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Academic companies’ pay on the bonds they issue is

Academic
Research on Corporate Leverage

Corporate leverage is the degree to which a
company uses fixed-return securities such as debt and preferred equity. The
more debt financing a company uses, the higher its financial leverage. A high
degree of financial leverage means high interest payments, which negatively
affect the company’s bottom-line earnings per share.

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Modigliani and Miller

This
model states that, in an environment of no taxes the capital structure of a
corporate does not matter but the risk of underlying assets and revenue
generating ability matters.

The tradeoff theory assumes that there are
benefits to leverage within a capital structure up until the optimal capital
structure is reached. The theory recognizes the tax benefit from interest payments
– that is, because interest paid on debt is tax deductible, issuing bonds
effectively reduces a company’s tax liability. Paying dividends on equity,
however, does not. Thought of another way, the actual rate of interest
companies’ pay on the bonds they issue is less than the nominal rate of
interest because of the tax savings. Studies suggest, however, that most
companies have less leverage than this theory would suggest is optimal.

firms
have to make a tradeoff between

the
benefits of cheap debt finance on the one hand and the costs

associated
with high levels of gearing (such as the risk of bankruptcy) on

the
other. If the correct balance can be achieved, the cost of finance will

fall to a
minimum point, maximizing NPVs and hence the value of the

firm.

Key Practical Aurguments
against M theory

Bankruptcy
risk

As gearing increases so does the possibility of
bankruptcy. If

shareholders become concerned, this will reduce the
share price and

increase the WACC of the company.

Agency
costs: restrictive conditions

In order to safeguard their investments
lenders/debentures holders often

impose restrictive conditions in the loan agreements
that constrains

management’s freedom of action.

E.g. restrictions:

Tax
exhaustion

After a certain level of gearing companies will
discover that they have no

tax liability left against which to offset interest
charges.

Kd(1 – t) simply becomes Kd.

Borrowing/debt
capacity

High levels of gearing are unusual because companies
run out of

suitable assets to offer as security against loans.

Companies with

assets, which have an active secondhand

market, and low levels of

depreciation such as property companies, have a high
borrowing

capacity.

Difference
risk tolerance levels between shareholders and

Directors

Business failure can have a far greater impact on
directors than on a

welldiversified

investor. It may be argued that directors have a
natural tendency to be cautious about borrowing.

The Traditional View

the
traditional view has no theoretical basis

but common
sense. It concludes that a firm should have an optimal level of

gearing,
where WACC is minimised, BUT it does not tell us where that

optimal point is. The only way of finding the optimal point is by
trial and error.

 

At low levels of gearing:

Equity
holders see risk increases as marginal as gearing rises, so

the
cheapness of debt issue dominates resulting in a lower WACC.

At higher levels of gearing:

Equity
holders become increasingly concerned with the increased

volatility
of their returns (debt interest paid first). This dominates the

cheapness
of the extra debt so the WACC starts to rise as gearing

increases.

With the following from Goldman’s
Robert Boroujerdi, we can finally close the book on whether US corporate
leverage is at all time highs. It is… and it’s even higher on a
“normalized” basis.

As the Goldman strategist writes, even as corporate defaults
remain near historically low levels, froth (there’s that word again) “has
been building in the form of corporate leverage. While this may not present a near-term risk, the
widespread increase in debt resulting in stretched leverage metrics bears
watching, in our opinion.”

Goldman adds that while the pullback in Energy earnings in recent
years has stressed aggregated Net Debt/EBITDA, even excluding that
sector, the ratio is at the highest
point since the financial crisis

Inspired from Zerohedge.com

 

Dealing
with ‘gearing drift’

Profitable companies will tend to find that their
gearing level gradually

reduces over time as accumulated profits help to
increase the value of

equity. This is known as “gearing drift”.

Gearing drift can cause a firm to move away from its
optimal gearing

position. The firm might have to occasionally increase
gearing (by

issuing debt, or paying a large dividend or buying
back shares) to return

to its optimal gearing
position.

Research at Behavioral
Finance.

Behavioural
finance combines, social and psychological human perception about prices of
commodities.

For
example.

If
a price of a commodity Rise by 10%. It will be perception that there will be a
price drop after that. So the investor start selling off and the price drops.

And
if a of a commodity drops by 10%. It will be perception that there will be a
price up after that. So the investor start purchasing and the price rises.

Why
is behavioral finance necessary?
When using the labels “conventional” or
“modern” to describe finance, we are talking about the type of
finance that is based on rational and logical theories, such as the capital asset pricing
model (CAPM) and the efficient
market hypothesis (EMH). These
theories assume that people, for the most part, behave rationally and
predictably. (For more insight, see The
Capital Asset Pricing Model: An Overview, What Is Market
Efficiency? and Working Through The Efficient Market Hypothesis.)

For a while, theoretical and empirical evidence
suggested that CAPM, EMH and other rational financial theories did a
respectable job of predicting and explaining certain events. However, as time
went on, academics in both finance and economics started to find anomalies and
behaviors that couldn’t be explained by theories available at the time. While
these theories could explain certain “idealized” events, the real
world proved to be a very messy place in which market participants often
behaved very unpredictably. 

Homo Economicus
One of the most rudimentary assumptions that
conventional economics and finance makes is that people are rational
“wealth maximizers” who seek to increase their own well-being.

According to conventional economics, emotions and other extraneous factors do
not influence people when it comes to making economic choices. 

In most cases, however, this assumption doesn’t
reflect how people behave in the real world. The fact is people frequently
behave irrationally. Consider how many people purchase lottery tickets in the
hope of hitting the big jackpot. From a purely logical standpoint, it does not
make sense to buy a lottery ticket when the odds of winning are overwhelming
against the ticket holder (roughly 1 in 146 million, or 0.0000006849%, for the
famous Powerball jackpot). Despite this, millions of people spend countless
dollars on this activity.

These anomalies prompted academics to look to
cognitive psychology to account for the irrational and illogical behaviors that
modern finance had failed to explain. Behavioral finance seeks to explain our
actions, whereas modern finance seeks to explain the actions of the
“economic man” (Homo
economicus).

Anomalies

The presence of regularly occurring anomalies in conventional
economic theory was a big contributor to the formation of behavioral finance.

These so-called anomalies, and their continued existence, directly violate
modern financial and economic theories, which assume rational and logical
behavior. The following is a quick summary of some of the anomalies found in
the financial literature.

January Effect
The January effect is named after the phenomenon in which the average
monthly return for small firms is consistently higher in January than any other
month of the year. This is at odds with the efficient market hypothesis, which
predicts that stocks should move at a “random walk”. 
The Winner’s Curse
One assumption found in finance and
economics is that investors and traders are rational enough to be aware of the
true value of some asset and will bid or pay accordingly.

Equity Premium Puzzle
An anomaly that has left academics in finance and economics scratching
their heads is the equity premium puzzle. According to the capital asset
pricing model (CAPM), investors that hold riskier financial assets should be
compensated with higher rates of returns.

Inspired from Investopedia

On The Impossibility of Perfect Capital Markets.

The
general equilibrium theory developed by Walras, Arrow, Debreu, Radner and
others, and expounded in Arrow and Hahn (1971), involves linear budget
constraints and market clearing prices. For intertemporal environments, this is
what is required for “perfect” capital markets, in which agents are free to
borrow and lend at the same market rate of interest for all loans of the same
maturity, and the rates of interest adjust to match the plans of borrowers and
lenders. This theory is for an economy of honorable agents, who always satisfy
their intertemporal budget constraints. Agents never expose themselves
deliberately to the risk of default. With perfect foresight, no default would
ever occur. Without perfect foresight, of course, some agents may be unable to
avoid bankruptcy ex post, as was realized by Green (1974) and Bliss (1976),
amongst others. 1 Yet in the theory of temporary equilibrium, as surveyed
recently by Grandmont (1982, 1988), agents still arrange their affairs so that,
according to their own expectations, they can fulfill their budget constraints
with probability one. As Milne (1980) has pointed out, this is consistent with
two traders making a contingent contract which each is sure that he himself can
honor, and yet is sure that the other cannot! By contrast, the world is full of
less honorable agents who, to the extent that they find it profitable, will
knowingly incur debts which they may find themselves unable to honor.

There are also other Factors which have to be considered

The
Need for Credit Rationing
Feasible
Allocation Mechanisms
Additional
Incentive Constraints.

Inspired from Stanford

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