Modigliani and Miller (1958)

-- Assumptions
 In a ‘perfect’ world,
 No taxes
 No default risk
 Perfect capital markets:
 Firms and investors can borrow/lend at the same rate
 No information asymmetry
 No transaction costs
 No agency costs

0 Jun Zhou, RSB, Dalhousie :: COMM 4240

 Modigliani and Miller (1958)
- the Modigliani-Miller theorem – No Tax Case
 MM I: the value of the firm does not depend on its capital structure
VU = VL

 Implication: r0  rWACC

 MM II: the required rate of return on equity increases with the debt-
equity ratio of the company
D
rE  r0  (r0  rD )
E

1 Jun Zhou, RSB, Dalhousie :: COMM 4240

MM Proposition II (no taxes)
Cost of capital

D
rE  r0   (r0  rD )
E

D E
r0 rWACC   rD   rE
DE DE

rD rD

Debt-to-equity Ratio
(D/E)
2 Jun Zhou, RSB, Dalhousie :: COMM 4240
The (Static) Trade-off Theory
 The world is not perfect …

 Companies can determined the optimal capital structure

by trading off
 The benefits of debt
 Interest tax shield
 Reduce the agency cost of equity
 The costs of debt
 Costs of Financial distress (direct and indirect)

3 Jun Zhou, RSB, Dalhousie :: COMM 4240

MM propositions I & II -- with corporate taxes
 MM Proposition I (with corporate taxes)
 Firm value increases with leverage:

VL  VU  TC D
 TCD is the present value of interest tax shield

 MM Proposition II (with corporate taxes)

 The required rate of return on equity increases with leverage
(but some of the increase in equity risk and return is offset by
interest tax shield):
D
rE  r0   (1  TC )  (r0  rD )
E

4 Jun Zhou, RSB, Dalhousie :: COMM 4240

MM Proposition I (with corporate taxes)

VL  VU  TC D

(Interest tax shield)

D
5 Jun Zhou, RSB, Dalhousie :: COMM 4240
MM Proposition II (with corporate taxes)
Cost of capital D
rE  r0   (r0  rD ) No taxes
E

D
rE  r0   (1  TC )  (r0  rD ) With Corporate taxes
E

r0

D E
rWACC   rD  (1  TC )   rE
DE DE
rD

Debt-to-equity
ratio (D/E)
D/E=0
6 Jun Zhou, RSB, Dalhousie :: COMM 4240
 Costs of Financial Distress
 Financial distress
 A firm cannot cover its interest expense because of an earnings shortfall
 A financially distressed firm is more likely to liquidate
 The possibility of bankruptcy decreases firm value
 Direct costs:
 Legal and administrative costs
 Indirect costs:
 Impaired ability to conduct business
 Agency costs of debt

7 Jun Zhou, RSB, Dalhousie :: COMM 4240

Impaired ability to conduct business
 Impacts on non-financial stakeholders
 Leads to spillover costs on non-financial stakeholders
 Customers
 Workers
 Suppliers
 Their response to financial distress

 Impact on competition

8 Jun Zhou, RSB, Dalhousie :: COMM 4240

Agency costs of debt
 Agency conflicts between shareholders and debtholders
can lead managers to
 Selfish strategy 1: risk shifting
 Selfish strategy 2: debt overhang
 Selfish strategy 3: milking the property
 These conflicts arise when debt-to-equity ratio is high
 Consequence:
 Financing decisions may affect investment decisions
 Cost of debt may increase

9 Jun Zhou, RSB, Dalhousie :: COMM 4240

Selfish strategy 1: Risk shifting
 XYZ owes $100 to bondholders next period.
 Cash flows next period come from project 1 or 2
 Project 1:
 recession (prob=50%) ⇒ CF=100
 expansion (prob=50%) ⇒ CF=200
 Project 2:
 recession (prob=50%) ⇒ CF=0
 expansion (prob=50%) ⇒ CF=250
 Each project requires an investment of $140 (the cash held
by the company) today
 What project will the company choose?

10 Jun Zhou, RSB, Dalhousie :: COMM 4240

Selfish strategy 2: Debt Overhang
 XYZ owes $300 to bondholders next period
 Consider a project that guarantees $350 in one period
 The project requires an investment of $300
 The firm only has $200 in cash
 Assume the firm cannot raise more debt
 Stockholders will have to supply an additional $100 to
finance the project
 Will they accept?

11 Jun Zhou, RSB, Dalhousie :: COMM 4240

Selfish strategy 3: milking the property
 Liquidating dividends
 Suppose the firm paid out a $200 dividend to the
shareholders. This leaves the firm insolvent, with nothing
for the bondholders, but plenty for the former shareholders
 Such tactics often violate bond indentures and the law
 Increase perquisites to shareholders and/or
management

12 Jun Zhou, RSB, Dalhousie :: COMM 4240

When consider financial distress
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCD

Maximum Present value of

firm value financial distress costs
V = Actual value of levered firm
VU = Value of firm with no debt

0 Optimal Amount D
of Debt

13 Jun Zhou, RSB, Dalhousie :: COMM 4240

 Agency Costs of Equity
 What do managers really want?
1. Create value for shareholders?
Or
2. Relax and enjoy perquisites, or Invest in fun industries?

 Agency costs of equity

 The difference between firm value if managers prefer 1 and firm
value if managers prefer 2

14 Jun Zhou, RSB, Dalhousie :: COMM 4240

Agency costs of equity – an example
 Eugénie works for company XYZ, which is worth $1 million.
The company is all-equity financed, and Eugénie owns 100%
of its equity
 Eugénie needs to raise $2 million, either through debt (interest
rate = 12%) or through equity

15 Jun Zhou, RSB, Dalhousie :: COMM 4240

Agency costs of equity (cont.)
 Agency costs of equity
 The manager of a firm has more incentive to shirk if he has to
share benefits with other equity holders
 Jensen (1986): The higher the free cash flows of the firm, the
higher the possibilities for managers to waste them
 by obtaining more perquisites or
 by investing in bad projects (overinvestment)

16 Jun Zhou, RSB, Dalhousie :: COMM 4240

Agency costs of equity (cont.)
 Solutions:
 Monitor managers
 Align managers’ incentives with the interests of stockholders

 Increase dividends
 An increase in debt will reduce the ability of managers to
pursue wasteful activities
 Implication for the optimal capital structure: Debt is good

17 Jun Zhou, RSB, Dalhousie :: COMM 4240

The Trade-Off Theory
 The world is not perfect …

 Companies can determined the optimal capital structure

by trading off
 The benefits of debt
 Interest tax shield
 Reduce the agency cost of equity
 The costs of debt
 Costs of Financial distress (direct and indirect)

18 Jun Zhou, RSB, Dalhousie :: COMM 4240

The Pecking Order Theory
 Myers (1984)
 Idea behind the theory:
 Asymmetric information: managers know more about the firm
value than investors
 Firms may be undervalued or overvalued
 Managers are reluctant to issue underpriced equity
 Investors rationally interpret most management decisions to
raise equity as a sign that the firm is overvalued and the stock
price falls

19 Jun Zhou, RSB, Dalhousie :: COMM 4240

The Pecking Order Theory (cont.)
 When they need money, firms should use
 First, internal cash
 More flexibility
 No information revelation
 Next, debt
 Less information asymmetry issues than with equity
 Reveals the company has no internal cash
 Last, equity
 Reveals the company cannot use debt & has no cash
 Reveals stock price is too high

20 Jun Zhou, RSB, Dalhousie :: COMM 4240

The Pecking Order Theory (POT)
 Due to information asymmetry and adverse selection,
when they need money, firms should use
 First, internal cash
 Next, debt
 Last, equity

 Compared with the trade-off theory, POT implies:

 There is no target D/E ratio
 Profitable firms use less debt
 Companies like financial slack

21 Jun Zhou, RSB, Dalhousie :: COMM 4240

Survey Evidence
 Survey approach
 Pro: researchers can ask qualitative questions
 Con: it measures beliefs rather than actions

 Graham and Harvey (2001JFE, 2002 JACF)

 solicited responses from approximately 4,440 companies
 Received 392 completed surveys
 nearly 100 questions on capital budgeting and capital structure
decisions

22 Jun Zhou, RSB, Dalhousie :: COMM 4240

 Top 3 factors affecting debt issuances:
 Financial flexibility
 Credit ratings
 Earnings volatility

Debt decisions are influenced by a desire to avoid getting the firm

into financial distress.

23 Jun Zhou, RSB, Dalhousie :: COMM 4240

Financial Flexibility
 Financial flexibility refers to the ability of a firm to respond in
a timely and value-maximizing manner to unexpected changes
in the firm's cash flows or investment opportunity set.

 Survey finding:
 By maintaining flexibility, most companies mean preserving unused
debt capacity.
 It’s also interesting to note that although many companies say their
excess debt capacity is intended mainly to finance possible future
expansions and acquisitions, such firms also seem intent on retaining
much of that unused debt capacity even after expanding.
 such flexibility tends to be associated with maintaining a target credit
rating

24 Jun Zhou, RSB, Dalhousie :: COMM 4240

 44% had “strict” or “somewhat strict” targets or ranges
 Such targets were more common among
 Larger companies, investment-grade companies, regulated companies
25 Jun Zhou, RSB, Dalhousie :: COMM 4240
What does the survey tell us about the Pecking
Order Theory?
 When managing their capital structures, companies need to take account
of the transaction costs and signaling effects

 “What seems to emerge from our survey, then, is that information

disparities and signaling effects do not play a major role in determining
companies’ capital structure targets. But, as the pecking order story
suggests, such information costs do appear to influence the form and
timing of specific financing choices”

 “… almost two thirds of the CFOs (see Figure 5) cited recent stock price
performance as an important factor in decisions to issue stock, with
periods of stock price appreciation providing “windows of opportunity.”
 “…it was the factor most frequently cited by speculative-grade and
non-dividend- paying firms”

26 Jun Zhou, RSB, Dalhousie :: COMM 4240