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MAF Corporate Finance, Spring 2007: Part B: Financing and Payout Decisions'

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His model- two car dealers: one good, one bad. ... Only bad car remains. Price falls to 1000. Myers-Majuf (1984) 'securities may be lemons too. ... – PowerPoint PPT presentation

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Title: MAF Corporate Finance, Spring 2007: Part B: Financing and Payout Decisions'


1
MAF Corporate Finance, Spring 2007Part B
Financing and Payout Decisions.
  • Major Assumption in Corporate Finance Firm
    attempts to maximize Shareholder Wealth.
  • Firms 3 main decisions a) What to invest in? b)
    How to finance? C) What to pay out/ retain in
    business?

2
MUTUALLY EXCLUSIVE PROJECTS.
3
COMPARING NPV AND IRR
NPV
531
519
Discount Rate
10
22.8
25.4
PROJ D
PROJ C
Select Project with higher NPV Project C.
4
Dynamic Investment Appraisal
  • Traditional Investment Appraisal Static
  • NPV Now or Never.
  • Real Options Now or Later Covered in Part D
    of Course.
  • gt Decision Trees Dynamic/sequential and
    Flexible.
  • gt Sensitivity Analysis.

5
Decision Trees and Sensitivity Analysis. (Example
From Ross, Westerfield and Jaffe). New Project
Test and Development Phase Investment
100m. 0.75 chance of success. If successful,
Company can invest in full scale production,
Investment 1500m. Production will occur over
next 5 years with the following cashflows.
6
Production Stage Base Case
Date 1 NPV -1500
7
Decision Tree.
Date 1 -1500
Date 0 -100
NPV 1517
Invest
P0.75
Success
Do not Invest
NPV 0
Test
Do not Invest
Failure
P0.25
Do Not Test
Invest
NPV -3611
Solve backwards If the tests are successful, SEC
should invest, since 1517 gt 0. If tests are
unsuccessful, SEC should not invest, since 0 gt
-3611.
8
Now move back to Stage
1. Invest 100m now to get 75 chance of 1517m
one year later?
Expected Payoff 0.75 1517 0.25 0 1138. NPV
of testing at date 0 -100
890
Therefore, the firm should test the project.
Sensitivity Analysis (What-if analysis or Bop
analysis) Examines sensitivity of NPV to changes
in underlying assumptions (on revenue, costs and
cashflows).
9
Sensitivity Analysis. - NPV
Calculation for all 3 possibilities of a single
variable expected forecast for all other
variables.
Limitation in just changing one variable at a
time. Scenario Analysis- Change several
variables together. Mosher Case study. Break -
even analysis examines variability in
forecasts. It determines the number of sales
required to break even.
10
Break-even Analysis. Accounting
Profit.
Breakeven Point 2091 Engines.
NPV.
Breakeven Point 2315 Engines.
11
I. FINANCING DECISION
12
Capital Structure and Firm Value. Value of the
firm Discounted Value of future cashflows
available to the providers of capital. Value of
the firm Value of Equity Value of debt.
where
gt WACC equityKe debt Kd (1-T).
13
Miller- Modigliani Irrelevance Theorem.
Two firms, identical cashflows, same risk, but
one firm is unlevered, the other is levered.
Irrelevance Theorem Without Tax, Firm Value is
independent of the Capital Structure.
14
K
K
Without Taxes
With Taxes
D/E
D/E
V
V
D/E
D/E
15
Comparing MM and CAPM.
16
Capital Structure Irrelevance without
taxes. Example A firm has annual NCF 100K.
(cashflow is a perpetuity.) Risk free rate rf
7. E(rm) 17. Debt/total MV 20. and Cost of
levered equity (from CAPM) 12. WACC 11. V
100/0.11 909K. Now it changes its capital
structure to Debt/Total MV 35. Levered Beta
will change, to 0.61 gt cost of levered equity
13.2 gt WACC 11 gt V 909K.
17
Example Firm A current capital structure Debt/
Total MV 20. Risk free rate 7. Tax rate
50. Systematic risk of firms equity,
A. Change Capital Structure, and take on new
project of same operating risk as current
risk. new project has 9.25 expected return. What
is firms current WACC, and new WACC? Should it
take new project?
18
  • Solution
  • Calculate current cost of equity, using CAPM.
  • Ke .07 0.17-.070.5 0.12.
  • 2. Therefore, current WACC 10.3.

3. Calculate unlevered cost of equity. From MM
4. Calculate new WACC using MM New WACC
9.44. Therefore, firm should not take new
project, even at 35 debt.
19
B. Comparing projects with different
risks. Project 1 required date 0 investment
100, Expected NCF at date 1 135, Systematic
risk, Project 2 required date 0 investment
100, Expected NCF at date 1 130, Systematic
risk, Solution Project 1 Cost of Unlevered
Equity for the new project, using CAPM
19. WACC for the new project, at 20 debt, using
MM 17.1 gt NPV 15.29. Project 2 Cost of
unlevered equity 13. WACC at 20 debt, 11.7
gt NPV 16.39. Select Project 2.
20
Project 1 has a higher return than project 2, but
it is riskier. Investors require a higher return
for project 1. So, project 2 is
selected. ----------------------------------------
----------------------------------- gt Capital
Budgeting- each project must be evaluated at a
cost of capital reflecting Business Risk and
Financial Leverage.
21
Separability of Financing and Investment
Decisions. Implication of MM Irrelevance Theorem
A firms financing decision is separate from
its investment decision. Pie Model of firm value.
D
Equity
DEBT
E
MM said it does not matter how you slice the pie
between debtholders and equity holders- total
size of pie is the same.
22
Combining Tax Relief and Debt Capacity
(Traditional View).
K
V
D/E
D/E
23
But Risky debt is irrelevant!
K
Prove this!
V
D/E
24
Trade-Off View of Optimal Capital Structure.
V
Eg Agency Costs/ signalling
D/E
K
D/E
25
Optimal Capital Structure. Under MM irrelevance,
value of firm is independent of capital
structure. Capital structure does not
matter. Reasons for Optimal Capital
Structure. Taxes. Bankruptcy Costs. Debt Capacity
(traditional view). Agency Costs (Selfish
Manager). Signalling.
26
  • MM Irrelevance Theorem- Firm Value and WACC
    independent of Capital Structure- Capital
    Structure does not matter- Pie Model.
  • Problem No prescription to firms on how to
    finance projects.
  • Introduce tax relief on debt gt 100 debt!
  • Personal Taxes.
  • Bankruptcy Costs.
  • Traditional View.

27
Agency Costs (Selfish Manager). Jensen and
Meckling (1976). If firm issues equity (reduced
managerial ownership of firm value), Manager
pursues private benefits (private jet, plush
offices, time off to play golf), reducing firm
value. -If firm issues debt, manager has
incentive to take risky projects
(risk-shifting). Trade-off Optimal Capital
Structure.
V
D/E
D/E
28
Agency Costs (continued). Hart (1984)- Effort
Level. Equity holders are soft- Manager can
reduce effort. Debt holders can liquidate the
firmgt Bankruptcy gt manager losing job. This
threat may lead to manager working harder gt
Increasing firm value. Therefore, increasing debt
increases firm value.
29
Agency Costs- Continued. Free cashflow (Jensen
1986). -Managers may have pet negative NPV
projects. Equity gt free cashflow gt managers
can take these bad projects gt firm value
falling. Debt gt reduces free cashflow. Managers
cannot take the bad projects gt Firm value
rises. - Important in Mergers.
30
Asymmetric Information. Manager has inside
information. Issuing debt or equity may reveal
this information to the market. Myers-Majluf. -Fir
m has 50/50 chance of good or bad news. Market
values this firm at an average. Then Manager
observes this news market does not. If bad news
arrives, firm is currently overvalued in the
market manager will issue shares This signals
bad news, and share price falls. If Good news
arrives, firm is undervalued in the market, and
manager will not issue shares. Therefore, Issuing
equity signals bad news, firm value falls.
31
Asymmetric Information (continued). Ross (1977)-
Debt has bankruptcy threat. Manager has
compensation based on firm value, but is
penalised financially if firm goes
bankrupt. Market cannot observe whether manager
is good or bad. Good manager issues debt- signals
that he is not too worried about bankruptcy
therefore, firm value rises. Bad Manager is
worried about bankruptcy- does not issue debt.
Firm Value falls. Empirical Evidence- Issuing
equity causes firm value to fall- Debt causes
firm value to rise- contrary to MM.
32
Section 4 Optimal Capital Structure, Agency
Costs, and Signalling. Agency costs - managers
self interested actions. Signalling - related to
managerial type. Debt and Equity can affect Firm
Value because - Debt increases managers share
of equity. -Debt has threat of bankruptcy if
manager shirks. - Debt can reduce free
cashflow. But- Debt - excessive risk taking.
33
AGENCY COST MODELS. Jensen
and Meckling (1976). - self-interested manager -
monetary rewards V private benefits. - issues
debt and equity. Issuing equity gt lower share of
firms profits for manager gt he takes more perks
gt firm value Issuing debt gt he owns more equity
gt he takes less perks gt firm value
34
Jensen and Meckling (1976)
V
Slope -1
V
A
V1
B
B1
If manager owns all of the equity, equilibrium
point A.
35
Jensen and Meckling (1976)
V
Slope -1
V
A
B
V1
Slope -1/2
B
B1
If manager owns all of the equity, equilibrium
point A. If manager owns half of the equity, he
will got to point B if he can.
36
Jensen and Meckling (1976)
V
Slope -1
V
A
B
V1
Slope -1/2
V2
C
B
B1
B2
If manager owns all of the equity, equilibrium
point A. If manager owns half of the equity, he
will got to point B if he can. Final equilibrium,
point C value V2, and private benefits B1.
37
Jensen and Meckling - Numerical Example.
Manager issues 100 Debt. Chooses Project B.
Manager issues some Debt and Equity. Chooses
Project A.
Optimal Solution Issue Debt?
38
Issuing debt increases the managers fractional
ownership gt Firm value rises. -But Debt and
risk-shifting.
39
OPTIMAL CAPITAL STRUCTURE. Trade-off Increasing
equity gt excess perks. Increasing debt gt
potential risk shifting. Optimal Capital
Structure gt max firm value.
V
V
D/E
D/E
40
Other Agency Cost Reasons for Optimal Capital
structure. Debt - bankruptcy threat - manager
increases effort level. (eg Hart, Dewatripont and
Tirole). Debt reduces free cashflow problem (eg
Jensen 1986).
41
Agency Cost Models continued. Effort Level,
Debt and bankruptcy (simple example). Debtholders
are hard- if not paid, firm becomes bankrupt,
manager loses job- manager does not like
this. Equity holders are soft.
What is Optimal Capital Structure (Value
Maximising)?
42
Firm needs to raise 200, using debt and equity.
Manager only cares about keeping his job. He has
a fixed income, not affected by firm value. a) If
debt lt 100, low effort. V 100. Manager keeps
job. b) If debt gt 100 low effort, V lt D gt
bankruptcy. Manager loses job. So, high effort
level gt V 500 gt D. No bankruptcy gt Manager
keeps job. High level of debt gt high firm
value. However trade-off may be costs of having
high debt levels.
43
Free Cashflow Problem (Jensen 1986). -Managers
have (negative NPV) pet projects. -Empire
Building. gt Firm Value reducing. Free Cashflow-
Cashflow in excess of that required to fund all
NPV projects. Jensen- benefit of debt in
reducing free cashflow.
44
Jensens evidence from the oil industry. After
1973, oil industry generated large free
cashflows. Management wasted money on unnecessary
R and D. also started diversification programs
outside the industry. Evidence- McConnell and
Muscerella (1986) increases in R and D caused
decreases in stock price. Retrenchment-
cancellation or delay of ongoing projects. Empire
building Management resists retrenchment. Takeover
s or threat gt increase in debt gt reduction in
free cashflow gt increased share price.
45
Jensen predicts young firms with lots of good
(positive NPV) investment opportunities should
have low debt, high free cashflow. Old stagnant
firms with only negative NPV projects should have
high debt levels, low free cashflow. Stultz
(1990)- optimal level of debt gt enough free
cashflow for good projects, but not too much free
cashflow for bad projects.
46
Income Rights and Control Rights. Some
researchers (Hart (1982) and (2001), Dewatripont
and Tirole (1985)) recognised that securities
allocate income rights and control
rights. Debtholders have a fixed first claim on
the firms income, and have liquidation
rights. Equityholders are residual claimants, and
have voting rights. Class discussion paper Hart
(2001)- What is the optimal allocation of control
and income rights between a single investor and a
manager? How effective are control rights when
there are different types of investors? Why do we
observe different types of outside investors-
what is the optimal contract?
47
 
48
Signalling Models of Capital Structure Assymetric
info Akerlofs (1970) Lemons Market. Akerlof
showed that, under assymetric info, only bad
things may be traded. His model- two car dealers
one good, one bad. Market does not know which is
which 50/50 probability. Good car (peach) is
worth 2000. Bad car (lemon) is worth
1000. Buyers only prepared to pay average price
1500. But Good seller not prepared to sell.
Only bad car remains. Price falls to
1000. Myers-Majuf (1984) securities may be
lemons too.
49
Asymmetric information and Signalling Models. -
managers have inside info, capital structure has
signalling properties. Ross (1977) -managers
compensation at the end of the period is
D debt level where bad firm goes
bankrupt. Result Good firm D gt D, Bad Firm D lt
D. Debt level D signals to investors whether the
firm is good or bad.
50
Myers-Majluf (1984). -managers know the true
future cashflow. They act in the interest of
initial shareholders.
Expected Value 190 305 New
investors 0 100 Old
Investors 190 205
51
Consider old shareholders wealth Good News Do
nothing 250. Good News Issue Equity Bad
News and do nothing 130.
Bad News and Issue equity
52
Old Shareholders payoffs Equilibrium
Issuing equity signals that the bad state will
occur. The market knows this - firm value
falls. Pecking Order Theory for Capital Structure
gt firms prefer to raise funds in this
order Retained Earnings/ Debt/ Equity.
53
Evidence on Capital structure and firm
value. Debt Issued - Value Increases. Equity
Issued- Value falls. However, difficult to
analyse, as these capital structure changes may
be accompanied by new investment. More promising
- Exchange offers or swaps. Class discussion
paper Masulis (1980)- Highly significant
Announcement effects 7.6 for leverage
increasing exchange offers. -5.4 for leverage
decreasing exchange offers.
54
  • Practical Methods employed by Companies.
  • Trade off models PV of debt and equity.
  • Pecking order.
  • Benchmarking.
  • Life Cycle.

Increasing Debt?
time
55
Practical Trade-off ModelOpler and Titman.
56
Market Timing and Capital Structure Baker and
Wurgler 2002
  • BW argue that firms current capital structure
    merely results from cumulative attempts to time
    equity market.
  • Issue equity when equity overvalued.
  • Repurchase equity when equity undervalued.
  • But, if market efficient, and investors rational?

57
Baker and Wurgler 2002 continued.
  • Is effect of market timing persistent?
  • Or do firms rebalance to an optimal debt level in
    the long-run?
  • BW regress leverage on past average MTB ratios
    negative relationship.
  • gt evidence of persistence of timing/ no
    rebalancing.
  • BW do not consider adjustment costs.

58
Do Firms Rebalance Capital Structure? Leary and
Roberts 2005.
  • LR consider adjustment costs.
  • Shocks to leverage.
  • Simulate time path of leverage according to
  • A) fixed costs
  • B) Proportional costs.
  • C) Fixed plus proportional costs.

59
Leary and Roberts 2005 continued.
  • Test sample data against simulations.
  • Evidence of slow rebalancing due to adjustment
    costs.
  • Implication firms not always operating at
    optimal leverage (even if they know what it is!)

60
Robinson Model.
61
Trade-off V pecking order Some evidence.
  • In practice, do firms use trade-off model or
    pecking order model?
  • Evidence is Mixed.

62
Capital Structure and Product Market Competition
  • A study that links Corporate Finance and
    Industrial Organisation literature.
  • Traditionally, the two seemingly unrelated areas
    were studied in isolation until the mid 1980s.
  • Firms use debt strategically in the face of PMC

63
THEORETICAL MODELS
  • Limited liability model (Brander and Lewis, 1986,
    Maksimovic, 1988, Showalter, 1995)
  • Deep purse model (Fudenberg, 1986, Brander and
    Lewis, 1988, Bolton and Scharfstein, 1990).

64
LIMITED LIABILITY MODEL
  • Brander and Lewis (1986)
  • One of the pioneering theoretical papers.
  • Based on Jensen and Meckling (1976) leverage
    induces shareholders to pursue risky strategies.

65
LIMITED LIABILITY MODEL
  • Brander and Lewis (1986)
  • Firms compete in Cournot (quantities)
    competition.
  • Firms which take on more debt, will have
    incentive to pursue strategies that increase
    returns in non-bankrupt states and lower returns
    in bankrupt states.
  • Higher debt gt higher quantities.
  • The limited liability effect of debt.

66
LIMITED LIABILITY MODEL
  • Showalter (1995)
  • Bertrand competition - limited liability effect
    of debt causes firm to increase its prices when
    demand is uncertain.
  • Cournot competition gt strategic substitutes.
  • Bertrand competition gt strategic complements.

67
LIMITED LIABILITY MODEL
  • Cournot gt the marginal profit of one firm
    decreases when output of the other firm
    increases. More leverage induces firm to increase
    output on its rivals expense.
  • Bertrand gt the marginal profit and equilibrium
    price of a firm rises, corresponding to its
    rivals increase in price

68
LIMITED LIABILITY MODEL
  • Summary
  • Cournot gt leverage toughens competition.
  • Bertrand gtleverage softens competition.

69
DEEP PURSE MODEL
  • Bolton and Scharfstein (1990)
  • Firms with greater access to capital
    (less-leveraged) can sustain any losses until
    they succeed in eliminating their
    higher-leveraged rivals.

70
Limited Liability and Deep Purse model
  • The difference between them is that in deep purse
    model, it is the less leveraged firm which has an
    incentive to increase output or decrease price in
    order to increase a cutthroat competition.

71
EMPIRICAL EVIDENCE
  • Empirical papers such as Chevalier (1995),
    Phillips (1995), Kovenock and Phillips (1997)
    support the argument that debt softens
    competition.

72
MARKET POWER and DEBT
  • The relationship can be explained by the limited
    liability and the deep purse model.
  • Limited liability models gt positive
    relationship.
  • Deep purse models gt negative relationship.

73
MARKET POWER and DEBT
  • Empirical Tests
  • Mixed results.
  • Positive relationship Rathinasamy et al, 2000,
    Phillips, 1995).
  • Negative relationship Chevalier, 1995, Phillips,
    1995).
  • Non-monotonic Pandey, 2002, Fairchild, 2004.

74
  • II PAYOUT DECISION
  • Dividends.
  • Share Repurchases.

75
Dividend Policy
  • Miller-Modigliani Irrelevance.
  • Gordon Growth (trade-off).
  • Signalling Models.
  • Agency Models.
  • Gordon Growth (trade-off).
  • Lintner Smoothing.
  • Dividends versus share repurchases.

76
Early Approach.
  • Three Schools of Thought-
  • Dividends are irrelevant.
  • Dividends gt increase in stock prices.
  • Dividends gt decrease in Stock Prices.

77
A. Dividend
Irrelevance. Assume All equity firm. Value of
Firm Value of Equity discounted value of
future cashflows available to equity holders
discounted value of dividends (if all available
cashflow is paid out).
If everything not reinvested is paid out as
dividends, then
78
Miller Modiglianis Dividend Irrelevance.
MM used a source and application of funds
argument to show that Dividend Policy is
irrelevant
Source of Funds Application of Funds
79
-Dividends do not appear in the equation. -If the
firm pays out too much dividend, it issues new
equity to be able to reinvest. If it pays out too
little dividend, it can use the balance to
repurchase shares. -Hence, dividend policy
irrelevant. -Key is the availability of finance
in the capital market.
80
Example of Dividend Irrelevance using Source and
Application of Funds. Firm invests in project
giving it NCF 100 every year, and it needs to
re-invest, I 50 every year. Cashflow available
to shareholders NCF I 50. Now, NCF I
Div NS 50. If firm pays dividend of 50, NS
0 (ie it pays out exactly the cashflow available
no new shares bought or sold). If firm pays
dividend of 80, NS -30 (ie it sells new shares
of 30 to cover dividend). If firm pays dividend
of 20, NS 30 (ie it uses cashflow not paid out
as dividend to buy new shares). In each case, Div
NS 50.
81
Miller-Modigliani Home-made Dividends.
82
B. Gordon Growth Model. Where does growth come
from?- retaining cashflow to re-invest.
Constant fraction, K, of earnings retained for
reinvestment. Rest paid out as dividend. Average
rate of return on equity r. Growth rate in
cashflows (and dividends) is g Kr.

83
Example of Gordon Growth Model.
How do we use this past data for valuation?
84
Gordon Growth Model
(Infinite Constant Growth Model). Let

18000
85
  • Finite Supernormal Growth.
  • Rate of return on Investment gt market required
    return for T years.
  • After that, Rate of Return on Investment Market
    required return.

If T 0, V Value of assets in place
(re-investment at zero NPV). Same if r
86
Examples of Finite Supernormal Growth.
T 10 years. K 0.1.
  • Rate of return, r 12 for 10 years,then 10
    thereafter.

B. Rate of return, r 5 for 10 years,then 10
thereafter.
87
Are Dividends Irrelevant? - Evidence higher
dividends gt higher value. - Dividend irrelevance
freely available capital for reinvestment. -
If too much dividend, firm issued new shares. -
If capital not freely available, dividend policy
may matter. C. Dividend Signalling - Miller and
Rock (1985). NCF NS I DIV Source
Uses. DIV - NS NCF - I. Right hand side
retained earnings. Left hand side - higher
dividends can be covered by new shares.
88
Div - NS - E (Div - NS) NCF - I - E (NCF - I)
NCF - E
( NCF). Unexpected dividend increase - favourable
signal of NCF.
E(Div - NS) E(NCF - I) 300. Date 1
Realisation Firm B Div - NS - E (Div - NS)
500 NCF - E ( NCF). Firm A Div - NS - E (Div
- NS) -500 NCF - E ( NCF).
89
Dividend Signalling Models.
  • Bhattacharya (1979)
  • John and Williams (1985)
  • Miller and Rock (1985)
  • Ofer and Thakor (1987)
  • Fuller and Thakor (2002).
  • Fairchild (2002).
  • Divs credible costly signals Taxes or borrowing
    costs.

90
Dividends as signals of expected cashflows
Bhattacharya 1979.
  • Asymmetric Info about cashflows.
  • Investors invest over short horizons.
  • Dividends taxed at higher rate than capital
    gains.
  • gt signalling equilibria.
  • Shorter horizon gt higher dividends.

91
Bhattacharya 79 (continued)
  • Existing Shareholders informed.
  • Outside investors not informed.
  • All-equity.
  • Universal Risk-neutrality.
  • Existing shareholders maximise liquidation value
    of firm.

92
Bhattacharya 79 Continued.
  • New project Uncertain cash flow
  • Firm announces a committed dividend
  • If dividend is paid.
  • Current shareholders receive after tax.
  • Outside financing required for reinvestment
    reduced by

93
Bhattacharya 79 Continued.
  • If still paid.
  • Shortfall made up by external finance or
    curtailing new investments.
  • Cost to current shareholders

94
Bhattacharya 79 Continued.
  • Uniformly distributed between 0 and t, with
    mean
  • Choose to maximise
  • FOC

95
Bhattacharya 79 Continued.
  • Equilibrium
  • Where
  • D is increasing in the tax rate.
  • D is a decreasing function of r.
  • D is increasing in t.
  • Also, see Bhattacharya 1980, and Talmor 1981.

96
Hakansson 1982.
  • Dividend signalling in a pure exchange economy.
  • Bayesian updating.
  • Conditions when dividends are good, bad or when
    investors are indifferent.

97
Signalling, FCF, and Dividends.Fuller and Thakor
(2002)
  • Empirical Contest between Signalling and FCF
    hypotheses.
  • Divs costly signals signalling plus FCF.
  • If dividend too low FCF problem (cf Jensen
    1986).
  • If dividend too high costly borrowing.

98
Fuller and Thakor (continued).
  • 2 types of firm good and bad.
  • Good firms future
  • Bad firms future

99
Fuller and Thakor (continued)
  • At date 1, outsiders observe signal
  • If firm G,
  • If firm B,
  • Thus, if or mkt knows
    firm type. Divs used to eliminate FCF.
  • If mkt cannot identify type.
    Thus, divs used to signal type and eliminate FCF.

100
Fuller and Thakor (continued)
  • Firms dividend announcement trades-off costly
    borrowing versus FCF problem.
  • Bayesian updating.

101
Dividend Signalling Current Income/future
InvestmentFairchild (2002).
  • Conflicts
  • High/low dividends signal high/low income
  • But high/low dividends affect ability to
    re-invest (cf Gordon Growth)
  • If ve NPV FCF High divs good.
  • But if ve NPV high div bad gt signal jamming
    ambiguous.

102
Fairchild (2002) continued.
  • 2 all-equity firms manager
  • Date 0 Project investment.
  • Date 1 Net income, with
  • Revealed to the manager, but not to investors.
  • Mkt becomes aware of a new project P2, with
    return on equity
  • Manager commits to a dividend

103
Fairchild (2002) continued
  • Date 1.5 Mgr pays announced dividend
  • P2 requires investment
  • Mgr cannot take new project.
  • Date 2, If P2 taken, achieves net income. Mgr has
    private benefits

104
Fairchild (2002) continued
  • Mgr maximises
  • Bayesian Updating.
  • Adverse selection
  • Mgr can either signal current income (but
    no re-investment),
  • or re-invest (without signaling current income).

105
Fairchild (2002) continued
  • Signalling (of current income) Equilibria
  • A) Efficient re-investment Pooling
  • B) Inefficient Non re-investment, or
  • C) Efficient Non re-investment separating

106
Fairchild 2002 (continued)
  • Case 2 Moral Hazard
  • Mgr can provide credible signal of type
  • Effective communication (Wooldridge and Ghosh)
  • Now, use divs only due to FCF.
  • Efficient re-investment.
  • Inefficient re-investment.
  • Efficient non re-investment.

107
Fairchild 2002 Summary
  • Case 1 Adverse selection inefficiency when mgr
    refuses to cut dividend to take ve NPV project.
  • Case 2 Moral hazard mgr reduces dividend to
    take ve NPV project.
  • Integrated approach Effective mgrl
    communication/ increase mgrs equity stake.

108
Fairchild 2002 (continued)
109
Agency Models.
  • Jensens Free Cash Flow (1986).
  • Stultzs Free Cash Flow Model (1990).
  • Easterbrook.
  • Fairchild (2002) Signalling moral hazard.

110
D. Lintner Model. Managers do not like big
changes in dividend (signalling). They smooth
them - slow adjustment towards target payout
rate.
K is the adjustment rate. T is the target payout
rate.
111
Using Dividend Data to analyse Lintner Model. In
Excel, run the following regression
The parameters give us the following
information, a 0, K 1 b, T c/ (1 b).
112
Dividend Smoothing V optimal re-investment
(Fairchild 2003)
  • Method-
  • GG Model derive optimal retention/payout ratio
  • gt deterministic time path for dividends, Net
    income, firm values.
  • Compare with stochastic time path to determine
    smoothing policy.

113
Deterministic Dividend Policy.
  • Recall
  • Solving
  • We obtain optimal retention ratio

114
Analysis of
  • If
  • If with
  • Constant r over time gt Constant K over
    time.

115
Deterministic Case (Continued).
  • Recursive solution

When r is constant over time, K is constant. Net
Income, Dividends, and firm value evolve
deterministically.
116
Stochastic dividend policy.
  • Future returns on equity normally and
    independently distributed, mean r.
  • Each period, K is as given previously.
  • Dividends volatile.
  • But signalling concerns smooth dividends.
  • gt buffer from retained earnings.

117
Dividends V Share Repurchases.
  • Both are payout methods.
  • If both provide similar signals, mkt reaction
    should be same.
  • gt mgrs should be indifferent between dividends
    and repurchases.

118
Evidence.
  • Mgrs think divs reveal more info than
    repurchases.
  • Mgrs smooth dividends/repurchases are volatile.
  • Dividends paid out of permanent
    cashflow/repurchases out of temporary cashflow.

119
Motives for repurchases (Wansley et al, FM
1989).
  • Dividend substitution hypothesis.
  • Tax motives.
  • Capital structure motives.
  • Free cash flow hypothesis.
  • Signalling/price support.
  • Timing.
  • Catering.

120
Repurchase signalling.
  • Price Support hypothesis Repurchases signal
    undervaluation (as in dividends).
  • But do repurchases provide the same signals as
    dividends?

121
Repurchase signalling (Chowdhury and Nanda
Model RFS 1994)
  • Free-cash flow gt distribution as commitment.
  • Dividends have tax disadvantage.
  • Repurchases lead to large price increase.
  • So, firms use repurchases only when sufficient
    undervaluation.

122
Open market Stock Repurchase SignallingMcNally,
1999
  • Signalling Model of OM repurchases.
  • Effect on insiders utility.
  • If do not repurchase, RA insiders exposed to more
    risk.
  • gt Repurchase signals
  • a) Higher earnings and higher risk,
  • b) Higher equity stake gt higher earnings.

123
Signalling with Dividends, Repurchases and
equity.Asquith and Mullins FM 1986
124
Repurchase as an option.Ikenberry and Vermaelen
FM 1996
125
Repurchase Signalling Isagawa FR 2000
  • Asymmetric information over mgrs private
    benefits.
  • Repurchase announcement reveals this info when
    project is ve NPV.
  • Repurchase announcement is a credible signal,
    even though not a commitment.

126
Costless Versus Costly SignallingBhattacharya
and Dittmar 2003
  • Repurchase announcement is not commitment.
  • Costly signal Actual repurchase separation of
    good and bad firm.
  • Costless (cheap-talk) Announcement without
    repurchasing. Draws analysts attention.
  • Only good firm will want this s

127
Repurchase timing
  • Evidence repurchase timing (buying shares
    cheaply.
  • But market must be inefficient, or investors
    irrational.
  • Isagawa.
  • Fairchild and Zhang.

128
Repurchases and irrational investors.Isagawa 2002
  • Timing (wealth-transfer) model.
  • Unable to time market in efficient market with
    rational investors.
  • Assumes irrational investors gt market does not
    fully react.
  • Incentive to time market.
  • Predicts long-run abnormal returns
    post-announcement.

129
Repurchase Timing evidence.
130
Repurchase timing Fairchild and Zhang 2004
131
Repurchase Catering.
  • Baker and Wurgler dividend catering
  • Fairchild and Zhang dividend/repurchase
    catering, or re-investment in positive NPV
    project.

132
  • III NEW RESEARCH
  • Venture Capitalist/Entrepreneur Contracting and
    Performance.
  • Introduction to Behavioral Finance see research
    frontiers course.

133
C. Venture Capital Financing
  • Active Value-adding Investors.
  • Double-sided Moral Hazard problem.
  • Asymmetric Information.
  • Negotiations over Cashflows and Control Rights.
  • Staged Financing
  • Remarkable variation in contracts.

134
Features of VC financing.
  • Bargain with mgrs over financial contract (cash
    flow rights and control rights)
  • VCs active investors provide value-added
    services.
  • Reputation (VCs are repeat players).
  • Double-sided moral hazard.
  • Double-sided adverse selection.

135
Financial Contracts.
  • Debt and equity.
  • Extensive use of Convertibles.
  • Staged Financing.
  • Cotrol rights (eg board control/voting rights).
  • Exit strategies well-defined.

136
Fairchild (2004)
  • Analyses effects of bargaining power, reputation,
    exit strategies and value-adding on financial
    contract and performance.
  • 1 mgr and 2 types of VC.
  • Success Probability depends on effort

gt VCs value-adding.
where
137
Fairchilds (2004) Timeline
  • Date 0 Bidding Game VCs bid to supply finance.
  • Date 1 Bargaining game VC/E bargain over
    financial contract (equity stakes).
  • Date 2 Investment/effort level stage.
  • Date 3 Renegotiation stage hold-up problems
  • Date 4 Payoffs occur.

138
Bargaining stage
  • Ex ante Project Value
  • Payoffs

139
Optimal effort levels for given equity stake

140
Optimal equity proposals.
  • Found by substituting optimal efforts into
    payoffs and maximising.
  • Depends on relative bargaining power, VCs
    value-adding ability, and reputation effect.
  • Eg E may take all of the equity.
  • VC may take half of the equity.

141
Payoffs
E
VC
Equity Stake
0.5
142
Ex post hold-up threat
  • VC power increases with time.
  • Exit threat (moral hazard).
  • Weakens entrepreneur incentives.
  • Contractual commtiment not to exit ealry.
  • gt put options.

143
Other Papers
  • Casamatta Joint effort VC supplies investment
    and value-adding effort.
  • Repullo and Suarez Joint efforts staged
    financing.
  • Bascha Joint efforts use fo convertibles
    increased managerial incentives.

144
Introduction to Behavioural Finance.
145
Incomplete Contracting Approach
  • See Tirole (2006) Book
  • Chapters 3, 4 and 6.
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