what is a common misconception of debt and value of shares?
that increasing debt will ALWAYS lead to an increase in the value of shares, this is not necessarily true because one has to consider the increase in risk as well.
it is true that, since equity investment is lower in the presence of high leverage, the % return on equity increases, BUT the dispersion (RISK) of equity returns increases PROPORTIONALLY.
Higher risk requires higher remuneration, EXACTLY EQUAL to the additional yield determined by greater debt, CANCELING out any value effect.
assuming no tax shield
three possible methods of estimating the cost of equity capital
- CAPM
- HISTORICAL series of past returns (market or accounting returns)
- implied return in CURRENT stock prices (DDM)
3 fundamental elements for the validity of returns when using stock market returns to compute cost of equity
- use of homogenous comparables and a significant number of companies with also similar financial leverage, MUST delever/relever (IF we want to use comparables)
- reference period of 10 or more years
- remove any outliers
how do you DELEVER the k_e (in the context of using historical mkt data to compute target’s k_e)?
a. find the WACC for each company
b. average the WACC (from this you can “imply” a less distorted figure of k_e for the target)
c. compute EV of the target using average WACC
what is a cool thing about using the stock market return method for estimating cost of equity?
apart from the monetary component of dividends, there is also the return determined by the increase in prices. If the market is efficient, the return offered by the share as a percentage of price remains constant, regardless of the value of cashflows and aligned with its cost of capital.
using accounting returns to estimate k_e (unlevered and levered)
in the long run, accounting return should approximate the cost of capital (Tobin’s Q tends to 1 and so does P/B value)
UNLEVERED
K_o = ROI net of taxes = NOPAT / NIC
LEVERED
K_e = ROE = net profit / accounting equity
!!! still a SUB_OPTIMAL method because it considers historical variables but not prospective ones.
implied returns in stock prices, the DDM
which are the two ways for estimating g in the DDM?
- on a historical basis
evaluating the historical percentage growth of dividends over a long period - on a prospective basis
g = ROE * plowback ratio
!!! plowback ratio is HISTORICAL
!!! ROE could either HISTORICAL or PROSPECTIVE
!!!!!!!!!!!!!!!!!!!!!!!!!!! payout ratio = Div_t / NP_t-1
implied k_e and from k_e to WACC exercise
slide 21
the basic assumtpions of Modigliani and Miller (1958), what are the issues?
what are the results obtained?
A)
1. NO taxation, NO transaction costs, and NO BC
doesn’t consider TRADE_OFF theory
- PERFECT financial markets and information
doesn’t consider
- moral hazard
- agency costs
- adverse selection (pecking order theory) - PERFECT rationality of investors and management
doesn’t consider irrationality
- market timing theory
- debt overhang theory
also, the cost of money is assumed to be the same for investors and companies
B)
1. EV is independent of capital structure
- k_e levered = k_e unlevered + risk premium
!!! the DISTRIBUTION of RISK is still CHANGED, BUT the RISK associated to the COMPANY as a whole is UNCHANGED (operating cashflow does not change).
optimal level of debt issues:
1. trade off theory (M&M 1963)
there exists an optimal capital structure based on the marginal value of tax shield and bankruptcy costs
optimal level of debt issues: 2. agency theory (moral hazard)
involves a contractual relationship with the delegation of power to an agent. A risk emerges due to the opportunistic behavior of the parties, who tend to maximize their OWN utility.
a. possibility of opposing interests
b. condition of information asymmetry (the agent has more information than the principal), so the principal cannot be guaranteed that the agent will always act in his interest
extra: 2 different effects determine agency costs
- equity agency costs: the more the % of equity owned by managers, the more they are aligned to shareholder’s interests. From this it emerges that debt acts as a “DISCIPLINE” mechanism binding managers to their promise to pay future cashflows.
!!! managers vs shareholders !!! - debt agency costs: in a limited liability regime, shareholders cannot lose more than their initial investment. The risk of failure associate with a new investment in the case of bankruptcy are borne by creditors. The more the debt the more the incentive to undertake risky investments.
!!! shareholders (higher upside risk) vs creditors (higher downside risk) !!!
rational lenders will assume this perspective and require a higher rate a priori which is proportional to the level of risk shifting.
SOLUTION: OPTIMAL capital structure corresponds to the level of financial leverage that MINIMIZES total AGENCY COSTS (the sum of equity and debt agency costs)
optimal level of debt issues: 3. debt overhang theory
excess debt reduces access to further financing, EVEN in the presence of POTENTIALLY FAVORABLE INVESTMENTS
problem for shareholders: assume EV < D_nom , shareholders will be reluctant to invest in a project even if with positive NPV because the benefits will be collected by creditors
problem for debtholders: further increase in the level of debt will also increase the probability of failure. Furthermore, shareholders bear most of the benefits.
optimal level of debt issues: 4. pecking order theory
REMOVAL of PERFECT SYMMETRIC INFORMATION (management has the advantage).
in the presence of INFORMATION ASYMMETRY between company managers and the market, companies will FIRST resort to forms of FINANCING whose value is LESS SENSITIVE to INFORMATION that is the object of the asymmetry.
companies with the best prospects will want to issue debt, companies with worse prospects will issue equity to share any losses in value with new shareholders.
Firms order the possible sources of financing on a priority of convenience:
- internal financing (NOT subject to information asymmetry)
- debt (first RISK FREE, then RISKY, then increasingly CLOSE to equity)
- equity, when it is no longer convenient or possible to issue debt
optimal level of debt issues: 5. market timing theory
companies resort to the most convenient form of financing at a precise moment in time.
this theory does not care about financial leverage or financing choice, it only exploits an arbitrage process linked to the irrational behavior of the market.
extra:
overvaluation allows to rais capital with less equity issued, and shareholders’ dilution is negligible.
are the different theories of capital structure generally considered mutually exclusive?
NO
a. each theory is based on removing a particular hypothesis from the irrelevance of capital structure theory in M&M. It is likely that MULTIPLE hypotheses are VIOLATED. The aim is to determine how much SUPPORT from EACH theory and verify the MOST economically RELEVANT
b some theories regard the OPTIMAL RATIO D/E (trade-off), others on the DYNAMIC increase of equity or debt (pecking order theory)
!!! the purpose of the theories is NOT to SUGGEST a correct way to FINANCE investments, on the contrary, their role is to DESCRIBE the BEHAVIOR of companies.
one misconception about pecking order and trade off theories
the trade off theory defines the level of debt and the financial leverage, the pecking order theory the VARIATIONS in the nature of the sources of additional financing
