Professional Documents
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Agency Theory
Probability
High risk
0
E(EBIT)
EBIT
General Rule: The greater the business risk, the lower the
optimal debt ratio.
EBITL
EBITH
Impact on WACC
Impact on WACC
Cost of debt (RD) is interest payable on debt.
RD reduced due to govt. subsidy on interest payments.
Taking on debt therefore reduces WACC.
As we take on debt we
Increase firm value due to interest tax shield benefit
But also increase cost of bankruptcy.
Taxes:
Tax benefit from leverage only important to firms in
a tax-paying position (i.e. Profitable)
Firms with substantial tax shields from other
sources (e.g. Depreciation) receive less benefit.
Not all firms have same tax rate. Higher tax rate,
greater incentive to borrow.
Financial Distress:
Firms with greater risk of financial distress will borrow
less than those with less risk.
Trades off higher E(ROE) and EPS against higher risk. The
tax-related benefits of leverage are exactly offset by the
debts risk-related costs.
The target capital structure is the mix of debt, preferred
stock, and common equity with which the firm intends to
raise capital.
Diamond (1989)
Firms have incentive to pursue safe projects
Debtholders dislike firms with history of risky investments
Build history of safe investments for best lending terms
May be incentive for small firms to take on risky investments early
in life
If they survive without defaulting, will eventually switch to safe
projects
Therefore likely that younger firms have less debt than older ones
An equity issue
Good news (+ve NPV projects)?
Bad news (shares overvalued)?
A debt issue
Share prices don't fall - convey more positive news
Management feels they can service new debt
Ross (1977)
Managers possess more information on firm than market
Managers benefit if equity value increases
Managers penalized if firm goes bankrupt
Investors take high debt levels as sign of quality
Low quality firms have higher marginal costs of debt and
therefore issue less debt
Ross (1977)
Finds that firm value and D/E ratio positively related
However, greater debt also increases bankruptcy costs
Quality firm able to accommodate costs of debt,
however.
Existing may have captured more return if debt used instead of equity
Avoid this by issuing security not undervalued by market (e.g. Debt)
Booth (2001):
Factors influencing capital structure decisions similar
across developing and developed markets regardless of
significant differences in financial environments
Find that firms with good profits tend to have less debt
(pecking order)
Also significant information asymmetries exist making
external financing potentially expensive.
Also support for impact of asset intangibility on debt
levels.