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Published by: Benjamin Tan on May 20, 2012
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  • Turning to capital structure
  • Some facts about capital structure
  • Industries Vary in Their Capital Structures
  • Debt vs. equity
  • Equity is a call option
  • Questions we will try to answer:
  • Why is MM so important?
  • The MM theorem shows that such arguments are flawed
  • Original MM (1958) home- made leverage proof:
  • MM and the cost of capital
  • Effect of leverage on returns in the MM world
  • (A) Is new issuance zero NPV?
  • Using M-M Sensibly
  • MM applies to all corporate finance decisions
  • Bottom line
  • Relaxing the Assumptions of MM
  • The effect of corporate taxes
  • Example: Debt tax shield
  • Where do we stand now?
  • To summarize
  • The Dark Side of Debt: Cost of Financial Distress
  • MM and bankruptcy
  • Direct costs of financial distress
  • Direct costs are too small
  • A simple example
  • The debt overhang problem
  • Intuition:
  • What about raising capital in other ways than equity?
  • Financial distress & product market competition
  • Assets sold at fire-sale prices
  • Managerial loss of focus/attention
  • An option analogy
  • Consequences
  • The problem of measuring costs of financial distress
  • We now have a trade-off theory of capital structure
  • Practical Implications

The Miller & Modigliani theorem

Turning to capital structure
The two key questions in corporate finance:  Valuation: How do we distinguish between good investment projects and bad ones?  Financing: How should we finance the investment projects we choose to undertake?  We now turn to the second question.

Some facts about capital structure

Firms finance themselves through retained earnings (internal financing) and selling securities in the market (external financing) Internal financing (retained earnings) biggest source of financing for firms
Firms in countries with less developed financial markets use particularly little external financing

3. The external financing is done by issues of debt, equity and hybrid securities (such as convertible debt and preferred equity)

Sources of financing vary over time and over business cycle  Private sources: Private equity. External financing is raised both in private and public markets 5. private placements of bonds and equity  Public sources: IPOs. Seasoned equity issues. bank debt. public bond issues  Equity issues increase when stock market returns have been high for some period of time  Debt/borrowing issues less cyclical .4.

4. India  Low leverage countries: UK. cars  Low leverage industries: biotech. Capital structures vary across different industries and countries  High leverage industries: Utilities. US . Thailand. Indonesia. software/internet. Australia. hardware  High leverage countries: Korea. airlines.

3 3.1 21.S. Debt in book value.7 17.5% *D/(D+E).5 21. Equity in market value U.Industries Vary in Their Capital Structures Industry Electric and Gas Food Production Paper and Plastic Debt Ratio* (%) 43.9 30. data .4 Equipment Retailers Chemicals Computer Software Average over all industries 19.2 22.

equity Equity and debt (and other corporate securities) differ along two dimensions: (1) Division of value .Debt is senior to equity → get the value of the firm  (2) Division of control - until debt paid off Equity gets whatever is left after debt has been paid Equity holders control firm as long as not bankrupt Debt holders control firm when firm is bankrupt .Debt vs.

i. a call option with strike D  Debt gets V – max (0.Equity is a call option  Equity gets max (0.D) E(V) Face of debt Payment to debt holders. V . V – D) = min (V. D(V). V=D(V)+E(V) D(V) V Face of debt .e. E(V).D). Payment to Equity holders.

can you ad value to existing owners (equity and debt holders) through decisions on the RHS of the balance sheet?  If yes.e.Questions we will try to answer:  Is there an “optimal” capital structure. i. and how? . an optimal mix between debt and equity?  More generally.. does the optimal financial policy depend on the firm’s operations (Real investment policy).

for example. but also for investments Black Scholes option pricing. relies on arbitrage arguments introduced in this paper  One way to thing about it: what role does capital structure have in a neoclassical fully competitive model with frictionless markets  Answer: None!  Like the CAPM .The Miller and Modigliani (MM) capital structure irrelevance theorem  MM (1958) maybe the most important paper in finance  Not only for corporate finance.

it also implies when it is relevant. .Why is MM so important? We don’t believe it. literally Since markets are not perfect. and fully competitive Strength of theorem is that by showing when capital structure is irrelevant. frictionless.

which hurts shareholders But we can’t have too much debt. because then we go bankrupt → Optimal capital structure .To get some perspective: preMM views Typical pre-MM view: debt is typically cheaper than equity  Interest rate on debt is lower than the investors’ required return on equity  Equity issues are dilutive: decrease earnings per share.

e.V = E(FCF) / (1+R) In “efficient markets” (i. .The MM theorem shows that such arguments are flawed The value of the firm is given by expected cash flows and the investors discount rate (or required rate of return) for these cash flows . the MM assumptions) capital structure affects neither of these.

the weighted average cost of capital to the firm will always equal R .• V = E(FCF)/(1+R) • Capital structure is just one way of splitting cash flows between different investors. but the total value of the firm remains the same • Although the required returns of debtholders and equityholders may differ.

• Suppose the free cash flow to a levered firm is the same as to an all equity financed firm. financing does not matter! Value is maximized by taking all +NPV as before. . • Then.The Miller Modigliani Irrelevance Proposition • Suppose the NPV of a new issue is zero.

. not the way the pizza is divided between investors.The firm finances its projects by promising free cash flow from operations to different types of investors (debt and equity holders).The size of the pie is the sum of the free cash flows – it depends on the investment policy.• Intuition: (Yogi Berra). . When is it true that financing is irrelevant? .

Original MM (1958) homemade leverage proof:  “Twin” firms A and B with identical cash flows of CF .B has debt of D. value of equity = EA = VA . value of equity = EB.  Miller and Modigliani claim that VA = VB.A is all-equity financed. otherwise there would be an arbitrage opportunity . VB = EB + D.

Suppose debt D is risk less. If buy all of B’s equity.This costs you EB.Otherwise there would be an arbitrage opportunity. of VB = VA. . must cost the same to assemble: EB = EA – D. . . . but borrow on own account D of the purchase pries.You get CF – D(1+RD) = company’s whole cash flow less personal interest you owe.CR – D(1 + RD) = company’snet profits after interest .So cost to you is EA – D. you get: . Since strategies yield same net cash flow to you. Instead suppose you buy all of A’s equity.

What is essential is that there are no arbitrage opportunities (financial markets are competitive and complete). Does all this seem a bit esoteric…? Capital structure arbitrage is currently a popular hedge fund strategy. MM does not rely. for example. . NOTE: We have not assumed anything about how NPV is calculated. on CAPM being true.

. when you lever up. These two effects exactly cancel.D/(D+E)*rD + E/(D+E)*rE = rA . the equity becomes riskier and requires an even higher return.MM and the cost of capital  We have seen that when a firm levers up (finances with debt).18%  It is true that debt requires a lower return. The weighted average cost of capital remains the same:  In our example: .(10/11)*(10%)+(1/11)*(100%)= 18. it increases the risk ness of its equity.  However.

Effect of leverage on returns in the MM world return on assets D E ra  rD  rE DE DE  Return on equity (“MM proposition II”): rE = rA + (D/E)(rA-rD)  Risk of equity: βE = βA + (D/E)(βA – βD) .

Returns and leverage Expected Returns rE rA rD Debt becomes risky Debt/Equity .

Do we believe the MM assumptions?  MM irrelevance theorem holds if A.  Do we believe that these assumptions are true in the real world? . The free cash flow to a levered firm is the same as to an all equity financed firm. B. NPV of a new issue of debt or equity is zero.

(A) Is new issuance zero NPV?   I. New investors just demand fair return on their investment. the firm may be able to make money by offering a cash flow stream with attractive risk characteristics to certain clientele. Investors can choose any consumption pattern by borrowing. . The first two are: Financial markets are competitive. lending.  There are 3 conditions for this to be true. If not. and hedging. Financial markets are complete:   II.

 For a typical corporation. these two conditions probably hold It is hard to think that a corporation could make money by issuing some new. eotic security that did not exist before There are close substitutes available for any security that a company can issue Making profits from pure financial engineering is better left to the investment banks than regular corporations! .

BUT: if the manager has private information about prospects of the firm. MM does not hold! → Could potentially issue misvalued securities and make money! . Prices reflect all existing information (strong form efficiency) . But there is a third condition as well: 3.

3. 2. There are no transaction costs from issuing securities (or the same costs for debt and equity) Managers and employees always work to maximize the value of the firm . The assumptions for this to be true are: 4.  As we will see. all of these assumptions may not always hold in real world.(2) Are FCF Levered = FCF All Equity?  1. No taxes (or no asymmetric tax treatments) There are no extra costs of financial distress.

It obviously leaves important things out.  But it gets you to ask the right question: How is this financing move going to change the size of the pie?  Helps you avoid making the wrong arguments.Using M-M Sensibly  M-M is not a literal statement about the real world. such as the cost of capital argument above. .  Lets go back to some logical fallacies that MM can address.

the opportunity cost of capital for the firms assets  In an MM world. “Debt is cheaper than equity because it has a low interest rate”  What matters for the value of the firm is RA. when you take on more leverage. your RE will increase to keep RA constant .

. long-term vs.MM applies to all corporate finance decisions  M-M Theorem was initially meant for capital structure. dividend policy is irrelevant. short-term debt is irrelevant. etc.  Indeed. the proof applies to all financial transactions because they are all zero NPV transactions. but applies to all aspects of financial policy:        capital structure is irrelevant. risk management is irrelevant. buying back shares is irrelevant. purely diversifying acquisitions are irrelevant.

 We know that value is given by discounting the right hand side Free Cash Flows  LHS does not matter for value.(dividends) – (net proceeds from new financing) = (cash flow from operations) – (new investment)  In other words: think about the choice of whether to pay a dividend or not.  If we increase our dividend we can always issue new equity (or debt) to offset this shortfall  If we decrease our dividend we can always repurchase some shares (or pay down some debt) to offset. if RHS given .

 Although the return on the firm’s assets may go down if you keep cash on your balance sheet. net payments to financial markets do not matter. as long as retained cash flow earns a fair market return and is paid out at some future point. required return also goes down since firm cash flows become less risky  under MM.  $ 100 of excess cash today is worth $ 100 regardless of whether pay out now or later. As long as excess cash retained earns a market return. Total payout policy does not matter either .

.  Important principle: Deciding how much debt to take on and deciding how much cash to pay out is essentially the same decision Cash = Negative debt!  This is why we should consider Net Debt = Debt – Excess Cash when we evaluate capital structure and unlever betas. Essentially the payout policy argument is the same as the debt irrelevance argument.

Bottom line  Using the MM theorem.  To understand capital structure and payout policy in the real world we will now see what happens when we relax some of the MM assumptions:  What if there are corporate and personal taxes?  Costs of financial distress?  Conflicts of interest among managers. we can understand what does (and doesn’t) matter for financial policy. equity holders. and debt holders?  Managers are better informed than investors? .

Now: How does the M world differ from the real world? .Financial policy: Plan of Attack 1.  Taxes  Costs of financial distress  Other Frictions 2. Modigliani-Miller Irrelevance Proposition (1958):  In a world with out frictions. financial policy is completely irrelevant – does not change value of firm.

. 2. 3. 5. No issuance costs.Relaxing the Assumptions of MM  1. Markets are strong form efficient.  Not true 4. New investors get zero NPV. Managers and employees do not have an incentive to deviate from +NPV rule. 6. No differential tax treatment. No costs of financial distress. Markets are complete. The financial policy does not change the free cash flow from real investment policy. Almost true Financial markets are competitive. 7.

while dividends are not  Hence. (and for most other countries). but that interest and dividends have a different tax treatment  In the U.S. there is a strict tax advantage to financing with debt rather than equity  As a matter of fact. implies firms should have 100% debt!  Which we clearly don’t observe… . the interest payments of corporations are taxdeductible.The effect of corporate taxes  The importance of taxes was first noted by MM  Problem is not taxes per se.

what is the value of the firm? .Example: Debt tax shield  A firm generates $ 100M in profits for sure every period in perpetuity. If the firm is 100% equity financed.  Risk-free rate is 10%  Corporate tax rate (TC) is 40%. This is the only cash flow the firm has.

 Every period.10 = 600  Now the firm takes of $ 500M of debt.40)*100= 60  V = E = 60/0. FCF = (1 – 0. What is the coupon of the debt? .

10 = 300 .40)*(100–50) = 30  Value of equity = 30 / 0. The debt is risk-free → debt holders require 10% → $ 50M coupon  What is the value of the equity?  Each period equity holders get the Net Income of the firm: (1-0.

firm value is V = E + D = $ 500 + $ 300 = $ 800  The firm value has increased by $ 200! Another way to think about this:  VL = VU + PVTS  VL = value of the levered firm  VU = value of the unlevered firm  PVTS = PV of the Interest Tax Shield  In this case PVTS = $ 200M. Why? . Since the value of debt is $ 500.

.10 = $ 200M.$ 20 / 0. yearly tax savings are 40%*$50 = $20M  Hence.e. Each period the firm saves TC*I in taxes where TC is the corporate tax rate and I is the interest payment  I. the Present Value of the Tax Shield is PVTS .

It assumes that D is constant (ta shield is a perpetuity) Taz shield and debt payments have same systematic risk → can discount the tax shield at RD What is the optimal level of debt for this company? . This is also equal to TC*D = 40%*$500 = $200  the PVTS = TC*I/RD But the interest payment I D*RD The PVTS becomes TC*D*RD/RD=TC*D PVTS = TC*D is a “back of the envelope” formula.

Who gains from taking on the debt?  Say that the firm has 1000 shares outstanding  Before taking on any debt. and buys back $500 worth of shares  Think about this as happening in two .60/share  Now the firm takes on $500 of debt. each share is worth $600/100=$0.

60 to $0.80 → equity gets the whole $200 gain of the new debt tax shield! .(1) The firm raises $500 in debt.$500 = $800 Share price increased from $0. Firm now consist of the PV of future firm cash flows plus $500 in cash The value of firm is Cash + VU + PVTS= $500 + 600 + 200 = $1300 The value of equity is E = $1300 .

$500 = $800 E = V – D = $800 . Value of the firm is now $1300 .8 = 625 shares.(2) Firm does a share repo of $500 → buys back $500/0.$500 = $300 The equity market cap is lower. but equity holders wealth consist of $300 in stock + $500 in cash = $800 .

after tax profits are $6M/yr  What is the PV of this $100 T-bond investment? .Same argument applies to payout policy  Keeping excess cash of C in the company gives you a “negative” tax shield of t*C  Assume you keep $100 of excess cash in the firm and invests it in T-bonds @ 10%. say → Pre-tax profits increase by $10M/yr (perpetuity) if TC=40%.

reduces value of cash to $60!  if we keep excess cash of C in the firm rather than paying it out. this cash is only worth (1.1 = $60 → Keeping $100 of excess cash in the firm.TC)*C  I.e. cash has a “negative tax shield” of TC*C!  Here (and in general) keeping excess cash in firm is like having negative debt! . rather than paying it out. PV = CF/r = $6/0.

. or something must be missing from our analysis.Many firms (Microsoft. . . Intel) hoard large amount of cash.Where do we stand now?  Adding corporate taxes to MM’s world suggest firms should be 100% debt financed and keep 0% excess cash! Firm’s value  Seems extreme:  Either CFO’s are missing something.Average debt ratio has been around 35% in lastD/E decades.

In addition, most firms effectively pay less than the statutory rate in corporate taxes
 Will not make profits every year  Net operating losses (NOLs) can be carried back and forward to offset profits in other years.  Some firms have large non-debt tax shields, such as depreciation, investment tax credits, etc.

 Firms have a lower tax benefit of debt if
 Profits more volatile  firm already has a lot of debt Have NOLs and substantial non-debt tax shields → less likely to have profits left to shield with additional debt

John Graham (Journal. of Fin. -00) estimated the U.S. effective corporate tax rate at about 30%

 Bottom line: the effect of personal taxes and NOLs on the value of the interest tax shield is complex. Depends on
 % of firm’s securities held by institutions and individuals  whether investors adjust portfolios in a tax-efficient way  the volatility of the firm’s profits, NOLs, and tax shelters

 Still, clear that even after accounting for personal taxes and effective corporate tax rate, a substantial debt tax shield remains in the U.S.
 Back-of-the envelope calculations of T in the U.S. typically come in around 10-20%  Will vary from company to company, however
 As low as 2% vs. as high as 35%

can value PV (debt tax shields) as the discounted cash flow stream from the tax shield: E (taxshieldyear1) E (taxshieldyear 2) PV ( DebtTaxShield )    ..  More generally.. highly levered firms. 2 1  rdts (1  rdts ) What should the discount rate rdts be?  We have used rd which is true if the risk of the tax shield is the same as the risk of the debt.Debt Tax Shield Calculation – Note!constant.  In many instances. perpetual  Formula T*D assumes debt.g. e. closer to rA . the tax shield is likely to be riskier than the debt → makes sense to use a higher discount rate.

To summarize
 If the only MM assumption we relax is taxes, we get the following
 Firm should finance themselves with 100% debt  All excess cash should be paid out to shareholders

 Does not seem to match very well what we observe in reality…

The Dark Side of Debt: Cost of Financial Distress
 If taxes were the only issue, (most) companies would be 100% debt financed.  Common sense suggests otherwise: If the debt burden is too high, the company will have trouble paying.  The result: financial distress.
 Can lead to value destruction that would not have happened in the absence of debt

MM and bankruptcy
 Note: the possibility that a firm defaults on its debt obligations does not in itself violate MM – as long as this does not impose any additional costs on the business!  In the MM world, when the value of equity falls to zero, debt holders take over the firm. There should be no costs to bankruptcy – no reduction in cash flows generated by the company.

advisory fees… Example: K-Mart spent more than $ 100 million on lawyers. and other advisors wile in bankruptcy. accountants. .What are the costs of financial distress and how big are they?  Most obvious: Direct costs of bankruptcy  Legal expenses. investment bankers. court costs.

Direct costs of financial distress  Direct costs represent (on average) some 2-5% of total firm value for large companies and up to 20-25% for small ones.02% of firm value! .  But this needs to be weighted by the probability of bankruptcy: (/07% per year for NYSE-AMEX firms). Overall. expected direct costs tend to be very small: about .

indirect costs of financial distress that could potentially be much more important  And that would be incurred even if the distressed firm is able to avoid outright bankruptcy or default! .Direct costs are too small  The tax shield represents gain of 10-35 cents for a dollar of debt  Direct costs of bankruptcy are too small to account for the low debt ratios we see in reality.  But there are other.

What could these indirect costs be?  Inability to invest in the right projects  Inefficient liquidation of assets  Inability to respond to competition  Losing valuable customers. and suppliers  Time and focus wasted negotiating with creditors rather than running the business . employees.

g. why can’t the firm just issue more equity. when firm’s not being able to access enough funds to be able to make the optimal operating decisions and still service the debt. would you invest money in a firm on . to both service the debt and cover investments?  Well.e.The importance of liquidity constraints  I.  But why do firms become liquidity constrained when they have too much debt?  E.

discount rates are zero.5  Assume everyone risk neutral. and there are no taxes  This is not important.A simple example  Firm has assets in place which will pay off next period:  Boom: Worth 100 with Probability = 0. but makes things simple  The value of the firm is then simply expected cash flows next period  So: firm value V = 60 .5  Bust: Worth 20 with Probability = 0.

0)  Debt is under water: trading below par . E = 50 Bust: D = V = 20.F). E = 25 Debt = min(V. the debt will be paid off in full. in the bust the firm will default Boom: D = F = 50. Assume this firm has debt outstanding with a face value F = 50  What is the value of equity and debt?  The payoffs for debt and equity:  So in the boom. Equity = max(V-F. E = 0 So today: D = 35.

The debt overhang problem  Assume that this firm has a new investment:  Invest 10 today  Worth 15 tomorrow for sure (both in boom and bust)  Positive NPV = 5 → optimal to invest  Boom: cash flows increase to 115  Bust: cash flows increase to 35  Firm value increases from 60 to 75  The firm’s cash flows would not be  Assume firm has no liquid assets and needs to raise cash to invest  Will equity-holders put in the money to invest? .

since would lose 7.5.5 – 10 = -2.5  E = 32. increased by 7. increased by 7. If invests: V = 75  The firm increases in value by 15.5 Equity will NOT invest. E = 65  Bust: D – 35.5. which is more than the 10 the equity holders put in → good thing! But how is value split between equity and debt?  Boom: D = 50.5 . E = 0 Today:  D = 42.

regardless of investment  I.e. since debt is already as safe as it can be  E.Intuition:  Wealth transfer to debt holders!  Problem arises because debt is risky  Debt is senior and will get part of surplus → junior claimants will not contribute capital  Risk-less debt → no wealth transfer. if F=20 → D=20.g. the debt overhang the problem arises when there is a significant probability that the debt will not be paid off = firm is in financial distress! .

5 → everyone gains!  Then we could issue risk-free debt with a face value of 10 to finance the investment. E = 0 .What about raising capital in other ways than equity?  As long as the new securities issued are junior to the existing debt.  A solution would be to finance the new investment with debt that is senior to the existing debt. Old D = 50. Old debt worth 37. New D = 10. E = 55  Bust: Cash flows of 35. Old D = 25.  Boom: Cash flows of 115. Equity worth 27. this problem will arise. New D= 10.5.

 In the real world. this may be hard and take time  Why do you think this is? We will get back to this question. the “Debtor in possession” (DIP) financing rule in U. .S. debt typically has covenants preventing issues of new debt of the same (“pari passu”) or higher seniority  Although one would think that the existing creditors would be willing to renegotiate these terms since the investment makes everyone better off. chapter 11 bankruptcy is meant to alleviate the debt overhang problem  Allows a bankrupt firm to issue new senior debt.

What are the costs when this happens?  Having to cut profitable new investment  Lots of evidence that financially distressed firms cut capital expenditures and R&D while in distress  Harder to say how much value was permanently lost as a result. .g. GM and Ford? Indirect Costs of Financial Distress  As in the example above  This is probably the most common and obvious problem firms experience in distress. So we understand why firms have a hard time getting new funds in financial distress.  Or maybe this could even be a good thing in some cases?  E.

trucking industry . etc.g. E. cannot respond to competitors price changes.Financial distress & product market competition  Firms that are financially constrained may have a harder time responding to competition  There is evidence that highly levered firms can lose market share to competitors with lower leverage. studies of the supermarket industry.

etc. employee relationships  Firms in financial distress have a harder time keeping customers. service. . employees. supplier.Financial distress & customer. suppliers  Especially costly when long-term relationships are valuable  Would you want to work for a firm that is about to go bust?  Firms with high-skilled labor that is hard to retrain  Firms with long-term supplier relationships  Firms with durable goods  Customers rely on firm being there for warranties.

semiconductor wafers. with a limited number of other buyers that could use them  E. that may be so specific that not possible to sell them  Can explain why tech firms (semiconductor. software. biotech) have extremely low leverage . like R&D and intangibles. telecom assets  To avoid default and bankruptcy  As part of a bankruptcy proceeding/liquidation  Some assets.Assets sold at fire-sale prices  Firms in financial distress are often forced to sell off assets  Problem: price obtained is often less than what the assets are worth to firm  Firm’s assets are often highly specific. oil rigs.g.

S. Especially problematic when have to sell assets fast. cars)  E.g. financial buyer  As a result. airlines sell aircraft at a 15% discount when the average airline is in financial distress Often used as an argument to have a bankruptcy code that allows firms to reorganize rather than liquidate assets (such as the U. and other industry firms are also facing problems  Other industry firms are also constrained and cannot pay as much → Have to sell to a nonindustry. cyclical industries face higher firesale costs for this reason (airlines. Chapter 11 code)  Bankruptcy liquidations experience fire-sale discounts of 30-50% .

etc. time. → Less time and ability to run regular operations!  Often. and attention of managers and employees  Negotiate with creditors. firms in financial distress often hire a new management team  Original managers responsible for current problems  Some types of managers better at handling financial distress and “turnarounds” . informing shareholders dealing with media.Managerial loss of focus/attention  Resolving bankruptcy takes considerable effort.

one of which is riskier than the other. Are equity.“Games” played by shareholders at the expense of creditors Question: Suppose a levered firm is choosing between two projects with equal NPV.and debt holders indifferent between the two? .

0)=min(V.F)  Debt’s claim: risk free bond minus put option  Options 1.01: option value increases in risk  E value increases in risk. F.  Equity gets man(V-F.0)  Equity gets the upside.An option analogy  Equity’s claim: a call option with a strike price equal to the face value of debt. D value decreases in risk . but does not bear the full downside  Debt gets F-max(F-V.

 Suppose firm consists of one risky cash flow in a year: Value in a year Firm Equity Debt Cash flow in a year  Equity is like a call option on the value of the firm Face Value .

Equity holders are reluctant to contribute capital to safe projects. even when they have positive NPV: Underinvestment / 3. Equity holders prefer riskier projects. even when they may have negative NPV: 2.Consequences 1. Anything that increases risk of debt without destroying value decreases value of debt and increases value of equity Overinvestment / Asset substitution / Risk shifting Debt overhang .

5 Firm value V = 60 Firm has debt with a face value F = 50 Boom: D = F = 50. E = 0 So today: D = 35.5 Bust: Worth 20 with Probability = 0. E = 25 Debt is under water: trading below .Let’s return to our previous example Firm has payoffs next period: Boom: Worth 100 with Probability = 0. E = 50 Bust: D = V = 20.

. E = 58  Bust: V = 20 – 10 + 0. increase by 4  V – 59. 0 in bad state  Negative NPV = 9-10 = -1 → should not invest!  What if usus up 10 in cash and invests in this project?  Boom: V = 100 – 10 + 18 = 108. and debt holders pay on the downside. assume that firm has 10 in cash sitting around  Would go to debt holders in bad state  Costs 10 as before. decrease by 5. decrease by 1  Risk-shifting problem: shareholders like risky projects where they get upside. Assume there is a second investment project  In addition. E = 0  Today:  Wealth transfer from debt to equity!  D = 30. D = 50. D = 10. but pays off 18 in good state. E = 29.

wealth transfer from debt to equity! . new D = 10. old D = 50.  Old D = 30. old D = 10. E = 0  Same thing happens:  New D = 10.  Boom: V = 100 + 118 = 108. Equity holders decide to issue 10 in senior debt to invest in project.” but that there was no covenant preventing the firm from issuing senior debt. decrease by 5. They get their money back. New debt has face value of 10.  E = 29. increase by 4 Again.What if firm did not have any cash “lying around. E = 58  Bust: V = 20. new D = 10.

in the hope that firm is luck and equity gets “in the money” Famous example of this: Eastern Airlines bankruptcy.S. Chapter 11 code has been criticized: Although such covenants make the debt overhang problem worse.This explains why creditors demand seniority covenants This is also a reason why the U. . it curbs the riskshifting problem Allows equity to continue the firm for too long in bankruptcy.

 Making excessive dividends or share repurchases  Using cash or senior debt to take over a (risky) firm. RJR Nabisco announced intention to acquire company in a leveraged buyout with new debt.  KB Toys and Bain Capital article .  In 1988.The risk-shifting problem in practice Maybe hard to find evidence of firms literally taking on “risky projects” in distress But we do observe instances where firms take more ”subtle” actions that dilute their debt  Spin-offs of safer part of business (Marriott)  Play for time: Postpone efficient liquidation in hope of a miracle (Eastern Airlines).

Who pays for this riskshifting behavior?  If equity holders gain from diluting debt holders. isn’t this a benefit of debt (to equity)?  “Problem” is that creditors aren’t stupid… → Will demand higher interest rates when firm borrows in the firms place → Will impose covenants restricting firm behavior  Impose restrictions on investment. “Browse” Smith & Warner (packet) for examples. spinoffs and asset sales. .  Etc. payout policy.

this does not necessarily mean that the firm would have to incur deadweight costs of distress  Although such debt restructuring occur. creditors are often dispersed and face conflicts of interest among themselves .Why can’t we avoid costs of financial distress by renegotiating with creditors?  If a firm faces liquidity problems. they costly and sometimes not feasible  Could negotiate with creditors to write down debt. postpone interest. or ease covenants in exchange for additional interest or some equity in the company  How can creditors know whether funds will be used for a “good” project? What if the firm is really risk-shifting?  In addition.

U. The problem is how to distinguish value loss due to financial distress from economic distress E. it is very hard to measure exactly how big they are. Airlines files for bankruptcy in August 2002 (and then again in September 2004) .The problem of measuring costs of financial distress  Although we believe that financial distress costs can be substantial.S.g.

 But operations were still generating positive cash flows  Probably best estimates we have. still. such as LBOs? Problems with these estimates? . relative to tax benefits.  So if these firms expected a 10% chance of going into distress.  Which kind of firms are likely to undergo highly leveraged transactions. say: E(COFD) = 10%*20%=2%  Seems low.  That had previously undergone leveraged buyouts (LBOs) and recapitalizations.Andrade & Kaplan (Journal of Fin. 1997) look at a sample of financially distressed firms They estimate indirect costs of financial distress of up to 20% of firm value.

We now have a trade-off theory of capital structure The value of a leveraged firm is: V(with debt) = V(all equity) + PV(tax shield) – PV(costs of distress) Pr( distress ) t * Costst  (1  r ) t PV (costs of distress) t=0   Probability of distress increases with leverage and decreases with excess cash. . PV (costs of distress) increases with leverage and decreases with excess cash.


.Practical Implications  Companies with “low” expected distress costs and high tax benefits should load up on debt to get tax benefits.  Companies with “high” expected distress costs should be more conservative.


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