Transcript Slide 1

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
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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)
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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?
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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
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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
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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
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Example
Balance Sheet for a Company in Distress
Assets
Cash
Fixed Asset
Total
BV
$200
$400
$600
MV
$200
$0
$200
Liabilities
LT bonds
Equity
Total
BV
$300
$300
$600
MV
$200
$0
$200
What happens if the firm is liquidated today?
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Selfish Strategy 1: Take Large Risks
Example cont’d
The Gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Cost of investment is $200 (all the firm’s cash); Required return is 50%
1. What is the NPV the gamble?
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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
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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?
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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
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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
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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
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Integration of Tax Effects and Financial Distress Costs:
Summarizing the Trade Off of Debt
Advantage of Borrowing
Disadvantage of Borrowing
1. Tax Benefits:
Higher tax rate  Higher tax benefits
1. 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
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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)
0
B*
Optimal amount of debt
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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
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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
L
G
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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
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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
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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.
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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
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Empirical evidence
• Tradeoff 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
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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.)
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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?
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• Assigned Problems # 17.2, 3, 5, 6, 7, 8
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