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59 Cards in this Set
- Front
- Back
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assumptions pecking order theory |
- firm has assets and new project - mng info > mkt info - mng acts in best interest current shareholders - firm has no cash-> needs to issue equity to finance new project
Key distinctions: Not a static theory of capital structure Model aims to explain incremental financing choices |
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• P’ • V • Va • Vn • E |
• Market value of the old shares if the firm issues and invests •Market value of the old shares if the firm does not issue and does not invest • Instrinsic value of the company (known to managers) •Instrinsic value of the old shares • Instrinsic value of the new shares • Amount raised by selling new share |
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important pecking order theory conclusions |
- firm only invests in project in bad scenario - old shareholders sell shares at discount in good scenario - positive NPV project does not get funding in bad scenario. solution: internal funding |
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Loose ends pecking order theory |
i) Managerial objective function: why act on behalf of old shareholders only? |
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the reverting bond |
– At time 0, manager has private info re firm value. |
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implications of pecking order concerning investment |
•Will generally be underinvestment relative to first-best. (As long as debt, other securities are not a frictionless solution.) • Level of investment an increasing function of: stock of cash on hand, cashflow, untapped capacity to issue lowrisk debt. • Underpinnings of "financial accelerator" models in macro, e.g., Bernanke-Gertler (1989). |
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implications of pecking order concerning capital structure |
• Firms reluctant to issue equity, and resulting peckingorder behavior. • With costs of distress, get "modified" pecking order; more willingness to use equity when leverage high or investment prospects strong. • Observed price drops on announcement of stock issue. • Leverage ratio not stable; reflects cumulation of past profitability and investment decisions. Only reverts back toward "target" very slowly, if at all. • Makes sense to hoard cash during good times. |
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Interpretation Pecking Order Theory |
• Asymmetric info constrains SEOs but not other forms of external equity finance; hence Myers-Majluf a theory of issuance but not really of capital structure. |
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signaling manipulating |
bridging information gap between firm and investors
altering market’s perception of firm to your advantage |
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lowry capital demand proxies |
Change in number of new corporations Sales growth GDP growth Investment growth
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information asymmetry proxies lowry |
change in AR and earnings dispersion change in analyst dispersion |
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investor sentiment proxies |
Future EW market returns Fund discount |
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Lowry findings, why does # IPOs fluctuate so much? |
- in times of economic expansion, rise demand for capital, firms go public - driven by changes in investor optimism - during periods of high undertainty firms take advantage of info asymmetry |
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Grullon findings |
- repo firms: reduction in systematic risk - repo firms: reduction in cost of capital - mkt reaction more positive when firm likely to overinvest - mkt underreacts because underestimate decline in cost of capital - open market repo not followed by increase in operating performance |
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reasons open market repurchases |
1. signal better prospects 2. reduce fcf at mng disposal |
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grullons findings and cash-flow-signaling hypothesis |
The signaling hypothesis predicts that future earnings (and other profitability measures) should improve after share repurchase announcements. It also predicts that the information conveyed in the repurchase should also have an impact on the market’s expectations of future profitability. We find no evidence that repurchasing firms experience an improvement in future profitability relative to their peer firms. In fact, some of the performance measures indicate that repurchasing firms underperform their peers. We also find that analysts revise their expectations downward after the announcement of a share repurchase program. |
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grullon and free cash flow hypothesis |
- We find that repurchasing firms reduce their current level of capital expenditures and research and development (R&D) expenses. |
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When are agency problems of free cash flow likely to arise, according to grullon? |
We suggest that repurchases may be associated with a firm’s transition from a higher growth phase to a lower growth phase. As firms become more mature, their investment opportunity set becomes smaller. These firms have fewer options to grow, and their assets in place play a bigger role in determining their value, which leads to a decline in systematic risk |
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if investment opportunities decline after share repurchase announcements, why would the market react positively to such events? |
s by alluding to the notion that the market is already aware of the reduction in profitable investments, and it reacts positively to share repurchase announcements because these events reduce the amount of free cash flows at management’s disposal. Thus, the news (about the repurchase in this case) is about the reduction in agency costs. Second, as argued in Grullon, Michaely, and Swaminathan (2002), it is quite possible that the market, at least to some degree, is more aware of the decline in profitability than of the decline in risk that is associated with the decline in investments. The repurchase announcement makes the market more aware of both the decline in agency costs and the decline in risk |
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dividends and repo's are motivated by what factors according to grullon? |
When future investment opportunities are contracting, an increase in cash payouts conveys important information about management commitment to reduce the agency costs of free cash flow when those costs are potentially more pronounced. An increase in cash payouts also conveys information about changes in the risk profile and the cost of capital of the firm. |
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fundamental assumptions Vishny Shleifer |
In this theory, transactions are driven by stock market valuations of the merging firms. The fundamental assumption of the model is that financial markets are inefficient, so some firms are valued incorrectly. In contrast, managers are completely rational, understand stock market inefficiencies, and take advantage of them, in part through merger decisions. Mergers in this model are a form of arbitrage by rational managers operating in inefficient markets.
managers rationally respond to less-than-rational markets |
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predictions Shleifer Vishney |
(1) acquisitions are disproportionately for stock when aggregate or industry valuations are high, and for cash when they are low;
(2) the volume of stock acquisition increases with the dispersion of valuations among firms;
(3) targets in cash acquisitions earn low prior returns, whereas bidders in stock acquisitions earn high prior returns;
(4) bidders in stock acquisitions exhibit signs of overvaluation, such as earnings manipulation and insider selling;
(5) long-run returns to bidders are likely to be negative in stock acquisitions, and positive in cash acquisitions;
(6) despite negative long-run returns, acquisitions for stock serve the interest of longterm shareholders of the bidder;
(7) acquiring a firm in another industry may yield higher long-run returns than a related acquisition;
(8) management resistance to some cash tender offers is in the interest of shareholders;
(9) managers of targets in stock acquisitions are likely to have relatively short horizons or, alternatively, get paid for agreeing to the deal. |
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unique feature PE |
play role in mng |
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compensation from LP to GP |
1. fixed mng fee 2. carried interest |
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worries Phallipou |
VC funds as growth catalysts and BO funds as healthy arbitrageurs. It is only with knowledgeable LPs and trustees that this critically important industry can experience a sustainable growth |
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most visible manifestations of massive organizational change in economy, according to Jensen. |
Takeovers, corporate breakups, divisional spin-offs, leveraged buyouts, and going-private transactions. public equity is disappearing |
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new organizations gains |
-operating efficiency -employee productivity -shareholder value
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developments 80s according to jensen |
1. capital mkts in transition (mv of E tripled) 2. most widespread going private transaction (LBO): larger and more frequent 3. entire industries reshaped |
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decline in public corp is not due to |
1. tax deductability of interest 2. bankers and mng cashing out by transitory LBO to take public again later 3. systematic fleecing of shareholders and bondholders by insiders that have superior knowledge about true value |
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going public still viable option for |
companies with profitable inv opp that exceed internal cash (eg biotech, electronics, computering, financial services, pharma)
not suitable were long term growth is slow eg steel, chemicals, brewing, tobacco: cash rich, lowgrowth, decling sectors: pressure on mng because of wasteful spending |
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three major forces that are said to control mng in public corp |
1. product mkts 2. intrnal control systems led by BoD 3. capital mkts |
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reasons debt is good |
- compells mng limit waste of fcf (less empire building, bloated staffs, percs, organizational ineff) - risk of losing job when bankrupt - too high debt, companies force themselves to rethink and refocus, leaner efficient organizations - even new mng -mng discipline + resolving conflict of fcf - control function of debt |
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disadvantages of debt |
1. debt overhang (proceeds of positive NPV projects go to debt, not do the project) 2. higher risk of bankruptcy 3. asymmetric info then company might need cash to invest in pos NPV projects 4. earnings mng to meet interest payments 5. risk shifting: debtors mainly carry risk rather than shareholders. |
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Finding Fang Lerner Ivashina |
- direct investments perform better than public market indices (especially buyouts and those made in 90s) - limited outperformance of direct investments relative to PE benchmarks - Co investments underperform corresponding funds with which they coinvest - solo investments outperform fund inv. |
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coinvestments |
institutional investor coinvests in a deal that is originated by a PE fund mnger |
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solo investments |
institutional investor originates and invests in transaction alone |
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direct investments |
co investment solo investments |
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explanations for financial intermediaries |
1. pooling transaction costs 2. information/expertise advantages |
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why co investments underperform inv of corresponding funds?
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institutional investors can only co-invest in deals that are available to them. In particular, these transactions are substantially larger than an average sponsor's deal and appear to be concentrated at times when ex post performance is relatively poor. |
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results Fang etc. |
-First, the findings highlight the power of intermediation in the private equity setting. Our findings show that the net returns of the direct investments are in many cases similar to partnership transactions. Because private equity funds charge higher fees, this implies that the gross returns for investments intermediated by fund managers are substantially larger.
-Second, as predicted by theory, the power of intermediation is especially evident in information-sensitive environments. The performance of the direct deals deteriorates in settings where information problems make either deal selection or monitoring more difficult, for example, VC investments and those that are geographically distant from the investor, consistent with the theoretical arguments in Leland and Pyle (1977) and Diamond (1984).
-Third, our results hint at a complex set of agency problems between intermediaries and the ultimate investors that are not fully captured by most models of financial intermediation: for instance, the tendency of co-investments undertaken by these groups to cluster in the most overheated markets and largest deals. This is surprising from a theoretical perspective, as one would expect managers’ reputation concerns should curtail this behavior. One limitation of our data is that the time series is not long enough to investigate this issue in a repeated setting.
Overall, our results suggest that it is difficult for investors to capture the “rent” that private equity managers earn by investing directly. |
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homemade leverage |
investors leverage in their own portfolio to adjust leverage choice by firm. perfect substitute if they can lend and borrow for the same rate as the firm. |
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how can investor replicate payoffs of unlvered equity? |
- by buying both debt and equity of the firm: identical CF as unlevered firm. |
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leverage recapitalization |
when firm repurchases significant percentage of its outstanding shares with debt (number of shares decrease but value per share remains same).
share prices should rise due to immediate value creation from increase in leverage |
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MM1 |
E+D=U=A total market value of firms securities is equalt to mv of assets, whether firm is levered or unlevered
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MM2 |
the cost of capital of levered equity increases with the firms market value debt-equity ratio
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firms wacc is independent of |
its capital structure and its equal to its equity cost of capital, whcih matches the cost of its assets |
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Enterprise value does not depend on capital structure because.. |
you discount with wacc and wacc does not depend on capital structure |
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net debt |
debt-cash-shortterm investements |
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what happens to EPS when leverage increases? |
- expected eps increase - leverage effect-> volatility increase - shareholders demand higher rturn -effects cancel out and price share stays same
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when does issuing new shares not lead to dilution |
-when sold at fair price |
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interest expenses |
reduce corp tax rate: incentive to use debt |
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wether firm defaults depends on... |
relative value of assets and liabilities. not on cash flows. |
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3 keyfactors that determine PV of financial distress costs |
1. probability 2. discount (depends on mkt risk, will be higher for high beta firms) 3. magnitude |
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level debt too low |
- loss of tax benefits - excessive perks - wasteful investments - empire building
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debt level too high |
- excess interest payments - financial distress costs - excessive risk taking - under-investment/debt overhang |
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declaration date record date payment dat |
board authorizes dividend, firm is obligated to make the payment
shareholders recorded by this date receive payment
dividend is paid |
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why is optimal leverage lower for high growth companies? |
- often low current cf, so dont need tax shield - large cost of fin. distress - often human capital (cost of distress) - agency costs higher: need flexibility, sometimes need extra financing when new investment, more difficult with bank breathing down your neck - rather reinvest than pay interest - need all the cash they have to reinvest |
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conclusion vishny model |
- if target is less undervalued than acquirer: in short run acquisition bad idea in long run acquisition good idea
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underpricing |
- underwriters take into account the info they acquire during bookbuilding process: reduces exposure to risk: underpricing decreases possibility that bank has to sell for less than offer price - info assymetry between underwriter and potential investors: uncertainty about IPO price may lead to biased offering prices - reward for investor taking risk - asymm info among investors: underwriter has to underprice so that uninformed investors will also buy |
