intends to issue
equity to invest in a project, this is bad
news and stock prices will go down. That
is the market will ASSUME this is a bad
firm.
• Therefore the firm will never issue equity if
it can avoid it to finance in projects.
• Thus pecking order.
Empirical Evidence
• We tend to see that firms:
1. Use internal funds to invest in projects if
available
2. Use least risky securities as possible if it has
to finance these projects externally.
3. Announcement of a new Debt issue has a
small negative impact on stockprice
4. Announcement of a new Equity issue has a
strong negative impact on stockprice
Empirical Evidence
• Schwartz & Aronson: Leverage tends to decline
as the proportion of total value of the firm
consists of Growth Opportunities.
• Information costs: Very strong relationship
between type of capital structure change and
price change It is difficult to distinguish between
tradeoff theory and Pecking Order
• Taxes: Leverage increases associated with high
taxes
Generalizing
• When we look at established Capital
Structures we tend to find evidence that
supports a static tradeoff theory of capital
structure
• When we consider changes in capital
structure (issuing debt or equity,
repurchases, calls, etc.) there tends to be
a significant pecking order component