Overview bm02fi

Rotterdam School of Management

Corporate Finance (BM02FI)

Overview of first 4 lectures
by dr. Arjen Mulder
In this course we have started off with Modigliani and Miller (1958), who claimed that in the
absence of taxes, costs of financial distress, agency costs, information asymmetry, etc., the capital
structure of a firm is irrelevant (and its dividend policy, etc.). We know from the undergraduate
phase that if we introduce taxes and the costs of financial distress, that it should be possible to
find some minimum cost of capital rwacc for which a firm may maximise its value. Yet, in spite
of the appealing simplicity and internal consistency, it proves to be very, very difficult to find
empirical evidence for the classical (static) tradeoff theory of capital structure. To emphasize
this difficulty, we have discussed Fama & French (1998), who basically find no relationship
between capital structure and firm value (or at best a weakly negative relationship). Since
particularly the costs of financial distress seem to be case-specific, it is not possible to come up
with fine regression analysis results. Hence, I therefore have included some particular papers
that should give you a better feeling for the tax benefits of debt (Graham, 2000; Korteweg,
2010; Van Binsbergen et al., 2010) and for the costs of financial distress (Andrade & Kaplan,
1998; James & Kizilaslan, 2014). Graham (2000) takes a very smart approach in estimating
the benefits of the tax shield on debt. Instead of looking for the net effects (incl. the costs of
distress, that were case-specific), Graham analyses the gross tax benefits associated with debt
financing. In fact, Graham determines some kind of maximum value of the tax shield on debt.
If we then have a look at Andrade & Kaplan (1998) who analyse the distress costs for highly
leveraged transactions, then it appears that the costs of financial distress are not so high. What
matters more, is the cost of economic distress. The explanation is quite intuitive. If you have
a firm that operates in a profitable market, but due to your poor financial structure you go
bankrupt, then it is not difficult for your creditors to sell your assets in the marketplace. But
if your market/industry is in distress, then the scrap value of your assets may be nil, which
may result in a very expensive liquidation. The James & Kizilaslan (2014) in fact stretches
this analysis, by introducing asset specificity into the topic of distress. The main idea is that
highly specific assets (as airplanes) can probably only be redeployed by industry peers (read:
competitors). Yet, this has the nasty consequence that if such a company with highly specific
assets defaults (and the cause was economic distress and not mismanagement), its peers are
probably also suffering from poor demand for the industrys products or services. Hence, these
peer firms are unlikely to be in the position to pay a decent price for the assets of the defaulting
firm in case of a fire sale auction (read: they will at best take over these assets at a bargain).
Industry outsiders would also only be willing to take over these assets for cheap (because they
first need to invest in learning how to manage these specific assets). The James & Kizilaslan
paper reasons that financiers will likely anticipate the subsequent drop in value (as reflected in
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Overview bm02fi

Rotterdam School of Management

a likely high loss given default or LGD, or a low recovery rate). Since the expected recovery
rate on loans that finance these highly specific assets is so poor, financiers will likely charge a
high interest coupon rate on the loan, or only fund a fraction of the asset with a loan, or demand
additional collateral. Whatever these creditors/financiers will do, the net effect is that capital
costs go up. The reason for including this particular paper is that I want you to understand
that there can be many idiosyncratic reasons that distort the oversimplified capital structure
optimisation picture that you were typically exposed to in the undergrad Corporate Finance
courses. Asset specificity is but one of them, and I hope that papers like these help you to put
other findings in a broader perspective.
The Korteweg (2010) paper does analyse the net benefits to financial leverage, thus Korteweg
does make a brave attempt to balance the pros associated with financial leverage (as tax benefits,
etc.) against the cons (as costs of financial distress, agency costs, etc.). The Korteweg paper
can be put under the header of the dynamic tradeoff theory (see the Frank & Goyal, 2008
paper), which combines the old static tradeoff theory and the behavioural pecking order theory.
A first reason to include this paper is the fact that you should take away some interesting
conclusions from this paper (as underlevering being less expensive than overlevering; separation
of the costs of suboptimal leverage into (1) transaction cost of moving towards the optimum,
and (2) opportunity cost of foregoing the benefits of optimal leverage; etc.). A second reason for
inclusion is that its elegance sharply contrasts with the earlier papers (e.g., Modigliani & Miller;
Fama & French) and you may develop a feeling how the field of corporate finance has advanced
over the past decades. We also did the Van Binsbergen et al. (2010) paper, which arrives at
similar conclusions as the Korteweg paper, but using a totally different theoretical framework.
In the Warr et al. (2012) paper, we saw confirmed that the adjustment towards the optimal
capital structure depends on whether a firms stocks are overpriced or underpriced. In theory
there is an incentive for overlevered firms to issue stocks (or amortise debt) but if the stocks
are currently undervalued in the market it means that management gives away ownership rights
for peanuts (and the incumbent stockholders are probably insufficiently compensated for their
dilution of interests). Hence, the Warr et al. paper shows the (fairly intuitive) linkage between
adjustment speed and the over-/undervaluation of a firms stocks.
One of the claims of John Graham (2000) was that firms leave money on the table by underleveraging. Though Korteweg (2010) already gave some hints why firms could be suboptimally
leveraged, we also analysed some agency problems between insiders and outsiders on the one
hand, and between equityholders and debtholders or between incumbent stockholders and new
stockholders on the other (cf. Myers & Majluf, 1984), and we finally introduced another market
imperfection (in terms of Modigliani & Miller), and that was asymmetric information. Each
of these problems/imperfections impact the actual corporate leverage choice.
It appeared that under asymmetric information buyers (of shares, but also of commodities)
have a hard time to distinguish between high quality offers and low quality ones. To give you

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Overview bm02fi

Rotterdam School of Management

some feeling for this phenomenon, I briefly discussed the lemons problem, and showed you
part of the Nobel prize lecture by George Akerlof. In his classical 1970 paper (that we did not
discuss, but it was part of the video), Akerlof introduces two nasty problems. First, there is
the lemons problem, where the lemon refers to a car of a poor quality. The lemons problem
shows that if a buyer cannot distinguish between high and low quality of the supplies, then she
will apply a discount to her maximum willingness to pay (WTP). Due to that discount, it may
no longer be interesting for the high quality offers to sell, which implies that if the top quality
offers disappear, the average quality of all offers in the market is lowered. This lowered quality
implies that buyers apply an even bigger discount to their maximum WTP, etc. This negative
spiral is called the adverse selection problem, and it is based on the assumption that the quality
of the supplies cannot be influenced by the sellers. There exists another problem, namely moral
hazard, for example if insured behave more recklessly, or if the buyer of the car abuses it and
then returns it (would there be a return policy).
Given a first intuition about the concept of signals, we entered into a whole new world of
research, where we learned that every action of a firm (management) may be interpreted by
the market as a signal. For example, in Myers & Majluf (1984) issuing equity was a signal of
overvalued equity, whereas financial slack had a positive signal value. Frank & Goyal (2008)
tried to put all these theories together by first discussing a static and dynamic version of the
tradeoff theory of debt, and then the pecking order theory (incl. the adverse selection problem).
In this survey paper it appeared that different types of firms use different forms of financing.
This notion opens the floor for a deeper discussion of the firm specific characteristics that may
be of interest. We discussed the Chemmanur et al. (2009) paper, that investigated to what
extent (superior) management is able to overcome the informational gap (and issue securities at
a higher price). This is an interesting avenue, because if management indeed is able to overcome
the informational gap, then these firms no longer need to commit to dissipative signals as
dividend payments (e.g., the zero leverage firms of Korteweg); high leverage for the sake of
signalling only (Ross paper); or holding large amounts of slack (Myers & Majluf).
Lastly, we discussed the Leary and Roberts (2014) paper. So far, the assumption was that
at any point in time every firm has its own optimal capital structure, and management of these
firms would thus strive for obtaining that particular optimal capital structure. We implicitly
assumed that managers would make these capital structure decisions in isolation, yet that Leary
and Roberts challenge that assumption. That is, some (smaller, less successful) firms seem to
be inclined to imitate the capital structure decisions of their larger and more successful peers.
Altogether, you should now have a thorough understanding of the concept of capital structure. In order NOT to loose yourself in the details, you may re-read the papers, and ask yourself
the following questions and take this as a summary. Beware that at the exam, I will NOT ask
you for details w.r.t. the papers I have asked you to read. Instead, I want you to understand how
the authors of each paper came to their main conclusions. To help you out at the exam, I would

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Overview bm02fi

Rotterdam School of Management

typically give away one of these conclusions, and then ask you to reflect on it. Alternatively,
I could give away some other crucial element of a paper (major assumption or very important
equation), and again ask you to reflect on it. I strongly advise you to have a look at the past
exam I have uploaded at BlackBoard (in the left-hand side menu On the exam) to familarise
yourself with the format of the exam.
Below I have listed a number of questions that should serve as a reading guide for the papers.
Obviously, you cannot derive any rights from the current document, and obviously, the exam
questions need not have a 100% overlap with the below suggestions. The idea is that the reading
guide should help you to raise critical questions when reading the papers and the below specific
questions are mere examples.

Lecture 1:
1. Modigliani & Miller (1958): Summarise and explain the four propositions by Modigliani &
Miller, of which three come from their 1958 paper, and one was mentioned in class. You
must be able to explain the propositions, and in addition, I want you to be able to reflect
on them. For example, I may give you an example from another paper we have discussed,
and ask you to relate it why the other authors find a value creating/destroying effect of
capital structure whilst according to Modigliani & Miller there should not be any effect.
2. Fama & French (1998): Fama and French find no relationship that debt adds value to the
firm, even though the tax shield on debt theories predict it should. Frustrated by the
disappointing regression results, Fama & French have tried to improve the analysis by
controlling for various firm-specific factors. Yet, they acknowledge the potentially poor
quality of their control variables as a potential explanation for the poor regression results,
because they would contain some sort of information. Why are their control variables
considered to be poor, and explain the information content (distortion) of these control
variables.
3. Graham (2000): What is the size of the gross tax shield on debt (Graham, 2000), and why
does Graham not include the costs of distress in his analysis? How much money do firms
leave on the table ? You must be able to explain the methodology/approach Graham has
taken.
4. Korteweg (2010): Be able to understand and explain (not derive mathematically) equations
(1) through (8). Understand how Figure 1 has been constructed. Understand (and be able
to explain) the regression results of the paper. You must able to understand and explain
the findings of Arthur Korteweg to the four research questions he addresses in this paper.

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Overview bm02fi

Rotterdam School of Management

Lecture 2:
5. Andrade & Kaplan (1998): What is the potential size of the costs of financial distress, and
its distinction from the costs of economic distress. Explain why the two types of distress
should be disentangled.
6. Van Binsbergen et al. (2010): Be able to understand and explain (not derive mathematically) equations (1) through (5). Understand how Figures 1 and 2 have been constructed.
Understand (and be able to explain) the five steps procedure the authors have taken to
estimate the expected marginal tax rate for firms (section II). Understand (and be able to
explain) the regression results of the paper. You must able to understand and explain the
findings this paper.
7. James & Kizilaslan (2014): Be able to explain how asset specificity impacts loan pricing
(incl. the intermediate steps of the reasoning) and the use of restrictive covenants for loans
that finance these specific assets. Also you should be able to explain how in turn this may
impact the optimal capital structure for a firm that holds these specific assets.
Lecture 3:
8. Myers & Majluf (1984): Explain why financial slack has a value. Assuming shareholders
are passive, what agency conflict is eliminated by slack? Assuming shareholders are passive, how can the value of slack disappear? Why would active shareholders be indifferent
about the financing structure of a firm?
9. Frank & Goyal (2008): Frank and Goyal notice how financing patterns differ across various
types of firms, in particular the differences between private firms, small public firms, and
large public firms. This is an extremely lengthy paper, and I only want you to be able
to remember some main findings. You must be able to summarise how the three types of
firms (private, small public, large public) finance their investments, and explain in your
own words why these finance patterns occur the way the are.
10. Warr et al. (2012): Explain which types of firms can expect to see a high (low) adjustment
speed towards their optimal capital structure. Explain the patterns for both debt and
equity issues.
Lecture 4:
11. Ross (1977): You should be able to explain why under information asymmetry, the willingness to pay of investors for any share lies in between the value of the shares of firms of
type A and B in the full information setting. You should be able to explain and reproduce
Figure 1.

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Rotterdam School of Management

12. Chemmanur et al. (2009): Explain how management quality is measured, and how it can
impact both the financial policy of a firm, as well as its investment policy. Explain why/to
what extent superior management quality may substitute for (other) signals as dividend
payments, cash holdings, etc.
13. Leary and Roberts (2014): Explain why, and which types of firms (managers) are likely to
imitate the financial policies of peer firms, and the impact of this copying on the optimality
of capital structures.

Note that the above questions need NOT be asked for at the exam, but if you can answer the
above questions you should do fine for my part of the exam. When you are at the exam, you will
see that for every question there is a MAXIMUM answer length. Though we take that cap very
serious (and penalise overlength answers) you should NOT treat that maximum as a desired
total outcomeIn many cases, if you truly understand the paper you may answer a question
in less than 10 lines. It is not the length of the exposure that counts, but the content of your
answer. Be brief, yet precise and complete.
I wish you best of luck in preparing for the exam, and I hope your interest in the theme of
corporate finance has grown even more as compared to when your just enrolled to this class.
Arjen Mulder.

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