Optimal Capital Structure and Apple.

Today Apple announced a $17 billion bond issuance to allow it to return capital to shareholders and at the same time increase the firm's leverage.    Even with this issuance, AAPL will still have a very low debt to total assets ratio of about 10% based on book values and a mere 4% based on market value.

For most firms, the optimal capital structure (i.e. the blend of debt and equity) is not zero debt.   We know this because the Trade-Off theory states that firms should trade off the benefits of debt (interest tax deductibility) against the costs of debt (mainly bankruptcy costs).  The optimal capital structure results in the highest firm value because it minimizes the firm's cost of capital.   Students of corporate finance should fully understand what is going on here  -- we discuss this in great detail in my MBA class.

Clearly AAPL has a way to go before bankruptcy costs loom, but in the meantime the positive stock price reaction observed today confirms that the firm is moving in the right direction.

Opportunistic Capital Structure

Aswath Damodaran has an interesting post on whether firms have an optimal capital structure or are more opportunistic and sell whatever security seems cheap at the time.

The idea of an optimal capital structure is often formally called the trade off theory.  The theory states that firms have an optimal capital structure that is based on the trade off of the costs and benefits of debt.  Debt is cheap (tax deductible) but too much increases the risk (and expected costs) of bankruptcy.  Therefore firms pick an optimal combination of both.  Recent work however, shows that there is evidence that firms often time security markets when they issue equity (I've published a couple of papers on this topic).  This theory has come to be known as the market timing theory of capital structure.

Damodaran suggests that perhaps firms have an optimal target and use market timing to take advantage of mispricing opportunities around this target.  This is actually the topic of a working paper of mine (with Bill Elliott of UTEP, Ozde Oztekin of KU and Anjo Koëter Kant of VU University).   In this paper we argue that firms adjust faster or slower to their targets depending on whether market timing makes it advantageous to do so.  In effect we overlay market timing on top of the trade off model of capital structure.  The paper is currently being revised as it is working its way through the review process at a journal so I don't have a current version to post, but when we get through the review process I'll post a more detailed discussion.

Fama on regulation and the financial markets

Gene Fama - the person credited for developing the efficient markets theory - talks about whether or not markets are still efficient and whether the efficient markets theory still works.

His main points:
1. Of course markets are still efficient.
2. Even professionals cannot time the market. (In other words - buy index funds)
3. Although he prefers less regulation, the concept of banks being too big to fail is a problem. TBTF occurs because the government cannot let a huge bank fail because of the risk to the financial system. In essence the government unwillingly gives a guarantee to the bank. His solution, which is one I have also mentioned before, is to increase capital requirements. He wants huge capital requirements - 40% or more. In this case government regulation is needed to combat this TBTF problem.

Interest expense and taxes

We know from basic corporate finance that firms can deduct interest expense from their taxes. I didn't realize that if you have enough debt, you could actually have a negative tax rate.

Hard to believe, but the Government will actually pay you to lever up.

Bank Tax

In class this week we talked a bit about a bank tax to prevent banks getting too big to fail. Greg Mankiw (a Havard economist) weighs in the on the debate. He agrees with the idea of the tax.

More on bank capital ratios

In my MBA class last night we watched "The Trillion Dollar Bet" about Long Term Capital Mgmt. I believe that a large part of LTCM's problem was not the bets they were taking but the leverage that they were using. The recent financial meltdown has, again been in large part due to excessive leverage.

Which brings us to the question of banks being too big to fail. Here's another blog arguing that we need capital ratios that increase with size. Very large banks that become too big to fail should hold very large amounts of capital.

For more discussion, see my recent post about about how implicit and explicit government guarantees encourage excessive leverage.