Why Manage Risk?
Modigliani‐Miller Capital Structure Theorem • Modigliani and Miller showed that, under idealistic conditions, it does not matter whether a firm uses no debt, a little debt or a lot of debt in its capital structure. • The conclusion rests on two basic assumptions: 1. The cash flows that a firm generates are not affected by how the firm is financed. 2. Financial markets are perfect. 3. There is also an implicit assumption that investors hold well diversified portfolios 2
M&M Theorem • The cash flows that a firm generates are not affected by how the firm is financed. • No taxes (corporate or personal) • No bankruptcy costs • No informational asymmetry • No agency problems 3
M&M Theorem • Financial markets are perfect • No transaction costs • No taxes • No “clientele effects” • Note: This assumption implies that all market participants can borrow and lend at the same rate. 4
M&M Theorem • Assumption 1 implies that the cash flows to the firm are determine by “real” decisions ‐ investment and operating decisions • Assumption 2 implies that the total value of claims on the firm is determined by the cash flows that result from the “real” decisions 5
Capital Structure Irrelevance • Taken together, these assumptions imply that purely financial decisions do not affect the value of the firm • Leverage • Types of debt (secured, senior) • Types of shares (preferred, common) • Dividend policy • Hedging/Insurance • These assumptions also imply that purely financial decisions do not affect the firm’s overall cost of capital (WACC) 6
Capital Structure Irrelevance • The basic logic of the argument is that, under the two main assumptions, individual investors can do anything the firms can do and at the same cost. • E.g., If an investor thinks the firm has too little debt, they can buy shares on margin. The cost of the loan to buy the shares is the same as the firm’s cost of (equally risky) debt. 7
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Why Do Financial Decisions Matter? • The M&M Theory is not important because anybody thinks it is a reasonable description of reality • In the real world, financial decisions matter a lot. • This tells us that one or more of the M&M assumptions does not hold in the real world. • The M&M Theory is important because it tells us • Why capital structure matters • What determines the optimal capital structure • Why risk management matters 9
Violations of Assumption 1 • There are three reasons why capital structure affects the total cash flows available to its debt and equity holders: 1. Interest is a tax ‐ deductible expense, while dividends are not. Thus, after taxes, firms have more money to distribute to their debt and • equity holders if they use more debt financing. 2. Debt financing creates a fixed legal obligation. If the firm defaults on its payments, the creditors can force the firm into • bankruptcy and the firm will incur the added cost that this process entails. 3. The threat of bankruptcy can influence the behavior of a firm’s executives as well as its employees and customers. 10
Violations of Assumption 2 • Transaction costs can be important and because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow. • When this is the case, firm values may depend on how they are financed because individuals cannot substitute their individual borrowings for corporate borrowings to achieve a desired level of financial leverage. • “Clientele effects” can be important • Financial institutions are regulated and may bear additional costs or restrictions on buying certain securities 11
Taxes and Bankruptcy Costs • Suppose that all of the M&M assumptions hold, except interest is a tax ‐ deductible expense. • Then firms should be 100% financed with debt • However, a firm cannot keep on increasing debt because if the firm’s debt obligations exceed it’s ability to generate cash, it will be forced into bankruptcy and incur financial distress costs. • Furthermore, debt financing also severely limits the firm’s flexibility to raise additional funds. 12
Taxes and Bankruptcy Costs • Suppose all of the M&M assumptions hold (including no taxes) but that bankruptcy is costly. • Then the use of any debt at all implies the firm has some (possibly quite small) risk of bankruptcy. • This reduces the firm’s expected cash flows and therefore reduces that value of the firm • In this scenario, all firms are 100% equity financed 13
Tradeoff Theory of Capital Structure • Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors: • Interest expense is tax deductible. • Debt makes it more likely that firms will experience financial distress costs. 14
Agency Costs • Debt financing can help reduce agency costs. • Debt financing by creating fixed dollar obligations will reduce the firm’s discretionary control over cash and thus reduce wasteful spending. 15
Asymmetric Information • When firms issue new shares, it is perceived that the firm’s stock is overpriced and accordingly share price generally falls. • This provides an added incentive for firms to prefer debt. 16
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Capital Structure and Asymmetric Information • Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital: • Internal sources of financing • Marketable securities • Debt • Hybrid securities • Equity 18
Managerial Implications 1. Higher levels of debt can benefit the firm due to tax savings and potential to reduce agency costs. 2. Higher levels of debt increase the probability of financial distress costs and offset tax and agency cost benefits of debt. 19
M&M Theorem and Risk Management • Suppose the M&M assumptions hold 1. The cash flows that a firm generates are not affected by how the firm is financed. 2. Financial markets are perfect. Then any activity that simply rearranges the firms cash • flows does not affect firm value Best known result is that split between payments to • shareholder and bondholder doesn’t affect firm value 20
M&M Theorem and Risk Management • What other activities simply rearrange cash flows? • Corporate reorganization • How firm’s activities are divided among subsidiaries, divisions • Financial risk management (hedging) • “Pure” risk management (loss control, insurance) • If these activities are costly, then they reduced firm value • Commissions/fees on hedging activities • Expenditures on loss control • Loadings in insurance premiums 21
M&M Theorem and Risk Management • We know that these activities do affect firm value • Why? • Same reason capital structure affects firm value • M&M assumptions do not hold 22
M&M Theorem and Risk Management • Suppose M&M assumptions do not hold • Then corporate structure may affect firm value • Organization of activities into subsidiaries • Isolate high risk activities in subsidiary, can bankrupt separately 23
M&M Theorem and Risk Management • Suppose M&M assumptions do not hold • Firm may be able to manage their financial risk at lower cost than individuals • Lower transaction costs increases value • Lower bankruptcy risk increases firm value 24
M&M Theorem and Risk Management • Suppose M&M assumptions do not hold • Risk management may improve managerial incentives • Want to reward managers who make “good” decisions • Can observe outcomes more easily than managerial inputs • “Noisy” outcomes make it harder to reward good decisionmakers • Good managers want to be rewarded for their ability • Reducing noise allows for sharper incentives • Reducing noise is attractive to good managers 25
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