BUSFIN 703 – Corporate
Finance
Week 9 – Capital Structure Policy
Dr. Marty Pham
Learning objectives
After this lecture, you should be able to:
• understand and discuss the advantages and disadvantages of capital
sources.
• explain the cost of underwriting new equity security offerings, investment
bankers prefer that the securities be under-priced, and calculate the total
cost of an initial public offering.
• discuss the costs of bringing an open public offer to market and calculate
the total cost of issuing an open public offer.
• describe the two Modigliani and Miller propositions, the key assumptions
underlying them and their relevance to capital structure decisions
• discuss some of the practical considerations that managers are concerned
with when they choose a company’s capital structure.
• describe the trade-off and pecking order theories of capital structure
choice and explain what the empirical evidence tells us about these
theories
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Stages of equity financing
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Bootstrapping
Initial funding of the company:
• The process used by entrepreneurs to raise “seed” money and obtain
other resources necessary to start their businesses is often called
bootstrapping.
• The initial “seed” money usually comes from the entrepreneur or other
founders, loans from family members and friends, and loans secured
from credit cards etc.
• Crowdfunding involves raising money from many people who each
contribute a relatively small amount
• The seed money, in most cases, is spent on developing a prototype of
the product or service and a business plan.
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Venture capital
• The bootstrapping period usually lasts no more than 1 – 2 years.
• Venture capitalists are individuals or companies that help new
businesses get started and provide much of their early-stage
financing.
• Individual venture capitalists, angels (or angel investors) are typically
wealthy individuals who invest their own money in emerging
businesses at the very early stages in small deals.
[Link]
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Venture capital
Venture capitalists provide more than financing:
▪ The extent of the venture capitalists’ involvement depends on the
experience of the management team.
▪ One of their most important roles is to provide advice.
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Venture capital
Why venture capital funding is different:
1. The high degree of risk involved in starting a new business.
2. Types of productive assets.
• Often intangibles
3. Informational asymmetry problems.
• An entrepreneur knows more about his or her company’s prospects
than a lender does.
4. The cost of venture capital funding is very high, but the high rates of
return earned by venture capitalists are not unreasonable.
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Venture capital – Risk reduction
How venture capitalists reduce their risk:
▪ They use several tactics when they invest in new ventures:
✓ staged funding: gives the venture capitalist an opportunity to
reassess the management team and the company’s financial
performance over funding stages.
✓ personal investments: require an entrepreneur/founder to have
substantial skin on the game.
✓ syndication: VC funds co-invest in startup businesses to share the
risk, especially in case of seed and early-stage investments.
[Link]
idUSKBN28L1AL
✓ co-management of entrepreneurial firms.
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Venture capital – Exit strategies
• Venture capitalists are not long-term investors in companies, but usually
exit over a period of three to seven years.
• Every venture capital agreement includes provisions identifying who has
the authority to make critical decisions concerning the exit process.
• Exit strategy provisions usually include the following:
✓ timing (when to exit)
✓ the method of exit
✓ what price is acceptable.
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Venture capital – Exit strategies
• Strategic buyer: Sell part of the company’s equity to a strategic buyer
in the private market like private equity funds.
• Financial buyer: sales to financial buyers
• Initial public offering (IPO): selling an ordinary share to the public for
the first time.
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IPO
• Potential advantages:
❑ The amount of equity capital that can be raised in the public equity
markets is typically larger.
❑ Additional equity capital can usually be raised through follow-on
seasoned public offerings at a low cost.
❑ Going public can enable an entrepreneur to fund a growing business
without giving up control.
❑ There is an active secondary market in which shareholders can buy
and sell their shares.
❑ Publicly traded companies find it easier to attract top management
talents and to better motivate current managers.
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IPO
Disadvantages:
• the high cost of the IPO due to the underwriting process with
investment banks;
• underpricing problems;
• the costs of complying with ongoing disclosure (transparency)
requirements;
• encourages managers to focus on short-term profits rather than long-
term wealth maximization.
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IPO
• Investment bankers provide three basic services when bringing
securities to market – origination, underwriting, and distribution.
• Underwriting is the risk-bearing part of investment banking.
• The securities can be underwritten in two ways:
1. on a stand-by basis: investment banker guarantees the issuer a fixed
amount of money from the share sale (more typical).
2. on a best-effort basis: investment banking company makes no
guarantee to sell the securities at a particular price.
o Investment banker does not bear the price risk associated with
underwriting.
o One of the investment banker’s most difficult tasks is to determine
the highest price at which the bankers will be able to quickly sell
all the shares being offered.
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IPO
The underpricing debate:
• The issuer prefers the share price to be as high as realistically possible
while the underwriters prefer some degree of underpricing.
• In a stand-by offering, the underwriters will suffer a financial loss if the
offer price is set too high; under a best-effort agreement, the issuing
company will lose.
• If underpricing is significant, the investment banking company will
suffer a loss of reputation for failing to price the new issue correctly
and raising less money for its client than it could have.
• IPOs are consistently underpriced:
- Typically priced between 10 and 25 percent below the price at which
they close at the end of first day of trading.
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IPO
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IPO
Three basic costs are associated with issuing share in an IPO:
1. Underwriting spread: the difference between the amount
paid by the underwriters in a new issue of securities and the
price at which securities are offered for sale to the public.
2. Out-of-pocket expenses:
• Legal fees, lodgment fees and other expenses.
3. Underpricing
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IPO
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IPO
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Debt financing
• Corporate debt can help companies:
- Address working capital gaps (e.g., paying suppliers on time may
lower corporate cash on hands before customer payments) and
optimize supply chain operation;
- Fund the purchase of assets in the short term for future growth;
- Manage seasonable fluctuations (e.g., a raincoat producer);
- Facilitate customer relationship/commitments;
- Maintain equity balance and reduce the economic costs of issuing
new equity;
- Enjoy interest tax shield;
- Discipline their financial decisions.
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Debt financing
1. Selling debt securities, such as corporate bonds or bills, in the financial
market to raise funding from creditors.
2. Commercial bank lending:
Type of Loan Features
3 – 18 months → less rigorous lending process
Asset based
Short Term Small amount of borrowed funds
(ST)
Unsecured or secured
Used for working capital management and other short-term purposes
12 months – 30 years → lengthy lending process.
Use future earnings/cash flows to repay
Long Term
Larger amount of borrowed funds
(LT)
Secured by pledged collateral
Used for long-term initiatives, acquisitions, or risk management
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Short-term debt financing
Self-liquidating loans
• Suitable for normal business cycle.
• Used to pay for short-term increase in accounts receivable or inventory. The loan
will be settled using the cash flows generated by the selling of inventory or
collection of receivables.
Borrowing Purchase of inventory Selling Repayment
The company The company The company The company
approaches use the converts or sells repays the loan
bank or lending borrowed funds its inventory to using cash flows
institution to to purchase consumers and generated by
seek a self- inventory receive cash selling off the
liquidating loan inflows inventory
to purchase
inventory
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Short-term debt financing
Working capital loans
• Maturity: <1 year.
• Mostly used to cover short-term operational needs such as purchasing raw
materials and covering seasonal capital needs.
• Can be either unsecured or secured by accounts receivable or inventories.
• Interest is relatively high, and the bank will charge a commitment fee on
unused amount.
• A compensating deposit may be required.
Equipment financing
• Cover temporary shortfalls of funds to purchase business equipment.
• The equipment or machine is used as the collateral.
• Higher interest than traditional loans.
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Long-term debt financing
Term Loans
• These medium to long-term loans are used to finance purchase of
long-term assets.
• Maturity: > 1 year.
• Repayment of loan are from future earnings or cash flow.
• Secured by fixed assets.
• Interest rates can either be fixed or floating rates and higher than
those of ST loans.
• Usually paid off in even amounts over a fixed payment schedule. There
could be an interest moratorium (grace period) on the term loans so
that payment coincides with cash-flow.
• Early repayment can trigger penalties.
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Long-term debt financing
Discussion #1: If you are managers of a business, would you
choose fixed or floating-rate term loans?
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Long-term debt financing
Revolving credit facility
• More flexible than term loans: over the allotted period, the borrowers
can draw against the loan (up to a pre-specified credit limit), repay it
and take it out again.
• This loan facility is helpful for businesses whose revenue and cash flow
are fluctuating and uncertain.
• Maturity: up to 5 years.
• Variable and high interest rates for late repayments are usually charged
by lending institutions.
• This type of credit is associated with high fees and can adversely affect
business credibility.
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Long-term debt financing
Syndicated loans
• When the project needs a large amount of funding, a group of lenders
will lend to a single borrower to share risk.
• The coordinator, or lead lending institution, originates the loan, forms
the syndicate, and processes the payments.
• Most syndicated loans are floating-rate loans, and the interest rate is
based on a reference rate + a spread.
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Capital structure policy
• Capital structure is the mix of debt and
equity that a company uses to finance
its operations. It is an important
decision for companies to make, as it
can have a significant impact on their
valuations and risk profile.
• A higher fraction of debt indicates a
higher degree of financial leverage.
• The optimal capital structure
minimizes the cost of financing the
company’s projects. It is also the capital
structure that maximizes the total value
of those projects and, therefore, the
overall value of the company.
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Capital structure theories
1. Modigliani-Miller propositions: The Modigliani-Miller theorem states
that the value of a company is independent of its capital structure,
assuming that there are no taxes or transaction costs.
2. Trade-off theory: The trade-off theory states that companies choose
a capital structure that balances the benefits of financial leverage
(increased earnings per share thanks to tax savings) against the costs
of financial leverage (increased risk of default).
3. Pecking order theory: The pecking order theory states that
companies prefer to finance their operations with internal funds,
followed by debt, and then equity. This is because equity is the most
expensive source of capital.
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Modigliani and Miller Propositions
• Modigliani and Miller Proposition I states that the capital structure
decisions a company makes will have no effect on the value of the
company in a perfect capital market where:
1. there are no taxes
2. there are no information or transaction costs
3. the real investment policy of the company is not affected by its
capital structure decisions.
• Consistent with MM1, debt increases the risk of equity
• Leverage merely changes the allocation of cash flows between
shareholders and debtholders, without altering the total cash flows of the
firm → capital structure irrelevance.
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Modigliani and Miller Propositions
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Modigliani and Miller Propositions
M&M Proposition II: The levered cost of equity is a linear increasing
function of the firm’s market value debt-to-equity ratio.
The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value
debt-equity ratio.
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Modigliani and Miller Propositions
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Modigliani and Miller Propositions
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Modigliani and Miller Propositions
If financial policy matters, it must be because:
1. tax matters
2. information or transaction costs matter
3. capital structure choices affect a company’s real
investment policy.
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The benefits of using debt
The most important benefit of using debt is that companies can deduct
interest payments for tax purposes but cannot deduct dividend payments.
• This makes it less costly to distribute cash to security holders through
interest payments than through dividends.
The total dollar amount of interest paid each year and the amount that will
be deducted from the company’s taxable income is
D × k(Debt)
• This will result in a reduction in tax paid (the interest tax shield) of D
× k(Debt) × t, where t is the company’s marginal tax rate that applies
to the interest expense deduction.
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The benefits of using debt
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The benefits of using debt
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The benefits of using debt
• Underwriting spreads and out-of-pocket costs are much lower for
bond sales.
• Debt provides managers with incentives to focus on maximizing
the cash flows that the company produces since interest and
principal payments must be made when they are due.
→ Debt can be used to limit the ability of bad managers to waste
shareholders’ money (i.e., the agency benefit of debt)
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The costs of using debt
Insolvency costs:
• Insolvency costs also referred to as costs of financial distress, are costs
associated with financial difficulties that a company might get into
because it uses too much debt financing.
• Companies can incur insolvency costs even if they never actually file
for insolvency.
• Direct insolvency costs are out-of-pocket costs that a company
incurs due to financial distress.
• Indirect insolvency costs are costs associated with changes in the
behavior of people who deal with a company in financial distress.
• Discussion #3: Are bankruptcy and financial distress the same? Can
you think of any indirect costs associated with financial distress?
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The costs of using debt
• The use of debt increases the volatility of a company’s earnings and
the probability that the company will get into financial difficulty.
Consequently, increased risk causes managers to make more
conservative decisions.
• Shareholders may have incentives to use the borrowed money in
ways that are not in the best interests of the lenders → shareholder-
lender conflict of interest.
• Two typical agency problems associated with debt financing:
1. Asset substitution: the shareholders have an incentive to
substitute less risky assets for more risky assets such as
negative-NPV projects.
2. Underinvestment: occurs when managers and shareholders
forego positive-NPV projects as they are risk-averse, especially in
a financially distressed company.
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Trade-off theory
• The trade-off theory of capital structure says that managers choose a
specific target capital structure based on the trade-offs between the
benefits and the costs of debt.
• The theory says that managers will increase debt to the point at which
the costs and benefits of adding an additional dollar of debt (MC = MB)
are …………… because this is the capital structure that maximizes
company value.
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Trade-off theory
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Pecking order theory
Internal funds
Debt
Equity
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The end!