Professional Documents
Culture Documents
Katharina Lewellen
Finance Theory II
March 5, 2003
Target Capital Structure Approach
3. Trading off the two gives you the “static optimum” capital
structure. (“Static” because this view suggests that a
company should keep its debt relatively stable over time.)
2
Target Capital Structure Approach, cont.
VU VL according to MM
Optimal capital
structure
Leverage
3
Implications of the “target leverage”
approach
Firms should:
¾ Issue equity when leverage rises above the target level
¾ Buy back stock (or pay dividends) when leverage falls below
the target capital structure
4
What really happens?
Stock prices drop (on average) at the announcements of
equity issues
Companies are reluctant to issue equity
They follow a “pecking order” in which they finance
investment:
¾ first with internally generated funds
¾ then with debt
¾ and finally with equity
5
Stock price reaction to equity issue announcements
0.5
0
Cumulative Excess Return (%)
-0.5
-1
-1.5
-2
-2.5
-3
-3.5
-10 -8 -6 -4 -2 0 2 4 6 8 10
Day after announcement
Average cumulative excess returns from 10 days before to 10 days after announcement for
531 common stock offerings (Asquith and Mullins (1986))
6
Sources of Funds: US Corporations 1979-97
100
80
% of total financing
60
40
20
0
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
-20
-40
7
Sources of Funds: International 1990-94
Internal
Internal Debt
Debt Equity
Equity
90 120
80 100
70 80
% of total financing
60 60
50
40
40
20
30
0
20 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
-20
10
0 -40
US Japan UK Canada France
8
Seasoned Equity Offerings (SEOs) 1970-96
100
80
Number of SEOs
60
40
20
0
7001 7301 7601 7901 8201 8501 8801 9101 9401 9701
Date (YearMonth)
9
Initial Public Offerings (IPOs) 1960-99
140
120
100
Number of IPOs
80
60
40
20
0
6001 6307 6701 7007 7401 7707 8101 8407 8801 9107 9501 9807
Date (YearMonth)
10
Incorporating These Concerns
11
Managers with more information than investors
- The Lemons Problem
12
Equity financing: Example
Let’s set aside taxes and financial distress
13
Case 1: Managers know as much as outside investors
Suppose that XYZ does not have the cash but can issue
$12M in equity
¾ Once the project funded, the firm is worth 100 + 20 = $120M
¾ Raise $12M by selling 10% of shares (after issue)
¾ Existing shareholders get 90% * 120 = $108M
¾ To be compared with $100M if did not invest
¾ Existing shareholders gain $8M
Internal financing
¾ As before, existing shareholders gain $8M
Equity financing
¾ Raise $12M by selling 10% of shares (after issue), valued by the
market at 120 (i.e., 100 + 20).
¾ Existing shareholders get 90% * (150 + 20) = $153M.
¾ Existing shareholders gain only $3M
15
Case 2 (cont.): How about debt financing?
16
Why Is Safe Debt Better Than Equity?
17
Lemon’s problem: Implications
If your assets are worth $150M, you will not want to issue
equity, but will finance internally or with debt
18
Example (cont.): Market Reaction
19
Evidence on equity issue announcements
0.5
0
Cumulative Excess Return (%)
-0.5
-1
-1.5
-2
-2.5
-3
-3.5
-10 -8 -6 -4 -2 0 2 4 6 8 10
Day after announcement
Average cumulative excess returns from 10 days before to 10 days after announcement for
531 common stock offerings (Asquith and Mullins (1986))
20
Evidence on announcement effects
21
Example (cont.): Underinvestment
22
Key Point: Investment Depends on Financing
23
Pecking Order and Capital Structure
24
Key Point
25
AIRLINES
0.60
0.50
0.40
%
0.30
0.20
0.10
0.00
1980 1985 1990 1995
Industry Leverage
26
AIRLINES
0.60
0.50
0.40
0.30
%
0.20
0.10
0.00
1980 1985 1990 1995
27
Target Capital Structure Approach, cont.
VU VL according to MM
Optimal capital
structure
Leverage
28
Key Point: Timing of Equity Issues
29
Initial Public Offerings (IPOs) 1960-99
140
120
100
80
60
40
20
0
6001 6307 6701 7007 7401 7707 8101 8407 8801 9107 9501 9807
Date (YearMonth)
30
Evidence on timing of equity issues
31
Managerial Behavior and Capital Structure
32
Agency Problems
Principals = Agents =
Shareholders Managers
Potential problems:
¾ Shirking
¾ Empire Building
¾ Perks (private jets)
¾ Risk avoidance
33
Avoiding Agency Costs
Compensation policy
34
A Classic Agency Problem: The Free Cash
Flow Problem
35
Example of FCF Problems
Evidence from the Oil Industry (Jensen, 1986)
36
Example of FCF Problems (cont.)
What did managers do?
37
Can leverage reduce FCF problem?
38
Leveraged Buyouts (LBOs)
39
Capital Structure: An Extended Checklist
Taxes
¾ Does the company benefit from debt tax shield?
Information Problems
¾ Do outside investors understand the funding needs of the firm?
¾ Would an equity issue be perceived as bad news by the market?
Agency Problems
¾ Does the firm have a free cash flow problem?
40