FINN 36003 Final Exam Concept Review

Financial Distress Costs

• Offset the advantages of debt (tax shield)

• Includes direct and indirect costs

Direct Financial Distress Costs

• Legal fees

• Administrative fees

• Accounting fees

• Expert witness fees (Bankruptcy Court)

• Account for 2-10% of asset value

Indirect Financial Distress Costs

• Impaired ability to conduct business

• Hurt relationships with customers and suppliers

• Agency costs (of debt)

Agency Relation

Principal (such as shareholders) hire an agent (such as managers) to act in their best interests.

Agency Problem

The agent pursues their own self-interests, rather than acting in the best interest of the principal.

Agency Cost of Equity

• The cost of addressing the conflict of interests between managers and shareholders

• Managers pursue their best interests at the expense of shareholders

Agency Cost of Debt

• Cost of addressing conflicts of interests between shareholders and bondholders

• Arises because shareholders, though having to ay bondholders first, have control rights over firm cash before the debt expires

Types of Agency Costs of Debt

1. (Shareholders’) Incentives to take high-risk projects (asset substitution)

2. Incentives to reject value-adding projects (debt overhang)

3. Incentives to milk the property

Protective Covenants

• Agreements in bond contracts

• Used to address the agency problem of debts

• If broken, could lead to defaults

Positive Covenants

• Furnish periodic financial statements to the lender

• Main adequate working capital/solvency ability

Negative Covenants

• Limitations on the amount of dividends

• Borrower cannot sell/lease assets without the lender’s permissions

• Borrower may not merge with another firm

• Borrower cannot pledge any of its assets to other lenders

Agency Costs of Equity - Theory of Capital Structure

• Managers could pursue self-interest behavior by expending corporate cash for personal uses

  • The more free cash a firm has, the more likely managers are to do so

• An increase in debt (decrease in free cash flows) reduces managerial incentives to pursue self-interest corporate expenses

  • Additional benefit of debt in addition to interest tax shield

• An increase in debt results in increasing agency costs of debt and decreasing agency costs of equity

Trade-Off Theory

• There is a trade-off between the tax advantage of debt, the costs of financial distress, and agency costs

• An optimal capital structure exists to balance these effects

• Optimal debt to equity ratio balances benefit of debt (tax shield, reduced agency costs of equity) with its costs (bankruptcy, agency costs of debt)

Signaling Theory

• Assumes that there is information asymmetry between corporate insiders and outside investors

• Optimal capital structure exists where marginal subsidy to debt equals the marginal cost of debt

• From the outside, uninformed investors view debt as a “signal” of firm value

  • Profitable firms take on more debt as they can afford interests and enjoy tax shields

  • Stock prices reacts positively when issuing debt, negatively when issuing equity

Pecking-Order Theory

• Firms finance based on how cheap the financing method is

  • Rule 1: Use internal cash (financial slack) first

  • Rule 2: If out of internal cash, issue debt next

  • Rule 3: If reaching debt capacity, issue new equity

• At odds with the tradeoff theory

  • There is no target debt-to-equity ratio

  • Profitable firms use less debt

  • Companies like financial stock

• No optimal capital structure exists

Capital Recapitalization

• Restructuring a company’s funding by changing its mix of debt and equity

• Used to provide liquidity, reduce risk, or finance growth without selling the business

• Used as repellant against hostile takeovers

Leveraged Buyouts (LBOs)

• Private equity firms use 70-90% of debt and 10-30% of equity to buyout targets, take them private, restructure over 4-6 years, and then go public again

• Sometimes private equity firms work with founders/CEOs, referred to as “management buyouts”

• Large debt provides higher tax shields and better managerial incentives, but also have a higher likelihood of financial distress

Side Effects of Financing

1. Interest tax shield (predominant)

2. The costs of issuing new securities

3. The cots of financial distress

4. Other subsidies to debt financing

Cash Dividends

• Payments are smoothed out over time

• Once a firm begins, it rarely stops paying them

• Tend to steadily increase over time

Declaration Date

When the board of directors declares a payment of dividends.

Cumulative-Dividend Date

When the buyer of the stock receives the dividend payment.

Ex-Dividend Date

When the seller of the stock retains the dividend; on or the second business day before record date.

Record Date

When the corporation prepares a list of all individuals believed to be stockholders as of this date.

Price Behavior

• In a perfect world, stock price will fall by the amount of the dividend on the ex-dividend date

• In the real world, stock price will fall by the amount of after-tax dividend on the ex-dividend date

Irrelevance of Dividend Policy

• Does not impact firm value under perfect capital market

  • No transaction costs, no taxes, no arbitrage

• Investors can create whatever income stream they prefer by using “homemade dividends”

Why do Firms Go Public?

• Life Cycle Theory

• Market Timing Theory

• More appealing to potential acquirers

• Competitive advantage

Life Cycle Theory

• Going public is necessary when a firm grows sufficiently large

• Liquidity needs of shareholders

Market Timing Theory

Firms go public when the market is “hot”.

Competitive Advantage

Being the first in an industry to go public confers a “first mover” advantage.

Pros of Firms Going Public

• Access to capital

• Provide existing shareholders to diversify risk (sell shares to public market)

Cons of Firms Going Public

• Issuing costs are high (high cost of equity + fees to investment banks)

• IPO shares are typically underpriced

Public Issuance Procedure

1. Management gets approval of the board

2. The firm prepares and files a registration statement with the SEC

3. The SEC studies the registration statement during the waiting period

4. The firm prepares and files an amended registration statement with the SEC

5. If everything is copasetic with the SEC, a price is set and a full-fledged selling effort gets underway

Steps in Public Offering

1. Pre-writing conferences (takes several months)

2. Registration statements (20-day waiting period)

3. Pricing the issue (Usually on the 20th day)

4. Public offering and sale (After the 20th day)

5. Market stabilization (30 days after the offering)

Tombstone

Written advertisement placed by investment bankers, who give basic details about the issue and, in order of importance, the underwriting groups involved in the deal.

Methods for Issuing Securities for Cash

• Firm Commitment

• Best Efforts

• Dutch Auction

Major Players in the IPO Markets

• Issuers

• Underwriters

• Outside Investors

• Venture Capitalists

Firm Commitment Underwriting

• Most common method used in US

• Issuing firm sells the entire issue to the underwriting syndicate

• Syndicate resells the issue to the public

• Underwriter makes money on the spread between the price paid to the issuer and the price received from investors when the stock is sold

• Syndicate bears the risk of not being able to sell the entire issue for more than the cost

Best Efforts Underwriting

• Underwriter makes their “best effort” to sell the securities at an agreed-upon offering price

• Company bears the risk of the issue not being sold

• The offer may be pulled if there is not enough interest at the offer price

  • Company does not get the capital, and they incur substantial flotation costs

• Typically has the highest offering price

Dutch Auction Underwriting

• Underwriter accepts a series of bids that include number of shares and price per share

• The price that everyone pays is the highest price that will result in all shares being sold

• There is incentive to bid high to make sure you get in on the auction but knowing that you will probably have to pay a lower price than you bid

• Used by the US Treasury for years

Underwriters

• A group of several investment banks

• Provide advice on the feasibility and pricing of IPO offerings

• Market the securities and underwrite the shares

Venture Capital

• Investment type that focuses on start-up, high-risk ventures

• Very high required returns - 30-40%

• When start-up firms grow sufficiently large, they exit and go public

IPO Underpricing

• Typically below market price

• Causes the issuer to “leave money on the table”

Reasons for IPO Underpricing

• Information asymmetry, especially for young, high-tech companies

• To attract investors to buy the issues

Seasoned Equity Offerings (SEOs)

• A new equity issue by an already publicly traded company

• Market value of the existing equity drops on the announcement of a new issue of common stock

Effects of Seasoned Equity Offerings

• Since managers are insiders, perhaps they are selling new stock because they think it is overpriced

• If the market infers that the managers are issuing new equity to reduce their debt-to-equity ratio due to the specter of financial distress, the stock price will fall

• Falling earnings