Governance – samenvatting
Week1
Debt
- Higher priority when firm goes bankrupt
- Interest rights
Equity
- Voting power
- Dividend can be paid
- Less priority when firm goes bankrupt
- Potential price increase
Firm value related to capital structure (***)
- Future value of firm is not influenced by capital structure
- Present value of firm is affected by capital structure
This is via the rd and the re which affect the WACC, and therefore the NPV
In the example in the lecture you see that when the scenario is low it is bett
are probably not liquid enough to pay for the interest obligations, if the scen
more profitable
Modigliani & Miller (1958)
Homemade leverage = replicating the investing in a leveraged firm (which m
investing in an unlevered firm while taking out a personal loan as an individu
Because you want less risk but you want the high upwards potential
buy more shares
so it does not matter for investors what the capital structure of a company is since investors can
portfolio with personal loans
Proposition 1 Modigliani & Miller
= The value of an asset remains the same, regardless of how the net operating cash flows, generat
between different classes of investors
Pie theory: you can’t change the size of the pie by cutting it into different sized slices
BUT: how can it be since the interest rate on debt is lower than return on equity??
Proposition 2 Modigliani & Miller
= The cost of equity, re, on a leveraged firm is equal to the cost of equity of an unleveraged firm with
on the degree of financial leverage
D
r e =r 0+ (r 0 −r d )
E
,Assumptions Modigliani & Miller
- Individuals borrow at same rate as corporations
- No information asymmetry or transaction costs
- No taxes
- No costs of financial distress
- Fixed investment policy
3 Critics on the M&M assumptions
1 Taxes
Modigliani & Miller proposition 1 with taxes
Leverage will increase firm value because interest is tax deductible so will increase after-tax cash flows av
- The value of leveraged firm is equal to the value of unlevered firm of same risk + present value of ta
- Personal taxes also matter since people then want a higher return on their investment, so for the co
cost of capital
- Corporate tax is still most important, so debt still has high benefit to Net earnings
EBITDA
- Depreciation and Amortization
= EBIT
- Interest
= EBT
- tax
= Net earnings
From your Net earnings the dividend is paid, and you get the retained earnings
2 Financial distress
Average cost of financial distress is 10-20% of firm value
Direct cost of financial distress = paying lawyers, accountants, selling assets
Indirect cost of distress = rumors of getting into distress which could already lead to decrease of firm value
3 Fixed investment policies: Agency costs
Shareholders have upside potential (so in default times will still choose risky project)
Bond/debt holders have downside risk
Managers might want empire build (take out extra loan to grow, then more interest so less remains for sha
Static tradeoff theory
Trade-off between tax shields and the costs of financial distress
1 Leverage regressions
What influences debt ratio of firm?
Leverageit = + * Xit-1 + 𝜀it
How to measure leverage?
- Total book leverage
- LT book leverage
- Total market leverage
- LT market leverage
, Theoretical predictions relation between firm characteristics and optimal debt ratios
- Firm size positive (bigger firms are more stable so higher debt ratio’s)
- Fixed assets positive (use as collateral to sell when in distress)
- Growth opportunities negative (since probably not liquid enough to pay interest obligation
- Profitability positive (they want to pay less cash so use interest tax shield)
- Firm risk
Studies find this relation between firm characteristics and optimal debt ratios
Theoretical predictions between firm characteristics and optimal debt ratios
- Firm size positive √
- Fixed assets positive √
- Growth opportunities negative √
- Profitability negative profitability debt choices in reality not as rational as what wo
- Firm risk negative volatility in earnings so unsure of interest can be paid
2 Financing decisions
Do firms move towards target debt ratio?
Distinguish between issue decisions and repurchase decisions
Firms seem to move towards target but slowly
3 Mean reversion analysis
Do firms move around a target debt ratio?
Debt ratio differs over time, they move around target without consistent pattern, but they do kind of adjust
Conclusions
- Most predictions of standard trade-off theory are consistent with the data, but profitability and levera
- Firms are surprisingly conservative in use of debt (even firms with low financial distress)
- Besides financial difficulty and agency costs, also the financial flexibility could reduce optimal debt r
= they don’t really want too much deb so they use the flexibility to reduce debt
Week1
Debt
- Higher priority when firm goes bankrupt
- Interest rights
Equity
- Voting power
- Dividend can be paid
- Less priority when firm goes bankrupt
- Potential price increase
Firm value related to capital structure (***)
- Future value of firm is not influenced by capital structure
- Present value of firm is affected by capital structure
This is via the rd and the re which affect the WACC, and therefore the NPV
In the example in the lecture you see that when the scenario is low it is bett
are probably not liquid enough to pay for the interest obligations, if the scen
more profitable
Modigliani & Miller (1958)
Homemade leverage = replicating the investing in a leveraged firm (which m
investing in an unlevered firm while taking out a personal loan as an individu
Because you want less risk but you want the high upwards potential
buy more shares
so it does not matter for investors what the capital structure of a company is since investors can
portfolio with personal loans
Proposition 1 Modigliani & Miller
= The value of an asset remains the same, regardless of how the net operating cash flows, generat
between different classes of investors
Pie theory: you can’t change the size of the pie by cutting it into different sized slices
BUT: how can it be since the interest rate on debt is lower than return on equity??
Proposition 2 Modigliani & Miller
= The cost of equity, re, on a leveraged firm is equal to the cost of equity of an unleveraged firm with
on the degree of financial leverage
D
r e =r 0+ (r 0 −r d )
E
,Assumptions Modigliani & Miller
- Individuals borrow at same rate as corporations
- No information asymmetry or transaction costs
- No taxes
- No costs of financial distress
- Fixed investment policy
3 Critics on the M&M assumptions
1 Taxes
Modigliani & Miller proposition 1 with taxes
Leverage will increase firm value because interest is tax deductible so will increase after-tax cash flows av
- The value of leveraged firm is equal to the value of unlevered firm of same risk + present value of ta
- Personal taxes also matter since people then want a higher return on their investment, so for the co
cost of capital
- Corporate tax is still most important, so debt still has high benefit to Net earnings
EBITDA
- Depreciation and Amortization
= EBIT
- Interest
= EBT
- tax
= Net earnings
From your Net earnings the dividend is paid, and you get the retained earnings
2 Financial distress
Average cost of financial distress is 10-20% of firm value
Direct cost of financial distress = paying lawyers, accountants, selling assets
Indirect cost of distress = rumors of getting into distress which could already lead to decrease of firm value
3 Fixed investment policies: Agency costs
Shareholders have upside potential (so in default times will still choose risky project)
Bond/debt holders have downside risk
Managers might want empire build (take out extra loan to grow, then more interest so less remains for sha
Static tradeoff theory
Trade-off between tax shields and the costs of financial distress
1 Leverage regressions
What influences debt ratio of firm?
Leverageit = + * Xit-1 + 𝜀it
How to measure leverage?
- Total book leverage
- LT book leverage
- Total market leverage
- LT market leverage
, Theoretical predictions relation between firm characteristics and optimal debt ratios
- Firm size positive (bigger firms are more stable so higher debt ratio’s)
- Fixed assets positive (use as collateral to sell when in distress)
- Growth opportunities negative (since probably not liquid enough to pay interest obligation
- Profitability positive (they want to pay less cash so use interest tax shield)
- Firm risk
Studies find this relation between firm characteristics and optimal debt ratios
Theoretical predictions between firm characteristics and optimal debt ratios
- Firm size positive √
- Fixed assets positive √
- Growth opportunities negative √
- Profitability negative profitability debt choices in reality not as rational as what wo
- Firm risk negative volatility in earnings so unsure of interest can be paid
2 Financing decisions
Do firms move towards target debt ratio?
Distinguish between issue decisions and repurchase decisions
Firms seem to move towards target but slowly
3 Mean reversion analysis
Do firms move around a target debt ratio?
Debt ratio differs over time, they move around target without consistent pattern, but they do kind of adjust
Conclusions
- Most predictions of standard trade-off theory are consistent with the data, but profitability and levera
- Firms are surprisingly conservative in use of debt (even firms with low financial distress)
- Besides financial difficulty and agency costs, also the financial flexibility could reduce optimal debt r
= they don’t really want too much deb so they use the flexibility to reduce debt
