Chapter 16: Limits to the use of debt policy Costs of financial distress Direct costs Indirect costs Capital structure with corporate taxes and financial distress: the Static Tradeoff Model Capital structure under Asymmetric Information: the Pecking Order Theory WSU EMBA Corporate Finance

Recap of Chapter 15 and the Modigliani and Miller model The Modigliani and Miller model of Chapter 15 offered a simple introduction to capital structure. The difference between the value of an unlevered firm and a levered version of the same firm is the present value of the tax shield. Financial distress effects were ignored. VL = VU + PV(tax savings), or with perpetual debt; VL = VU + TCB WACC = [D/(D+E)][1 – TC][rD] + [E/(D+E)][rE] In Chapter 16, we now incorporate the concepts of financial distress and asymmetric information. WSU EMBA Corporate Finance

Financial distress and/or default on the debt Any corporate debt issue certainly has a non-zero probability of default or distress. Think not only of the probability of whether financial distress will come. Think also of the value that will be lost if financial distress does come. Financial distress or actual default/bankruptcy may be very costly to many firms. WSU EMBA Corporate Finance

The costs of financial distress Direct costs Direct costs are the quantifiable costs such as legal fees and administrative expenses associated with financial distress, default, or bankruptcy. Indirect costs The impaired ability to conduct business Agency costs associated with financial distress Managerial decision making can be affected as a result of financial distress. WSU EMBA Corporate Finance

Example of financial distress: Against-the-wall Corp. The firm has bonds that are due tomorrow. Note the differences between the Book Value (BV) and current Market Value (MV). It appears as though the firm will default on the debt tomorrow. Assets BV MV Liabilities Cash $200 Bonds $300 Fixed assets $400 $0 Equity Total $600 WSU EMBA Corporate Finance

Selfish investment strategy #1: the incentive to take large risks As is, the bondholders will seize the $200 cash tomorrow and the corporation will be dissolved. At current market value, the equity is worthless. Today, the equity holder has nothing to lose! Assume a high risk project exists. It costs $200 now and has the following payoffs tomorrow: $1000 paid with 10% probability $0 paid with 90% probability The expected payoff is (0.1)($1000) + (0.9)($0) = $100. NPV = -$200 + $100 = -$100, a negative NPV!!! WSU EMBA Corporate Finance

Selfish investment strategy #1: the incentive to take large risks If the $200 risky project is not accepted: Tomorrow the bonds are in default with 100% probability. The bondholders are owed $300, but the firm only has $200, so the firm is dissolved. The equity is worthless. If the $200 risky project is accepted: Tomorrow, chances are 90% that the project pays $0. The bonds default and pay nothing. The equity is also worthless. However, tomorrow there is a 10% chance that the risky project has a $1000 payoff. Bonds are paid their promised $300 and the equity thus has $700 left over! WSU EMBA Corporate Finance

Selfish investment strategy #1: the incentive to take large risks Without taking on the project, the equity is worthless. Once the project is accepted today, the equity immediately becomes worth its expected payoff. PV equity = (0.1)(1000 - 300) + (0.9)(0) = $70 PV bonds = (0.1)(300) + (0.9)(0) = $30 Note that the firm value has fallen from $200 to $100. If the goal is to simply maximize shareholder wealth, then under financial distress, there is an incentive to take high risks (risk shifting). A 10% chance of receiving $700 is certainly better than a 100% chance of receiving nothing! WSU EMBA Corporate Finance

Selfish investment strategy #2: the incentive to underinvest Alternatively, the firm has a riskless project. It costs $300 today and has a certain payoff of $350 tomorrow. Should this NPV = +$50 project be accepted? To fund this project, the equity holders must kick in $100 so that the firm will have $300. If accepted, the project pays $350 and the bondholders receive their $300 promised payment. The equity then receives the remaining $50. Why pay in $100 to receive $50. This positive NPV project is thus rejected. If accepted, it only shores up the bonds. WSU EMBA Corporate Finance

Summarizing the selfish investment strategies Another recourse is to milk the property by paying a liquidating dividend to the equity. Note that these issues are irrelevant to an all equity or, to a large extent, a financially sound firm. The presence of risky debt leads to agency problems between the debtholders and shareholders. Obviously there are bond contracts and restrictive covenants (as well as state and federal laws). Bondholders are well aware of financial distress related issues. Risky debt must pay a premium over less risky debt due to all the potential future distress related problems. The firm and thus its shareholders must bear this higher interest rate that is demanded as bondholder compensation. WSU EMBA Corporate Finance

Modifying the Chapter 15 model to incorporate financial distress We augment the Chapter 15 model to incorporate financial distress costs. VL = VU + PV(tax shield) – PV(costs of financial distress) Since the maximization of VL is the primary goal, the above equation suggests that there must be some optimal debt-to-equity (D/E) ratio that maximizes VL. At the optimal D/E ratio: (1) The total firm value VL is maximized and (2) the weighted average cost of capital or WACC is minimized. A tax shield versus debt tradeoff thus exists. WSU EMBA Corporate Finance

Figure of the Static Tradeoff Model of capital structure Debt /Equity ratio Value of firm Modigliani - Miller model, V L =V U +PV(tax shield) , from Chapter 15. It ignores financial distress costs. Optimal D/E Actual value of firm Present value of tax shield financial distress costs WSU EMBA Corporate Finance

WACC is minimized at the optimal debt-to-equity ratio Debt/Equity rat io % cost of source of capital r Optimal D/E WACC, first it decreases but eventually increases with D/E WACC is minimized at the “optimal” D/E ratio. Here, the value of the firm V L is maximized E , the firm’s cost of equity, always increasing with D/E D WSU EMBA Corporate Finance

WSU EMBA Corporate Finance Static tradeoff model Different firms and industries will likely have differing levels of debt capacity, financial distress issues, etc. The following slide presents the static tradeoff figure for three hypothetical firms Firm 1 has a high level of debt capacity and has a high optimal D/E ratio. Firm 2 has less debt capacity and a lower optimal D/E ratio. Firm 3 has no debt capacity. Any debt makes the firm less valuable, and therefore, the firm should be unlevered or all equity financed. WSU EMBA Corporate Finance

Three firms with different levels of debt capacity. WSU EMBA Corporate Finance

Typical characteristics of high leverage firms Most of value derives from assets currently in place. Future growth opportunities will typically not contribute a large part of the firm’s current value. Assets are easily transferred or redeployed to another use with little or no loss in value. Transportation type firms fit this profile. Stable earnings Assets are tangible or physical in nature WSU EMBA Corporate Finance

Typical characteristics of low leverage firms Most of current value derives from future growth opportunities. For such firms, relatively large amounts of risky debt can potentially create a future underinvestment problem. Growth opportunities serve as poor collateral for current debt. Assets are intangible in nature, such as R&D skills, human capital, and organizational skills. Assets are not easily transferred or redeployed to another use. Earnings are nonexistent, low, or unstable Too much debt or perhaps any debt makes the firm too risky due to a high likelihood of default on the debt. WSU EMBA Corporate Finance

Pecking Order Theory and Information Asymmetry The Static Tradeoff Model (predating the 1980s) did not incorporate information asymmetry. In reality, information asymmetry exists between corporate managers and outsiders. The Pecking Order Theory (1984) assumes that: (1) Corporate managers are better informed and thus possess superior information concerning the true value and future prospects of the firm (2) Managers act in the best interest of existing shareholders. The Pecking Order Theory suggests that the behavior and actions of managers (especially financing decisions) constitute important signals to the outsiders concerning managers’ private beliefs. WSU EMBA Corporate Finance

Pecking Order Theory of corporate financing To reiterate, we assume that managers know if the firm is either overvalued or undervalued, and they also want to act in the best interest of existing shareholders. Outsiders are unable to verify any managerial announcement or claim. In order to protect existing shareholders, managers will fund new corporate investments in the following pecking order: Retained cash flow (what we refer to as internal equity) Straight debt (the safest security for the market to price) Convertible debt (debt with equity option) Common stock (external equity) – viewed by the market with the most skepticism. Equity is the most difficult security to evaluate. Managers will also desire financial slack, e.g., cash holdings and unused debt capacity that can fund future investments. WSU EMBA Corporate Finance

Pecking order theory and asymmetric information We observe that relative to debt issues, actual equity issuances are rare. Within an industry, we observe that the most profitable firms are usually the least levered firms. The more profitable firms had more operating cash flow to reinvest and thus have lower leverage. Therefore the firms that appear to have the largest degree of debt capacity are actually the least levered firms in the industry. The less profitable firms had to access the debt markets in order to invest and keep up with industry growth. Given the asymmetric information problems, equity issuances would be rare and only used as a last resort. WSU EMBA Corporate Finance

Pecking order theory and asymmetric information Empirical evidence reveals the following market reaction to announcements that will change financial leverage: Announcements of actions that decrease leverage result in stock price decreases, e.g., an equity for debt swap. Announcements of actions that increase leverage result in stock price increases, e.g., a debt for equity swap (such as a leverage recapitalization). The following slide illustrates why managerial announcements that change leverage typically signal information about the value of the firm. WSU EMBA Corporate Finance

Asymmetric information and managerial signaling thru capital structure WSU EMBA Corporate Finance