Advanced Corporate Finance Capital Structure II. Thomas J. Chemmanur Carroll School of Management Boston College

Transcription

1 Advanced Corporate Finance Capital Structure II Thomas J. Chemmanur Carroll School of Management Boston College

2 WHEN DOES FINANCIAL STRUCTURE MATTER? -It matters when there is an unsatisfied clientele of investors (excess demand) for certain kinds of securities -It matters when there are market imperfections: *Taxes corporate taxes - Personal taxes - Non-debt tax shields *Costs of financial distress (otherwise called bankruptcy costs)

3 Costs of financial distress ->Any costs (or reduction in cash flow) arising from the fact that the firm is bankrupt. ->The fact that the firm is bankrupt does not matter in itself (see example in notes) ->Bankruptcy costs vary across industries *The effects of the above three imperfections are discussed in my topic note 4 (for you to read for your personal interest: not required for the exam) * Asymmetric information is another market imperfection which makes capital structure relevant, and will study such effects in detail in this class

4 STOCK ISSUES UNDER SYMMETRIC (FULL) INFORMATION: Numerical Illustration (see topic note 4, page 11) Data given to you: Value of a firm without new project/product = 1,000,000 New project NPV = 500,000 Number of shares currently outstanding = 50,000 Investment required = $600,000

5 If there is symmetric information, value of firm before equity issue = value of firm without new product + NPV of new product/project = 1,000, ,000 = 1,500,000 Price per share = 1,500,000/50,000 = $30/share If the firm sells 20,000 shares at this price, it can raise 20,000*30 = $600,000, needed for investment. Value of firm after equity issue = 1,500, ,000 = 2,100,000 Price per share = 2,100,000/70,000 = $30/share.

6 In other words, price before equity issue = price after equity issuing. So issuing correctly valued equity does not depress stock price. The problem arises when the firm s equity is undervalued. For example, if the firm had to sell equity at $20 per share (instead of the true value of $30), then:

7 Number of new shares to be issued = 30,000, since $600,000/20 = 30,000. In this case, value of shares after information about new product becomes public: Firm value/80,000 = 2,100,000/80,000 = $26.25 per share. Loss in value = $ = $3.75, Relative to the case where the firm implements new project with internal financing.

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9 Announcement effect of stock issues: read article by Asquith & Mullins (course packet) Abnormal returns for seasoned equity issues: Event study Average loss in market value = 31% of funds raised. Average fall in stock price = 3% Event-study methodology: 1. Step-1: compute benchmark return ( normal return)

10 R jt = R ft + β j [R mt - R ft ] for stock j, day t (using market model based on CAPM) 2. STEP-2: Compute actual return achieved, R jt of stock. 3. STEP-3: Compute residual return, ε jt = R jt - R jt = Actual - Expected (benchmark) 4. STEP-4: Compute average abnormal return, of whole sample of stocks:

11 AR t = 1 N N εjt J =1 5. STEP-5: Compute cumulative abnormal return (CAR) from several days prior to study to several days after. CAR = T t =1 ARt T = Number of days over which study is conducted.

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13 An interesting point to note in the above event study is that the fall in stock price after equity issues is not a temporary blip: One month after the announcement, the car is - 3.5%. Another event study of firms initiating (starting to pay) dividends is also given in the Asquith and Mullins reading (course packet)

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15 THE IMPACT OF STOCK ISSUES ON FIRM VALUE UNDER ASYMMETRIC INFORMATION Consider a firm consisting of (I) Assets in place (existing projects needing no further investment to generate cash flows) (II) New project with a positive NPV, to be funded (new investment needed) Insiders have private information about value of assets in place, π, with time 1 cash flows given below:

16 π 0.5 H = L = 50 Outsiders do not observe π; they believe that π can be H or L with a probability 1/2. NEW PROJECT: t = 0 t = 1 I C

17 Investment required, I. Cash flow from new project, C, at time t = 1 One period project. Cost of capital = r (Assume that all investors are risk-neutral, so r = risk-free rate). No asymmetric information about new project value. Since project has positive NPV, C/(1+r) > I

18 To begin with, assume that the firm can finance the new project with equity only. Let S denote the fraction of equity that has to be offered to new shareholders in return for capital I. Expected cash flow from the firm as a whole (cash flows from assets in place plus the new project) at t = 1 after the new project is implemented: = [0.5(100) + 0.5(50) + C]

19 Fraction of this t = 1 cash flow going to new share holders is S Cash flow to new shareholders = S[0.5(100) + 0.5(50) + C] Present (t = 0) value of this cash flow = S[0.5(100) + 0.5(50) + C]/(1 + r) This has to equal I if the firm is to raise an amount I for investment by selling equity: S[0.5(100) + 0.5(50) + C]/(1+r) = I (1) If the above condition is satisfied, new share holders can break even by investing in the firm

20 Example-1: r = 10% or 0.1, I = 10, C = 12 Check: Project is + NPV, since 12/1.1 > 10. Substituting in equation (1) above: S[0.5(100) + 0.5(50) + 12]/1.1 = 10 S = 11/87 = OR 12.6% For entrepreneur/insiders: Equity issue makes sense, if and only if: (1 - S)(π + C) π (2) Cash flow with project Cash flow without project

21 FOR TYPE-H INSIDER Substituting π =100, C = 12, S = Equation (2) becomes: ( )( ) 100 Since < 100 Equity issue condition not satisfied FOR TYPE-L INSIDER Substituting π =50, C = 12, S = 0.126

22 ( )( ) > 50 Equity issue condition satisfied for type L What does this mean in practice? *Managers with very favorable private information would prefer to pass up positive npv projects rather than issue equity. *Managers with less favorable private information, however, find it worthwhile to issue equity.

23 However, outsiders are no fools: what will they infer when a firm announces an equity issue? That the insider s private information is unfavorable (i.e., A firm issuing equity is a type- L firm in our example).

24 Empirical Implications of Above Theory: (I) Equity-issue announcements are followed by a drop in share price, on average (since they convey bad news). (II) In many cases, firms will give up positive NPV projects, because of asymmetric information. (III) When should managers make equity issues despite asymmetric information? When the net present value of the project given up is larger than any loss in value coming from the fall in share price.

25 Example-2 C = 20, so project NPV is larger; Keep everything else the same as in example-1: r = 0.1, I = 10 Substituting in equation (1): S[0.5(100) + 0.5(50) + 20]/1.1 = 10 S = 11/95 = OR 11.57% OF EQUITY. From the type-h entrepreneur s point of view: (from (2)):

26 ( )( ) 100 Equity issue condition is satisfied for type H firm, since ; So type H firm makes share issue. From the type-l entrepreneur s point of view: Share issue makes sense if and only if: ( )( ) > 50 So equity issue condition satisfied for type L firm as well.

27 *So both types issue equity if project npv large enough. *No negative announcement effects in this case. What about the alternatives to equity? How do they perform under asymmetric information?

28 Example-3: Risk-less debt financing Let C=12 as in example-1. If the firm can issue debt, face value, F, of debt to be issued to finance project = I(1 + r), Since I = F/(1 + r) F = 10(1.1) = $11. Regardless of whether the firm is an H or an L type, it can always pay back the debt, so it is riskfree (since 50 > 11). In general, as long as the project is positive NPV, it will be funded, if the firm is able to issue risk-free debt to fund it.

29 For manager, a debt issue makes sense if and only if: π + C - F π (3) cash flow with project cash flow without project For H-type manager (3) becomes: = For L-type manager (3) becomes: = So both types issue debt and undertake project.

30 *Thus while the type-h firm would have passed up a positive value NPV project if it had to finance with equity (example- 1) it would implement the project if it could finance with risk-free debt. *Internal financing (retained earnings) has basically the same properties as risk-free debt: the firm would implement all positive NPV projects if it had enough internal financing available.

31 In general, it can be shown that there is a Pecking order of External Financing: Internal financing, riskless debt: most desirable to use Risky debt, preferred equity, convertible debt: in-between, in terms of loss in value Common equity (common stock): least desirable in terms of loss in value

32 This is because it can be shown that the less information sensitive a security is, less the loss in value to current shareholders from using it to finance a project. Equity is therefore a last resort for firms raising external financing. This seems to be true empirically: in many years, the net issue of equity (equity issues minus repurchases) is negative in the U.S. Internal financing dominates external financing by a large percentage

33 INTERNAL VERSUS EXTERNAL FINANCING: HISTORICAL TREND SOURCESOF LONG-TERM FINANCING (%) Internal Financing External Financing Net new long-term borrowing Net new stock issues Data are derived from Value Line Selection and Opinion. Industrial Composite Financial Results (February 13,1987) and Board of Governors of the Federal Reserve System, Division of Research and Statistics. Flow of Funds Accounts.

34 What about stock repurchases? Repurchases work in a way opposite to equity issues: they convey insider s favorable private information (i.e., signal that firm s equity is undervalued). *Tender offer repurchases: usually shares bought at a premium to market. *Open-market repurchases: small quantities of shares bought periodically in the open market through brokers.

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36 Stock repurchase event study (from reading by Asquith and Mullins in the course pack): Tender offer: Average announcement abnormal return 17% 13% seems permanent Open market: 3% announcement effect 2% seems to be permanent (But: Prior underperformance of 7%)

37 Integrating Market Imperfections into Capital Budgeting: Adjusted Present Value (NOT Required for the Exam) 1. Compute base-case NPV using weighted average cost of capital, r A. r A = (E/V) r E + (D/V)r D or r A = r F + β A (r m - r F ) Asset beta of firm

38 2. Adjusted Present Value, APV of a project = Base-case NPV + PV of tax shield from debt due to project PV of incremental bankruptcy costs - Costs due to asymmetric information 3. Accept project only if APV > 0.

39 Integrating market imperfections into Capital Budgeting Using APV A Numerical example (Problem in my topic note 4, page 15): One period project: t=0 t=1 I = $1,000 C = $1,200 r A = 20% or 0.2 I C

40 (a) NPV = 1,200/(1 + r) - I = 1,200/1.2-1,000 = 0 (b) Amount raised = $1,000 Debt = 0.3(1,000) = $300 Interest paid = 0.1(300) = $30 Debt tax shield = 30*0.2 = $6 PV of debt tax shield = 6/1.1 = $5.95 APV = = $5.95, so accept project (c) Amount raised from equity = $700 + Flotation cost(10%) Amount raised = 700/0.9 =

41 Flotation cost = $77.77 APV = = < 0 So reject project