Tài chính doanh nghiệp - Chapter 14: Capital structure decisions

Chapter 14Capital Structure DecisionsLearning ObjectivesOutline empirical evidence from recent studies on capital structure.Assess the implications of the evidence for the trade-off, pecking order and free cash flow theories.Explain how financing can be viewed as a marketing problem.Outline the main factors that financial managers should consider when determining a company’s financing strategy.IntroductionMM analysis is useful in showing that if capital structure is important, the reasons must relate to factors that MM excluded by their assumptions.Four main theories of capital structure:MM leverage irrelevance — company value depends on investment rather than financing decisions.Trade-off theory — emphasises tax benefits of debt.Pecking order theory — information on projects is asymmetric and internal finance is highest in pecking order.Free cash flow theory — emphasises agency costs with the discipline of debt reducing unprofitable investment.Company Financing: Some Initial FactsIn the US, most investment by non-financial companies is financed from internal cash flows, followed by external debt finance and then by equity.The pattern in Australia is similar, with over 50% of finance coming from internal equity over 2000–2004.High-growth companies have investment needs that exceed cash flow and, as a result, these high-growth companies depend heavily on share issues (equity finance).Company Financing: Some Initial Facts (cont.)Relationships between industry characteristics and capital structure have been reported in several studies.Paper, steel and airline companies typically have high leverage.Pharmaceutical and electronics companies typically have low leverage.These observations suggest that capital structure decisions are important.Evidence on Capital Structure: TaxesEffects of personal and company tax tend to be offsetting:Deductions for interest on debt reduce company tax.However, at the investor level, interest is taxed more heavily than dividends and capital gains.However, managers may view non-debt tax shields, such as investment tax credits or tax losses being carried forward, as substitutes for interest deductions.Evidence on Capital Structure: Taxes (cont.)Evidence of any significant relationship between leverage and taxes is sparse.MacKie–Mason (1990) argues that this is because most studies have tested for average rather than marginal effects.Examining individual financing decisions on a marginal basis for companies near the point of tax exhaustion, MacKie–Mason (1990) found strong evidence that taxes do influence financing decisions.Evidence on Capital Structure: Taxes (cont.)Evidence for the US shows that high tax rate companies borrow more heavily than those with low tax rates.Evidence on imputation tax systems for Canada, New Zealand and Australia suggest that imputation removes the tax advantages of debt financing.Imputation reduces corporate financial leverage.Evidence on Capital Structure: Financial DistressTrade-off theory — financial distress is the negative to be offset against tax benefits of debt.Direct costs of financial distress are small, but companies likely to fail incur indirect costs.Loss of sales due to uncertainty, with company management focusing on aversion of failure rather than operations.Indirect costs of financial distress seem much larger than direct costs but are very difficult to measure.Evidence on Capital Structure: Financial Distress (cont.)The costs associated with financial distress can reduce company value, but are they large enough to have an economically significant effect?Direct bankruptcy costs appear to be small.Indirect bankruptcy costs found to be significant.Andrade and Kaplan (1998) — need to separate economic and financial distress.Study economically sound firms, find net costs of financial distress 10–20% of firm value.Evidence on Capital Structure: Agency CostsDebt and under-investment:High-growth companies with intangible assets will find debt expensive and difficult to obtain.Companies that borrow and struggle to service debt will find it difficult to pursue other investments.Debt will lead to under-investment.Debt and over-investmentMature companies with high free cash flows may pursue unprofitable investments.Increased debt acts to discipline managers, curbing the inclination to over-invest, Jensen (1986).Evidence on Capital Structure: Agency Costs (cont.)Leverage is generally negatively correlated with a company’s investment opportunities.Barclay, Smith and Watts (BSW) (1995), found evidence to confirm that a company’s investment opportunities are an important determinant of leverage.BSW’s results are opposite to those predicted by pecking order theory.Evidence on Capital Structure: Agency Costs (cont.)Maturity and priority of debtPrevious discussion has implicitly assumed that all debt is the same.However, debt can have many different features (maturity, security, priority etc.).Managers must not only decide how much debt to use but also what type of debt to use.Growth companies tend to use debt of shorter maturity and higher priority than mature companies.Evidence on Capital Structure: Agency Costs (cont.)Maturity and priority of debt (cont.)Barclay and Smith (1996):A company’s investment opportunities influence the maturity and priority of debt.Growth companies are more likely to use shorter-term debt (greater flexibility).Growth companies are perceived to be riskier and so will be forced to issue higher-priority secured debt.Evidence on Capital Structure: Information Costs and Pecking Order TheoryPecking order theoryManagers prefer internal finance.Managers adapt target dividend payout ratios to their company’s investment opportunities (but dividends are ‘sticky’).If internally generated cash flows are inadequate, the company draws first on its cash and marketable securities.If external finance is required, the company issues debt first, then hybrids, and, finally, equity.Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.)The pecking order theory predicts that the announcement of a new share issue will cause the company’s share price to fall.Pilotte (1992) found that the share price response to new financing, while negative, depends on the company’s investment opportunities and is not only related to the type of security being issued.Price falls were larger for mature companies relative to growth companies.Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.)Pecking order theory implies that a company’s leverage depends on the difference between operating cash flows and investment needs over time.Pecking order theory suggests that leverage is negatively related to profitability.Several studies confirm this prediction — Jarrell and Kim (1984), Titman and Wessels (1988), Ranjan and Zingales (1995), Wald (1999), Graham (2000), and Graham and Harvey (2001) over different time periods and in different countries. Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.)Testing pecking order and trade-off theoriesTrade-off theory predicts a target adjustment behaviour of a company’s debt levels.Pecking order theory predicts actual debt ratios will vary depending on need for external finance.Shyam-Sunder and Myers (1999) compared the theories — hard to distinguish statistically, evidence supports pecking order theory.Fama and French (2002) — trade-off theory unable to explain negative link between profitability and leverage.Evidence on Capital Structure: Information Costs and Pecking Order Theory (cont.)Testing pecking order and trade-off theories (cont.)Fama and French (2002) — Small growth companies with low leverage depend on equity issues, inconsistent with pecking order theory — expect more dependence on debt.Frank and Goyal (2003) — US evidence that small firms do not follow pecking order theory and evidence that larger firms adherence to pecking order theory declines over time.Evidence in support of pecking order theory is mixed, negative relationship between leverage and profitability is strongest evidence.However, several explanations consistent with trade-off theory are proposed in the literature — overall empirically open question.Evidence on Capital Structure: Dual Issues and Spin-OffsHovakimian, Hovakimian and Tehranian (HHT) (2004) study dual issues — companies that issue both debt and equity in same year expecting clean outcomes; i.e. debt ratio is more likely to be exactly what management want.Find firms make equity issues when market to book ratio is high — overvalued equity.No relationship between profitability and leverage after dual issue.Evidence supports hypothesis that firms have target capital structures.Mehrotra, Mikkelson and Partch (MMP) (2003) study spin offs — new companies that are formed when separated from existing companies — again, leverage ratios of new companies can be chosen deliberately.MMP find that higher leverage is associated with higher profitability, lower variability of industry operating incomes and greater proportion of tangible assets.No relationship between leverage and tax status.Apart from the absence of tax effect, MMP results are consistent with trade-off theory.Evidence on Capital Structure: Dual Issues and Spin-Offs (cont.)Assessing Theories of Capital Structure: Trade-Off TheoryTrade-off theory says firms should borrow until the marginal tax advantage of additional debt is offset by the marginal expected costs of financial distress.Myers (2001) argues that many firms could increase company value by increasing debt and reducing taxes without financial distress becoming a remote possibility.Wald (1999) finds that the most profitable firms borrow least; this indicates that these firms are not exploiting the tax shield provided by debt. Assessing Theories of Capital Structure: Trade-Off Theory (cont.)Trade-off theory explains some of the differences in capital structure of firms in different industries.Leverage is low when business risk is high and when assets are intangible (unable to be used as security).Predicts leveraged buyout targets as mature companies with stable cash flows, tangible assets and few growth opportunities.Assessing Theories of Capital Structure: Trade-Off Theory (cont.)Limitations of trade-off theoryCannot explain why companies are generally conservative in using debt finance.Negative relationship between leverage and profitability is not explained by trade-off theory.Cannot explain similar leverage levels across countries with different tax systems.Expect leverage to be higher in the US, where a classical tax system applies.Assessing Theories of Capital Structure: Pecking Order TheoryPecking order theory explains the popularity of internal financing, and that, when external finance is sought, it is usually debt.Also explains that less profitable firms need to borrow more.Low leverage in hi-tech industries?Mostly intangible assets so borrowing is expensive.Problem of debt induces underinvestment.Suggests that firms should raise external equity when all other sources are exhausted.Assessing Theories of Capital Structure: Free Cash Flow TheoryReflects conflict of interest between managers and shareholders.Wants to prevent managers from investing in low-return projects.High leverage forces company to pay out cash and adds value by preventing unprofitable investment.Primarily applicable to companies with high free cash flows and poor investment opportunities — typically ‘mature cash-cow firms’.Financing as a Marketing ToolChoosing a capital structure is essentially choosing a particular package of financial services to supply to investors. The instruments differ in:RiskReturnTaxation treatmentVoting rightsPriority in the event of liquidationDifferences also exist within categories. Determining a Financing StrategyEvidence indicates that financing decisions are important and influenced by many factors. The financing strategy should complement the investment strategy and take into consideration:Business risk.Asset characteristics.Tax position.Maintenance of reserve borrowing capacity.Other factors such as political and inflation risk.Determining a Financing Strategy (cont.)Business riskVariability of net cash flows from a company’s assets is typically taken as business risk.The greater the company’s business risk, the less it can borrow without raising probability of bankruptcy.Thus, capital structure decisions and the optimal capital structure will be affected by business risk.Determining a Financing Strategy (cont.)Asset characteristicsDistinction between tangible and intangible assets important for ability to borrow.Similarly, distinction between company specific assets and general purpose assets is also important in determining ability to borrow.Issue is the value of these assets as security against debt.Agency costs associated with high levels of intangible assets — high monitoring costs mean debt is expensive and therefore not used by firms with high levels of intangibles.Determining a Financing Strategy (cont.)Tax positionTax savings associated with debt depend on tax system in place in a particular country.Key point is that with an imputation system as we have in Australia, the tax benefits associated with debt as a form of finance are at least partly neutralised.This neutrality does not apply to non-resident shareholders of Australian companies — as a consequence, various classes of shares are issued to minimise the wastage of franking credits.Determining a Financing Strategy (cont.)Maintenance of reserve borrowing capacityInformation asymmetry issues create problems when seeking external equity finance to fund new projects — associated bad signals.As a consequence, firms like to maintain reserve borrowing capacity to easily fund investment opportunities.Allen (2000) finds that 60% of Australian companies retain reserve borrowing capacity or ‘financial slack’.While valuable, creates free cash flow problems and may destroy shareholder value — Jensen (1986).Determining a Financing StrategyOther factors: political and inflation riskMultinational companies will structure international projects using little equity and high levels of debt raised in the host country — this minimises political risk.Inflation has an impact on interest rates, so floating rate borrowers need to consider inflation when deciding on debt levels.Important to understand if cash flows and sales revenues can increase in the case of inflation, neutralising the problem.Case Study: Australian Plantation Timber (APT)APT reported $9m profit for 6 months ending 31 December 2000. Paying a dividend with net assets of $200m.On 30 July 2001, APT went into voluntary administration after its bank, owed $40m, refused to provide further funding.Business involves planting and managing timberlots, which were sold as tax-effective investments.Case Study: Australian Plantation Timber (cont.)Changes in tax laws drove firm to buy land up front and prepare it for sale to investors/clients.Due to a tax crackdown, firm had a surplus of 7000 hectares of land.APT had a short-term loan facility which, after negotiations, was not extended.APT’s problems stemmed from poor capital structure planning.Case Study: Australian Plantation Timber (cont.)Two major financing problems:First, used short-term finance (bank loan) to purchase illiquid assets (land).Reasonable strategy if the land was sold on to clients as it had in the past.However, tax crackdown led to excess supply of illiquid inventory.Case Study: Australian Plantation Timber (cont.)Two major financing problems (cont.):Second, management of timberlots was paid for in one upfront payment, even though services were provided over 10 years.This is also OK if the present value of the costs of services is correctly calculated and charged and then correctly managed (annuitised).Cash flow depended heavily on current sales.With poor sales, cash flows were also poor, putting the firm in financial distress.Case Study: Australian Plantation Timber (cont.)Firm has since organised a financial restructuring, at heavy cost to existing shareholders.Following these financial difficulties, in 2002, another forestry company Integrated Tree Cropping took a 50% stake in APT — diluted original shareholders to 35%.In 2004, ITC made a successful takeover offer for the remaining shares.SummaryMM’s results imply that capital structure is not important. Similarities within industries and differences between industries suggest capital structure does matter.Factors affecting capital structure include taxes, costs of financial distress, companies’ investment opportunities and free cash flows.Trade-off, pecking order and free cash flow theories all have empirical support, suggesting no one theory is right or wrong.Summary (cont.)Financing can be treated as a marketing problem.Firms need to offer investors instruments that satisfy their tastes for risk–return tradeoffs, tax treatment and voting rights.Financing strategy should complement investment strategy.Need to consider business risk, asset characteristics, tax position, political and inflation risk and the need for reserve borrowing capacity.