Money and Banking

Mr. Vaughan

Modigliani-Miller and

Financial Structure

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Financial-Structure Puzzles

Eight, interrelated puzzles, about financial structure:1. Financial system boasts a broad array of marketable securities

and financial intermediaries—and heterogeneity is increasing. *

2. Internal finance is more important than external finance for firms—not just in U.S., but all over developed world. *

3. Firms seeking external finance rely more heavily on banks than securities markets—not just in U.S. but all over developed world.

4. Only large, well-established corporations can tap securities markets to finance operations—not just in U.S. but all over developed world.

* Not listed in Mishkin.

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Financial-Structure Puzzles(continued)

Eight, interrelated puzzles, about financial structure:5. U.S. firms selling securities rely more heavily on bonds than on

stocks. (Common, but not universal, pattern in developed world.

6. Debt contracts typically are extremely complicated legal documents placing substantial restrictions on borrowers.

• Collateral is a common feature of debt contracts.

7. As financial markets have grown more sophisticated, financial intermediation has become more important economically. *

8. Financial system is heavily regulated—not just in U.S., but all over developed world.

* Not listed in your text.

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Sources of External FinanceCross-Country Comparisons

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Understanding Financial StructureModigliani-Miller Theorem

Theorem: In frictionless capital markets, firm value depends solely on cash flows from assets. Capital structure—i.e., how assets are financed—plays no role.

Corollary: NPV of investment projects doesn’t depend on financing.

Definition: Frictionless capital market

• Perfect Competition

• No transactions costs

• No information asymmetries

• No tax/regulatory distortions

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Understanding Financial StructureModigliani-Miller Theorem

Intuition: • Cash flows from assets

determine the size of pie.

• Capital structure—debt/equity mix—merely slices pie.

• Firm cannot make pie larger by slicing it differently.

Debt Equity

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Modigliani-Miller TheoremLogic

Consider two firms with identical cash flows from assets:

• One has debt (levered firm) in capital structure; other (un-levered firm) does not.

• Investors can borrow privately on same terms as levered firm.

• Total value of firm is defined as market value of debt plus the market value of equity. So: Total value of un-levered firm = total value of outstanding shares Total value of levered firm =

total value of outstanding debt + total value of outstanding shares.

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Modigliani-Miller Theorem:Logic

Levered Firm:Cash Flows from Assets

- Firm’s Debt Service

Dividends = Net Cash Flows

Un-levered Firm:Cash Flows from Assets

= Dividends

- Private Debt Service

= Net Cash Flows

• Net cash flows are identical.• Investors care only about net cash flows. • Arbitrage guarantees total value of levered firm will

equal total value of un-levered firm.

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Explanations for Financial-Structure Puzzles

MM identifies frictions that make financing choices important:

1. Transactions costs 2. Asymmetric information costs3. Taxation and Regulation

Financing arrangements reflect efforts to minimize transactions costs, information costs, tax burden, and regulatory burden.

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Transactions Costs

Definition: Time/money spent channeling funds from surplus units to deficit units.

Forms:• Search costs• Negotiation costs• Enforcement costs

Implication: Small firms and large firms needing small amounts of financing will rely on internal finance or bank finance.

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Transactions Costs

Another Form: Bankruptcy costs

Definition: Loss of firm value arising from financial distress• Explicit bankruptcy costs: lawyers and

accountants fees, etc.

• Implicit bankruptcy costs: loss of sales, loss of trade credit, key employees, etc.

Implication: Firms with intangible assets and attractive growth opportunities will shy away from debt financing.

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Asymmetric-Information Costs

Definition: Costs of overcoming two types of information problems:

• Adverse selection: separating good from bad risks before execution of financial contract.

• Moral hazard: insuring economic agents with delegated authority live up to contract terms.

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Asymmetric-Information Costs: Adverse Selection

Example: Lemon’s Problems1. If investors can't distinguish good and bad securities, they

will offer only average value.

2. Good securities will be undervalued, so firms won't issue them; bad securities will be overvalued, so too many will be issued.

3. Investors do not want bad securities, so market falls apart.

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Solutions to Lemon’s Problems• Information production by disinterested third party

– Limited by free-rider problem

• Signaling– collateral

– net worth

– reputation (a form of collateral)

• Government regulation

• Financial intermediation

Asymmetric-Information Costs Adverse Selection

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Financial Frictions in Action Pecking Order Theory of Financing

Adverse selection make some financing vehicles much more expensive than others.

Example: • Managers want to issue new stock only when it is

overvalued.

• Stock issuance is “bad” signal.

• Stock issuance causes price of outstanding stock to fall.

• Decline in stock price is part of cost of external finance.

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Financial Frictions in Action: Pecking Order Theory of Financing

Firms use financing with smallest adverse selection costs (i.e., smallest information asymmetries) first.

Pecking order:1. Internal Funds

2. Bank Debt

3. Public Debt

4. Public Equity

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Financial Frictions in Action: Pecking Order Theory of Financing

Implications: • Financial slack is valuable.

• Observed capital structures reflect availability of positive net present value projects.

No optimal debt/equity mix.

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Principal-Agent Problem: Principal designates agent to act on his behalf. Because monitoring/ disciplining are costly, agent has scope to pursue his own interest at the expense of principal.

Examples: 1. Separation of ownership from control allows managers to

use firm resources to pursue personal interests instead of maximizing shareholder value.

2. Separation of savers/investors allows investors to use surplus funds to pursue personal interests rather than accepting capital projects with highest NPV.

Asymmetric-Information Costs Moral Hazard

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Solutions to moral-hazard problems:

• Debt finance

– Motivates managers to maximize shareholder value by absorbing “free cash flow”

– Reduces costs of monitoring investors

• Government regulation

• Financial intermediation

Asymmetric-Information Costs: Moral Hazard

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Features of debt contracts that reduce moral-hazard problems:

• Restrictive covenants• Collateral requirements• Net worth requirements• Reputation (a form of collateral or net worth)

Asymmetric-Information Costs Moral Hazard

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Catalysts in Financial Markets

Δ Technology

Δ Shape of financialintermediaries and markets

Economic and Political “Shocks”

Δ Transactions CostsΔ Information Costs

Δ Relative Return from Granting Rents

Δ Taxation and Regulation

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Catalysts in Financial Markets

Technological improvements:• Advances in finance and statistical theory• Advances in computing speed, power, and

storage space• Advances in transportation and

telecommunication

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Regulation of Financial Markets

Justification (according to Mishkin):1. Increase Information to Investors

• Decreases adverse selection/moral hazard problems

2. Ensuring Soundness of Financial Intermediaries• Chartering, reporting requirements, restrictions on assets and

activities, deposit insurance, and anti-competition measures.

3. Improving Monetary Control• Reserve requirements

• Deposit insurance Market failure!

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Two better reasons (in MDV’s view)

1. Hysterical political reaction to real/ perceived crisis

2. “Rent” seeking– Use of government power to secure return

above opportunity cost (economic rents)

Regulation of Financial Markets

Technological and political/economic shocks alter returns to taxing/regulating.

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Example of hysterical political reaction to real or perceived crisis plus rent seeking:

Glass-Steagall (1933):• Established firewall between investment and

commercial banking.• Based on idea that investment banking would

increase risk of commercial banking and conflict of interest existed.

Regulation of Financial MarketsGlass-Steagall Act (1933)

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Regulation of Financial MarketsGlass-Steagall Act (1933)

But...• Portfolio theory indicates combining commercial and

investment banking actually reduces risk.

• Evidence from 1920s indicates bonds underwritten by investment bank subs of commercial banks performed well (no evidence of massive fraud).

• Public benefits from economies of scope available by

combining commercial and investment banking.

Mistake not fixed until 1999

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Recent Trends in Financial Markets

1. Financial entrepreneurship

2. Globalization

3. Democratization

4. Deregulation

5. Evolution of financial intermediation

All these trends have their roots in technological or political/economic shocks!

Questions over

Money and BankingMr. Vaughan

Modigliani-Miller and

Financial Structure