0. Capital structure II Bankruptcy cost McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

1. Costs of Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
The possibility of bankruptcy has a negative effect on the value of the firm.
However, it is not the risk of bankruptcy itself that lowers value.
Rather, it is the costs associated with bankruptcy.

2. Example: Company in Distress
Firm A(debt=0) Firm B ( debt=100 in 1 year) Assets Boom Rec Boom Rec Cash flow $150 $80 $150 $80 BH $0 $0 $100 $80 SH $150 $80 $50 $0
Boom and Rec occur with prob=50%. No taxes
Debt due in one year with Interest rate=5%, assume debt and equity bear the same risk(same discount factor)
The value of the two firms are still the same:
the risk of bankruptcy itself will not lower value.
The company plans to be in business for one more year.
So cash for BH = interest + principle.
VA= VB= (150 X X0.5)/1.1= Noting that there is no bankruptcy cost.
Normally, equity holders bear more risk and has a higher required return. The calculations would be more complicated but the conclusion would not change.

3. Example: Company in Distress
Firm B ( debt=100) Assets Boom Rec Cash flow $150 $80 BH $100 $ 60 SH $50 $0
there is bankruptcy
cost=$20 in 1 year
PV(FDC) = (20*0.5)/1.05=9.52
S= (50 * )/1.05= B= (100* *0.5)/1.05 = 76.19
V = S+B= =100
It is the costs associated with bankruptcy which reduces the firm value !
If there is bankruptcy cost, then
VB= (50 X 0.5 +(150X X 0.5))/1.1=125 /1.1 <VA

4. Where come the Financial Distress Costs
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business (e.g., lost sales)
Agency Costs
Mangers/stockholders may take selfish strategies to the detrimental of the interest of bondholders or the firm.
These strategies are costly because they may lower the market value of the whole firm.
Agency costs: the stockholders are tempted to pursue selfish strategies to the damage of the bondholders. These strategies are costly because they may lower the market value of the whole firm.

5. Direct costs Direct cost can be born by creditors in case of default.
Legal fees and lawyers appointments
Enron: $30 milliion/month on legal and accounting fees ≈$1b in total, 10% of asset value.
WorldCom: $600m,
Lehman brother: nearly $ 2 billion.
Time spent to renegotiate the debt repayment schedule
Creditors often wait several years for a reorganization plan to be approved.
The US bankruptcy code:
Chapter 7 liquidation: firm’s asset is sold through auction. The proceeds are used to pay the creditors and firm ceases to exist.
Chapter 11 reorganization: debt is prolonged, in exchange, firm propose a reorganization plan and during the time, the firm continue to operate the business.
the plan must vote among creditors and approved by the court.
If cannot be approved, chapter 7 is put forth.

6. Indirect costs
Sales are frequently lost because of both fear of impaired service and loss of trust.
Difficulties in hiring and retaining good people often result in forgone revenues, opportunity costs, etc.
Reluctance of bankruptcy by government, bondholders may cause further damage.
Total cost of financial distress can range from 3-20% of the firm value.

7. Who pays for bankruptcy costs?
Apparently, BH bears the bankruptcy cost, why should SH care about costs borne by BH?
BH are not foolish: anticipating they will get less in case of bankruptcy, pay less for the debt initially.
How much less?
Precisely =PV (bankruptcy costs)
BH asks for a higher interest payment to compensate the costs before bankruptcy occurs.
Less money available for SH.
=> Ultimately, these costs are shifted to stockholders.

8. What happens to the MVBS?
Firm A (unlevered)
Assets | Equity
| Debt 0
Total | B+S
Firm B (debt=100 in 1 year)
Assets 100 | Equity 23.81
| Debt 76.19
Total 100 | B+S 100
The firm sells a bond for but has to pay 100 in 1 year.
Assume firm A has 100 shares outstanding, what will be the price change if the firm announce a change in capital structure to that of firm B (issue debt, repurchase shares)?
True or False: If bankruptcy costs are only incurred once the firm is in bankruptcy and its equity is worthless, then these costs will not affect the initial value of the firm.

9. Agency cost (SH vs BH)
The selfish strategies represent agency costs between bondholders and stockholders.
These costs exist because stockholders enjoy limited liability and payoffs to bondholders are limited.
When a firm is in financial distress, investment strategies that maximize firm value may no longer maximize the value of stockholders.
Selfish Strategy 1: Incentive to take large risks
Selfish Strategy 2: Incentive toward underinvestment
Selfish Strategy 3: Milking the property

10. Selfish Strategy 1: Take Risks
The Gamble Probability Payoff in 1 year Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Debt payment due next year =$ 300 Expected CF from the Gamble = $1000 × $0 = $100
The last investment decision is made today before the bonds are on time tomorrow.
NPV = –$200 +
$100
(1.50)
NPV = –$133

11. Selfish Strategy 1: Take Risks
Expected CF from the Gamble
To Bondholders = $300 × $0 = $30
To Stockholders = ($1000 – $300) × $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
$20 =
$30
(1.50)
PV of Bonds With the Gamble:
$47 =
$70
(1.50)
PV of Stocks With the Gamble:

12. Selfish Strategy 2: Underinvestment
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%.
NPV = –$300 +
$350
(1.10)
NPV = $18.18
Should we accept or reject?

13. Selfish Strategy 2: Underinvestment
Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
$ =
$300
(1.10)
PV of Bonds With the Project:
– $54.55 =
$50
(1.10)
PV of Stocks With the Project:
– $100

14. Selfish Strategy 3: Milking the Property
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

15. Can Costs of Debt Be Reduced?
Short-term debt
With long-term debt, equity holders have more opportunities to ripe the bond holders’ interests.
Agency costs are smallest for short-term debt.
Protective Covenants
SHs make agreements with BHs in hopes of lower rates.
A broken covenant leads to default.
Examples: prohibit to pay large dividends , restrict the types of investment, limit the issue of new debt.
Debt contracts
- frequently limit dividends or transfers of wealth to stockholders.
Limit the additional borrowing (e.g. allowing additional debt unless the ratio: earning/interest >2.0)
restrictions to selling assets or making major investment outlays without the permission of debt holders.
But the contract is costly: you have to spend money in order to save money.

16. 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 lawyers, respectively.
The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.
VT = S + B + G + L
The role of manager is to
Max the marketable claims(S+B)
Min the non marketable claims (L+G) S
S+B= marketable claims: that the investors spend their money in order to have it back in the future.
G+L= non marketable claims: the government and lawyers pay noting but still claim part of the pie.
The role of financial manager is to maximize the marketable claim while minimizing the nonmarketable claims. B G L

17. Tax Effects VS Financial Distress
There is a trade-off between the tax advantage of debt and the costs of financial distress.
The optimal capital structure should be such that the marginal benefit from tax shield equals the marginal cost of financial distress.
It is difficult to express this with a precise and rigorous formula.

18. Trade-off theory of capital structure
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

19. Other benefit of leverage—agency benefits
Agency costs arises also between managers and the firm
Managers with higher ownership concentration are more likely to work hard to the shareholder’s interest.
Debt financing avoid the dilution of ownership.
However, ownership becomes diluted overtime as a firm grows.
Conflict of interest between managers and shareholders
Taking large, unprofitable investments, pay too much for acquisitions, hire unnecessary employess…
Reducing free cash to discipline managers: issuing debt (use free cash to pay interest and principal)
Small, young firms enjoy higher concentration in ownership.
Large firms’ows diluted because
Original owners retired
Firms may need to raise new capital instead of debt
Owners try to diversify their investment.

20. Other benefit of leverage —Debt Signaling
Under information asymmetry: investors may not know the firm’s profitability.
Debt can be viewed as a signal of firm value.
Firms with high anticipated profits will take on a high level of debt.
The signal is credible because high leverage is too costly for low profitable firms.
Problem: Suppose that Beltran currently uses all-equity financing, and that Beltran’s market value in one year’s time will be either $100 million or $50 million depending on the success of business. Currently, investors does not know which value the firm will end, but the manger has information that success is virtually certain. Will leverage of $25 million make the manager’s claims credible? How about leverage of $55 million?
Credibility principle:
Claims in one’s self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.
Solution to the problem:
- If leverage is substantially less than $50 million, Beltran will have no risk of financial distress regardless of the outcome. As a result, there is no cost of leverage
even if Smith does not have positive information. Thus, leverage of $25 million would not be a credible signal of strength to investors.
- However, leverage of $55 million is likely to be a credible signal. If Smith has no positive information, there is a significant chance that Beltran will face bankruptcy under this burden of debt. Thus Smith would be unlikely to agree to this amount of leverage unless she is certain about the firm’s prospects.

21. Can trade-off theory explain the company’s behavior?
Yes:
Most of the companies have a target debt ratio.
Which company has higher debt ratio?
Company with risky and intangible assets v.s. with tangible and safe assets.
Company paying heavy taxes v.s. low taxes
Profitable firm v.s. less profitable firm
No:
Some successful firms still run with little debt: Google.
Debt ratios today are no higher than they were in the early 1900s, when tax rates are low.
Trade-off theory: aspects influencing the capital structure
Tax: heavy tax=> high D
Profitability: profitable firm=> high D.
Volatility: risky business=> low D.
- High-tech growth companies, with risky and mostly intangible assets, normally have little debt ratio
- Airlines borrow heavily because their tangible and relatively safe assets.

22. Debt or Equity under Information asymmetry
The manager must know more about his firm than investors.
Equity value is unknown to investors (Lemon problem)
If the firm is overvalued, the stock price will fall in the future. Then the manager can make profit for the current shareholders by selling it at a high price.
However, investors anticipating this will not purchase the stock, until the price falls. (adverse selection problem)
=>Better to issue debt, the value of which is less sensitive to managers’ private information!
However, issue debt may also suffer from information problem, especially risky debt.
=> Better use the firm’s own money, i.e. retained earning.
If overvalued, then issue equity.
Investors anticipate 1, stock price fall.
Manager anticipate 2, only most overvalued issues equity can make money.
Investors anticipate 3, if some firm issues equity, it is the most overvalued. Stock price falls largely, even more under the true value.
Manager anticipate 4, will not issue any equity.
E.g. High-tech, high-growth companies’ assets are mostly intangible and bankruptcy or financial distress would be especially costly.
So the cost of fooling the investors are mainly the cost linking to financial distress.

23. Implication for capital structure —The Pecking-Order Theory
Rule 1: Use internal financing first
Using cash can avoid the cost of financial distress
Firms first fund their project with retained earnings (target div/ payout ratio)
Rule 2: Issue debt next, new equity last
Information asymmetry is less for Debt than for Equity: issue debt up to the debt capacity (the level which just leads to financial distress)
Issue the safest securities first
Internal financing (short-term financing):
if generated CF is more than capital expenditures, the firm pays off debt or invest in marketable securities.
if less, the firm first draws down its cash balance or sells its marketable securities.

24. Implication of the Pecking-order theory
There is no target D/E ratio
Two kinds of equity: internal (1st order) and external (last order).
Debt to equity ratio may be lower if large internal funds are used.
Profitable firms use less debt
The attraction of interest tax shield is at 2nd order
Companies like financial slack
Firms will accumulate cash today in order to fund profitable projects in the future.

25. Choice of capital structure
According to the POT, what are the most likely capital structures?
Highly profitable firms with lots of investment opportunities
Highly profitable firms with limited investment opportunities
Less profitable firms with little investment opportunities.
High profitable firms with lots of investment opportunities– internal financing=> lower debt ratio
Highly profitable with limited investment opportunites—debt financing=> higher debt ratio. Basically, tax shields is more important
less profitable with little investment opportunities—external equity financing=> lower debt ratio.

26. Bright side and dark side of financial slack
having cash, marketable securities, readily salable real assets, and ready access to debt markets or to bank financing.
Most valuable to firms with plenty of positive NPV growth opportunities.
Dark side: free cash flow hypothesis
Managers may attempt to pursue wasteful activities: investing too much (agency cost: manager v.s. company)
Discipline managers: issuing debt (use free cash to interest and principal)

27. Average leverage by industrial sectors
(source BMA p. 750, data 2008)
Debt ratios depend on four main factors (Rajan and Zingales 1995, JOF):
Size: large firm > small
Tangible assets: fixed assts > intangible assets
Profitability: more profitable < less profitable
Market to book ratio: higher ratio< lower ratio.

28. International Comparison of Capital Structure
Fan, J. P., Twite, G. J., & Titman, S. (2011). An International Comparison of Capital Structure and Debt Maturity Choices. Journal of Financial and Quantitative Analysis, 47(1),
Corporate financing choices are determined by firm characteristics and institutional environment
Institution environment:
Ability of creditors to enforce legal contracts:
Strength of legal system
Corruption
Bankruptcy code
Tax treatment: are corporate profits double taxed?
Supplies of capital: Large banking sector or not Firm characteristics:
Asset tangibility , profitability, firm size, market-to-book ratio

29. Median Leverage ratio

31. Source: lecture notes of Damodaron