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The firms financial policy

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Title: The firms financial policy


1
The firms financial policy
2
The capital structure issue
  • The capital structure issue refers to the mix of
    securities and financing sources used by firms to
    finance their investments in real assets
  • This mix is presented by the proportions of debt
    and equity on the right-hand side of the firms
    balance sheet
  • What should guide a firm in its decision of the
    debt-equity mix?
  • The guiding principle should be to maximize the
    value of the firm or, equivalently, the value of
    the firms stock

3
Which factors affect the firms choice of debt
vs. equity?
  • Financial managers must choose the appropriate
    debt level that
  • Is consistent with the firms funding needs,
    given the uncertainty of future operating
    earnings
  • Maintains the firms access to capital markets
  • Maximizes shareholder value by borrowing at the
    lowest cost of capital
  • The choice of the firms optimal financing mix is
    usually based on a tradeoff between the benefits
    and costs of choosing debt vs. equity

4
The benefits and costs of debt
  • Benefits of debt
  • Debt is tax deductible
  • Debt imposes discipline on managers
  • Costs of debt
  • Higher levels of debt increase the probability of
    financial distress
  • Debt can create conflicts between stockholders
    and bondholders
  • Higher levels of debt lower the financial
    flexibility of the firm

5
The benefits of debt
  • First, firms can deduct interest payments from
    their taxes, which adds value to the firm
  • Considering two firms, the first using only
    equity financing and the second using a mix of
    debt and equity, we see that the second firm
  • Receives the tax savings from interest payments
  • Alternatively, is faced with a lower (after-tax)
    cost of debt
  • Firms that are faced with higher tax rates are
    more likely to have higher debt ratios, while
    firms that have benefits from other tax shields
    (depreciation) are more likely to have lower debt
    ratios

6
  • Second, debt imposes more discipline on the
    firms management
  • Managers may want to allocate the firms free
    cash flows according to their preferences
  • This may be a problem for mature firms that may
    have few profitable investment opportunities
    (push for acquisitions)
  • A higher level of debt imposes discipline on
    managers because it limits the free cash flows
    that can be allocated at their discretion

7
The costs of debt
  • First, higher levels of debt increase the
    probability of financial distress in a firm
  • Given a certain level of debt payments, firms
    with more volatile operating earnings are faced
    with a higher probability of financial distress
  • The costs of financial distress can be very high
    for a firm and managers would prefer to avoid
    them
  • Direct costs
  • Indirect costs

8
  • Second, debt may create conflicts between
    stockholders and bondholders within a firm
  • Managers, acting in the interest of stockholders
    may want to pursue investments with high risk
  • Creditors do not want managers to pursue projects
    of high risk as this affects the firms ability
    to pay back its obligations
  • Creditors frequently include covenants that
    restrict the use of borrowed funds by managers

9
  • Third, higher debt comes with the cost of lower
    financial flexibility for the firm
  • Financial managers value financial flexibility
  • They want to choose a level of debt that allows
    them to pursue the firms business strategy
  • They also want to maintain adequate unused debt
    capacity that will cover the firms potential
    future borrowing needs
  • They care about preserving the firms credit
    rating (investment grade)

10
Financial leverage and the returns to stockholders
  • Stockholders must consider the impact that
    financial leverage has on the returns to equity
    when they examine the tradeoff between debt and
    equity
  • Higher leverage can lead to higher returns for
    stockholders, compared to a scenario of low
    leverage, when the firms earnings are good
  • However, when earnings are low, higher leverage
    results in higher losses for stockholders
    compared to the scenario of low leverage

11
Example 1 Financial leverage, EPS and ROE
  • Suppose that the GL corporation has assets of 8m
    which are financed only with equity of 8m
    (400,000 shares with a current price of 20 per
    share)
  • The firm is considering restructuring its capital
    structure by issuing debt of 4m and use the
    proceeds to purchase 200,000 of its shares (equal
    to 4m)
  • The companys new capital structure has 50 debt,
    so the debt-equity ratio is 1
  • What is the impact on ROE and EPS if the interest
    rate is 10?

12
The variability of ROE and EPS is magnified with
financial leverage
13
EBIT-EPS RelationshipAt the EBIT level of
800,000, the firm is indifferent between the two
capital structures. If EBIT is projected above
800,000, leverage is beneficial to the firm
With debt
Disadvantage to debt
EPS
No debt
2
Advantage to debt
Break-even EBIT
800,000
EBIT
- 2
14
Is there an optimal capital structure?
  • According to the tradeoff theory of capital
    structure, the firm examines the benefits and
    costs of debt when selecting its financing mix
  • As a starting point in this analysis, we can
    consider the two propositions by Modigliani and
    Miller (MM) who proved that
  • The firms choice of capital structure has no
    impact on firm value
  • The firms choice of capital structure does not
    affect its cost or availability of capital

15
MM Proposition IThe pie model
  • Assume a world where there are
  • No taxes
  • No transaction costs
  • No possibility of default
  • MM Proposition I
  • The value of the firm is independent of the
    firms capital structure

16
The firms assets and operations and, thus, cash
flows are the same regardless of how they are
financed
17
MM Proposition II Financial leverage and the
cost of equity
  • MM Proposition II
  • The firms cost of equity increases as the firms
    financial leverage increases
  • Implication The firms cost of capital is
    constant regardless of the debt ratio
  • Any attempt by the firm to substitute cheap
    debt for expensive equity fails to reduce the
    firms overall cost of capital because it makes
    the remaining equity more expensive

18
  • This means that the rate of return on equity
    increases enough to offset the higher risk that
    stockholders face from the firms increased
    leverage
  • To see this, recall that
  • WACC (D/V)rD (E/V)rE
  • Denote WACC by rA (the required return on the
    firms assets) and rewrite
  • rE rA (rA rD)(D/E)

19
The firms cost of capital is unaffected by the
firms capital structureAs D/E increases, the
cost of debt is constant and cost of equity
increases linearly initially. But, as the cost of
debt increases with default risk, the cost of
equity increases at a slower rate so that cost of
capital is constant
Cost of equity
Cost of equity increases at a slower rate as fi
nancial leverage increases
Cost of financing
Cost of capital
Cost of debt
Cost of debt increases as default risk increases
Risk-free debt
Risky debt
Debt-equity ratio
20
MM Propositions with taxes
  • MM Proposition I and corporate taxes
  • We know that borrowing through debt implies that
    the firm receives the benefit from the interest
    tax shield
  • Consider a firm that has raised financing through
    debt equal to the amount D and that this debt is
    fixed and perpetual (meaning it will be rolled
    over indefinitely)
  • This implies that the interest expense (D ? rD)
    and the interest tax shield (D ? rD ? t) are a
    perpetuity

21
  • The value of the interest tax shield for the firm
    is equal to the PV of this perpetuity or
  • PV of interest tax shield (D ? rD ? t)/rD t ?
    D
  • Thus, if the value of the unlevered firm (with no
    debt) is equal to VU, then the value of the
    levered firm is
  • VL VU (t ? D)

22
Value of the levered firm is always higher than
that of unlevered firmIllogical conclusion
Firms capital structure should be 100 debt
VL
Value of the firm
t ? D
VU
Total debt
23
  • Some problems with the above conclusion are
  • Firms will not always have income to shield
  • Firms also shield income in other ways (e.g.,
    depreciation, write-offs for RD)
  • The marginal tax rate may not always be the same
  • The risk of the tax shield is not the same as the
    risk of interest payments

24
  • MM Proposition II and corporate taxes
  • Assuming corporate taxes exist, the result of MM
    proposition II is written as follows
  • rE rU (rU rD)(D/E)(1 t),
  • (rU cost of capital for unlevered firm)
  • Note that from the WACC equation, the firms cost
    of capital decreases with higher leverage,
    implying that in a world with taxes, debt matters
    for the firms cost of capital

25
Tradeoff theory and optimal capital structure for
the firm
  • According to the tradeoff theory of capital
    structure, the firm considers in its decision of
    the level of debt
  • The benefit form the interest tax shield
  • The costs from the higher probability of
    bankruptcy
  • The firm should borrow up to the point where
  • Marginal benefit of the tax shield Marginal
    cost of
  • financial distress

26
With corporate taxes and costs of financial
distress, the firms value is maximized at the
optimal level of debt, D
VL
Value of the firm
PV of tax shield
Financial distress costs
Max firm value
VU
D
Debt ratio
Optimal debt
27
The Pecking Order Theory
  • According to this theory of the firms capital
    structure, there exists asymmetric information
    between the firms managers and outside
    investors
  • Managers know more about the true value of the
    firms existing assets or new investment
    opportunities
  • Assume also that managers act in the interests of
    shareholders, meaning they attempt to maximize
    shareholder value and refuse, in general, to
    issue undervalued shares

28
  • If a firm issues new shares, two scenarios can
    explain this decision
  • The firm has good growth opportunities, which
    would be something good for outside investors who
    buy the new shares
  • The firms managers are trying to take advantage
    of their belief that the firms existing assets
    are currently overvalued, which would be bad news
    for investors
  • Given the problem of asymmetric information,
    outside investors are only willing to buy new
    shares if these are offered at a markdown

29
  • Thus, firms with undervalued assets and future
    growth opportunities will refuse to issue shares,
    even if it means passing by a positive NPV
    project, because this would imply a drop in the
    shareholder value
  • This implies that if a firm has multiple choices
    of financing sources, it would prefer other
    sources as opposed to equity
  • For example, given the fact that debt has fixed
    cash flows and priority over equity, debt
    financing will not affect the firms share price
    that much

30
  • All this leads to a pecking order of firm
    financing
  • Internal financing (retained earnings) is
    preferred over external financing
  • If the firm needs external financing, then it
    will prefer debt over equity
  • If debt capacity is reached, then firms issue
    equity
  • Implication start with debt, then use hybrid
    securities, then equity

31
Implications of the pecking order theory for firm
financing
  • The pecking order theory explains why most of the
    external financing of firms comes from debt as we
    observe in the data
  • It also explains why profitable firms borrow less
    (also observed in the data) not because their
    target debt ratio is low, but because they have
    higher retained earnings
  • Also, according to the pecking order theory, firm
    dividends are sticky, meaning that firms do not
    like to cut dividends to finance their
    investments rather firms prefer to maintain a
    buffer stock/financial slack to finance
    investments when earnings are low

32
The Free Cash Flow Theory
  • The assumption that managers always act in the
    best interest of shareholders has weak support
    from practical experience and evidence
  • If this assumption does not hold, then there may
    be a dark side to having a lot of free cash flows
    (retained earnings)
  • Managers may use those cash flows to expand their
    perks or attempt to build an empire through
    acquisitions, all at the expense of shareholder
    value

33
  • This scenario is more commonly found in mature
    firms whose operating cash flows significantly
    exceed their profitable investment opportunities
  • Under the above scenario, agency costs (the costs
    that shareholders will incur to ensure that
    managers act in their best interests) can be
    mitigated through higher levels of debt
  • Thus, a higher level of debt, despite its impact
    on the probability of financial distress, is
    beneficial to shareholders because it disciplines
    managers (by limiting the behaviors described
    above) by reducing the amount of free cash flows
    at their discretion

34
Practical issues in the design of corporate
financial policy
  • The design of corporate financial (or capital
    structure) policy must be viewed from three
    perspectives
  • The perspective of the firms marginal investor
  • The perspective of the firms competitive
    position in its industry
  • The internal perspective

35
Capital structure from the investors perspective
  • From the perspective of the firms stockholders,
    the choice of the firms capital structure must
  • Maximize shareholder wealth
  • Maximize the value of the firm
  • Minimize the firms cost of capital
  • Failure to achieve these goals may lead to a
    reaction from the markets, which could
    potentially include a takeover
  • Financial managers must examine alternative
    capital structures and evaluate their impact on
    firm value

36
  • The evaluation of alternative capital structure
    must take into consideration
  • The firms cost of debt
  • The firms cost of equity
  • The debt/equity mix and its impact on the WACC
  • A comparison of the firms P/E ratio,
    market-to-book ratio, and EBIT multiples to those
    of comparable firms
  • The firms bond rating
  • The firms current ownership structure and the
    potential actions of large shareholders
  • Bottom line Financial managers must think like
    investors

37
Capital structure from the firms competitive
perspective
  • From a competitive perspective, the firms choice
    of capital structure must be compared to those of
    the firms competitors to identify any potential
    advantages or disadvantages
  • Given that any firms capital structure will most
    likely differ from those of its competitors, the
    goal is to examine and understand those
    differences
  • What is the competitors historical pattern of
    capital structure?
  • Why has there been a recent change in the capital
    structure of one or more of the competitor
    firms?

38
Capital structure viewed from the internal
perspective
  • From the internal perspective, the choice of
    capital structure must be consistent with the
    firms future goals and expectations
  • The idea is that the firm should not run out of
    cash if it has plans for future growth given the
    firms dividend policy
  • Using forecasts of cash flows, financial
    statements and sources-and-uses-of-funds
    statements help the financial manager decide on
    what is the best capital structure given the
    alternative scenarios

39
  • The financial manager would like to
    estimate/consider
  • The unused debt capacity associated with the
    firms current rating and debt level
  • The cost of capital associated with each credit
    rating and whether the firms chosen debt-equity
    mix achieves the lowest cost of capital
  • The maturity structure of the firms securities
    in order to avoid maturity mismatches and the
    risk from changing interest rates
  • The impact of the firms capital structure on the
    control of managers

40
A useful tool The FRICT framework
  • A useful tool in the capital structure analysis
    is to evaluate the capital structure decision by
    using the FRICT framework
  • FRICT stands for
  • Financial flexibility
  • Risk
  • Income
  • Control
  • Timing

41
  • Financial flexibility does the capital structure
    maintain the firms financial flexibility? We can
    look at bond ratings, coverage ratios,
    capitalization ratios
  • Risk what are the business risks faced by the
    firm? What is the variability of the firms EBIT
    and how does it affect shareholders? A useful
    tool is the EBIT-EPS analysis
  • Income how does the chosen capital structure
    affect value creation? Examine projected EPS,
    ROE, cost of capital, and estimate firms value
    through DCF analysis

42
  • Control how does the firms capital structure
    affect the control of the firm? How are the
    firms stockholders and bondholders affected in
    that respect?
  • Timing is this the best time to change the
    firms capital structure? What are the conditions
    in capital markets? We can examine the yield
    curve (term structure of interest rates), trends
    in interest rates and P/E multiples

43
Survey of 392 CFO(Source Graham and Harvey)
  • Do you have optimal/target debt-equity ratio?
  • Very strict / somewhat tight target 44
  • Flexible target 37
  • No target 19
  • What factors affect amount of debt for your
    firm?
  • Financial flexibility (fund for future
    projects) 59
  • Credit rating 57
  • Earnings volatility 48
  • Tax advantage of interest deductibility 45
  • Costs of bankruptcy / financial distress 21
  • Have debt to make unattractive takeover
    target 5
  • Tax cost faced by investors when they receive
    interest 5
  • To ensure that upper management works hard 2
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