...Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns Thomas J. George e-mail:tom-george@uh.edu C. T. Bauer College of Business University of Houston Houston, TX 77240 and Chuan-Yang Hwang e-mail:cyhwang@ntu.edu.sg Division of Banking and Finance Nanyang Business School Nanyang Technological University Singapore 639798 April 2009 Acknowledgments: We are grateful to David Bates, Alex Boulatov, Gerry Garvey, Rick Green, Bing Han, Praveen Kumar, Scott Richardson, Tom Rourke, Mike Stutzer, Sheridan Titman, Stuart Turnbull, Toni Whited, Huai Zhang, an anonymous referee and participants at the Western Finance Association and China International Conferences for helpful comments and discussions. George acknowledges research support from the C.T. Bauer Professorship. A Resolution of the Distress Risk and Leverage Puzzles in the Cross Section of Stock Returns Abstract We revisit findings that returns are negatively related to financial distress intensity and leverage. These are puzzles under frictionless capital markets assumptions, but consistent with optimizing firms that differ in their exposure to financial distress costs. Firms with high costs choose low leverage to avoid distress, but retain exposure to the systematic risk of bearing such costs in low states. Empirical results are consistent with this explanation. The return premiums to low leverage and low distress are significant in raw returns, and even stronger in risk-adjusted returns. When in...
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...Financial Leverage And Capital Structure Policy 0 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure 1 Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt 2 Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC 3 How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 4 The Effect of Leverage Example:...
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...Table of contents Contents i. Introduction to Leverage 3 ii. Significance of the Issue 3 iii. What is Leverage? 4 iv. Kinds of Leverage 4 a) Financial Leverage. 4 b) Operating Leverage. 4 c) Combined Leverage 5 v. Risks of Leverage 5 vi. Conclusion 5 vii. List of references 6 i. Introduction to Leverage In finance, Leverage is considered to be any financial instrument or loaned capital used to increase the potential return of an investment. Leverage is usually used in real estate and often in the automobile industry in the form of mortgage to purchase houses or vehicles. Leverage aids both the shareholder and the firm, but it comes with great deal of risk. If an investor makes use of leverage to create an investment and it doesn’t go in his or her favor, their loss is much larger than it would've been if they hadn’t used leverage. Leverage amplifies both gains and losses. In the business world, a firm is able to make use of leverage to try to produce shareholder wealth, but if it is unsuccessful to do so, the interest expense and credit risk of damaging the shareholder's value. Leverage can be used in many branches of finance including bonds, stocks, currencies, commodities and also other investments. Leverage can either be a good or bad thing for the firm depending on the situations that arise. ii. Significance of the Issue Leverage is one of the main topics in finance, one cannot study finance without coming across words like investments, loans, mortgages...
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...THE CEO AFFECTS THE RISK POLICY OF FIRM OLD DOMINION UNIVERSITY FIN 863 FINAL PROJECT BY SONIK MANDAL CHARLIE SWARTZ INTRODUCTION Agency theory states that the goals of the owners and the managers of a firm diverge in a way that the managers take less risk since their ownership of the company is much less compared to the owners of the firm who have a much bigger stake in the company. Thus managers being risk averse, they forego profitable ventures if they anticipate them to be risky (Guay, 1999, Jensen & Meckling, 1976). Making the salary structure more convex by introducing more option-based compensation and stock awards is one way owners try to align the goals of the managers with the owners. But managerial wealth attached to the firm is only a fraction of their total personal wealth in the portfolio. Other components of manager’s total wealth could be stocks owned in other companies, real estate portfolio, and other debt related securities. A lot of research has been done in the past explaining how managerial compensation structure (options, stock awards etc.) affect his risk taking abilities (Knopf et al. 2002, Rogers, 2002, etc.). But not much research has been done showing how manager’s outside wealth affects his risk taking in the firm. As far as we know, the only paper that has looked at this relationship is by Elsila et al. 2013 but that paper only looked at the Swedish listed firms. They found that higher...
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...LEVERAGE ANALYSIS Leverage arises from the presence of fixed costs in a firm’s cost structure. Two types of leveragea) Operating Leverage and b) Financial Leverage. •Operating leverage arises from fixed operating costs (depreciation, salaries, advertisement etc). •Financial leverage from the presence of fixed financing costs such as interest. Concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk. Operating Leverage The use of fixed operating costs as opposed to variable operating costs. A firm with relatively high fixed operating costs will experience more variable operating income if sales change. So it is the responsiveness of the firm’s EBIT to fluctuations in sales. Costs • Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions). Total Revenue Rs }EBIT Total Cost + Breakeven point Q1 Quantity { - FC Operating Leverage • What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? Total Revenue Rs + FC } Q1 EBIT Total Cost = Fixed { New Breakeven Point with FC Old Breakeven Point with VC &FC Quantity With high operating leverage, an increase in sales produces a relatively larger increase in...
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...available to a company? What is business risk and financial risk? What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure? 1 What is “Capital Structure”? Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, eg warrants, convertible bonds 2 What is “Capital Structure”? Balance Sheet Current Assets Current Liabilities Debt Preference shares Ordinary shares 3 Fixed Assets Financial Structure What is “Capital Structure”? Balance Sheet Current Assets Current Liabilities Debt Preference shares Ordinary shares Fixed Assets Capital Structure 4 Sources of capital Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities Loan capital Warrants Convertible bonds Bank loans Corporate bonds 5 Ordinary shares (common stock) Risk finance Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders A high rate of return is required Provide voting rights – the power to hire and fire directors No tax benefit, unlike borrowing 6 Preference shares (preferred stock) Lower risk than ordinary shares – and a lower...
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...The firm is currently financed completely with equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures: ------------------------------------------------- ------------------------------------------------- % Financed With Debt rd ------------------------------------------------- 0% --- ------------------------------------------------- 20 8.0% ------------------------------------------------- 30 8.5 ------------------------------------------------- 40 10.0 ------------------------------------------------- 50 12.0 ------------------------------------------------- ------------------------------------------------- If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium...
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...PROFESSIONAL UNIVERSITY DEPARTMENT OF MANAGEMENT Report on Capstone Project “Impact of financial risk on capital structure decision in cement industry of India” Submitted to Lovely Professional University In partial fulfilment of the Requirements for the award of Degree of Master of Business Administration Supervisor: Mr. Rohit Bansal Submitted by: Shalini Sahay 10808654 Khalid Anwar 10805151 Suman Saurabh 10808885 Varun Kakkar 10810014 Gurpreet Singh 10806126 DEPARTMENT OF MANAGEMENT LOVELY PROFESSIONAL UNIVERSITY JALANDHAR NEW DELHI GT ROAD PHAGWARA PUNJAB 1 CERTIFICATE This is to certify that the project report titled “Impact of financial risk on capital structure in cement industry of India” carried out by Miss. Shalini sahay has been accomplished under my guidance & supervision as a duly registered MBA student of the Lovely Professional University, Phagwara. This project is being submitted by him/her in the partial fulfilment of the requirements for the award of the Master of Business Administration from Lovely Professional University. Her dissertation represents her original work and is worthy of consideration for the award of the degree of Master of Business Administration. ___________________________________ (Name & Signature of the Faculty Advisor) Date: 2 CERTIFICATE This is to certify that the project report titled “Impact of financial risk on capital structure in cement industry of India” carried out by Mr.Khalid anwar has been accomplished...
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...CHAPTER 14 FINANCIAL AND OPERATING LEVERAGE Q.1. A.1. Explain the concept of financial leverage. Show the impact of financial leverage on the earnings per share. The use of fixed-charges sources of funds, such as debt and preference capital, along with owners’ equity in the capital structure is known as financial leverage (or gearing or trading on equity). The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus will increase the return on the owners’ equity. The role of financial leverage in magnifying the return of the shareholders’ is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and other sources or debentures or bonds) can be obtained at a cost lower than the firm’s rate of return on net assets. So, when the difference between the earnings generated by assets financed by the fixedcharges funds and costs of these funds is distributed to the shareholders, the earnings per share (EPS) (or return on equity, ROE) increases. EPS is calculated by dividing profits after tax (PAT) (net of preference dividend) by the number of shares outstanding. Example: All-equity Debt-equity 1. Investment 500,000 500,000 2. Equity capital 500,000 250,000 3. Debt capital @ 15% 0 250,000 4 EBIT 120,000 120,000 5. Less: Interest 0 37,500 6. PBT 120,000 82,500 7. Less: Taxes @ 50% 60,000 41,250 ------------8. PAT 60,000 41,250 9. No. of equity shares 50,000 25,000 10. EPS (5 ÷...
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... In brief, the MM theory states that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent from its corporate financing decisions. In fact, the MM theory provided conditions under which a firm’s financial decisions do not affect the value of the firm. The fundamental conditions under which a firm’s leverage becomes irrelevant to its market value, hence the MM proposition hold includes: * No taxation * No transaction costs exist * No default risk * Perfect and frictionless markets * Firms and investors can borrow at the same interest rate The MM theorem might seem extraneous but it provides cornerstone for corporate finance. However, the classic question “How do firms choose their capital structure?” remain unanswered. In finance, the term ‘capital structure’ refers to the technique followed by corporations to finance its assets through combination of equity, debt, or hybrid securities [2]. In simple terms, a firm's capital structure is the symphony of its liabilities. For example, a firm that possesses $40 billion in equity and $60 billion in debt is said to be 40% equity-financed and 60% debt-financed. The firm's ratio of debt to equity that is 60% is referred to as the ‘firm's leverage’. Leverage and Gearing are two terms that are often used interchangeably, gearing ratio is the proportion of the capital employed by the firm which comes from outside of the business finance, e.g. by taking...
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...The firm is currently financed completely with equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures: ------------------------------------------------- ------------------------------------------------- % Financed With Debt rd ------------------------------------------------- 0% --- ------------------------------------------------- 20 8.0% ------------------------------------------------- 30 8.5 ------------------------------------------------- 40 10.0 ------------------------------------------------- 50 12.0 ------------------------------------------------- ------------------------------------------------- If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium...
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...hybrid securities. Stewart C. Myers argues that there is “no magic” in leverage and there is nothing supporting a presumption that more debt is better. He adds that debt maybe better than equity in some cases, worse in others or it may be no better and no worse. Thus, all financing choices are equally good. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. There are many views on capital structure including the traditional views as well as the competing views offered by Modigliani and Miller. Traditional views on capital structure point to the existence of an optimal capital structure. An optimal capital structure is simply a mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital. According to the traditional views on capital structure, changes in capital structure benefit the stockholders if and only if the value of the firm increases. Conversely, these changes hurt the stock holders if and only if the value of the firm decreases. This result holds true for capital structure changes of many different types. Thus, managers should choose the capital structure that they believe will have the highest firm value because the capital structure will be most beneficial to the firm’s...
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...1. Discuss the signaling effects for a firm associated with increasing leverage or implementing a stock repurchase. Increasing leverage is increasing debt of the firm. Leverage is associated with net income/EBIT. In general the higher this ratio the higher the risk because in good times higher leverage gives better results but on the the other hand in bad times high leverage causes problems, because increase in leverage will cause an increase of the beta of the firm. Moreover leverage increases Earnings per share, but still creates risk. Modigliani and Miller says that no capital structure is better than the other because this doesn’t change the total value of the outstanding shares by changing the capital structure. But the required return will be higher since leverage increases risk. As for stock repurchase, instead of paying dividend company may choose stock repurchase. There are 3 ways. First one is , companies may simply purchase their own stock, just like an investor buying in the market. In these open market purchases , the firm’s name is not given as the buyer. So , the one who sells the stock does not know whether the shares were sold back to the firm or to another investor. Secondly , tender offer is another way in which the firm makes a call to its stockholders that it has an intention of buying a fixed number of shares at a pre-determined price. As the last one firm may prefer to buy from specific investor and this process is known as targeted purchase. It...
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...CHAPTER 12 Risk, Cost of Capital, and Capital Budgeting Multiple Choice Questions: I. DEFINITIONS WACC e 1. The weighted average of the firm’s costs of equity, preferred stock, and after tax debt is the: a. reward to risk ratio for the firm. b. expected capital gains yield for the stock. c. expected capital gains yield for the firm. d. portfolio beta for the firm. e. weighted average cost of capital (WACC). Difficulty level: Easy CAPM b 2. If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the: a. return on the stock minus the risk-free rate. b. difference between the return on the market and the risk-free rate. c. beta times the market risk premium. d. beta times the risk-free rate. e. market rate of return. Difficulty level: Easy CHARACTERISTIC LINE c 3. The best fit line of a pairwise plot of the returns of the security against the market index returns is called the: a. Security Market Line. b. Capital Market Line. c. characteristic line. d. risk line. e. None of the above. Difficulty level: Medium USE OF DEBT c 4. The use of debt is called: a. operating leverage. b. production leverage. c. financial leverage. d. total asset turnover risk. e. business risk. Difficulty level: Medium WEIGHTED...
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...in a WACC calculation.”[2] “WACC depends on percentage of debt and common equity (wd) and (ws), the cost of debt (rd) and cost of stock (rs ) and the corporate tax rate (T)”.[3] WACC = wd(1 – T)rd + wsrs The effect of debt on WACC and Free Cash Flow is influenced by impact of the capital structure on value.[4] Capital structure affects the WACC and FCF of a company in many ways. The debt holders have a right to a cash flow before shareholders, which means that dividend can't be paid out unless all obligations toward debt holders for the specific period of time are met. Because of that, the cost of stock, rs goes up.[5] A high debt increases the risk of bankruptcy for a company, which might able to meet all payments. This risk of bankruptcy causes pre-tax cost of debt, rd, to increase.[6] In addition, increased risk of bankruptcy reduces ed free cash flow, which can be affected by legal costs of bankruptcy, “short sale” of assets, as well as decrease in sales, lost of customers, loss or reduction of credit line, decreased productivity of employees and managers who might feel need to “abandon the sinking ship”.[7] A positive effect of debt is that a company can deduct the interest expenses which allows to pay smaller taxes and at the same time allow a company...
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