The Theories of Medium/Long-term Financing Decision & Capital Structure
－Utilize capital markets to finance
investment and create value
一. Financing Instruments
Equity financing instruments
－Venture capital
－Common Stock
－Option-linked equity: Puttable common stock
一. Financing Instruments
Debt
－Bank loan
－Private debt
－Public bonds
－Fixed versus floating rate
－Option-linked bonds: Puttable versus callable
－Income bonds
Debt Financing Instruments
Advantages of debt
1. Tax Benefit
Higher tax rates－>Higher tax benefit
Disadvantages of debt
Cost: Higher business risk－>
Higher cost
2. Loss of future financing flexibility
Bonds Financing Instruments
Bonds Debenture
－Rating: AAA－C
－Sinking fund
－Call or put right
－Restrict on Investment, Financing and operation
一. Financing Instruments
Hybrid financing instruments
－Preferred stock
－Convertible instruments
－Warrants
二. Capital Structure Theories
Financial Market Efficiency
Definition: A financial market is efficient when market price reflect all available information.
“All available information ”includes:
1. Past price
2. All public information
3. All information including non-public (inside) information
Financial Market Efficiency
“ Prices reflect all available information ” means that financial transactions at market price,using the available information are zero NPV activities
Financial Market Efficiency
Stock price
Under or Delayed reaction
Efficient market reaction
Overreaction
0
Time
Financial Market Efficiency
Weak form: Past price do not predict future price changes
Semi-strong form: All public information does not predict future price changes
Strong form: All information, public and private,does not predict future price changes
New Finance: overreaction and underreaction
－Events reaction study
IPO underpricing
二. Capital Structure Theories
What do the theory Concern
－What are the factors that affect the determinants
of financing choice/options/actions ?
－Who are the actors ?
Complementary Research Methodologies
－ Mathematical Models, No Data
－ Large Sample Traditional
－ Large Sample Small Survey
－ Comprehensive Survey
－ Clinical
The Static Tradeoff Theory (I)
Market Value of Firm
Debt
Firm Value with Debt
Firm Value under All-Equity Financing
PV costs of Financial Distress
PV Interest Tax Shields
Capital Structure Theories (II)
M&M Theorem （Modigliani&Miller 1958)
The firm value is irrelevance of Capital Structure in an economist’s idealized world
of frictionless markets.
M&M Theorem
－There are no income taxes
－There are no transactions costs of financing
－The firm’s outside investors and its managers all share the some information about the firm’s future prospects, and
－The various stakeholders of the firm are able to costlessly resolve any conflicts of interest among themselves
Capital Structure Theories (III) ：
The Pecking Order of Financing Choices －Dynamic Capital Structure Theory
Donaldson(1961) observed and called the pecking order of firms’ financing choices, which described how managers make their financing decision.
1. Firms prefer to finance investment with retained earnings rather than external financing, firms adapt their dividend policies to reflect their anticipated investment needs.
The Pecking Order of Financing Choices －Dynamic Capital Structure Theory
2. If external financing is required, firms tend to begin with straight debt, next issue convertible bonds, and issue equity only as a last resort
3. If the firm have excess cash, it will tend to pay off its debt prior to pay dividend or repurchasing shares
Explanations of Pecking Order Behaviors
Taxes and transaction costs
Asymmetric Information (Myers and Majluf 1984) and Financing Costs
-Manager known better than outsider investors
-Information is not equally (and costlessly) available to all market participants.
Issuing equity conveys negative information to capital markets investors
这些理论依据资本市场有效性假设讨论企业债务与股权的权衡,没有考虑企业产品市场竞争特性和资本市场融资条件的变化对企业融资行为的重要影响，难以解释实践中的很多融资行为。大量的实践观察和实证分析表明，不同行业的许多企业财务政策保守，表现在财务杠杆显著低于主流资本结构理论给出的预测值(Under-leveraged)。例如，纽约证券交易所有上百家公司连续5年长期债务比例为0。
Organizational Theory
－Free Cash Flows (Michael Jensen1986)
Explain LBOs
Game Theory－Signaling Model(Ross1977)
－Securities Design
The Stakeholder Theory of
Capital Structure (IV)
The Costs Imposed on Stakeholders affect the Firms’ Financing Choice and Capital Structure
The Stakeholder Theory of
Capital Structure
Employee
Customers
Suppliers
Corporate
Strategy
Financing Decision
Competitors
The Trade-off between Debt Tax Gains and the Effect of Product Price
Suppose that Compaq produces computers at a
cost of $2,000 and sells them for $2,400. Given
this $400 operating profit, the firm is generating
larger taxable earnings. Compaq is considering
a large increase in financial leverage that will
save $58million per year in interest tax deduction
& also increase the probability of bankruptcy
from zero to 10%. With a marginal tax rate 0f
40%
If Compaq computers are worth $2,400 based on
the customers believe that Compaq bankruptcy is
even a remote possibility, and customers can be
assured of Compaq’s continued support of
upgrades and new software in the future. If
customers thought Compaq’s bankruptcy was
10% when Compaq increase leverage, and the
Compaq computer are worth$1,200. If Compaq
expects to sell 1 million computers per year,
should Compaq take on this added leverage?
Value computers as probability weighted average:
2,400×90% + 1,200×10% = $2,280
Pretax profits will be reduced $120milloin
Interest taxes deduction is $58million
Compaq is better off not taking on added debt
