Chapter 17 Limits to the Use of Debt Topics: 17.1 Costs of Financial Distress 17.2 Agency costs of debt 17.4 Integration of Tax Effects and Financial Distress Costs 17.7, 17.10 How Firms Establish Capital Structure

Bankruptcy Risk vs. Bankruptcy Costs The possibility of bankruptcy has a negative effect on the value of the firm However, it is not the risk of bankruptcy that lowers value, but rather the costs associated with bankruptcy (and, more generally, financial distress)

Example—firm bears costs of financial distress A firm borrows $1M for one year. There is a 90% chance of repayment and a 10% chance of bankruptcy. If bankruptcy occurs, the firm’s assets can be sold for $600,000. Suppose the bank charges interest so to earn an average return of 10% from similar companies. (1) What’s the expected cost of bond on the firm? (2) Now assume bankruptcy costs are $100,000. What’s the expected cost of bond on the firm?

Financial Distress Costs Direct costs: Legal and other deadweight costs While large in absolute amounts, they are usually small in terms of overall firm value (5%) Indirect Costs (20%) Impaired ability to conduct business Costs of negotiating and obtaining creditor approval for taking actions Underinvestment in research and development Selling off assets at fire sale prices Failure to perform needed maintenance Agency costs of debt The firm bears the costs of financial distress

17.2 Agency cost of debt An agency cost arises whenever you hire someone else to do something for you. It arises because your interests (as the principal) may deviate from those of the person you hired (as the agent). Stockholders interests are different from bondholders interests, because You (as lender) are interested in getting your money back Stockholders are interested in maximizing their wealth This conflict of interest is more pronounced when the firm is in distress and both parties want to recover

Three Types of Agency Costs of debt: Selfish Strategies by Equityholders in Distressed firms Incentive to take large risks Incentive toward underinvestment Milking the Property

Example $200 $0 Assets BV MV Liabilities BV MV Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? $200 $0

Selfish Strategy 1: Take Large Risks Example cont’d The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash); Required return is 50% What is the NPV the gamble?

2. However, equityholder will do the project. Why? Cont’d: 2. However, equityholder will do the project. Why? Expected CF from the Gamble To Bondholders To Stockholders PV of Bonds Without the Gamble PV of Stocks Without the Gamble PV of Bonds With the Gamble PV of Stocks With the Gamble

Selfish Strategy 2: Underinvestment (Selfish Stockholders Forego Positive NPV Project) Example cont’d: Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10%. What is the NPV of the project? Should equityholder accept the project?

Cont’d: Expected CF from the government sponsored project: To Bondholder To Stockholder PV of Bonds Without the Project PV of Stocks Without the Project PV of Bonds With the Project = = $272.73 PV of Stocks With the project = = -$54.55

Selfish Strategy 3: Milking the Property Example cont’d: Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. Such tactics often violate bond indentures. Increase perquisites to shareholders and/or management

Agency Costs of Debt: Summary Conflicts of interest between stockholders and bondholders result in: poor decisions about investments and operations higher interest rates to compensate lenders for potential problem Can these costs be reduced? debt consolidation (if we minimize the number of parties involved, negotiation costs will be lowered) bond covenants can also be seen as a means of reducing costs Consider the following three alternatives: (i) issue no debt (but this can be costly due to the foregone debt tax shield); (ii) issue debt without covenants (but this will result in much higher interest rates being charged on debt); or (iii) issue debt with covenants

Integration of Tax Effects and Financial Distress Costs: Summarizing the Trade Off of Debt Advantage of Borrowing Disadvantage of Borrowing Tax Benefits: Higher tax rate  Higher tax benefits Bankruptcy cost: Higher business risk  higher cost 2. Added Discipline: Greater the separation between managers and stockholders Greater the benefit 2. Agency cost: Greater the separation between stockholders and lenders  higher cost 3. Loss of future financing flexibility: Greater the uncertainty about future financing needs  higher cost

Integration of Tax Effects and Financial Distress Costs Value of firm under MM with corporate taxes and debt Value of firm (V) Present value of tax shield on debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt Debt (B) B* Optimal amount of debt

MM propositions with distress We can update MM Prop. 1 with taxes as: VL = VU + PV(interest tax shields) - PV(FDC) where FDC (financial distress costs) is a very general increasing function of the amount of debt. MM Prop. 2

The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy parties, respectively. VT = S + B + G + L S The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie. B G L

Static Tradeoff Theory of Capital Structure In the Pie model How much debt you take depends on the tradeoff between G and L maximizing the total value of the marketed claims (S+B) is equivalent to minimizing the total value of the non-marketed claims (G+L) The static tradeoff hypothesis says that the change in firm value when equity is replaced by debt is the PV of the debt tax shield minus the PV of increased costs of financial distress More generally, the tradeoff theory says the capital structure is determined by the tradeoff between the benefits and costs of debt The optimal amount of debt is when the marginal benefit equals marginal cost of debt

Another school of Capital Structure: The Pecking Order Theory Recap: Theory states that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1 Use internal financing first. Rule 2 Issue debt next, equity last. This theory focuses on the timing of security issuance, and relies on asymmetric information Asymmetric information assumes one party possesses more information than another. e.g., equityholders vs. bondholders on the value of the firm Consider a manager of a firm which needs new capital (debt or equity) If the manager believes that the stock is currently undervalued, debt would be better (instead of selling shares for less than their true worth) If the manager believes that the stock is currently overvalued, equity would be better

Pecking order cont’d Now consider the investor if the investor observes the firm issuing equity, this can be taken as a signal that the stock is currently overvalued (“signalling”) conversely, a firm issuing debt may be sending a signal that the stock is currently undervalued If the manager takes the investor’s inference into account, then the choice should always be debt (since if a firm tries to sell equity, investors will think it is overpriced and won’t buy it unless the price falls) Similarly, investors might be reluctant to buy bonds if they think that managers are issuing debt because it is currently overvalued This leads to the pecking order.

Comparing tradeoff theory with pecking order theory The pecking-order theory is at odds with the trade-off theory: There is no target B/S ratio. Profitable firms use less debt. “Financial slacks” are valuable. The pecking order is also consistent with avoiding issue costs and a desire by managers to avoid publicity

Empirical evidence Tradeoff theory Pecking order theory: Empirical evidence which is consistent with the tradeoff theory: changes in financial leverage affect firm values persistent differences in capital structures across industries highly leveraged firms tend to invest less Violations: The tradeoff theory fails to explain why many very profitable firms have low debt Pecking order theory: Consistent with the observed negative correlation between operating profits and leverage Consistent with profitable firms using less debt

How Firms Establish Capital Structure Survey evidence on some of the factors that affect the decision to issue debt. The survey is based on the responses of 392 CFOs, conducted by John Graham and Campbell Harvey. (Paper is enclosed as an optional reading.)

Review Questions Does the following increase or decrease the use of debt: 1. Agency costs of debt 2. Governments often step in to protect large companies that get into financial trouble and bail them out. If this were an accepted practice, what effect would you expect it to have on the debt ratios of firms? Why?

Assigned Problems # 17.2, 3, 5, 6, 7, 8