Chapter 7 Capital Structure

Learning Objectives
1. Describe the evidence that the primary factors that drive managers’ decisions about
capital structure are dilution, market timing, and financial flexibility, while
traditional considerations such as taxes, costs of financial distress, and information
asymmetries are secondary factors.
2. Compute behavioral adjusted present value (BPV) to analyze how corporate
managers balance the interests of long-term shareholders and short-term shareholders
when making decisions about financing, investment, catering, and market timing.
3. Explain why concerns about dilution and market timing lead to interdependencies
between financing and investment policy with the latter being sensitive to cash flows.
 This causes excessively optimistic, overconfident managers of cash rich firms to
adopt some negative net present value projects, and excessively optimistic,
overconfident managers of cash poor firms to reject some positive net present value
projects.
4. Identify excessive optimism and overconfidence in the psychological profile of
executives, and the associated impact of these phenomena on their decisions about
financing and investment.
5. Explain why in some circumstances, framing effects can inhibit some firms from
fully exploiting their debt capacity.
Traditional Treatment
 Managers are perfectly rational APV-maximizers, and markets are efficient.
 The traditional approach to capital structure developed to reflect the following five
elements:
 tax shields;
 expected costs of financial distress;
 signaling stemming from asymmetric information;
 management discipline; and
 financial flexibility.
 Pecking-order theory reflects signaling, and suggests that a firm does not have an
optimal debt-to-equity ratio.
Capital Structure in Practice
 In practice, decisions about capital structure reflect a mix of traditional and behavioral
considerations.
 Although many managers do at times target their firms’ debt-to-equity ratios
(consistent with trade-off theories), and do engage in behaviors that reflect pecking
order thinking, these are not the primary considerations.
 The primary considerations driving decisions about capital structure are dilution,
market timing, and financial flexibility.
 Survey by Duke/FEI
 In issuing new equity, the top factors are market timing and dilution of EPS
 In issuing new debt, the top factor is financial flexibility
New Equity: Market Timing
 Duke/FEI survey.
 Has your firm seriously considered issuing common stock?
 If ‘yes’, what factors affect your firm’s decision about issuing common stock?
 Second most important consideration is “the amount by which our stock is
undervalued or overvalued in the market.”
 63% of CFOs attach a high rating to the following factor: “If our stock price
has recently risen, the price at which we can sell is high.”
 According to the survey, managers tend to issue new equity when they believe their
current share price is overvalued.
 Issuing new share will lower debt/equity ratio.
 This behavior is consistent with gambler’s fallacy. Managers, thinking that the price is
high, will employ insider selling during high price, which later tend to drop (recall
long-term performance of IPO).
 However, when managers believe that the share price is low or undervalued, they tend
to repurchase their shares.
 Again, this will affect the target debt/equity ratio.
 Normally, investors underreact to repurchase.
 Evidence also shows that cost of equity drops when firm engages in repurchase.
New Equity: Earnings Dilution
 The highest rated consideration in respect to equity issuance was “earnings dilution.”
 In traditional theory, expected EPS is directly related to the debt-to-equity ratio.
 Therefore, an equity issue would lower the debt-to-equity ratio, thereby driving down
expected EPS.
 Executives appear to interpret lower EPS as dilution.
New Debt: Financial Flexibility
 The FEI survey tells us that the top factor is financial flexibility.
 Having enough internal funds available to pursue new projects when they come along.
 This item had a mean survey rating of 2.59: 60% rated it as either a 3 or 4.
Convertible Debt
 One way of issuing debt is selling convertible debt.
 More than 55% of CFOs who issue convertible debt view convertible debt as an
inexpensive way to issue “delayed” common stock.
 50% claim to issue convertible debt because their stock is currently undervalued.
Two Behavioral Issues
 Convertible debt can be interpreted as a cheap form of debt financing.
 This is because convertibility conveys a benefit on bondholders, the interest
rate on convertible debt tends to be less than the interest rate on fixed debt.
 Because convertible debt converts to equity only when the future stock price rises, it
appears to be a cheap form of equity as well.
  Convertible debt is not cheap financing.
 Hedge funds trade convertible debt to exploit mispricing, often making for
volatile stock prices.
Debt Timing
 Executives report that they engage in debt timing, seeking to attempt to time interest
rates by issuing debt when they judge that market interest rates are low.
 Executives are more prone to time market rates than their own credit ratings.
 This feature that is somewhat surprising because executives have private
information that is pertinent to their credit risk, but do not have private
information about market interest rates.
Target Debt-to-Equity Ratio
 Capital structure reflects traditional tradeoff considerations as well as market timing.
 Survey evidence indicates that executives assign tradeoff considerations a lower
priority than other competing concerns.
 50% indicate that “maintaining a target debt-to-equity ratio” is important.
 At the same time, this factor is rated fifth, below four others.
Pecking Order Theory
 The Duke/FEI survey reports little support for the asymmetric-information basis
underlying traditional pecking-order theory.
 To be sure, CFOs are reluctant to issue equity when they believe that their firms’
stocks are undervalued.
 However, the Duke/FEI survey finds little evidence to suggest that executives believe
that the source of the undervaluation is perceived information asymmetry.
Cash Flow Sensitivity
 The tendency for investment policy to depend on how much cash a firm holds is
known as the sensitivity of investment to cash flow.
 The evidence is strong that when firms receive more cash or take on less debt, they
invest more.
Excessive Optimism and Overconfidence
 Excessive optimism and overconfidence leads managers to overestimate future project
cash flows and underestimate project risk.
 As a result, these managers overestimate project NPV.
 When their firms are fairly valued in the market,the same biases lead them to
conclude that their firms are undervalued.
Cash Rich Firms and Negative NPV Projects
 If their firms are cash rich, managers have no need for external financing.
 As a result, they can use their cash to fund projects that they perceive to feature
positive (or zero) NPV, but which in reality feature negative NPV.
Cash Poor Firms and Positive NPV Projects
  Excessively optimistic, overconfident managers of cash poor firms face a dilemma.
 In computing APV, they overestimate both project NPV and the associated financing
side effects.
 In particular, their desire to avoid dilution can dominate their desire to fund a positive
net present value project.
 As a result, they reject positive NPV projects when they are cash poor and
have limited debt capacity.
Identifying Optimistic, Overconfident CEOs
 The press often describes some CEOs as “optimistic” and “confident.”
 There is good reason to suspect that these CEOs are actually excessively optimistic
and overconfident.
Longholders
 A second indication of CEO excessive optimism and overconfidence is that CEOs
hold their executive stock options until they are close to expiration.
 Risk aversion in the domain of gains leads people who delay exercising their
options to expect more than $25 million by accepting the risk of delay.
 But excessive optimism and overconfidence can trump loss aversion, and
induce people to delay exercising instead of accepting the sure $25 million.
Investment Policies
 The investment policies of firms with excessively optimistic, overconfident managers
display excessive sensitivity to cash flows.
 The evidence indicates that firms with longholder CEOs are more likely to rely on
internal cash to finance investment than other firms.
 Longholding figures prominently as one of the key determinants of investment
activity, along with cash flow, size of board of directors, and a measure of growth
opportunities.
Summary
 Survey evidence indicates that dilution and market timing are the top factors that
influence financial executives’ decisions about issuing new equity.
 The top factor influencing financial executives’ decisions about new debt is financial
flexibility.
 The BPV approach to capital structure features managerial biases and framing effects
as well as market sentiment, the market, or both.
 Excessively optimistic, overconfident managers of cash-poor firms are prone to reject
positive NPV projects because they overvalue the equity of their firms.
 Excessively optimistic, overconfident managers of cash-rich firms are prone to adopt
negative NPV projects because they overvalue the cash flows from those projects.
 The behavioral approach to capital structure suggests that firms with excessively
optimistic, overconfident managers take on more leverage and invest more than other
firms, and their investment policies exhibit excess sensitivity to cash flows.
 In some circumstances, framing effects can operate in the opposite direction, and
inhibit some firms from fully exploiting their debt capacity, a point also discussed in
Chapter 2.
 Empirical studies shows that firms with longholder CEOs have investment policies
that are excessively sensitive to cash flows.