Capital Structure - Assignment Example

Running head: CAPITAL STRUCTURE Capital Structure [The of the appears here] [The of the appears here] Introduction This research has been conducted to find out how firms establish their capital structures in the real world in the light of the famous Modigliani and Miller theory. Surveys of the theory of optimal capital structure always start with the Modigliani and Miller (1958) proof that financing doesn't matter in perfect capital markets. The Modigliani-Miller theory may be intuitive, but is it credible Are capital markets really sufficiently perfect After all, the values of pizzas do depend on how they are sliced. Consumers are willing to pay more for the several slices than for the equivalent whole. Perhaps the value of the firm does depend on how its assets, cash flows and growth opportunities are sliced up and offered to investors as debt and equity claims. There are surely investors who would be willing to pay extra for particular types or mixes of corporate securities. For example, investors cannot easily borrow with limited liability, but corporations provide limited liability and can borrow on their stockholders' behalf. There has been constant innovation in the design of securities and in new financing schemes. Innovation proves that financing can matter. If new securities or financing tactics never added value, then there would be no incentive to innovate (Myers 2001). Data Analysis Miller's Theory Modigliani and Miller's (1958) theory is exceptionally difficult to test directly, but financial innovation provides convincing circumstantial evidence. The costs of designing and creating new securities and financing schemes are low, and the costs of imitation are trivial. (Fortunately, securities and financing tactics cannot be patented.) Thus temporary departures from Modigliani and Miller's predicted equilibrium create opportunities for financial innovation, but successful innovations quickly become "commodities," that is, standard, low-margin financial products. The rapid response of supply to an innovative financial product restores the Modigliani and Miller equilibrium. Firms may find it convenient to use these new products, but only the first users will increase value, or lower the cost of capital, by doing so (Myers 2001). The Miller theory will be referred again in later parts of this paper. Corporate Taxation In 1977, Merton Miller revisited the issue of the impact of corporate taxation on the irrelevance propositions in a classic paper titled "Debt and Taxes" that shows perhaps better than any of his other papers how he could use arbitrage arguments to change how finance academics and practitioners understood how the world works (Miller 1977). In that paper, he pointed out that the tax advantage of corporate debt might be mostly if not completely illusory. Because interest on corporate debt is taxed as income for the holder of corporate debt, the interest paid on corporate debt must be high enough so that the after-tax income from holding corporate bonds is attractive relative to the income from equity which, when it accrues as capital gains, is taxed at a lower effective rate (Myers 2001). As a result, corporations get to deduct from their taxes interest payments but, because personal taxes on interest income are higher than on capital gains, the before-tax cost of capital on debt must be higher than on equity if investors are to hold debt (Stulz 2000). Interest is a tax-deductible expense. A taxpaying firm that pays an extra pound of interest receives a partially offsetting "interest tax shield" in the form of lower taxes paid. Financing with debt instead of equity increases the total after-tax dollar return to debt and equity investors, and should increase firm value (Myers 2001). Application of Taxation This present value of interest tax shields could be a very big number. Suppose debt is fixed and permanent, as Modigliani and Miller (1963) assumed, and that corporate income is taxed at the current 35 percent statutory rate. This is the marginal federal rate for most large corporations. State income taxes could add two or three percentage points to this rate. The firm borrows 1 million and repurchases and retires 1 million of equity. It commits to maintain this debt level and to make annual interest payments for the indefinite future. Absent taxes, this new debt does not increase or decrease firm value: the firm is borrowing on fair terms, so the money raised is exactly offset by the present value of the future interest payments. But for a taxpaying firm the net liability created by the 1 million debt issue is only 650,000, because the Internal Revenue Service effectively pays 35 percent of the interest payments. The after-tax net present value of this transaction would be NPV = + 1 - .65 = + .35 million. The gains from borrowing 10 million or 500 million scale up proportionally (Myers 2001). Such calculations are now understood as remote upper bounds. First, the firm may not always be profitable, so the average effective future tax rate is less than the statutory rate. Second, debt is not permanent and fixed. Investors today cannot know the size and duration of future interest tax shields. "Debt capacity" depends on the future profitability and value of the firm; it may be able to increase borrowing if it does well, or be forced to pay down debt if it does poorly. The future interest tax shields flowing to investors are therefore risky (Myers 2001). Third, the corporate-level tax advantages of debt could be partly offset by the tax advantage of equity to individual investors, namely, the ability to defer capital gains and then to pay taxes at a lower capital gains rate (Myers 2001). The tax rate on investors' interest and dividend income is higher than the effective tax rate on equity income, which comes as a mixture of dividends and capital gains. Corporations should see this relatively low effective rate as a reduction in the cost of equity relative to the cost of debt. Agency Costs Ever since Berle and Means (1932), research on corporate governance has stressed the adverse consequences of the separation of ownership and control in public corporations. Jensen and Meckling (1976) argued for the inevitability of agency costs in corporate finance. Corporate managers, the agents, will act in their own interests, and will seek higher-than-market salaries, perquisites, job security and, in extreme cases, direct capture of assets or cash flows. They will favour "entrenching investments" which adapt the firm's assets and operations to the managers' skills and knowledge, and increase their bargaining power vs. investors (Shleifer and Vishny, 1989). The investors can discourage such value transfers by various mechanisms of monitoring and control, including supervision by independent directors and the threat of takeover. But these mechanisms are costly and subject to decreasing returns, so perfect monitoring is out of the question (Myers 2001). The interests of managers and investors can also be aligned by design of compensation packages. Here again, perfection is out of reach. First, the manager never bears the full costs that managerial actions impose on investors--unless, of course, the manager is also the owner. Second, there is no pure, observable measure of the performance of managers. The actions of a manager may account for a small fraction of the variance of observable outcomes, such as returns on common stock or changes in earnings. Investors would like to reward effort, commitment and good decisions, but these inputs are imperfectly observable. Even if good performance on these dimensions were observable by some informed monitor, the performance would not be verifiable. A contract offering a bonus for, say, "good decisions" would not be enforceable, because the decisions could not be evaluated by a disinterested outsider or by a court of law. In other words, "complete contracts" cannot be written. Conflicts between debt and equity investors only arise when there is a risk of default. If debt is totally free of default risk, debt-holders have no interest in the income, value or risk of the firm. But if there is a chance of default, then shareholders can gain at the expense of debt investors. Equity is a residual claim, so shareholders gain when the value of existing debt falls, even when the value of the firm is constant (Myers 2001). Suppose that managers act in the interests of stockholders and that the risk of default is significant. The managers will be tempted to take actions that transfer value from the firm's creditors to its stockholders. There are several ways to do this. First, managers could invest in riskier assets or shift to riskier operating strategies. Higher risk increases the "upside" for stockholders. The downside is absorbed by the firm's creditors. Jensen and Meckling (1976) first stressed risk-shifting as an agency problem. Second, the managers may be able to borrow still more and pay out cash to stockholders. In this case the overall value of the firm is constant, but the market value of the existing debt declines. The cash received by stockholders more than offsets the decline in the value of their shares (Myers 2001). Third, the managers can cut back equity-financed capital investment. Normally the firm invests up to the point where the expected return just equals the cost of capital--that is, the point where the additional present value generated by investing just equals the investment required. But part of this additional present value goes to the firm's existing creditors, who are better protected once the investment is made. The greater the risk of default there will be greater the benefit to existing debt from additional investment. The gain in the market value of debt acts like a tax on new investment. If that tax is high enough, managers may try to shrink the firm and pay out cash to stockholders. Myers (1977) stressed this "underinvestment" or "debt overhang" problem. Fourth, the managers may "play for time," perhaps by concealing problems to prevent creditors from acting to force immediate bankruptcy or reorganization. This lengthens the effective maturity of the debt and makes it riskier. Again, creditors suffer and stockholders gain (Myers 2001). Application of Agency Costs There are many examples of these temptations at work. Asquith and Wizman (1990) found that announcement of a leveraged buyout triggered an average loss in market value of 5.2 percent for bonds lacking covenant protection. At the time, investors were willing to buy the debt of supposedly blue-chip companies with minimal covenants. Asquith and Wizman (1990) found that the value of bonds with strong covenants actually increased when leveraged buyouts were announced. When RJR Nabisco's management proposed a leveraged buyout, the market value of the company's existing debt fell instantly by more that 10 percent. Alexander, Edwards and Ferris (2000) examine the returns of a large sample of junk bonds traded on Nasdaq. They find evidence that junk-bond and common-stock returns have a negative correlation at the announcement of "wealth-transferring events," such as an impending leveraged buyout. Debt investors are of course aware of these temptations and try to write debt contracts accordingly. Debt covenants may restrict additional borrowing, limit dividend payouts or other distributions to stockholders, and provide that debt is immediately due and payable if other covenants are seriously violated (Myers 2001). The recognition of the implications of potential conflicts of interest between lenders and stockholders is an important notion. Prior to that recognition, the costs of financial distress seemed limited to the transaction costs of bankruptcy and reorganization, for example, legal and administrative expenses and the costs of negotiating a reorganization or liquidating assets. But the conflicts of interest mean that the mere threat of default can feed back into the firm's investment and operating decisions, for example by deterring investments with a positive net present value or shifting the firm to riskier strategies. Investors foresee these possibilities, so the threat of financial distress can drag down the current market value of the firm--which provides a good reason for operating at relatively conservative debt ratios. The agency costs of suboptimal investment and operating decisions are potentially much more serious than "workout" costs incurred post-default. However, Parrino and Weisbach (1999), who conducted extensive numerical experiments, found few cases in which significant value would be lost due to underinvestment at high debt ratios. These agency costs also help to explain why growth firms tend to rely on equity. They have more to lose; the debt-overhang problem is no problem for a firm lacking valuable investment opportunities. Also, the value of those opportunities, which depends on future investment decisions, is lousy collateral for a loan today. Would you lend today to a growth firm on the strength of its management's promise to undertake "all future investment projects with positive net present value" Even if the lender could identify all projects with a positive net present value, there would be no way to enforce such a contract (Myers 2001). Conflicts between Managers and Stockholders As Jensen and Meckling (1976) stressed, managers will act in their own economic self-interest. That self-interest can be redirected by share ownership, compensation schemes, or other devices, but the alignment between shareholders' and managers' objectives is necessarily imperfect. This brings us to Jensen's (1986) free cash flow theory, expressed in a brief but widely cited quotation (p. 323): "The problem is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it on organizational inefficiencies." The answer to Jensen's problem can be debt, which forces the firm to pay out cash. A high debt ratio can be dangerous, but it can also add value by putting the firm on a diet. The leveraged buyouts of the 1980s were of course the classic examples of diet deals. Contemporary accounts attributed various motives to the leveraged buyout organizers and investors: interest tax shields (Kaplan, 1989), artificially high junk bond prices (Kaplan and Stein, 1993), wealth transfer from existing bondholders, and attempts by raiders to capture value accruing to employees and other "stakeholders" in the target firm (Shleifer and Summers, 1988). There is some truth in each of these arguments, but with a decade's hindsight, it seems clear that the leveraged buyouts were first and foremost attempts to solve Jensen's (1986) free cash flow problem. They were shock therapy designed to cut back wasteful investment, force sale of underutilized assets, and generally to strengthen management's incentives to maximize value to investors. The role of leverage was to force managers to generate and pay out cash. Debt plays a similar role in leveraged restructuring, where a public firm all at once borrows a large fi-action of the value of its assets and pays out the proceeds to stockholders. Wruck (1995) provides a fascinating case study of the leveraged restructuring at Sealed Air Corporation (Myers 2001). Limitations These consequences do not hold for all types of firms. It does not appear that public corporations generally over-invest, nor that debt issues generally add value by disciplining management. Capital investments are generally viewed as good news by investors, that is, as having a positive net present value (McConnell and Muscarella, 1985). Shyam-Sunder (1991) found that announcements of debt issues had no significant effect on stock prices, even for junk debt issues, where the risk of default and the pressure on managers to "disgorge cash," are high. Jensen's (1986) key point--that debt can add significant value in diet deals--is nevertheless proved by many examples. It doesn't take a rocket scientist to appreciate why the managers of established companies do not voluntarily move to dangerous debt ratios. Conclusion & Recommendation Studies of capital structure focus on public corporations, not sole proprietors. These firms act as organizations, not individuals. They presumably act in the interests of some group or coalition of the managers or employees who make, or are affected by, the financial decisions of the firm. Treynor (1981), Donaldson (1983) and Myers (1993,2000) suggest that the firm acts to maximize the present value of current and future benefits to "insiders." The benefits come in various forms: cash, over and above opportunity wages; stock or options in the firm; and private benefits, such as perquisites (Myers 2001). The present value needs to be emphasised because insiders are investing and developing human capital in the expectation of future payoffs. The investment comes in the form of personal risk-taking, sweat equity (working extra-hard for less than an outside wage) and by specialization of human capital to the firm. So a general financial theory of the firm would model the co-investment of human and financial capital (Zingales (2000) and Myers (1999, 2000) Some basic theoretical work has been done here, focused primarily on the conditions under which insiders can raise financing from outside investors when insiders make the investment decisions and can extract cash or private benefits after the investment is made (for example, Hart, 1995; Burkart, Gromb and Panuzzi, 1997; Myers, 2000). But this work has not focused on the form of outside financing, for example, on the choice of debt vs. equity. There are, to my knowledge, no formally developed theories of capital structure derived from the conditions for efficient co-investment of human and financial capital (Myers 2001). References Alexander, Gordon J., Amy IC Edwards and Michael G. Ferri. 2000. "What Does Nasdaq's High-Yield Bond Market Reveal About Bondholder-Stockholder Conflicts" Financial Management. Spring, 29:1, pp. 23-39. Asquith, Paul and Thierry Wizman. 1990. "Event Risk, Covenants and Bondholder Risk in Leveraged Buyouts." Journal of Financial Economics. 27:1, pp. 195-214. Berle, A. A., Jr. and Gardiner C. Means. 1932. "The Modern Corporation and Private Property." New York: MacMillan. Burkhart, Mike, Denis Gromb and Fausto Panunzi. 1997. "Large Shareholders, Monitoring and the Value of the Finn." Quarterly Journal of Economics. 112, pp. 693-728. Donaldson, Gordon. 1984. "Managing Corporate Wealth: The Operation of a Comprehensive Financial Goals System." New York: Praeger. Hart, Oliver. 1995. "Firms, Contracts and Capital Structure." Oxford, UK: Oxford University Press. Jensen, Michael C. 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers." American Economic Review. May, 76:2, pp. 323-29. Jensen, Michael C. and William H. Meckling. 1976. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." Journal of Financial Management. 3:4, pp. 305-60. Kaplan, Steven N. 1989. "Management Buyouts: Evidence on Taxes as a Source of Value." Journal of Financial Economics. 44:3, pp. 611-32. McConnell, John J. and Chris Muscarella. 1985. "Corporate Capital Expenditure Decisions and the Value of the Firm." Journal of Financial Economics. July, 14:2, pp. 399-422. Miller, M.H., 1977, "Debt and Taxes," Journal of Finance 32(2), 261-275. Modigliani, Franco and Merton H. Miller. 1958. "The Cost of Capital, Corporate Finance, and the Theory of Investment." American Economic Review. June 48:4, pp. 261-97. Modigliani, Franco and Merton H. Miller. 1963. "Corporate Income Taxes and the Cost of Capital: A Correction." American Economic Review. June, 53:3, pp. 443-53. Myers, Stewart C. 1977. "Determinants of Corporate Borrowing." Journal of Financial Economics. November, 5:2, pp. 147-75. Myers, Stewart C. 1993. "Still Searching for Optimal Capital Structure." Journal of Applied Corporate Finance. Spring, 1:6, pp. 4-14. Myers, Stewart C. 1999. "Financial Architecture.'' European Financial Management. 5:2, pp. 133-41. Myers, Stewart C. 2000. "Outside Equity." Journal of Finance. June 55:3, pp. 1005-1037. Myers, Stewart C., (2001) "Capital Structure." Journal of Economic Perspectives, 08953309, Spring2001, Vol. 15, Issue 2 Parrino, Robert and Michael S. Weisbach. 1999. "Measuring Investment Distortions Arising from Stockholder-bondholder Conflicts." Journal of Financial Economics. July, 53:1, pp. 3-42. Shleifer, Andrei and Lawrence W. Summers. 1988. "Breach of Trust in Hostile Takeovers." Corporate Takeovers: Causes and Consequences. Alan J. Auerbach, ed. Chicago: University of Chicago Press. Shleifer, Andrei and Robert W. V'mlmy. 1989. "Management Entrenchment: The Case of Manager-specific Investments." Journal of Financial Economics. 25, pp. 123-39. Shyam-Sunder, Lakshmi. 1991. "The Stock Price Effect of Risky Versus Safe Debt." Journal of Financial and Quantitative Analysis. December, 26:4, pp. 549-58. Stulz, Ren M., 2000 "Merton Miller And Modern Finance. Financial Management" (Financial Management Association ), 00463892, Winter2000, Vol. 29, Issue 4 Treynor, Jack L. 1981. "The Financial Objective In The Widely Held Corporation." Financial Analysts Journal. 37, pp. 68-71. Wruck, Karen Hopper. 1995. "Financial Policy As A Catalyst for Organizational Change: Sealed Air's Leveraged Special Dividend." Journal of Applied Corporate Finance. Winter, 7:4, pp. 20-37. Zingales, Luigi. 2000. "In Search of New Foundations.'' Journal of Finance. August 55:4, pp. 1623-1653. Read More