Professor: Paul Maarek, Panthéon-Assas University.
Objective: When a firm needs to raise new funds to understake its investments, it must decide which type of security it will sell to investors. Even absent a need for new funds, firms can issue new securities and use the funds to repay debt or repurchase shares. What considerations should guide these decisions? We first explore these questions in a setting of perfect capital markets, in which all securities are fairly priced, there are no taxes or transaction costs, and the total cash flows of the firm’s projects are not affected by how the firm finances them. Although in reality capital markets are not perfect, this setting provides an important benchmark. Perhaps surprisingly, with perfect capital markets, the Law of One Price implies that the choice of debt or equity financing will not affect the total value of a firm, its share price, or its cost of capital. Thus, in a perfect world, a firm will be indifferent regarding the choice of financing for its expansion. This is the Modigliani-Miller theorem. This statement is at odds, however, with the observation that firms invest significant resources, both in terms of managerial time and effort and investment banking fees, in managing their capital structures. We will depart from the perfect capital market environment and explore various factors which explain that the capital structure of a firm matters and affect its value.
We first study the role of debt. The choice of leverage is of critical importance to a firm’s value and future success. As we will show, there are large and systematic variations in the typical capital structures for different industries. Corporations and investors must pay taxes on the income they earn from their investments. We will see that a firm can enhance its value by using leverage to minimize the taxes it, and its investors, pay. But, in this case, why don’t firms use more debt? When a firm has trouble meeting its debt obligations we say the firm is in financial distress.
We will consider how a firm’s choice of capital structure can, due to market imperfections, affect its costs of financial distress, alter managers’ incentives, and signal information to investors.
Each of these consequences of the capital structure decision can be significant, and each may offset the tax benefits of leverage when leverage is high.
Finally we study the payout policy of the firm. When a firm’s investments generate free cash flow, the firm must decide how to use that cash. If the firm has new positive-NPV investment opportunities, it can reinvest. When a firm has excess cash, it can hold those funds as part of its cash reserves or pay the cash out to shareholders. If the firm decides to follow the latter approach, it has two choices: It can pay a dividend or it can repurchase shares from current owners. These decisions represent the firm’s payout policy. We show that, as with capital structure, a firm’s payout policy is shaped by market imperfections, such as taxes, agency costs, transaction costs, and asymmetric information between managers and investors. We look at why some firms prefer to pay dividends, whereas others rely exclusively on share repurchases the cash and increase the value of the firm.
Grading: Final exam at the end of the semester.