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Lecture Business finance - Chapter 14: Capital structure decisions

Chapter 14 - Capital structure decisions. Learning objectives in chapter: Outline empirical evidence from recent studies on capital structure; assess the implications of the evidence for the trade-off, pecking order and free cash flow theories; explain how financing can be viewed as a marketing problem; outline the main factors that financial managers should consider when determining a company’s financing strategy. | Chapter 14 Capital Structure Decisions 2 2 2 2 2 2 Learning Objectives Outline empirical evidence from recent studies on capital structure. Assess the implications of the evidence for the trade-off, pecking order and free cash flow theories. Explain how financing can be viewed as a marketing problem. Outline the main factors that financial managers should consider when determining a company’s financing strategy. 2 2 2 2 2 2 Introduction MM analysis is useful in showing that if capital structure is important, the reasons must relate to factors that MM excluded by their assumptions. Four main theories of capital structure: MM leverage irrelevance — company value depends on investment rather than financing decisions. Trade-off theory — emphasises tax benefits of debt. Pecking order theory — information on projects is asymmetric and internal finance is highest in pecking order. Free cash flow theory — emphasises agency costs with the discipline of debt reducing unprofitable investment. 4 | Chapter 14 Capital Structure Decisions 2 2 2 2 2 2 Learning Objectives Outline empirical evidence from recent studies on capital structure. Assess the implications of the evidence for the trade-off, pecking order and free cash flow theories. Explain how financing can be viewed as a marketing problem. Outline the main factors that financial managers should consider when determining a company’s financing strategy. 2 2 2 2 2 2 Introduction MM analysis is useful in showing that if capital structure is important, the reasons must relate to factors that MM excluded by their assumptions. Four main theories of capital structure: MM leverage irrelevance — company value depends on investment rather than financing decisions. Trade-off theory — emphasises tax benefits of debt. Pecking order theory — information on projects is asymmetric and internal finance is highest in pecking order. Free cash flow theory — emphasises agency costs with the discipline of debt reducing unprofitable investment. 4 4 4 4 Company Financing: Some Initial Facts In the US, most investment by non-financial companies is financed from internal cash flows, followed by external debt finance and then by equity. The pattern in Australia is similar, with over 50% of finance coming from internal equity over 2000–2004. High-growth companies have investment needs that exceed cash flow and, as a result, these high-growth companies depend heavily on share issues (equity finance). 5 5 Company Financing: Some Initial Facts (cont.) Relationships between industry characteristics and capital structure have been reported in several studies. Paper, steel and airline companies typically have high leverage. Pharmaceutical and electronics companies typically have low leverage. These observations suggest that capital structure decisions are important. 6 6 Evidence on Capital Structure: Taxes Effects of personal and company tax tend to be offsetting: Deductions for interest on debt reduce company tax. However, at the .