Capital Structure I

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Topic10

• Capital Structure I

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Outline

• Learning Objectives
• Excel Features

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1 Learning Objectives

• LO 10.1 Explain an efficient market and its
  three types.
• LO 10.2 Discuss the evidence for the efficiency
  of the market.
• LO 10.3 Explain the impact of asset market
  structure and dynamic changes on the asset
  pricing process.
• LO 10.4 Explain the role of financial markets
  and corporate financial policy in the allocation
  of capital in a competitive economy.

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2 Excel Features Logical Functions

• IF(logical_test,value_if_true,value_if_false)
• NOT(logical)
• AND(logical1,logical2, ...)
• OR(logical1,logical2,...)
• TRUE( )
• FALSE( )
• logical value that is TRUE or FALSE

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3 Can Financing Decisions Create Value?

• Earlier parts of the book show how to evaluate
  investment projects according to the NPV
  criterion.
• The next four chapters concern financing
  decisions, such as
• How much debt and equity to sell
• When to sell debt and equity
• When (or if) to pay dividends
• We can use NPV to evaluate financing decisions.

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Creating Value through Financing

• Fool Investors
• Empirical evidence suggests that it is hard to
  fool investors consistently.
• Reduce Costs or Increase Subsidies
• Certain forms of financing have tax advantages or
  carry other subsidies.
• Create a New Security
• Sometimes a firm can find a previously-unsatisfied
  clientele and issue new securities at favorable
  prices.
• In the long-run, this value creation is
  relatively small.

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4 Efficient Market Hypothesis (EMH)

• An efficient capital market is one in which stock
  prices fully reflect available information.
• The EMH has implications for investors and firms.
• Since information is reflected in security prices
  quickly, knowing information when it is released
  does an investor little good.
• Firms should expect to receive the fair value for
  securities that they sell. Firms cannot profit
  from fooling investors in an efficient market.

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Foundations of Market Efficiency

• Investor Rationality
• Independence of events
• Arbitrage

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Stock Price Reactions
Stock Price
Overreaction to good news with reversion
Delayed response to good news
Efficient market response to good news
-30 -20 -10 0 10 20 30
Days before (-) and after () announcement
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Stock Price Reactions
Efficient market response to bad news
Stock Price
Delayed response to bad news
-30 -20 -10 0 10 20 30
Days before (-) and after () announcement
Overreaction to bad news with reversion
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4a The Different Types of Efficiency

• Weak Form
• Security prices reflect all historical
  information.
• Semistrong Form
• Security prices reflect all publicly available
  information.
• Strong Form
• Security prices reflect all informationpublic
  and private.

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Weak Form Market Efficiency

• Security prices reflect all information found in
  past prices and volume.
• If the weak form of market efficiency holds, then
  technical analysis is of no value.
• Since stock prices only respond to new
  information, which by definition arrives
  randomly, stock prices are said to follow a
  random walk.

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Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price
If it were possible to make big money simply by
finding the pattern in the stock price
movements, everyone would do it, and the profits
would be competed away.
Time
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Semistrong Form Market Efficiency

• Security prices reflect all publicly available
  information.
• Publicly available information includes
• Historical price and volume information
• Published accounting statements
• Information found in annual reports

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Strong Form Market Efficiency

• Security prices reflect all informationpublic
  and private.
• Strong form efficiency incorporates weak and
  semistrong form efficiency.
• Strong form efficiency says that anything
  pertinent to the stock and known to at least one
  investor is already incorporated into the
  securitys price.

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Information Sets
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What the EMH Does and Does NOT Say

• Investors can throw darts to select stocks.
• This is almost, but not quite, true.
• An investor must still decide how risky a
  portfolio he wants based on risk aversion and
  expected return.
• Prices are random or uncaused.
• Prices reflect information.
• The price CHANGE is driven by new information,
  which by definition arrives randomly.
• Therefore, financial managers cannot time stock
  and bond sales.

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4b The Evidence

• The record on the EMH is extensive, and, in large
  measure, it is reassuring to advocates of the
  efficiency of markets.
• Studies fall into three broad categories
• Are changes in stock prices random? Are there
  profitable trading rules?
• Event studies does the market quickly and
  accurately respond to new information?
• The record of professionally managed investment
  firms.

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Are Changes in Stock Prices Random?

• Can we really tell?
• Many psychologists and statisticians believe that
  most people want to see patterns even when faced
  with pure randomness.
• People claiming to see patterns in stock price
  movements are probably seeing optical illusions.
• A matter of degree
• Even if we can spot patterns, we need to have
  returns that beat our transactions costs.
• Random stock price changes support weak form
  efficiency.

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What Pattern Do You See?
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Event Studies

• Event Studies are one type of test of the
  semistrong form of market efficiency.
• Recall, this form of the EMH implies that prices
  should reflect all publicly available
  information.
• To test this, event studies examine prices and
  returns over timeparticularly around the arrival
  of new information.
• Test for evidence of underreaction, overreaction,
  early reaction, or delayed reaction around the
  event.

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Event Studies

• Returns are adjusted to determine if they are
  abnormal by taking into account what the rest of
  the market did that day.
• The Abnormal Return on a given stock for a
  particular day can be calculated by subtracting
  the markets return on the same day (RM) from the
  actual return (R) on the stock for that day
• AR R RM
• The abnormal return can be calculated using the
  Market Model approach
• AR R (a bRM)

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Event Studies Dividend Omissions
Efficient market response to bad news
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Event Study Results

• Over the years, event study methodology has been
  applied to a large number of events including
• Dividend increases and decreases
• Earnings announcements
• Mergers
• Capital Spending
• New Issues of Stock
• The studies generally support the view that the
  market is semistrong form efficient.
• Studies suggest that markets may even have some
  foresight into the future, i.e., news tends to
  leak out in advance of public announcements.

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The Record of Mutual Funds

• If the market is semistrong form efficient, then
  no matter what publicly available information
  mutual fund managers rely on to pick stocks,
  their average returns should be the same as those
  of the average investor in the market as a whole.
• We can test efficiency by comparing the
  performance of professionally managed mutual
  funds with the performance of a market index.

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The Record of Mutual Funds
Taken from Lubos Pastor and Robert F. Stambaugh,
Mutual Fund Performance and Seemingly Unrelated
Assets, Journal of Financial Exonomics, 63
(2002).
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The Strong Form of the EMH

• One group of studies of strong form market
  efficiency investigates insider trading.
• A number of studies support the view that insider
  trading is abnormally profitable.
• Thus, strong form efficiency does not seem to be
  substantiated by the evidence.

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5 Behavioral Finance

• Rationality
• People are not always rational.
• Many investors fail to diversify, trade too much,
  and seem to try to maximize taxes by selling
  winners and holding losers.
• Behavioral finance

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Behavioral Finance

• Independent Deviations from Rationality
• Psychologists argue that people deviate from
  rationality in predictable ways
• Representativeness drawing conclusions from too
  little data
• This can lead to bubbles in security prices.
• Conservativism people are too slow in adjusting
  their beliefs to new information.
• Security prices seem to respond too slowly to
  earnings surprises.

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Behavioral Finance

• Arbitrage
• Suppose that your superior, rational, analysis
  shows that company ABC is overpriced.
• Arbitrage would suggest that you should short the
  shares.
• After the rest of the investors come to their
  senses, you make money because you were smart
  enough to sell high and buy low.
• But what if the rest of the investment community
  doesnt come to their senses in time for you to
  cover your short position?
• This makes arbitrage risky.

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6 Empirical Challenges

• Limits to Arbitrage
• Markets can stay irrational longer than you can
  stay insolvent. John Maynard Keynes
• Earnings Surprises
• Stock prices adjust slowly to earnings
  announcements.
• Behavioralists claim that investors exhibit
  conservatism.
• Size
• Small cap stocks seem to outperform large cap
  stocks.
• Value versus Growth
• High book value-to-stock price stocks and/or high
  E/P stocks outperform growth stocks.

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Empirical Challenges

• Crashes
• On October 19, 1987, the stock market dropped
  between 20 and 25 percent on a Monday following a
  weekend during which little surprising news was
  released.
• A drop of this magnitude for no apparent reason
  is inconsistent with market efficiency.
• Bubbles
• Consider the tech stock bubble of the late 1990s.

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7 Reviewing the Differences

• Financial Economists have sorted themselves into
  three camps
• Market efficiency
• Behavioral finance
• Those that admit that they dont know
• This is perhaps the most contentious area in the
  field.

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Implications for Corporate Finance

• Because information is reflected in security
  prices quickly, investors should only expect to
  obtain a normal rate of return.
• Awareness of information when it is released does
  an investor little good. The price adjusts before
  the investor has time to act on it.
• Firms should expect to receive the fair value for
  securities that they sell.
• Fair means that the price they receive for the
  securities they issue is the present value.
• Thus, valuable financing opportunities that arise
  from fooling investors are unavailable in
  efficient markets.

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Implications for Corporate Finance

• The EMH has three implications for corporate
  finance
• The price of a companys stock cannot be affected
  by a change in accounting.
• Financial managers cannot time issues of stocks
  and bonds using publicly available information.
• A firm can sell as many shares of stocks or bonds
  as it desires without depressing prices.
• There is conflicting empirical evidence on all
  three points.

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Why Doesnt Everybody Believe?

• There are optical illusions, mirages, and
  apparent patterns in charts of stock market
  returns.
• The truth is less interesting.
• There is some evidence against market efficiency
• Seasonality
• Small versus large stocks
• Value versus growth stocks
• The tests of market efficiency are weak.

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8 Capital Structure and the Pie

• The value of a firm is defined to be the sum of
  the value of the firms debt and the firms
  equity.
• V B S

• If the goal of the firms management is to make
  the firm as valuable as possible, then the firm
  should pick the debt-equity ratio that makes the
  pie as big as possible.

S
B
S
B
Value of the Firm
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Stockholder Interests

• There are two important questions
• Why should the stockholders care about maximizing
  firm value? Perhaps they should be interested in
  strategies that maximize shareholder value.
• What is the ratio of debt-to-equity that
  maximizes the shareholders value?
• As it turns out, changes in capital structure
  benefit the stockholders if and only if the value
  of the firm increases.

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9 Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering
going into debt. (Maybe some of the original
shareholders want to cash out.)

• Current
• Assets 20,000
• Debt 0
• Equity 20,000
• Debt/Equity ratio 0.00
• Interest rate n/a
• Shares outstanding 400
• Share price 50

Proposed 20,000 8,000 12,000 2/3
8 240 50
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EPS and ROE Under Current Structure

• Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest 0 0 0
• Net income 1,000 2,000 3,000
• EPS 2.50 5.00 7.50
• ROA 5 10 15
• ROE 5 10 15
• Current Shares Outstanding 400 shares

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EPS and ROE Under Proposed Structure

• Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest 640 640 640
• Net income 360 1,360 2,360
• EPS 1.50 5.67 9.83
• ROA 1.8 6.8 11.8
• ROE 3.0 11.3 19.7
• Proposed Shares Outstanding 240 shares

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Financial Leverage and EPS
12.00
Debt
10.00
8.00
No Debt
Advantage to debt
6.00
Break-even point
EPS
4.00
2.00
0.00
1,000
2,000
3,000
Disadvantage to debt
EBIT in dollars, no taxes
(2.00)
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Assumptions of the Miller-Modigliani (MM) Model

• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets
• Perfect competition
• Firms and investors can borrow/lend at the same
  rate
• Equal access to all relevant information
• No transaction costs
• No taxes

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Homemade Leverage An Example
Recession Expected Expansion EPS of Unlevered
Firm 2.50 5.00 7.50 Earnings for 40
shares 100 200 300 Less interest on 800
(8) 64 64 64 Net Profits 36 136 236 ROE
(Net Profits / 1,200) 3.0 11.3 19.7 We are
buying 40 shares of a 50 stock, using 800 in
margin. We get the same ROE as if we bought into
a levered firm. Our personal debt-equity ratio is
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Homemade (Un)Leverage An Example

• Recession Expected Expansion
• EPS of Levered Firm 1.50 5.67 9.83
• Earnings for 24 shares 36 136 236
• Plus interest on 800 (8) 64 64 64
• Net Profits 100 200 300
• ROE (Net Profits / 2,000) 5 10 15
• Buying 24 shares of an otherwise identical
  levered firm along with some of the firms debt
  gets us to the ROE of the unlevered firm.
• This is the fundamental insight of MM

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MM Proposition I (No Taxes)

• We can create a levered or unlevered position by
  adjusting the trading in our own account.
• This homemade leverage suggests that capital
  structure is irrelevant in determining the value
  of the firm
• VL VU