Description
Financing decision is a decision that concerns the liabilities and stockholders' justness side of the firm's balance sheet. It can also be defined as a judgment made concerning the method of raising funds.
Capital Structure: Financing Decisions Lecture 6
Who are Modigliani and Miller (MM)?
• They published theoretical papers that changed the way people thought about financial leverage. • They won Nobel prizes in economics because of their work. • MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.
The Miller-Modigliani Theorem
• In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. • The value of a firm is independent of its debt ratio.
Assumptions of the Modigliani-Miller Model
• • • • Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets:
– – – – – Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes
The Capital-Structure Question and The Pie Theory • V=B+S
B S
Value of the Firm
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
Current Assets RM20,000 Debt RM0 Equity RM20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price RM50
Proposed RM20,000 RM8,000 RM12,000 2/3 8% 240 RM50
EPS and ROE Under Current Capital Structure
Recession EBIT Interest Net income EPS ROA ROE RM1,000 0 RM1,000 RM2.50 5% 5%
Expected RM2,000 0 RM2,000 RM5.00 10% 10%
Expansion RM3,000 0 RM3,000 RM7.50 15% 15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Capital Structure
Recession EBIT Interest Net income EPS ROA ROE RM1,000 640 RM360 RM1.50 5% 3% Expected RM2,000 640 RM1,360 RM5.67 10% 11% Expansion RM3,000 640 RM2,360 RM9.83 15% 20%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Both Capital Structures
All-Equity Recession EBIT RM1,000 Interest 0 Net income RM1,000 EPS RM2.50 ROA 5% ROE 5% Current Shares Outstanding = 400 shares Levered Recession RM1,000 640 RM360 RM1.50 5% 3% Expected RM2,000 0 RM2,000 RM5.00 10% 10% Expansion RM3,000 0 RM3,000 RM7.50 15% 15%
EBIT Interest Net income EPS ROA ROE
Expected RM2,000 640 RM1,360 RM5.67 10% 11%
Expansion RM3,000 640 RM2,360 RM9.83 15% 20%
Proposed Shares Outstanding = 240 shares
Financial Leverage and EPS
12.00 10.00 8.00 EPS 6.00 4.00 2.00 0.00 (2.00) Break-even point Debt No Debt
Advantage to debt
Disadvantage to debt
1,000
2,000
3,000
EBIT EBI in ringgit, no taxes
Homemade Leverage: An Example
Recession EPS of Unlevered Firm Earnings for 40 shares Less interest on RM800 (8%) Net Profits ROE (Net Profits / RM1,200) RM2.50 RM100 RM64 RM36 3% Expected RM5.00 RM200 RM64 RM136 11% Expansion RM7.50 RM300 RM64 RM236 20%
We are buying 40 shares of a RM50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:
B $800 2 = = 3 S $1,200
Homemade (Un)Leverage: An Example
Recession RM1.50 RM36 RM64 RM100 5% Expected RM5.67 RM136 RM64 RM200 10% Expansion RM9.83 RM236 RM64 RM300 15%
EPS of Levered Firm Earnings for 24 shares Plus interest on RM800 (8%) Net Profits ROE (Net Profits / RM2,000)
Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M
The MM Propositions I & II (No Taxes)
• Proposition I – Firm value is not affected by leverage VL = VU • Proposition II – Leverage increases the risk and return to shareholders rs = r0 + (B / SL) (r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity
The MM Proposition I (No Taxes)
The derivation is straightforward:
Shareholders in a levered firm receive EBIT ? rB B
Bondholders receive rB B
The present value of this stream of cash flows is VL
Thus, the total cash flow to all stakeholders is ( EBIT ? rB B) + rB B Clearly ( EBIT ? rB B) + rB B = EBIT The present value of this stream of cash flows is VU
?VL = VU
The MM Proposition II (No Taxes)
The derivation is straightforward:
rWACC B S = × rB + × rS B+S B+S
Then set rWACC = r0
multiply both sides by B+S S
B S × rB + × rS = r0 B+S B+S
B+S B B+S S B+S × × rB + × × rS = r0 S B+S S B+S S
B B+S × rB + rS = r0 S S
B B × rB + rS = r0 + r0 S S
B rS = r0 + (r0 ? rB ) S
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes
Cost of capital: r (%)
rS = r0 +
B × (r0 ? rB ) SL
r0
rWACC =
B S × rB + × rS B+S B+S
rB
rB
Debt-to-equity Ratio B S
The MM Propositions I & II (with Corporate Taxes) • Proposition I (with Corporate Taxes)
– Firm value increases with leverage VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is offset by interest tax shield
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt) rS is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity
The MM Proposition I (Corp. Taxes)
Shareholders in a levered firm receive ( EBIT ? rB B) × (1 ? TC )
Bondholders receive rB B
Thus, the total cash flow to all stakeholders is ( EBIT ? rB B) × (1 ? TC ) + rB B
The present value of this stream of cash flows is VL
Clearly ( EBIT ? rB B) × (1 ? TC ) + rB B = = EBIT × (1 ? TC ) ? rB B × (1 ? TC ) + rB B = EBIT × (1 ? TC ) ? rB B + rB BTC + rB B The present value of the first term is VU
The present value of the second term is TCB
?VL = VU + TC B
The MM Proposition II (Corp. Taxes)
Start with M&M Proposition I with taxes: Since
VL = VU + TC B
VL = S + B ? S + B = VU + TC B VU = S + B (1 ? TC )
The cash flows from each side of the balance sheet must equal:
SrS + BrB = VU r0 + TC BrB SrS + BrB = [ S + B(1 ? TC )]r0 + TC rB B Divide both sides by S B B B rS + rB = [1 + (1 ? TC )]r0 + TC rB S S S
Which quickly reduces to
B rS = r0 + × (1 ? TC ) × (r0 ? rB ) S
The Effect of Financial Leverage on the Cost of Debt and Equity Capital
Cost of capital: r (%)
rS = r0 +
B × (1 ? TC ) × (r0 ? rB ) SL
r0
rWACC =
B SL × rB × (1 ? TC ) + × rS B+SL B + SL
rB
Debt-to-equity ratio (B/S)
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-Equity
EBIT Interest EBT Taxes (Tc = 35% Total Cash Flow to S/H Recession RM1,000 0 RM1,000 RM350 RM650 Expected RM2,000 0 RM2,000 RM700 RM1,300 Expansion RM3,000 0 RM3,000 RM1,050 RM1,950
Levered
Recession EBIT RM1,000 Interest (RM800 @ 8% ) 640 EBT RM360 Taxes (Tc = 35%) RM126 Total Cash Flow RM234+640 (to both S/H & B/H): RM874 EBIT(1-Tc)+TCrBB RM650+RM224 RM874 Expected RM2,000 640 RM1,360 RM476 RM468+RM640 RM1,524 RM1,300+RM224 RM1,524 Expansion RM3,000 640 RM2,360 RM826 RM1,534+RM640 RM2,174 RM1,950+RM224 RM2,174
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-equity firm
S G
Levered firm
S G
B
The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by capital structure. • This is M&M Proposition I:
VL = VU
• Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. B
rS = r0 + SL × (r0 ? rB )
• In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders
Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. • This is M&M Proposition I:
VL = VU + TC B
• Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. • In a world of taxes, M&M Proposition II states that leverage increases the risk and return to shareholders.
B rS = r0 + × (1 ? TC ) × (r0 ? rB ) SL
Costs of Financial Distress
• Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. • Rather it is bankruptcy. the costs associated with
• It is the shareholders who bear these costs.
Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a small percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales) – Agency Costs
• Selfish strategy 1: Incentive to take large risks • Selfish strategy 2: Incentive toward underinvestment • Selfish Strategy 3: Milking the property
Balance Sheet for a Company in Distress
Assets Cash F.Asset Total BV MV RM200 RM200 RM400 RM0 RM600 RM200 Liabilities BV LT bonds RM300 Equity RM300 Total RM600 MV RM200 RM0 RM200
What happens if the firm is liquidated today?
The bondholders get RM200; the shareholders get nothing.
Selfish Strategy 1: Take Large Risks
The Gamble Win Big Lose Big Probability 10% 90% Payoff RM1,000 RM0
Cost of investment is RM200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = RM1000 × 0.10 + RM0 = RM100
$100 NPV = ?$200 + 1.50 NPV = ?$133
Selfish shareholders Accept Negative NPV Project with Large Risks
• Expected CF from the Gamble – To Bondholders = RM300 × 0.10 + RM0 = RM30 – To shareholders = (RM1000 - RM300) × 0.10 + RM0 = RM70 • PV of Bonds Without the Gamble = RM200 • PV of Stocks Without the Gamble = RM0 • PV of Bonds With the Gamble = RM30 / 1.5 = RM20 • PV of Stocks With the Gamble = RM70 / 1.5 = RM47
Selfish Strategy 2: Underinvestment
• Consider a government-sponsored project that guarantees RM350 in one period • Cost of investment is RM300 (the firm only has RM200 now) so the shareholders will have to supply an additional RM100 to finance the project • Required return is 10%
$350 NPV = ?$300 + 1.10 NPV = $18.18
•Should we accept or reject?
Selfish Shareholders Forego Positive NPV Project
• Expected CF from the government sponsored project: – To Bondholder = RM300 – To Stockholder = (RM350 - RM300) = RM50 • PV of Bonds Without the Project = RM200 • PV of Stocks Without the Project = RM0 • PV of Bonds With the Project = RM300 / 1.1 = RM272.73 • PV of Stocks with the project = RM50 / 1.1 - RM100 = -RM54.55
Selfish Strategy 3: Milking the Property
• Liquidating dividends
– Suppose our firm paid out a RM200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures.
• Increase perquisites to shareholders and/or management
The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. – Rule 1 • Use internal financing first. – Rule 2 • Issue debt next, equity last. • The pecking-order Theory is at odds with the trade-off theory: – There is no target D/E ratio. – Profitable firms use less debt. – Companies like financial slack
doc_368695945.pdf
Financing decision is a decision that concerns the liabilities and stockholders' justness side of the firm's balance sheet. It can also be defined as a judgment made concerning the method of raising funds.
Capital Structure: Financing Decisions Lecture 6
Who are Modigliani and Miller (MM)?
• They published theoretical papers that changed the way people thought about financial leverage. • They won Nobel prizes in economics because of their work. • MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977. The papers differed in their assumptions about taxes.
The Miller-Modigliani Theorem
• In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. • The value of a firm is independent of its debt ratio.
Assumptions of the Modigliani-Miller Model
• • • • Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets:
– – – – – Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes
The Capital-Structure Question and The Pie Theory • V=B+S
B S
Value of the Firm
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
Current Assets RM20,000 Debt RM0 Equity RM20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price RM50
Proposed RM20,000 RM8,000 RM12,000 2/3 8% 240 RM50
EPS and ROE Under Current Capital Structure
Recession EBIT Interest Net income EPS ROA ROE RM1,000 0 RM1,000 RM2.50 5% 5%
Expected RM2,000 0 RM2,000 RM5.00 10% 10%
Expansion RM3,000 0 RM3,000 RM7.50 15% 15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Capital Structure
Recession EBIT Interest Net income EPS ROA ROE RM1,000 640 RM360 RM1.50 5% 3% Expected RM2,000 640 RM1,360 RM5.67 10% 11% Expansion RM3,000 640 RM2,360 RM9.83 15% 20%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Both Capital Structures
All-Equity Recession EBIT RM1,000 Interest 0 Net income RM1,000 EPS RM2.50 ROA 5% ROE 5% Current Shares Outstanding = 400 shares Levered Recession RM1,000 640 RM360 RM1.50 5% 3% Expected RM2,000 0 RM2,000 RM5.00 10% 10% Expansion RM3,000 0 RM3,000 RM7.50 15% 15%
EBIT Interest Net income EPS ROA ROE
Expected RM2,000 640 RM1,360 RM5.67 10% 11%
Expansion RM3,000 640 RM2,360 RM9.83 15% 20%
Proposed Shares Outstanding = 240 shares
Financial Leverage and EPS
12.00 10.00 8.00 EPS 6.00 4.00 2.00 0.00 (2.00) Break-even point Debt No Debt
Advantage to debt
Disadvantage to debt
1,000
2,000
3,000
EBIT EBI in ringgit, no taxes
Homemade Leverage: An Example
Recession EPS of Unlevered Firm Earnings for 40 shares Less interest on RM800 (8%) Net Profits ROE (Net Profits / RM1,200) RM2.50 RM100 RM64 RM36 3% Expected RM5.00 RM200 RM64 RM136 11% Expansion RM7.50 RM300 RM64 RM236 20%
We are buying 40 shares of a RM50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:
B $800 2 = = 3 S $1,200
Homemade (Un)Leverage: An Example
Recession RM1.50 RM36 RM64 RM100 5% Expected RM5.67 RM136 RM64 RM200 10% Expansion RM9.83 RM236 RM64 RM300 15%
EPS of Levered Firm Earnings for 24 shares Plus interest on RM800 (8%) Net Profits ROE (Net Profits / RM2,000)
Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M
The MM Propositions I & II (No Taxes)
• Proposition I – Firm value is not affected by leverage VL = VU • Proposition II – Leverage increases the risk and return to shareholders rs = r0 + (B / SL) (r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity
The MM Proposition I (No Taxes)
The derivation is straightforward:
Shareholders in a levered firm receive EBIT ? rB B
Bondholders receive rB B
The present value of this stream of cash flows is VL
Thus, the total cash flow to all stakeholders is ( EBIT ? rB B) + rB B Clearly ( EBIT ? rB B) + rB B = EBIT The present value of this stream of cash flows is VU
?VL = VU
The MM Proposition II (No Taxes)
The derivation is straightforward:
rWACC B S = × rB + × rS B+S B+S
Then set rWACC = r0
multiply both sides by B+S S
B S × rB + × rS = r0 B+S B+S
B+S B B+S S B+S × × rB + × × rS = r0 S B+S S B+S S
B B+S × rB + rS = r0 S S
B B × rB + rS = r0 + r0 S S
B rS = r0 + (r0 ? rB ) S
The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes
Cost of capital: r (%)
rS = r0 +
B × (r0 ? rB ) SL
r0
rWACC =
B S × rB + × rS B+S B+S
rB
rB
Debt-to-equity Ratio B S
The MM Propositions I & II (with Corporate Taxes) • Proposition I (with Corporate Taxes)
– Firm value increases with leverage VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is offset by interest tax shield
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
rB is the interest rate (cost of debt) rS is the return on equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity
The MM Proposition I (Corp. Taxes)
Shareholders in a levered firm receive ( EBIT ? rB B) × (1 ? TC )
Bondholders receive rB B
Thus, the total cash flow to all stakeholders is ( EBIT ? rB B) × (1 ? TC ) + rB B
The present value of this stream of cash flows is VL
Clearly ( EBIT ? rB B) × (1 ? TC ) + rB B = = EBIT × (1 ? TC ) ? rB B × (1 ? TC ) + rB B = EBIT × (1 ? TC ) ? rB B + rB BTC + rB B The present value of the first term is VU
The present value of the second term is TCB
?VL = VU + TC B
The MM Proposition II (Corp. Taxes)
Start with M&M Proposition I with taxes: Since
VL = VU + TC B
VL = S + B ? S + B = VU + TC B VU = S + B (1 ? TC )
The cash flows from each side of the balance sheet must equal:
SrS + BrB = VU r0 + TC BrB SrS + BrB = [ S + B(1 ? TC )]r0 + TC rB B Divide both sides by S B B B rS + rB = [1 + (1 ? TC )]r0 + TC rB S S S
Which quickly reduces to
B rS = r0 + × (1 ? TC ) × (r0 ? rB ) S
The Effect of Financial Leverage on the Cost of Debt and Equity Capital
Cost of capital: r (%)
rS = r0 +
B × (1 ? TC ) × (r0 ? rB ) SL
r0
rWACC =
B SL × rB × (1 ? TC ) + × rS B+SL B + SL
rB
Debt-to-equity ratio (B/S)
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-Equity
EBIT Interest EBT Taxes (Tc = 35% Total Cash Flow to S/H Recession RM1,000 0 RM1,000 RM350 RM650 Expected RM2,000 0 RM2,000 RM700 RM1,300 Expansion RM3,000 0 RM3,000 RM1,050 RM1,950
Levered
Recession EBIT RM1,000 Interest (RM800 @ 8% ) 640 EBT RM360 Taxes (Tc = 35%) RM126 Total Cash Flow RM234+640 (to both S/H & B/H): RM874 EBIT(1-Tc)+TCrBB RM650+RM224 RM874 Expected RM2,000 640 RM1,360 RM476 RM468+RM640 RM1,524 RM1,300+RM224 RM1,524 Expansion RM3,000 640 RM2,360 RM826 RM1,534+RM640 RM2,174 RM1,950+RM224 RM2,174
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-equity firm
S G
Levered firm
S G
B
The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by capital structure. • This is M&M Proposition I:
VL = VU
• Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. B
rS = r0 + SL × (r0 ? rB )
• In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders
Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. • This is M&M Proposition I:
VL = VU + TC B
• Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. • In a world of taxes, M&M Proposition II states that leverage increases the risk and return to shareholders.
B rS = r0 + × (1 ? TC ) × (r0 ? rB ) SL
Costs of Financial Distress
• Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. • Rather it is bankruptcy. the costs associated with
• It is the shareholders who bear these costs.
Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a small percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales) – Agency Costs
• Selfish strategy 1: Incentive to take large risks • Selfish strategy 2: Incentive toward underinvestment • Selfish Strategy 3: Milking the property
Balance Sheet for a Company in Distress
Assets Cash F.Asset Total BV MV RM200 RM200 RM400 RM0 RM600 RM200 Liabilities BV LT bonds RM300 Equity RM300 Total RM600 MV RM200 RM0 RM200
What happens if the firm is liquidated today?
The bondholders get RM200; the shareholders get nothing.
Selfish Strategy 1: Take Large Risks
The Gamble Win Big Lose Big Probability 10% 90% Payoff RM1,000 RM0
Cost of investment is RM200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = RM1000 × 0.10 + RM0 = RM100
$100 NPV = ?$200 + 1.50 NPV = ?$133
Selfish shareholders Accept Negative NPV Project with Large Risks
• Expected CF from the Gamble – To Bondholders = RM300 × 0.10 + RM0 = RM30 – To shareholders = (RM1000 - RM300) × 0.10 + RM0 = RM70 • PV of Bonds Without the Gamble = RM200 • PV of Stocks Without the Gamble = RM0 • PV of Bonds With the Gamble = RM30 / 1.5 = RM20 • PV of Stocks With the Gamble = RM70 / 1.5 = RM47
Selfish Strategy 2: Underinvestment
• Consider a government-sponsored project that guarantees RM350 in one period • Cost of investment is RM300 (the firm only has RM200 now) so the shareholders will have to supply an additional RM100 to finance the project • Required return is 10%
$350 NPV = ?$300 + 1.10 NPV = $18.18
•Should we accept or reject?
Selfish Shareholders Forego Positive NPV Project
• Expected CF from the government sponsored project: – To Bondholder = RM300 – To Stockholder = (RM350 - RM300) = RM50 • PV of Bonds Without the Project = RM200 • PV of Stocks Without the Project = RM0 • PV of Bonds With the Project = RM300 / 1.1 = RM272.73 • PV of Stocks with the project = RM50 / 1.1 - RM100 = -RM54.55
Selfish Strategy 3: Milking the Property
• Liquidating dividends
– Suppose our firm paid out a RM200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures.
• Increase perquisites to shareholders and/or management
The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. – Rule 1 • Use internal financing first. – Rule 2 • Issue debt next, equity last. • The pecking-order Theory is at odds with the trade-off theory: – There is no target D/E ratio. – Profitable firms use less debt. – Companies like financial slack
doc_368695945.pdf