Question

Graham and Harvey (2001)’s Survey evidence on 392 CFOs find the following factors are important when deciding capital structure decision. Link these factor with the related theory and briefly explain what is the relation between the factor and the theory.

Factors: Financial flexibility; Insufficient internal funds; Interest tax savings; Credit rating; Bankruptcy or distress costs; Equity undervaluation or overvaluation

Theories: MM without tax; MM with tax; Static (Tradeoff); Free cash flow; Signaling; Pecking Order

The numbers of company going public (IPO) is dropping recently, could you think of a reason why?

Answer 1

The most important factors affecting debt policy are maintaining financial flexibility and having a good credit rating. When issuing equity, respondents are concerned about earnings per share dilution and recent stock price appreciation. In the real-world there is very little evidence that capital structure decisions are made according to academic theories related to asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. (If the effects of these theories are, for example, impounded into market prices and credit ratings, and executives respond to prices and credit ratings, it is always possible that executives react to these theories indirectly.)

Pecking-order theory: The pecking-order model assumes that firms do not target a specific debt ratio but instead use external financing only when internal funds are insufficient. Firms try to avoid issuing securities because they feel that they are often underpriced by the market. Having insufficient internal funds is a moderately important influence on the decision to issue debt. However, there is only modest evidence that firms issue equity because recent profits have been insufficient to fund activities.

Actual level of profitability of the firm is unknown, only the expected level is calculated based on assumption of perfect capital markets with corporate taxes. It is impossible to tell how interest tax savings impacts firm value.

Credit ratings are also important for large firms that are in the Fortune 500. Finally, CFOs are also concerned about earnings volatility when making debt decisions which is consistent with the trade-off theory’s prediction that firms reduce debt usage when the probability of bankruptcy is high. 2008 recession is the strongest evidence of conflict of interest between rating agencies and corporate debt. However, credit rating is still is an important factor in capital structure decisions.

Equity undervaluation: For capital restructure, Buybacks also plays a key role: reduce the number of shares outstanding in the market. It is important method of corporate restructuring. There could be many reasons why corporate choose to buy back shares: Improve the profitability on a per share basis, consolidate their stake in the company, prevent other companies from taking over, show the confidence of the promoters about their company, to support the share price from declining in the markets. However, there is strong evidence of information asymmetry is positively associated with stock repurchases. When information asymmetry between managers and shareholders is high, managers are also more likely to repurchase shares. By repurchasing, managers with stock option compensations are able to maximize their wealth by transferring the value from the stockholders who sell their shares to the managers themselves.

IPO high market volatility, uncertainity of economic growth an dcosts associated to fulfil regulatory requirements.