Capital structure decisions are basic part of doing business yet often misunderstood. In terms of modern financial theory and EMH it should not matter what we issue as there is a zero NPV. Managers, however, spend much time worrying about what to issue and when.

Why?

Partially because some of the assumptions we use in developing EMH do not hold, partially because of transaction costs, partially for agency cost reasons, and partially because the Investment banking community is convinced that what firms issue does matter.

You should know Advantages/disadvantages of issuing various types of securities.

These include the costs of issuing securities as well as the risks associated with increasing debt (increased financial leverage).

APV = adjusted Net Present value

if no costs APV=NPV

if APV<NPV, may pass up positive NPV projects

thus firms try to find ways to minimize impact:

Rights offers

Shareholders can buy at a discount. Always exercise (or sell) rights or you will suffer dilution and a loss of wealth.

DRIPS-issuing small amounts in lieu of cash dividend payments (investors are still taxed)

Firms can choose from many types of securities, but if MM I holds it makes no difference.

MM I stands for the famous Modigliani and Miller proposition. This states that a firm can not change its value by changing who the cash flows go to. (that is BH or SH)

One way to look at this is by looking at the adjusted present value of a project. This is the normal NPV adjusted for the costs of issuance.

If we ignore costs of issuing securities and if no transaction costs, then what we issue does not matter….reason? Investors can undo anything we do.

Modigliani and Miller (MM) Prop 1:

Suppose you own 1% equity in an Unlevered firm, the firm then leverages up…

You can still get one percent of the profit by buying the new 1% of the new bonds. You thus own 1% if both and would therefore get 1 % of profits.

Pizza analogy…size of pie is what matters! Slicing a pie into 16 slices is the same as 8 slices.

Thus, if there are no costs then any capital structure is as good as any other. But we know there are costs

So what does capital structure decision depend on?

MM show us when it does not matter. Notably, when there are no taxes, no transactions costs, and when operations are not influenced by the balance sheet.

To more fully answer this question, we have to take a step back and look at WACC

CETERIS PARIBUS: capital structure that minimizes WACC will maximize value of the firm. (why? advantage of deducting interest expense)

so would have mainly debt.

But in reality we don’t hold everything else constant.

For example risk increases. This is

MM prop 2

As risk increases, investors require a higher return. In total the benefits of debt are offset by the costs of debt.

so value of a firm = value of unlevered firm + tax benefits -Fin Distress costs

thus we have to look at where this risk (cost of financial distress)

is great....for these firms, they will be worth more with less debt

• Cost of fighting between stakeholder groups, cost of passing up positive NPV projects, expected costs of bankruptcy
• Lost revenues
• Increased expenses

• Credence goods
• Specialized assets
• High information asymmetries
• Intangible assets

• A subset of Financial distress costs
• Those costs stemming from Bankruptcy
• Direct and Indirect
• Warner (1977) suggests the Direct Costs are low
• Generally direct costs are not high enough to explain low debt levels
• Indirect Bankruptcy costs are higher

• Equity returns are preferred by shareholders on a tax basis.
• Why? Investors can "time" returns to avoid taxes, capital gains rate lower, etc.
• Thus debt while having tax advantages to the firm, has tax disadvantages to the investor. This lowers the benefit of debt.

Relative advantage of debt)

• We expect more debt for firms with assets in place. (Smith-Barclay)
• Why? Assets make better collateral, less opportunity for taking advantage of BH, less risk of passing up positive growth opportunities, etc.
• Low debt at high growth firms

Definitely can see this relationship in an industry analysis. Some industries have high debt/equity levels (steel) others (software manufacturers etc) have very low levels of debt.

With debt the firm may pass up positive NPV projects, assets make better collateral, etc.

Further types of assets matter. More specialized assets (those that are only valuable to your firm) make poor collateral. Thus if you have highly specialized assets you would likely have lower debt.

What is often firm's most valuable asset?

People. Using people as collateral illegal (1863). So firms with high percentage of value tied up in people assets, will have lower debt.

While all of this is true for both private and public firms, there are some differences:

• Closely held firms have great variability in the capital structures. As the owners (often managers as well) have undiversified portfolios, they tend to be more risk averse which would lead to less debt, BUT also may not want equity issue (for control reasons) thus they often finance extensively with debt.
• Smaller firms do not have same financing options available (example Commercial Paper)

Overall there is little evidence of a single "optimal" capital structure. More similarities within an industry, but even then great differences can exist.

Issuing Securities is tightly tied to the idea of an optimal capital structure. There are several theories that have been used to explain the issuance process. The most notable are the static tradeoff theory and the pecking order theory.

The tradeoff theory (also known as optimal capital structure theory) suggests that there is a target optimal capital structure and that managers want to get to this level. The firms may take temporary movements away from the target (as market conditions and the like change) but eventually want to get back to the optimal point.

The problem with this is that it would suggest that any issuance (which would be seen as a movement towards the optimal point) should be associated with a stock price increase. This is NOT the case as evidenced by 3% abnormal decline surrounding a SEO.

The Pecking Order theory (generally attributed to Myers and Majluf 1984) is based on the idea that information asymmetries exist between mangers and investors. This theory states that managers like to use internally generated cash to fund new projects. If this cash is not available they want to issue in order of riskiness: from safe to risky. Thus straight debt would be issued before preferred equity, which is before common equity.

Empirically this has much more support. There is still some doubt however as this order may be merely cost driven. (It is cheaper to issue debt than equity). Moreover upwards of 75% of spending is funded by internal cash. (more in some periods! Example 1991=97% (source Federal Reserve Flow of Funds)

What are the costs of issuance?

Direct costs of issuance

Out of pocket expenses

Lawyers, Investment bankers

Indirect costs of issuance

market reactions! (generally 3% down)

Time to market (managers time and window of opportunity in invetment)

Costs are large and tend to be "fixed." Thus want to issue as much as possible when you do issue. Spread out fixed costs.

Seasoned equity issues are quite rare. Often used as last resort. Investors know this and price accordingly. Hence 3% drop. Note this 3% drop can be an enormous percentage of the new funds raised.

IPOs difficult to assess…greater uncertainty, greater underpricing.

We also cannot explain the waves that exist in issues. Why do these waves exist? It is hard to say.

EMH says any time is as good as any other time, yet we definitely see waves. IPOs esp. Hot market vs cold market.

More in IPO file to follow.