Agenda

1. Recap - Previously on Corporate Finance

2. Basic Concepts - Capital structure, dry power, etc...
3. Framework: MM Theory (1958)
4. Article 1 - Capital Structure Puzzle
a. What is wrong with the current framework?
b. What are the proposed solutions under the baseline model?
c. Key Takeaways
5. Article 2 - Tax Sensitivity
a. Taxes as a first-order determinant of capital structure
b. Static vs. dynamic tradeoff models
c. Key Takeaways
6. Conclusion
a. Connecting the articles...
 1. Recap:
Terminal Value
What were the three
ways of estimating
terminal value, and
what assumptions
were they based on?
 Terminal Value

Liquidation Multiple Approach Stable Growth Model

The underlying assumption = The underlying assumption is The firm is seen as a going
the firm ceases to exist and that firm is seen as a going concern, with cash flow
sells assets to the highest concern. Applies multiple to growing at a constant rate
bidder. Liquidation value: 1) earnings, book value, etc. forever, assuming cash is
book value of assets and 2) However, keep in mind it is a reinvested into assets.
earning power of asset. relative form of valuation. Perpetual growth method.
 2. Key
Concepts
 Capital
Structure
Capital Structure
Definition: Capital structure refers to the mix of
debt, equity, and other financial instruments
used by a company to finance its overall
operations and growth. It is a snapshot of the
firm’s liabilities and equities that illustrates how
the firm’s assets are financed.
Cost of Capital
 Cost of Capital
Definition: The cost of capital is the rate of return
that a business must achieve to maintain its
market value and attract funds. It includes the cost
of debt (interest payments) and the cost of equity
(dividend payments or capital gains expected by
shareholders).
Leverage
 Leverage
Definition: Leverage in finance refers to the
use of borrowed money (debt) to amplify
potential returns to equity shareholders.
Financial leverage is quantified by the ratio
of debt to equity or debt to total capital.
Dry Powder
 Dry Powder
Definition: Dry Powder is the readily available
liquidity or cash that a corporation or a fund has
not yet allocated to investments or expenses. In
corporate finance, it usually refers to cash that can
be used to take advantage of investment
opportunities as they arise, pay down debt
quickly, or sustain operations through unforeseen
financial downturns.
Transitionary
Debt
 Transitionary Debt
Definition: Transitionary debt refers to temporary adjustments
in a firm's debt levels, often in response to external economic
changes, fiscal policy adjustments, or internal strategic decisions.
This concept captures the use of debt as a flexible tool in
dynamic capital structure management, where firms may increase
or decrease their leverage to navigate through transitional
periods before stabilizing their capital structure in alignment
with long-term goals.
 Marginal
Tax Benefit
Marginal Tax Benefit
Definition: Refers to the incremental financial benefit a
firm gains from the tax deductibility of interest expenses
on debt. This benefit increases as the firm’s marginal tax
rate increases, which can incentivize more debt financing.
3. Modigliani
and Miller
Theorem
 What do you know
about the
Modigliani and Miller
Theorem?
Modigliani-Miller Theorem
Proposed by Franco Modigliani and Merton Miller (1958), the theorem states
that in a frictionless market (no taxes, bankruptcy costs, agency costs,
or asymmetric information), the value of a firm is unaffected by its
capital structure. This theorem forms the basis for modern thinking on
capital structure, though real-world frictions lead to deviations from this
theory.
 Modigliani-Miller Theorem
Assuming the theorem holds, then:
a. The financing mix of the firm does not matter because the firm’s
value is determined by the quality of its investments.
b. The cost of capital of the firm does not change with leverage. The
cost of equity will increase and offset gains from when the firm
increased its leverage.

(Adika and Nugroho, 2013)

 4. Article 1:
Capital
Structure Puzzle
What is wrong with the leading models of
Capital Structure?
What is wrong with the leading
models of Capital Structure?
Managers do not have sufficient knowledge to optimize capital structure
with any real precision
Standard static trade-off models fail empirically because they ignore
funding
Without adequate funding, firms cannot generate value
POT focuses on the source of funds with the lowest current cost but
ignores debt capacity and cash balances for future use
Firms financing decisions are not uniquely determined by fundamentals
Why symmetric ignorance rather than symmetric information?
 What do managers try to achieve
when deciding on the financing mix
according to
traditional capital structure
theories?
Capital Cost Minimization
Tax Benefits of Debt (focus on
path-dependent leverage ratios)
Aversion to Financial Distress and
Agency Costs
Example of Applying MM Theorem in Real Life

(Vise, 1990)
Two Ways a Business Can Raise Money
Two Ways a Business Can Raise Money
Debt: This involves committing to scheduled payments in the
future, which typically include interest and the repayment of the
principal. Failing to meet these obligations can result in losing
control of the business.
Equity: This option allows you to receive any remaining cash flows
after all debt obligations have been met.
What Are The 6 Properties That Motivate The
Specific Features of The Baseline Model?
An Empirically Credible Model of Capital
Structure Must:
Recognize that chosen
Emphasize reliable Include incentives for a
financial policies are
access to funding, not connection between
not pinned down
optimizing the debt issuance and
uniquely by economic
debt/equity mix investment
fundamentals

Incorporate a role for Including a nontrivial

firms having, using, and Accommondate role for costly financial
replenishing dry powder managers acting on a intermediation in
(untapped debt capacity belief they can time providing reliable
and cash balances) to the capital markets access to funding for
meet funding needs operating firms
What does DeAngelo say about the Baseline
Model: Banking-Based Version in Section V?
The Baseline Model: Banking Based Version

This model assumes that external equity financing is unavailable and that raising debt
directly from households is prohibitively costly.
Role of Banks: In the absence of developed capital markets, banks serve as crucial
financial intermediaries.
Rationale for Bank Financing: Banks prefer to provide loans rather than take equity stakes
in firms because loans offer a clearer valuation and less risk exposure compared to equity.
The baseline model suggests that firms' reliance on bank financing influences their
capital structure decisions. It also implies that banks play a critical role in providing
liquidity through deposit debt, which is essential for households and forms the backbone
of firm financing.
The model points out that firms do not aim for a fixed target leverage ratio; instead, they
adjust their leverage based on ongoing financial needs and the economic environment.
 What does DeAngelo say
about the Baseline Model in
section VII?
 The Baseline Model General
Evolutionary Changes in Financing Arrangements: Even with increased options, a single
optimal capital structure is unlikely to emerge for any given firm due to the inherent
complexity of financial decision-making.

Experimentation and Evolution of Financial Practices: Firms, financial intermediaries, and

households are expected to continually experiment with new financial arrangements.
This experimentation is crucial in discovering more effective ways of accessing and
managing capital. The historical record shows significant experimentation across financial
products like junk bonds and leveraged loans, which have added layers of complexity to
capital structure decisions.
 The Baseline Model General
The Culling of Inferior Financial Practices: Financial practices have evolved to Darwinian
natural selection, where less effective practices are phased out over time and more
effective ones prevail. However, this process doesn't imply that only the best financial
policies survive; instead, it suggests a continuous adaptation and refinement of financial
strategies.
Decision Complexity for Managers: Despite the evolution and experimentation in
financial strategies, the paper underscores that managers still face considerable
uncertainty and complexity in identifying optimal financial policies. This complexity
arises from a lack of definitive theoretical and empirical guidance on how to balance
various financial policy options effectively.
Conclusion: The financial landscape is continuously evolving, with firms and managers
having to adapt and experiment with their strategies. The existence of multiple viable
strategies and the ongoing innovation in financial markets mean that the idea of a single
optimal capital structure may be more theoretical than practical.
What are Trade-Off Models?
 Traditional Trade-Off Model

Suggests that firms balance the benefits and costs of debt to determine their optimal
capital structure.
Tax Advantages: One of the primary benefits of using debt in a firm's capital structure
is the tax deductibility of interest payments. This tax shield can significantly reduce a
company's taxable income, thereby lowering its tax liability.
The core of the trade-off theory is that firms weigh these benefits and costs to
determine their optimal level of debt.
The optimal capital structure is achieved when the marginal benefit of the tax shield
from an additional unit of debt equals the marginal cost of the financial distress this
additional debt could cause.
What is the Pecking Order Model?
 Pecking Order Model
A theory developed by Mayers and Majluf (1984) suggesting that companies prefer
certain types of financing over others due to the asymmetric information between
corporate managers and external investors.
Internal financing first, debt over equity, and equity as last resort

More risk = Increasing Cost of Finance

Internal Financing External Financing External Financing

(Retained Earnings) Issuing Debt Issuing Equity

Information asymmetry leading to

higher cost of financing from
external parties
How Does the Baseline Model Differ from the
Trade-Off and Pecking Order Models?
How Does the Baseline Model Differ from the
Trade-Off and Pecking Order Models
A. Managerial Focus on Funding, Not Optimizing Debt-Equity Mix
The evidence suggests that managers prioritize reliable access to funding over
maintaining a specific debt-equity ratio.
This is shown by the lack of systematic actions by firms to adjust their leverage ratios in
response to stock price-induced leverage changes.
Studies, including those by Welch (2004) and DeAngelo (2021), demonstrate that
managers view debt as a funding tool rather than as a means to achieve a target
capital structure.
This indicates a shift away from the goal of maintaining a fixed leverage ratio,
supporting the baseline model's approach that does not target specific leverage levels.
How Does the Baseline Model Differ from the
Trade-Off and Pecking Order Models
B. Imperfect Managerial Knowledge
The baseline model accounts for imperfect managerial knowledge, which
impacts real-world capital structure decisions
This contrasts with the pecking order and trade-off models, which assume
managers have perfect knowledge for optimizing capital structures.
The baseline model suggests that managers are often indifferent among
multiple financing options because they cannot reliably distinguish significant
differences between them, leading to financial policy indeterminacies.
How Does the Baseline Model Differ from the
Trade-Off and Pecking Order Models
C. Additional Support for the Baseline Model
Other factors reinforcing the baseline model include:
The relationship between debt issuance and funding needs highlights the nature of
debt financing in relation to investment demands and other financial needs.
Empirical evidence shows the detachment of real-world deleveraging practices
from the predictions of static trade-off models, where firms often deleverage
below optimum leverage levels proposed by these models.

Points out that firms often engage in significant deleveraging and

cash accumulation, behaviors that are not adequately explained
by traditional models but are predictable within the baseline
framework.
How important is the “correct
funding mix” for the
functioning of non-financial
firms?
Key Takeaways
The financing mix of the firm does affect the firm's value
The Pecking Order Theory does not always apply in reality
The access to funding is important (not only debt/equity)
Funding is an innovation and growth driver
No assumption of full-knowledge optimization
The Baseline Model suggests no constant leverage but
instead a dynamic one based on the firm’s needs
The real world of capital structure is characterized by
substantial uncertainties and indeterminacies, meaning
that there is no clear-cut best way to arrange funding.
6. Conclusion
 Conclusion
Both articles address how firms make capital structure decisions in the face of
taxes, financial distress costs, and other market frictions.
DeAngelo's theoretical critique complements Heider and Ljungqvist's
empirical analysis by providing a conceptual framework that questions the
simplifying assumptions typically used in such empirical studies.
Heider and Ljungqvist provide empirical evidence that could either challenge
or support the theoretical critiques raised by DeAngelo, particularly regarding
how firms respond to changes in tax environments and the implications for
capital structure theory.
Together, these works suggest a need for refined theoretical frameworks to
better understand firm capital structure.
What does DeAngelo say about the Baseline
Model: Banking-Based Version in Section V?

What does DeAngelo say about the

Baseline Model in section VII?

How Does the Baseline Model Differ from the

Trade-Off and Pecking Order Models?