Tradeoff and Pecking Order Theories of Debt by Frank and Goyal (2)

5/23/2018 Tradeoff and Pecking Order Theories of Debt by Frank and Goyal (2)

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Tradeoff and Pecking Order

Theories of Debt

By Frank and Goyal

Presented to: Dr. Khurram S. Mughal

Presented on: 15-05-2014

Presented by:

Aneeza YounusZareen Fatima

Sadia Khaliq

Fahd Salman Mirza


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Layout

Conceptual Framework oftheories of debt

M&M Theory

Trade-off Theories

Pecking Order

Evidences

Conclusion

Aneeza Younus

Zareen

Fatima

Sadia Khaliq

Fahd Salman Mirza

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Capital Structure Puzzle

Basic Question?

How do firms choose their capital

structures?

Broadly, capital irrelevance, trade off and

pecking order theories explains capital

structure decisions

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Modigliani Miller Theorem

(Propositions)

FirstUnder some assumptions, the value ofcompany is independent of itsleverage(debt + preferred stock)

SecondMultiple equilibrium is determined wheredebt is issued by different firms keepingin view the personal and corporate taxwhich also affect economy wide leverageratio such as debt to asset ratio, debt toequity ratio etc.

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Assumptions of MM Theorem

1. No consideration of taxes2. No transaction costs

3. No costs of financial distress or bankruptcy

4. No agency costs

5. Lack of separtability between financing andoperations

6. Investors have homogeneous expectations

of company returns or future cash flows7. Individuals investors can borrow at the

same interest rate as that of a company orfirm

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The theory has unrealistic assumptions

Later on by filling the gaps in the theory

(assumptions), various researchershave given their own theories

Empirically, MM theory is difficult to test

Criticism on Theory

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Plus Points

It remained relevant up till 1980

Influenced the early development of

both the trade-off theory and peckingorder theory

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Trade Off TheoryCharacteristics:

Theory that capital structure is based on a trade-offbetween debt and equity

If debt is more, equity would be less and if debt is less,

equity would be more

Firm evaluates the various costs and benefits of leverageplans

Different leverage plans are dependent on taxes

(personal + corporate), bankruptcy costs, tax schedules

and transaction costs

If the actual leverage ratio deviates from the optimal one,

the firm will adapt its financing behavior in a way that

brings the leverage ratio back to the optimal level

Solution

Obtained when equilibrium or balance point is reached 8


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The Static Trade Off Theory

Firms leverage is determined by asingle period trade-off between the tax

benefits of debt and the deadweight

costs of bankruptcy

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The Dynamic Trade Off Theory

Presents a model of dynamic optimalcapital structure choice in the presence

of recapitalization costs such as tax

rates, tax codes, transaction andbankruptcy costs

Capital Structure may not alwayscoincide with their target leverage ratios

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Pecking order theory The pecking order theory suggests that there is an order of

preference for the firm of capital sources when funding is needed.

The firm will seek to satisfy funding needs in the following order:

Internal funds

External funds

Debt

Equity

Firm size and age are important determinants of capital structure

Larger firms use less leverage

Older firms use less leverage

pecking order models can be derived based on adverse

selection consideration and agency cost.

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Pecking Order Theory There are three factors that the pecking order

theory is based on and that must beconsidered by firms when raising capital.

1. Internal funds are cheapest to use (no issuancecosts) and require no private information release.

2. Debt financing is cheaper than equity financing.3. Managers tend to know more about the future

performance of the firm than lenders andinvestors. Because of this asymmetric information,investors may make inferences about the value ofthe firm based on the external source of capital thefirm chooses to raise. Equity financing inferencefirm is currently overvalued

Debt financing inferencefirm is correctly orundervalued

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Asymmetric-Information Costs

Definition:The costs of overcoming two types ofinformation problems:

Adverse selection:separating good from bad risks

before implementation of a financial contract.

Agency theory:insuring that economic agentswith proxy authority live up to the terms of their

contracts.

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Adverse selection

The key idea is that the owner-manager ofthe firm knows the true value of the firms

assets and growth opportunities.

Outside investors can only guess these

values. If the manager offers to sell equity,then the outside investor must ask why the

manager is willing to do so.

manager of an overvalued firm will be happy

to sell equity, while the manager of anundervalued firm will not.

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Adverse selection refers to a market process inwhich undesired results occur when buyersand sellers have asymmetric information(access to different information); the "bad"products or services are more likely to beselected.

Adverse selection make some financing vehicles

much more expensive than others Managers want to issue new stock only when it is

overvalued.

Stock issuance is a bad signal.

Stock issuance causes the price of outstandingstock to fall.

Decline in stock price is part of the cost ofexternal finance.

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http://en.wikipedia.org/wiki/Information_asymmetrieshttp://en.wikipedia.org/wiki/Information_asymmetries


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Conclusion of adverse selection

Adverse selection models can be alittle mild. It is possible to construct

equilibrium with a pecking order, But

adverse selection does not imply thatpecking order as the general situation.

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Agency theory

Principal-Agent Problem: Principal designates anagent to act on his behalf. But becausemonitoring and disciplining are costly, the agenthas scope to pursue his own interest at theexpense of the principal.

Examples:

1. Separation of ownership from control allows managersto use firm resources to pursue their own interestsrather than maximize shareholder value.

2. Separation of savers and investors allows investors touse surplus funds to pursue their own interests ratherthan accept the capital projects with the highest netpresent value.

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Debt Financing and Agency

Costs One agency problem is that managers

can use corporate funds for non-valuemaximizing purposes.

The use of financial leverage: Bonds free cash flow. Avoid bonuses and non-value adding

acquisition.

A second agency problem is the potential

for underinvestment. Debt increases risk of financial distress.

Therefore, managers may avoid riskyprojects even if they have positive NPVs.

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LEVERAGE DIFFERENCES

BETWEEN FIRMS

Debt ratios vary among firms on thebasis of :

Determining Factors correlated with

leverage

Debt conservatism puzzle

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Leverage Definition & Other

Econometric Issues

Leverage is defined asi. Book leverage (debt/total assets) or

ii. Market leverage (debt/total assets + market value ofequity)

Early studies focused on book leverage

because Debt is better supported by assets in place than growth

opportunities

Market value fluctuates, so gives unreliable figures

Backward looking

Subsequent studies focused on marketleverage because Book value only balance the two sides of balance sheet

Book value can be negative

Market value is forward looking

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Econometric Issues

1. Panel structure of data Can be overcome by using more than one methods

2. Incomplete data in panel

Can be overcome by multiple imputation

3. Outliers

Can overcome by rule of thumb (remove extreme

data), winsorization (most extreme tails of distribution

are replaced by most extreme value that has not been

removed) & robust regressions4. Assumptions about debt market

Use of book debt to study debt market

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LEVERAGE FACTORS

1. Leverage & growth

2. Leverage & Firm size

3. Leverage & Tangibility of assets

4. Leverage & profitability

5. Leverage & industry median debt ratios

6. Leverage & dividends

7. Leverage & expected inflation

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1. Leverage & Growth

i. Static trade-off theory predicts negativecorrelation between these variables because of:

Underinvestment problem

Growth firms lose their value when are in distress

Asset substitution issue In high growth firms, stockholders can easily increase project risk

Agency cost of free cash flow is less severe

ii. Pecking order theory predicts positive relation

between these variables

Different studies conclude negative correlation

between leverage & growth

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2. Leverage & Firm size

i. Static trade-off theory predicts positive correlationbetween variables because

Are more diversified

Low default risk

ii. Pecking order theory predicts negative correlation

between variables because

Adverse selection issue is low so equity issuance is

easy

Studies find positive relationship between leverage

& firm size

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3. Leverage & Tangibility of assets

Tangibility of assets is measured by:

Fixed Assets/ Total assets

i. Static tradeoff theory & Agency theory predicts

positive relation between variables because:

Easily collateralize-able

Difficult to replace high risk assets with low risk

assets

ii. Pecking order theory predicts negative relation

because:

Low information asymmetry makes equity issue less

costly

Studies found positive relation between leverage &

tangibility of assets

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4. Leverage & Profitability

i. Static trade off theory predicts positive relationbetween variables because:

Bankruptcy cost is low

Tax shields are more valuable

ii. Pecking order theory predicts negative relation

because: Profitable firms prefer internal financing

Studies find negative relation between leverage &profitability

5. Leverage & Industry median debt ratios

Different empirical studies find the positive relationbetween variables

Firms adjust their ratios towards industry ratios 26


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6. Leverage & Dividends

Static trade-off theory predicts positive relation ashigh levered firms should pay more dividend to seemless risky

Dynamic trade-off theory predicts negative relation

Pecking order theory predicts positive relation Empirical studies show negative relation between

leverage & dividends

7. Leverage & Expected Inflation Tax code suggests positive relation between

variables

Tax deduction on debt is higher if expected inflation

rate is higher 27


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DEBT CONSERVATISM Debt conservatism puzzle means that many firms are having

lower leverage than would maximize firm value

Miller find that bankruptcy cost is too small to offset large taxsubsidies of debt

He regarded tax gains & bankruptcy cost as horse & rabbitstew recipe

i. Bankruptcy cost

Direct bankruptcy costs are less than indirect ones Molina find that ex-ante cost of financial distress are

comparable to the current estimates of tax benefit of debt

ii. Tax Benefit

Information about tax shield is difficult to obtain

Graham & Tucker find that firms with tax shelters use lessdebt but their results are criticized by different researchers

Ju et al (2004) find that firms have more leverage thanoptimal ratio

Behaviorist approach find out that overconfident managerchooses more debt than rational one 28


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STUDIES OF LEVERAGE

CHANGES

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Tests of Pecking Order

Changes in debt have played an important role in

assessing pecking order theory because financing deficit

is suppose to drive debt

The regression of net debt issues on financing deficit has

slope equal to 1

Shyam-Saunders & Myers find a strong support for the

pecking order theory (0.75 regression slope)

Frank & Goyal (2003) found that equity is used more

than debt for financing deficit This shows that other cross-sectional factors are more

important than financing deficit

Support for pecking order theory is found among large

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Debt Capacity Lemmon & Zender gave the idea of debt capacity in

understanding rejection of pecking order theory that whenconstrained by debt capacity, firm issues equity otherwisedebt is issued

Firms with debt rating are unconstrained by debt capacity Hhalov & Heider (2004) argues that in case of information

asymmetry, debt has more adverse selection problem(asset volatility), so firms issue equity

Debt ratios donot rise prior to equity issues, suppotrespecking order theory (Korrajczyk et al. 1990)

Less than 40% firms follow pecking order while issuingdebt where as almost half of the firms follow order whileissuing equity

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Tests of Mean Reversion

Static trade-off theory predicts a debt ratio that depends upon

tax benefits & cost of financial distress (target adjustment

process)

But data reveals that leverage is quite stable in American firms

Early studies used long term average as a target assuming

factors causing change are constant Recent studies use two step procedure:

i. Target equation

ii. Adjusted equation

Different studies show that firms adjust towards target debt

ratio

But the speed with which adjustment towards target is made is

not a settled issue

Pattern of leverage changes are due to different adjustment

costs Levera e mean reversion ha ens throu h debt market

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Exit

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Previous literature & theories suggest that

Bankruptcy is the only way of exit

Mergers & acquisitions are more common reason for

exit than bankruptcy & liquidations Exit by merger is different from exit by liquidation

In exit by merger & acquisitions, assets receive more

value than exit by liquidation

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Effect Of Current Market Conditions On

Leverage Adjustment Choices

Factors affect leverage choices are

1. Market to book ratio

2. Inflation rate

But these two do not affect long term leverage ratio

Firms that issue equity in good markets have low

leverage ratio for a decade (Baker & Wurgler, 2002)

Different studies find that market timings have

effects on leverage but disappear after one 1-2years

Effect of shocks on equity are permanent

This idea was rejected because usually good equity

returns are followed by more stock issues 35


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Market Valuation of Leverage Changes

Predictions

What are the Valuation effects on repurchases or

exchanges of one security for another?

Trade-off Theory:

Firms will only take actions if they expect benefits. Market reaction to both equity and debt securities

will be positive

Two pieces of information confounding response to

leverage change:i) The revelation of the fact that the firms conditions

have changed, necessitating financing.

ii) The effect of the financing on security valuations


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Good news if the firm is issuing securities to take

advantage of a promising new opportunity that wasnot previously anticipated.

Bad news if the firm is issuing securities because

the firm actually needs more resources than

anticipated to conduct operations.Agency Perspective:

Equity issues by firms with poor growth prospects

reflect agency problems between managers and

shareholders. If this is the case, then stock prices would react

negatively to news of equity issues.

f C


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Pecking Order Theory:

Predicts that securities with more adverse selection(equity) will result in more negative market reaction.

Securities with less adverse selection (debt) will

result in less negative or no market reaction.

EvidenceEckbo and Masulis (1995)

Announcements of corporate debt issues and debt

repurchases have little if no effect on the market

value of the firm.Announcements of equity issues are generally

associated with a drop in the market value of the

firm.

Announcements of equity repurchases are

generally associated with an increase in the market



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Market Valuation of Leverage ChangesJung et al. (1996)

Firms without valuable investment opportunities

experience a more negative stock price reaction toequity issues than do firms with better investment

opportunities.

Firms with low managerial ownership have worse

stock price reaction to new equity issue

announcements than do firms with high managerial

ownership (Agency view)

Eckbo and Masulis (1992)

Examined stock price reactions to equity issues

conditional on a firms choice of flotation method.Announcements of security issues typically

generate a non-positive stock price reaction.

The valuation effects are the most negative for

common stock issues, slightly less negative for



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Natural Experiments

Blanchard et al. (1994) Examined a sample of 11 firms and found that firms

increased their long-term debt following the cash

windfall.

The pecking order predicts an increase in debt if

firms have attractive investment opportunities andborrow more money.

The increase in debt following cash windfalls is

inconsistent with the pecking order theory.

The agency theories predict that managers expandwhen possible.

Firms are able to increase debt because cash

windfalls increase a firms debt capacity.

Consistent with Agency theory.



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Natural Experiments

Cash can be viewed as negative debt, then, thecash windfall is a reduction in leverage.

If the original leverage was optimal, then the firm

needs to increase its debt (or repurchase equity) in

response to the windfall.

Compatible with the trade-off theory perspective.

Experiments on Tax

Calomiris and Hubbard (1995) show that firms

increased their debt after the introduction of theundistributed profits tax.

Consistent with firms increasing the amount of debt

to reduce taxes on retained profits.



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Natural Experiments

Experiments on Tax In 1986, there was a tax reform that reduced both

corporate and personal marginal tax rates.

Firms with high tax rates prior to the tax reform

reduced their debt the most after the tax reform.

(Consistent with Trade-Off theory) In 2003, there was a large cut in individual dividend

income taxes.

Chetty and Saez (2004) show that there was a

significant increase in dividend payments followingthe tax cut.

Goyal et al. (2002) examine the US defense

industry during the 1980-1995 period.

Examined how the level and structure of corporate

debt changed when growth opportunities declined.



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Natural Experiments

Experiments on Tax New debt issued increased significantly for

weapons manufacturers during the low growth

period.

Dittmar (2004) and Mehrotra et al. (2003) examine

the capital structure choices that firms make whenengaging in spinoffs.

Firms with higher tangibility of assets are allocated

more leverage. Assets with lower liquidation costs

have more leverage.



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Surveys

The most common criticism of survey approach isthat it measures beliefs rather than actions.

The approach implicitly assumes that managers

beliefs reflect reality.

Graham and Harvey (2001) This desire for financial flexibility seems

inconsistent with the pecking order theory since

dividend-paying firms value flexibility the most.

Firms that perceive their stock to be undervalued

are reluctant to issue equity.

CFOs consider the tax advantages of debt to be

moderately important.



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Surveys

Managers show great deal of concern about creditratings and earnings volatility in making debt

decisions.

European managers also rank financial flexibility as

the most important factor in determining their firmsdebt policy.

Tax advantage of interest expense ranked as the

fourth most important factor after financial flexibility,credit rating and earnings volatility.

Conclusion/Stylized facts


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According to the standard trade-off theory, taxes

and bankruptcy account for the corporate use of

debt.According to the standard pecking order theory,

adverse selection accounts for the corporate use of

debt.

Private firms seem to use retained earnings andbank debt heavily.

Small public firms make active use of equity

financing.

Large public firms primarily use retained earnings

and corporate bonds.

Direct transaction costs and indirect bankruptcy

costs appear to play important roles in a firms

choice of debt.

Over long periods of time, leverage [debt/assets] is



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Firms adjust their debt frequently. The financing

deficit plays a role in these decisions.

Aggregate dividends are very smooth and almostflat as a fraction of total assets for all classes of

firms.

After an IPO, equity issues are more important for

small firms than for large firms. Many small firmsissue equity fairly often.

Mergers and acquisitions are more common

reasons for exit than are bankruptcies and

liquidations.

Announcements of corporate debt issues and debt

repurchases have little if any effect on the market

value of the firm.

Announcements of equity issues are generally

associated with a drop in the market value of the



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Announcements of equity repurchases are

generally associated with an increase in themarket value of the firm.

The natural experiments papers are generally

easy to understand from the perspective of the

trade-off theory.


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Thank You

Documents

Tradeoff and Pecking Order Theories of Debt by Frank and Goyal (2)