Wrap up of Financing Katharina Lewellen Finance Theory II March 11 2003 Overview of Financing Financial forecasting Short run forecasting General dynamics Sustainable growth Capital structure Describing a firm s capital structure Benchmark MM irrelevance Theory 1 Static Trade Off Theory Theory 2 Pecking Order Theory An integrated approach Note Throughout we take operations as given 2 Forecasting a Firm s Funding Needs Question Given our operations and the forecast thereof will we need funding and how much Short run forecasting General dynamics The concept of sustainable growth Cash Cows and Finance junkies 3 Financial Forecasting General Approach Need a model of the firm s production function Use available data Common sense Specific knowledge of firm and industry Given this model forecast all items in the balance sheet except funding needs Infer the funding need from identity of Assets and Liabilities Net Worth 4 Forecasting Our approach Forecast Assets Forecast non bank liabilities excluding Net Worth Forecast Net Income Assume some starting value for Bank Loan Bank Plug Forecast interest using Bank Plug Forecast Net Worth Consistency check Assets Liabilities Net Worth If yes stop If not adjust Bank Plug Recall All we want are rough approximations 5 General Dynamics Sustainable Growth Rate g 1 d ROE Gives a very rough measure of how fast you can grow Assets without increasing your leverage ratio or issuing equity Sustainable growth rate increases when Dividends d decreases Profit margins NI Sales increases Asset turnover Sales Assets increases Leverage Assets NW increases 6 Key Points Key Point 0 The concept of sustainable growth does not tell you whether growing is good or not Key Point 1 Sustainable growth is relevant only if you cannot or will not raise equity and you cannot let D E ratio increase Key Point 2 Sustainable growth gives a quick idea of general dynamics Cash cows g g or Finance junkies g g Key Point 3 Financial and business strategies cannot be set independently 7 Capital Structure Describing a firm s capital structure MM theorem Theory 1 Static Trade off Theory Tax shield vs Expected distress costs Theory 2 Pecking Order Theory Implications for investment Implications for capital structure Pulling it all together 8 MM Theorem MM In frictionless markets financial policy is irrelevant Finance Theory 1 Financial transactions are NPV 0 QED Corollary All the following are irrelevant Capital structure Long vs short term debt Dividend policy Risk management Etc 9 Evaluate the following statements Issuing equity dilutes earnings per share and thus hurts current shareholders Equity in a levered firm is riskier than equity in an unlevered but otherwise identical firm Currently interest rates are high so it is better to issue equity than debt Currently short term interest rates are lower than long term interest rates so it is better to issue long term than short term debt 10 Using MM Sensibly When evaluating an argument in favor of a financial move Ask yourself Why is financing argument wrong under MM Avoid fallacies such as mechanical effects on accounting measures e g WACC EPS Win win Ask yourself what frictions does the argument rely on Taxes Costs of financial distress Information asymmetry Agency problems If none dubious argument If some evaluate magnitude 11 Financing Choices Debt vs Equity 12 Theory 1 Static Trade Off Theory Talks about costs and benefits of Debt relative to Equity The optimal target capital structure is determined by balancing Tax Shield of Debt Expected Costs of Fin Distress Note The theory does not give you a precise target but rather a range an order of magnitude 13 Tax Shield of Debt Debt increases firm value by reducing corporate tax bill This is because interest payments are tax deductible Personal taxes tend to reduce but not offset this effect V w debt V all equity PV tax shield Order of magnitude for PV tax shield Constant debt level t D t marginal tax rate depends on country tax credits etc Note A move that increases firm value will increase equity value 14 Expected Costs of Distress Two Terms Expected costs of financial distress Probability of Distress Costs if actually in distress 15 Probability of Distress Cashflow volatility Is industry risky Is firm s strategy risky Are there uncertainties induced by competition Is there a risk of technological change Sensitive to macroeconomic shocks seasonal fluctuations Etc Use past data but also knowledge of industry Beware of changes of environment 16 Indirect costs of financial distress Debt overhang Inability to raise funds to undertake investments Pass up valuable projects Do I need to invest Rivals become aggressive Do I have aggressive rivals Scare off customers and suppliers e g implicit warranty or specific investment Do other parties care Asset fire sales Are assets easily re deployable Are my assets valuable to other firms e g R D Who are potential buyers How many Will they be cash constrained when I want to sell my assets 17 Checklist for Target Capital Structure Tax Shield Would the firm benefit from debt tax shield Is it profitable Does it have tax credits Expected distress costs Are cashflows volatile Need for external funds for investment Competitive threat if pinched for cash Customers and suppliers care about distress Are assets easy to re deploy Note Hard to renegotiate debt structure increases distress costs Recall Massey s complex debt structure 18 Theory 2 Pecking Order Firms general financing choices Preferably use retained earnings Then borrow from debt market As a last resort issue equity Theory Info asymmetry between firm and market makes External finance more costly than internal funds Debt less costly than equity because less info sensitive 19 Implications for Investment The value of a project depends on how it is financed Some projects will be undertaken only if funded internally or with relatively safe debt but not if financed with risky debt or equity Companies with less cash and more leverage will be more prone to under invest Rationale for hoarding cash 20 Implications for Capital Structure If a firm follows the Pecking Order its leverage ratio results from a series of incremental decisions not attempt to reach a target High cash flow Leverage ratio decreases Low cash flow Leverage ratio increases There may be good and bad times to issue equity depending on the degree of information asymmetry Rationale for hybrid instruments 21 What Do We Do With Two Theories