25558 Issues in Corporate Finance Spring 2016
Individual Assignment
Instructions
• This assignment explores the pecking order theory of capital structure. You should begin your preparation by reading Chapter 17 of Hillier et al. (2012) (in particular, Sections 17.4 and 17.5), as well as Fama and French (2005). You should also read the conclusions in Myers (1984) and Myers and Maljuf (1984).
• The assignment uses data for a sample of U.S. firms, which can be found in the file Assignment Data.xls.
• The empirical results for Questions 2, 3, 5 and 6 should be presented in tables in an appendix entitled Appendix A: Tables. The estimated coefficients, t-statistics and R2 statistics for the three regressions in Questions 5 and 6 should be reported in a single table in that appendix.
• The graphical results for Questions 5 and 6 should be presented in an appendix entitled Appendix B: Graphs, with each graph appearing on a separate page.
• The main body of your submission (excluding the appendices) should not exceed six pages. The text should be formatted in a 12-point font, with double spacing between lines.
• The main body of your submission should consist of six sections, corresponding to the questions below, although you may include additional sub-sections. Please do not restate the questions themselves in your submission.
• The submission date is 17h00 on Tuesday, 11 October 2016. Attach a completed cover sheet to a printed copy of your assignment, using a single staple in the top-left corner, and deposit it in the allocated assignment box on Level 5 of Building 8. (Do not use any plastic sleeves or binders, etc.) Also submit a pdf version of your assignment, together with the Excel workbook containing your calculations, via Turnitin. • Your submission will be graded on the correctness of its analysis, the validity of its arguments, and the quality of its presentation (including its structure, clarity, and correct use of language).
• Note that this is an individual assignment, which you should complete independently, without collaboration or assistance. If you are uncertain about what this means, please consult the university guidelines on plagiarism and cheating.
Questions
Question 1. 10marks
(a) Write a brief overview of the pecking order theory of capital structure.
(b) What does the pecking order theory predict about new equity financing?
(c) What does the pecking order theory predict about share repurchases?
Question 2. 20marks
The following questions refer to Table 2 in Fama and French (2005).
(a) Interpret the evidence presented in Table 2 in relation to the pecking order theory. (b) Construct a table by extending Table 2 to include a fourth row for 2002 data.
(c) Compare the new row with the existing data in Table 2, and explain how it relates to the pecking order theory.
Question 3. 20marks
The following questions refer to Tables 2 and 3 in Fama and French (2005).
(a) Table 3 disaggregates firms into groups formed on size, profitability and growth, and examines how equity issuers differ from equity repurchasers in each group. Explain why this provides better evidence on the pecking order theory than the aggregate data in Table 2.
(b) Interpret the evidence presented in Table 3 in relation to the pecking order theory.
(c) Construct a table by extending the first three columns in Table 3 to include rows for 2002 data. Your table should extend Parts A and B of Table 3, for all three dSM groups.
(d) Compare this table with the table you constructed for Exercise 2, and interpret the results.
Question 4. 10marks
The following questions refer to Table 3 in Fama and French (2005).
(a) Describe the two ‘patches’ on the standard pecking order theory that were introduced by Myers (1984) and Myers and Maljuf (1984).
(b) What does the ‘patched’ pecking order theory predict about new equity financing?
(c) What does the ‘patched’ pecking order theory predict about share repurchases?
(d) Can the ‘patched’ pecking order theory explain the results in Table 3?
Question 5. 20marks
Use the sample data provided to estimate the following cross-sectional regression models: dLi Ei dSBi Ei
= a + ß + e and = a + ß + e,
Ai Ai Ai Ai
where dLi is the net growth in debt issues for firm i, dSBi is the net growth in its equity issues, Ai is the value its assets, and Ei is its earnings.
(a) Interpret the results of the regressions, paying specific attention to the magnitudes and statistical significance of the estimated coefficients.
(b) Create a scatter plot of new debt financing (dLi/Ai) against firm profitability (Ei/Ai), and include the predicted relationship between these two variables as a curve on the same graph.
(c) Create a scatter plot of new equity financing (dSBi/Ai) against firm profitability (Ei/Ai), and include the predicted relationship between these two variables as a curve on the same graph.
(d) Are these scatter plots consistent with the (standard or ‘patched’) pecking order theory? Your discussion should consider what the two graphs imply, when considered individually and together. You should also relate your results to the evidence in Parts B and C of Table 4 in Fama and French (2005).
Question 6. 20marks
Use the sample data provided to estimate the following cross-sectional regression model: d
Ai
where the variables dSBi and Ai are defined as before.
(a) Interpret the results of the regression, paying specific attention to the magnitudes and statistical significance of the estimated coefficients.
(b) Create a scatter plot of new equity financing (dSBi/Ai) against firm growth (dAi/Ai), and include the predicted relationship between these two variables as a curve on the same graph.
(c) Is this scatter plot consistent with the pecking order theory? You should separately consider the cases of low and high growth firms, and of net equity issuers and net equity repurchasers, in your discussion. You should also relate your results to the evidence in Parts B and C of Table 4 in Fama and French (2005).
(d) Explain why profitability and growth should be the two main explanatory variables for understanding variations in debt and equity issues, if the (‘patched’) pecking order theory is true. Based on the R2 statistics for your regressions, do you think this is the case?
References
Fama, E. F. and K. R. French (2005). Financing decisions: Who issues stock? J. Finan. Econ. 76(3), 549–582.
Hillier, D., M. Grinblatt, and S. Titman (2012). Financial Markets and Corporate Strategy (second European ed.). Maidenhead, Berkshire: McGraw-Hill Education.
Myers, S. C. (1984). The capital structure puzzle. J. Finance 39(3), 575–592.
Myers, S. C. and N. S. Maljuf (1984). Corporate financing and investment decisions when firms have information that investors do not have. J. Finan. Econ. 13(2), 187–221.