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Corporate Finance

Default and Bankruptcy in a Perfect

Financial Distress
When a firm has difficulty meeting its debt obligations
When a firm fails to make the required interest or principal
payments on its debt, or violates a debt covenant
After the firm defaults, debt holders are given certain rights to the assets

of the firm and may even take legal ownership of the firms assets
through bankruptcy.

An important consequence of leverage is the risk of

Equity financing does not carry this risk. While equity holders hope

to receive dividends, the firm is not legally obligated to pay them.

Armin Industries:
Leverage and the Risk of Default
Armin is considering a new project.
While the new product represents a significant advance over

Armins competitors products, the products success is uncertain.

If it is a hit, revenues and profits will grow, and Armin will be worth $150

million at the end of the year.

If it fails, Armin will be worth only $80 million.

Armin Industries: Leverage and the Risk of Default

Armin may employ one of two alternative

capital structures.
It can use all-equity financing.
It can use debt that matures at the end of the year with a total of

$100 million due.

Scenario 1: New Product Succeeds

If the new product is successful, Armin is worth $150

Without leverage, equity holders own the full amount.
With leverage, Armin must make the $100 million debt payment,

and Armins equity holders will own the remaining $50 million.
Even if Armin does not have $100 million in cash available at the end of

the year, it will not be forced to default on its debt.

Scenario 1:
New Product Succeeds (cont'd)
With perfect capital markets, as long as the value of the

firms assets exceeds its liabilities, Armin will be able to

repay the loan.
If it does not have the cash immediately available, it can raise the

cash by obtaining a new loan or by issuing new shares.

Scenario 1:
New Product Succeeds (cont'd)
If a firm has access to capital markets and can issue new

securities at a fair price, then it need not default as long

as the market value of its assets exceeds its liabilities.
Many firms experience years of negative cash flows yet remain


Scenario 2: New Product Fails

If the new product fails, Armin is worth only $80 million.
Without leverage, equity holders will lose $20 million.
With leverage, Armin will experience financial distress and the firm

will default.

In bankruptcy, debt holders will receive legal ownership of the firms

assets, leaving Armins shareholders with nothing.

Because the assets the debt holders receive have a value of $80 million, they
will suffer a loss of $20 million.

Comparing the Two Scenarios

Both debt and equity holders are worse off if the product

fails rather than succeeds.

Without leverage, if the product fails equity holders lose $70 million.
$150 million $80 million = $70 million.

With leverage, equity holders lose $50 million, and debt holders

lose $20 million, but the total loss is the same, $70 million.


Table 16.1 Value of Debt and Equity with and without

Leverage ($ millions)


Comparing the Two Scenarios (cont'd)

If the new product fails, Armins investors are equally

unhappy whether the firm is levered and declares

bankruptcy or whether it is unlevered and the share price
The decline in value is not caused by bankruptcy: the
decline is the same whether or not the firm has leverage.
If the new product fails, Armin will experience economic distress,

which is a significant decline in the value of a firms assets, whether

or not it experiences financial distress due to leverage.


Bankruptcy and Capital Structure

With perfect capital markets, Modigliani-Miller (MM)

Proposition I applies: The total value to all investors does

not depend on the firms capital structure.

There is no disadvantage to debt financing, and a firm will

have the same total value and will be able to raise the
same amount initially from investors with either choice of
capital structure.


Textbook Example 16.1


Textbook Example 16.1 (cont'd)


The Costs of Bankruptcy and Financial

With perfect capital markets, the risk of bankruptcy is not

a disadvantage of debt, rather bankruptcy shifts the

ownership of the firm from equity holders to debt holders
without changing the total value available to all investors.
In reality, bankruptcy is rarely simple and straightforward. It is often

a long and complicated process that imposes both direct and

indirect costs on the firm and its investors.


The Bankruptcy Code

The U.S. bankruptcy code was created so that creditors

are treated fairly and the value of the assets is not

needlessly destroyed.
U.S. firms can file for two forms of bankruptcy protection: Chapter 7

or Chapter 11.


The Bankruptcy Code (cont'd)

Chapter 7 Liquidation
A trustee is appointed to oversee the liquidation of the firms assets

through an auction. The proceeds from the liquidation are used to

pay the firms creditors, and the firm ceases to exist.


The Bankruptcy Code (cont'd)

Chapter 11 Reorganization
Chapter 11 is the more common form of bankruptcy for large


With Chapter 11, all pending collection attempts are automatically

suspended, and the firms existing management is given the

opportunity to propose a reorganization plan.

While developing the plan, management continues to operate the


The reorganization plan specifies the treatment of each creditor of

the firm.


The Bankruptcy Code (cont'd)

Chapter 11 Reorganization
Creditors may receive cash payments and/or new debt or equity

securities of the firm.

The value of the cash and securities is typically less than the amount

each creditor is owed, but more than the creditors would receive if the
firm were shut down immediately and liquidated.
The creditors must vote to accept the plan, and it must be approved

by the bankruptcy court.

If an acceptable plan is not put forth, the court may ultimately force

a Chapter 7 liquidation.


Direct Costs of Bankruptcy

The bankruptcy process is complex, time-consuming, and

Costly outside experts are often hired by the firm to assist with the

bankruptcy process.
Creditors also incur costs during the bankruptcy process.
They may wait several years to receive payment.
They may hire their own experts for legal and

professional advice.


Direct Costs of Bankruptcy (cont'd)

The direct costs of bankruptcy reduce the

value of the assets that the firms investors will ultimately

The average direct costs of bankruptcy are approximately 3% to

4% of the pre-bankruptcy market value of total assets.

In the real world, there are several costs directly related to

bankruptcy: legal expenses, court costs, advisory fees, the

opportunity cost of the time the CEO and CFO spend talking with


Direct Costs of Bankruptcy (cont'd)

Given the direct costs of bankruptcy, firms may avoid filing

for bankruptcy by first negotiating directly with creditors.

A method for avoiding bankruptcy in which a firm in financial

distress negotiates directly with its creditors to reorganize

The direct costs of bankruptcy should not substantially exceed the cost

of a workout.

Prepackaged Bankruptcy (Prepack)

A method for avoiding many of the legal and other direct costs of

bankruptcy in which a firm first develops a reorganization plan with

the agreement of its main creditors and then files Chapter 11 to
implement the plan
With a prepackaged bankruptcy, the firm emerges from bankruptcy

quickly and with minimal direct costs.


Indirect Costs of Financial Distress

While the indirect costs are difficult to measure accurately,

they are often much larger than the direct costs of

It is estimated that the potential loss due to financial distress is 10% to

20% of firm value

Agency Costs: conflicts between shareholders and debt holders

(examples: Fire Sale of Assets; Delayed Liquidation; Costs to

Weakened ability to operate (examples: decrease in sales, loss of

customers; Loss of Customers; Loss of Suppliers; Loss of

Employees; Loss of Receivables)


Overall Impact of Indirect Costs (cont'd)

When estimating indirect costs, two important points must

be considered.
Losses to total firm value (and not solely losses to equity holders or

debt holders, or transfers between them) must be identified.

The incremental losses that are associated with financial distress,

above and beyond any losses that would occur due to the firms
economic distress, must be identified.


Financial Distress Costs and Firm Value

Armin Industries: The Impact of Financial

Distress Costs
With all-equity financing, Armins assets will be worth $150 million if

its new product succeeds and $80 million if the new product fails.


Financial Distress Costs and Firm Value

Armin Industries: The Impact of Financial

Distress Costs

With debt of $100 million, Armin will be forced into bankruptcy if the

new product fails.

In this case, some of the value of Armins assets will be lost to

bankruptcy and financial distress costs.

As a result, debt holders will receive less than $80 million.
Assume debt holders receive only $60 million after accounting for the
costs of financial distress.


Table 16.2 Value of Debt and Equity with and without

Leverage ($ millions)


Financial Distress Costs and Firm Value

Armin Industries: The Impact of Financial

Distress Costs

As shown on the previous slide, the total value to all investors is

now less with leverage than it is without leverage when the new
product fails.
The difference of $20 million is due to financial

distress costs.
These costs will lower the total value of the firm with leverage, and
MMs Proposition I will no longer hold.


Textbook Example 16.2


Textbook Example 16.2 (cont'd)


Who Pays for Financial Distress Costs?

For Armin, if the new product fails, equity holders lose

their investment in the firm and will not care about

bankruptcy costs.

However, debt holders recognize that if the new product

fails and the firm defaults, they will not be able to get the
full value of the assets.
As a result, they will pay less for the debt initially (the present value

of the bankruptcy costs less).


Who Pays for Financial Distress Costs?

If the debt holders initially pay less for the debt, there is

less money available for the firm to pay dividends,

repurchase shares, and make investments.
This difference comes out of the equity holders pockets.
When securities are fairly priced, the original shareholders of a firm

pay the present value of the costs associated with bankruptcy and
financial distress.


Textbook Example 16.3


Textbook Example 16.3 (cont'd)


Optimal Capital Structure: The Tradeoff

Tradeoff Theory
The firm picks its capital structure by trading off the benefits of the

tax shield from debt against the costs of financial distress and
agency costs.


Optimal Capital Structure: The Tradeoff

Theory (cont'd)
According to the tradeoff theory, the total value of a

levered firm equals the value of the firm without leverage

plus the present value of the tax savings from debt, less
the present value of financial distress costs.



PV (Interest Tax Shield)

PV (Financial Distress Costs)


The Present Value of Financial Distress

Three key factors determine the present value of
financial distress costs:


The probability of financial distress.

The probability of financial distress increases with the amount of a

firms liabilities (relative to its assets).

The probability of financial distress increases with the volatility of a

firms cash flows and asset values.

The magnitude of the costs after a firm is in distress.

Financial distress costs will vary by industry.

Technology firms will likely incur high financial distress costs due to
the potential for loss of customers and key personnel, as well as a
lack of tangible assets that can be easily liquidated.
Real estate firms are likely to have low costs of financial distress since
the majority of their assets can be sold relatively easily.


The Present Value of Financial Distress

Costs (cont'd)
3. The appropriate discount rate for the distress costs.

Depends on the firms market risk

Note that because distress costs are high when the firm does poorly,
the beta of distress costs has the opposite sign to that of the firm.

The higher the firms beta, the more negative the beta of its distress
costs will be

The present value of distress costs will be higher for high beta


Optimal Leverage
For low levels of debt, the risk of default remains low and

the main effect of an increase in leverage is an increase in

the interest tax shield.
As the level of debt increases, the probability of default

As the level of debt increases, the costs of financial distress

increase, reducing the value of the levered firm.


Optimal Leverage (cont'd)

The tradeoff theory states that firms should increase their

leverage until it reaches the level for which the firm value
is maximized.
At this point, the tax savings that result from increasing leverage

are perfectly offset by the increased probability of incurring the

costs of financial distress.

The tradeoff theory can help explain

Why firms choose debt levels that are too low to fully exploit the

interest tax shield (due to the presence of financial distress costs)

Differences in the use of leverage across industries (due to

differences in the magnitude of financial distress costs and the

volatility of cash flows)


Figure 16.1 Optimal Leverage with Taxes

and Financial Distress Costs


Textbook Example 16.4


Textbook Example 16.4 (cont'd)


Exploiting Debt Holders: The Agency

Costs of Leverage
Agency Costs
Costs that arise when there are conflicts of interest between the

firms stakeholders

Management will generally make decisions

that increase the value of the firms equity. However, when

a firm has leverage, managers may make decisions that
benefit shareholders but harm the firms creditors and
lower the total value of the firm.


Exploiting Debt Holders: The Agency Costs of

Leverage (cont'd)
Consider Baxter, Inc., which is facing

financial distress.
Baxter has a loan of $1 million due at the end of the year.
Without a change in its strategy, the market value of its assets will

be only $900,000 at that time, and Baxter will default on its debt.


Excessive Risk-Taking and Overinvestment

Baxter is considering a new strategy
The new strategy requires no upfront investment, but it has only a

50% chance of success.

If the new strategy succeeds, it will increase the value of

the firms asset to $1.3 million.

If the new strategy fails, the value of the firms assets will

fall to $300,000.


Excessive Risk-Taking and Overinvestment (cont'd)

The expected value of the firms assets under the new

strategy is $800,000, a decline of $100,000 from the old

50% $1.3 million + 50% $300,000 = $800,000

Despite the negative expected payoff, some within the

firm have suggested that Baxter should go ahead with the

new strategy.
Can shareholders benefit from this decision?


Excessive Risk-Taking and Overinvestment (cont'd)

If Baxter does nothing, it will ultimately default and equity

holders will get nothing with certainty.

Equity holders have nothing to lose if Baxter tries the risky strategy.

If the strategy succeeds, equity holders will receive

$300,000 after paying off the debt.

Given a 50% chance of success, the equity holders expected

payoff is $150,000.


Table 16.3 Outcomes for Baxters Debt and Equity Under Each
Strategy ($ thousands)


Excessive Risk-Taking and Overinvestment (cont'd)

Equity holders gain from this strategy, even though it has

a negative expected payoff, while debt holders lose.

If the project succeeds, debt holders are fully repaid and receive $1


If the project fails, debt holders receive only $300,000.

The debt holders expected payoff is $650,000, a loss of $250,000

compared to the old strategy.

50% $1 million + 50% $300,000 = $650,000


Excessive Risk-Taking and Overinvestment (cont'd)

The debt holders $250,000 loss corresponds to the

$100,000 expected decline in firm value due to the risky

strategy and the equity holders $150,000 gain.
Effectively, the equity holders are gambling with the debt

holders money.


Excessive Risk-Taking and Over-investment

Over-investment Problem (or Asset Substitution)
When a firm faces financial distress, shareholders can gain at the

expense of debt holders by taking a negative-NPV project, if it is

sufficiently risky.

Shareholders have an incentive to invest in negative-NPV

projects that are risky, even though a negative-NPV project

destroys value for the firm overall.
Why? Think about option theory. Equity holders payoff is
equal to the payoff of a call option: unlimited upside, limited
downside (if you assume limited liability!).

The value of equity increases if the firm selects risky investment

Debt (a combination of the firms assets along with a short
position in a call option on those assets) becomes less valuable if
the firms investments become riskier.

Anticipating this bad behavior, security holders will pay less for the firm



Example: Howard Inc.

Howard Inc. has 2 mutually exclusive investment opportunities, R

and S, which it plans to fund with debt. Each investment costs $50
million. Project S pays off $60 million for certain, and Project R pays
off only $20 million when the economy is poor and $90 million when
the economy is good. Assume risk neutral investors.
A) What is the NPV of each project, assuming the economy is
equally likely to be favorable or unfavorable and the discount rate
is 0 percent?
Suppose Howard can raise the $50m by issuing a bond with a face
value of $50 million (because the lender naively think that the
company will take the safe project)
B) Which project Howards shareholders prefer?
C) What is the expected payoff to the nave lenders?
Now assume that the debt holders are sophisticated.
D) What must the debt holders be promised, which project will the
company select, and what do the shareholders gain?

Howard: Solution

NPV S = 10


NPV R = 5







Debt Holders Payoff





Equity Holders Payoff 10

Expected payoff to
Equity Holders



C) Expected payoff to 50
nave debt holders




Howard: Solution

D) Payoff to sophisticated debt holders:

Sophisticated debt holders know that equity holders
have an incentive to invest in project R. Thus, they will
demand a future payment of:
(20+ x)/2 = 50
If debt holders require a payment of 80 in the
favorable state, the payoff to equity holder of project R
is 10 (90-80) in the favorable state and 0 in the
unfavorable state
The expected payoff is 5.
Thus, shareholders are better off if they find a way to
commit themselves to select project S (10>5).


The reluctance to liquidate problem

One of the most difficult decisions a firm must make is whether to

remain in business.

It is optimal to liquidate if the net proceeds from liquidation exceed the

present value of the future cash flows that the firm would generate if it
were to continue operating.

Bankruptcy and liquidation are not the same thing!

Bankruptcy doesnt imply liquidation!

There are many bankruptcy procedures under which firms are reorganized and
continue operating (for example Chapter 11 in the U.S.)

Liquidation costs are the difference between the firms going concern value
(the present value of the future cash flows that the firms assets would
generate if it were to continue operating), and its liquidation value, which is
what the firm could collect by liquidating its assets and selling them.

Capital structure can affect liquidation policy.


The reluctance to liquidate problem

Managers of financially sounds firms, as representatives

of their equity holders, have an incentive to continue

operating their firm even when the liquidation values of
the firm exceed its going concern value. Why?
Because shareholders are residual claimants!
Shareholders are likely to receive nothing in a
liquidation. Continuing to operate is the more risky
project here!
Managers are also interested in keeping the firm
operating because they are likely to lose their jobs if the
firm liquidates.
Equity holders can also put more money into the firm if
this means to keep the firm going and, thus, to extend the
life of their claims. In doing so, they hope to make a profit
from the possible upside benefits that may be realized if
the firm continues to operate.


Debt Overhang and Under-investment

Now lets go back to Baxter and assume does not pursue

the risky strategy but instead the firm is considering an

investment opportunity that requires an initial investment
of $100,000 and will generate a risk-free return of 50%.
If the current risk-free rate is 5%, this investment clearly
has a positive NPV.
What if Baxter does not have the cash on hand to make the

Could Baxter raise $100,000 in new equity to make the



Table 16.4 Outcomes for Baxters Debt and Equity with and
without the New Project ($ thousands)


Debt Overhang and Under-investment

If equity holders contribute $100,000 to fund the project,

they get back only $50,000.

The other $100,000 from the project goes to the debt holders,

whose payoff increases from $900,000 to $1 million.

The debt holders receive most of the benefit, thus this project is a

negative-NPV investment opportunity for equity holders, even

though it offers a positive NPV for the firm.


Debt Overhang and Under-investment

Under-investment Problem
A situation in which equity holders choose not to invest in a positive

NPV project because the firm is in financial distress and the value
of undertaking the investment opportunity will accrue to
bondholders rather than themselves.

When a firm faces financial distress, it may choose not to

finance new, positive-NPV projects.

This is also called a debt overhang problem.


The Balance Sheet of a Firm in Financial Distress

$200 $200
Fix. Assets $400
$600 $200


$300 $200
$300 $0
$600 $200

What happens if you liquidate the firm today?

Debt holders get $200; Equity holders get nothing.


Example: Underinvestment
Consider a project that guarantees $350 next year.
The project costs $300 and the firm only has cash for

$200. Thus, shareholders must finance the remaining

Assume that the discount rate for similar projects is
NPV = $300 +
NPV = $18.18

Should we accept or reject the project?


Shareholders pass up positive NPV projects

Expected CF from the project: 350
To Bondholders = $300
To Stockholders = ($350 $300) = $50
PV of debt without project = $200
PV of equity without project= $0
(assume to put the $200 in bank deposit at 10%).

PV of debt with project:

PV equity with project:

$272.73 =
-$54.55 =


Shareholders pass up positive NPV projects

Accepting the project implies a wealth transfer from

shareholders to bond holders of $54.55. Bond holders

also obtain the projects NPV of $18.18
Shareholders will not accept the project even if NPV>0!!!
We have assumed equity financing. What happens if the
project is paid for with debt?


Shareholders pass up positive NPV projects

Lets consider the debt seniority:
New debt is junior to existing debt: No way the project is financed!
The project generates 350, senior debt gets 300, new debt holders

get 50 after investing100!

New debt is senior to existing debt:

New debt gets 100*(1+r), existing debt gets 350-100*(1+r). This is ok

with existing debt holders iff: [350-100*(1+r)]/(1.1)>200.

However, there are covenants that protect existing debt holders.
Covenants prevent the firm from issuing new debt with higher priority
than the existing one.
In this scenario, the debt contract has to be renegotiated. Easier said
than done
To renegotiate a debt contract is particularly difficult when there are
many debt holders (free-rider problem).


The Shortsighted Investment Problem

During the LBOs golden era of the late 1980s, there was

a common claim that the increased use of debt financing

by some firms worsened the shortsightedness of
American businesses.
Debt can lead firms to prefer lower NPV projects that pay
off quickly than higher NPV projects with lower initial
cash flows.

The intuition for this is rooted in the debt overhang problem

(refinance the existing debt is very costly!).


An Example: Lester
Lester Inc. has debt obligations that are due both next

year ($100) and in two years ($40). Lester can choose

between two projects:
Project A: short-term project generating cash flows of $50 in year
1 and 0 in year 2
Project B: short-term project generating cash flows of $20 in year
1 and $40 in year 2
The risk-free rate is 0. All cash-flows are certain.
The cash-flow from existing assets is $50 in year 1. In year 2, the
cash flow is:
In the favorable state (prob.= ), CF=$60,
In the unfavorable state (prob.= ), CF=$10.


An example: Lester
Year 1

Lester chooses A: Lester is able to pay its $100 debt

obligation in Year 1 ($50+$50).

Lester chooses B: Lester cannot meet its debt

obligation with its cash flows ($20+$50=$70). It needs
additional $30 of new debt. If it wants to issue junior
debt, Lester has to offer to pay the new lenders $50 in
year 2 to raise $30.

Why? (Hint: compute the expected payoff for junior debt

holders if the debt has a face value of $50).


Year 2
No project allows Lester to meet its debt obligation in the

unfavorable state.

Project A: cash for $10 but debt for $40

Project B: cash for $50 (10+40) but debt for $90 (40+50).
Equity is worth 0 in this state.

Favorable state:
Project A: $20 (60-40-0)
Project B: $10 (60-40+40-50)
Thus, the firms equity holders are better off selecting the

short-term project even though it has a lower NPV. Why?


Because there is a wealth transfer from debt holders

whose debt is due in Year 2 and equity holders!

These debt holders are paid in full in the unfavorable
state if the firm chooses the long-term project, but they
only receive $10 if the short-term project is chosen.
Thus, firms with large amounts of debt tend to pass up
high NPV projects in favor of lower NPV projects that
pay off sooner.


Cashing Out
When a firm faces financial distress, shareholders have

an incentive to withdraw money from the firm, if possible.

For example, if it is likely the company will default, the firm may sell

assets below market value and use the funds to pay an immediate
cash dividend to the shareholders.
This is another form of under-investment that occurs when a firm faces

financial distress.


Estimating the Debt Overhang

How much leverage must a firm have for there to be a

significant debt overhang problem?

Suppose equity holders invest an amount I in a new
investment with similar risk to the rest of the firm.
Equity holders will benefit from the new investment only if:



Textbook Example 16.5


Textbook Example 16.5 (contd)


Agency Costs and the Value of Leverage

Leverage can encourage managers and shareholders to

act in ways that reduce firm value.

It appears that the equity holders benefit at the expense of the debt

However, ultimately, it is the shareholders of the firm who bear

these agency costs.


Agency Costs and the Value of Leverage (cont'd)

When a firm adds leverage to its capital structure, the

decision has two effects on the share price.

The share price benefits from equity holders ability to exploit debt

holders in times of distress.

The debt holders recognize this possibility and pay less for the debt

when it is issued, reducing the amount the firm can distribute to

Debt holders lose more than shareholders gain from these activities and

the net effect is a reduction in the initial share price of the firm.


Agency Costs and the Value of Leverage

Agency costs of debt represent another cost of increasing

the firms leverage that will affect the firms optimal capital
structure choice.


Textbook Example 16.6


Textbook Example 16.6 (cont'd)


The Leverage Ratchet Effect

Captures the observations that, once existing debt is in



Shareholders may have an incentive to increase leverage even

if it decreases the value of the firm, and
Shareholders will not have an incentive to decrease leverage
by buying back debt, even if it will increase the value of the


Textbook Example 16.7


Textbook Example 16.7 (cont'd)


Debt Maturity and Covenants

The magnitude of agency costs often depends on the

maturity of debt.
Agency costs are highest for long-term debt and smallest for short-

term debt.

Debt Covenants
Conditions of making a loan in which creditors place restrictions on
actions that a firm can take

Covenants may help to reduce agency costs, however,

because covenants hinder management flexibility, they

have the potential to prevent investment in positive NPV
opportunities and can have costs of their own.


Motivating Managers:
The Agency Benefits of Leverage
Management Entrenchment
A situation arising as the result of the separation of ownership and

control in which managers may make decisions that benefit

themselves at investors expenses

Entrenchment may allow managers to run the firm in their

own best interests, rather than in the best interests of the



Concentration of Ownership
One advantage of using leverage is that it allows the

original owners of the firm to maintain their equity stake.

As major shareholders, they will have a strong interest in
doing what is best for the firm.


Concentration of Ownership (cont'd)

Assume Ross is the owner of a firm and he plans to

expand. He can either borrow the funds needed for

expansion or raise the money by selling shares in the
firm. If he issues equity, he will need to sell 40% of the
firm to raise the necessary funds.


Concentration of Ownership (cont'd)

Suppose the value of the firm depends largely on Rosss

personal effort.

By financing the expansion with borrowed funds, Ross retains

100% ownership in the firm. Therefore, Ross is likely to work

harder, and the firm will be worth more since he will receive 100%
of the increase in firm value.

However, if Ross sells new shares, he will only retain 60%

ownership and only receive 60% of the increase in firm value.


Concentration of Ownership (cont'd)

With leverage, Ross retains 100% ownership and will

bear the full cost of any perks, like country club

memberships or private jets.

By selling equity, Ross bears only 60% of the cost; the

other 40% will be paid for by the new equity holders.

Thus, with equity financing, it is more likely that Ross will

overspend on these luxuries.


Concentration of Ownership (cont'd)

By issuing new equity, the firm incurs the agency costs of

reduced effort and excessive spending on perks.

As shown before, if securities are fairly priced, the original owners

of the firm will pay these costs.

Using leverage can benefit the firm by preserving

ownership concentration and avoiding these agency



Reduction of Wasteful Investment

A concern for large corporations is that managers may

make large, unprofitable investments.

What would motivate managers to make

negative-NPV investments?


Reduction of Wasteful Investment

Managers may engage in empire building.
Managers often prefer to run larger firms rather than smaller ones,

so they will take on investments that increase the size, but not
necessarily the profitability, of the firm.

Managers of large firms tend to earn higher salaries, and they may also

have more prestige and garner greater publicity than managers of small
Thus, managers may expand unprofitable divisions, pay too much for
acquisitions, make unnecessary capital expenditures, or hire unnecessary


Reduction of Wasteful Investment

Managers may over-invest because they

are overconfident.
Even when managers attempt to act in shareholders interests, they

may make mistakes.

Managers tend to be bullish on the firms prospects and may believe

that new opportunities are better than they actually are.


Reduction of Wasteful Investment (cont'd)

Free Cash Flow Hypothesis
The view that wasteful spending is more likely to occur when firms

have high levels of cash flow in excess of what is needed after

making all positive-NPV investments and payments to debt holders


Reduction of Wasteful Investment (cont'd)

When cash is tight, managers will be motivated to run the

firm as efficiently as possible.

According to the free cash flow hypothesis,

leverage increases firm value because it commits the firm to

making future interest payments, thereby reducing excess cash
flows and wasteful investment by managers.


Reduction of Wasteful Investment (cont'd)

Leverage can reduce the degree of managerial

entrenchment because managers are more likely to be

fired when a firm faces financial distress.
Managers who are less entrenched may be more concerned about

their performance and less likely to engage in wasteful investment.

In addition, when the firm is highly levered, creditors

themselves will closely monitor the actions of managers,

providing an additional layer of management oversight.


Leverage and Commitment

Leverage may also tie managers hands and commit them

to pursue strategies with greater vigor than they would

without the threat of financial distress.

A firm with greater leverage may also become a fiercer

competitor and act more aggressively in protecting its

markets because it cannot risk the possibility of


Benefits of Financial distress with

committed stakeholders
There are situations where firms and stakeholders are not

transacting in a competitive market.

Example: negotiation with unions or a monopoly supplier.

After specialized investments in human or physical capital have

been made, the relationships between customers and suppliers,

employees and employers, develop into bilateral monopoly
relationship. In these situations, the terms of trades (wages,
prices) are open to negotiation.
Financial distress may provide the firm with a negotiating
advantage because suppliers and employees must consider how
their demands affect the firms survival.
High debt levels may facilitate employee concessions during

business downturns.

Financial distress may be helpful to obtain government

subsidies, especially if the firm is large.


CS & Product Market Competition

CS can affect the competitiveness of an industry.

We now examine how a firms leverage affects its

CS can be used by a firm to credibly commit to a
given strategy. A credible signal that the firm is
committed to a strategy (and cannot deviate from
it) can be a strategic advantage.


Debt & Product Market Competition

Assume we are in an oligopoly.
Oligopoly: many customers, few firms.
Debt can allow firms to commit to an aggressive output

policy that otherwise would not be able to carry out. The

aggressive output policy is necessary to repay the high
If there is no signal (debt), if the firm produced more
output, the additional production would reduce the price,
and , thus, reduce profits for both the firm and its
However, if the firm can send a credible signal, the
competitors may accommodate the firm by reducing their
output instead of engaging in a price war. In this case, the
aggressive policy does increase the firms profits.


Debt, output, and risk

How does a high debt ratio help a firm send a credible

The answer is: risk. Higher leverage increases a firms
incentive to invest in risky projects (we are only interested
in the upside of the investment project).
Higher output can be seen as a risky investment project.
Higher output increases risk because it leads to higher
profits when product demand is high, but lower profits
when demand is low.
If the firm has a high debt level, shareholders do not care about

the bad state of the world.


Debt & Product Market Competition The other side

of the story
However, this is not the full story. We know that debt financing can

lead firms to reduce their level of investment, and thus, to act less
Lets consider a firm that can increase its market share lowering
This firm will have smaller profits in the short-run because of lower
prices, but it will realize greater profits in the long run because of
the higher market share.
Gaining market share is thus an investment that becomes more or
less attractive as the relevant discount rate increases or
decreases. If the discount rate increases, the incentive to gain
market share decreases.
We already saw that highly levered firms use higher discount rates
to evaluate investments (because of the debt overhang problem).
Thus, this implies that highly levered firms will compete less
aggressively in the product market.


Debt & Predation

Debt will also affect rival firms strategies. In particular,

highly leveraged firm might be vulnerable to predation

from less leveraged competitors.

Less leveraged competitors may try to drive a highly leverage firm

out of business with a strategy of low prices (predation).

This strategy is particularly effective in industry where customers
and other stakeholders are concerned about the long-term viability
of the firms with which they do business.


Agency Costs and the Tradeoff Theory

The value of the levered firm can now be shown to be



PV (Interest Tax Shield)

PV (Financial Distress Costs)

PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)


Figure 16.2 Optimal Leverage with Taxes,

Financial Distress, and Agency Costs


The Optimal Debt Level

R&D-Intensive Firms
Firms with high R&D costs and future growth opportunities typically

maintain low debt levels.

These firms tend to have low current free cash flows and risky

business strategies.

Low-Growth, Mature Firms

Mature, low-growth firms with stable cash flows and tangible assets

often carry a high-debt load.

These firms tend to have high free cash flows with few good

investment opportunities.


Debt Levels in Practice

Although the tradeoff theory explains how firms should

choose their capital structures to maximize value to

current shareholders, it may not coincide with what firms
actually do in practice.


Debt Levels in Practice (cont'd)

Management Entrenchment Theory
A theory that suggests managers choose a capital structure to

avoid the discipline of debt and maintain their own job security
Managers seek to minimize leverage to prevent the job loss that

would accompany financial distress, but are constrained from using

too little debt (to keep shareholders happy).


Asymmetric Information and Capital

Asymmetric Information
A situation in which parties have different information
For example, when managers have superior information to

investors regarding the firms future cash flows


Leverage as a Credible Signal

Credibility Principle
The principle that claims in ones self-interest are credible only if

they are supported by actions that would be too costly to take if the
claims were untrue.
Actions speak louder than words.


Leverage as a Credible Signal (cont'd)

Assume a firm has a large new profitable project, but

cannot discuss the project due to competitive reasons.

One way to credibly communicate this positive information is to

commit the firm to large future debt payments.

If the information is true, the firm will have no trouble making the debt


If the information is false, the firm will have trouble paying its creditors

and will experience financial distress. This distress will be costly for the


Leverage as a Credible Signal (cont'd)

Signaling Theory of Debt
The use of leverage as a way to signal information to investors
Thus a firm can use leverage as a way to convince investors that it does

have information that the firm will grow, even if it cannot provide
verifiable details about the sources of growth.


Debt as a credible signal

To be credible, a signal must be costly. Thus, for a capital structure decision

to credibly convey favorable information to investors, a firm with poor

prospects must find it costly to mimic the decisions made by firms with
favorable prospects.

Good firms will use the less costly signal that permit them to separate themselves

from bad firms.

The increase in the debt level satisfies this requirement because it

increases the probability of bankruptcy more for bad firms than good firms.
To convince investors, good firms often take on much more debt than it
otherwise would have found optimal.
The amount of debt that firms must use to send a credible signal depends
on the managers incentive to increase the firms current stock price (to the
detriment of the future one).
If there is a big incentive to choose hit-and-run strategies, the amount of debt will

be higher.


Textbook Example 16.8


Textbook Example 16.8 (cont'd)


Issuing Equity and Adverse Selection

Adverse Selection
The idea that when the buyers and sellers have different
information, the average quality of assets in the market will differ
from the average quality overall
Lemons Principle
When a seller has private information about the value of a good,
buyers will discount the price they are willing to pay due to adverse


Issuing Equity and Adverse Selection

A classic example of adverse selection and the lemons

principle is the used car market.

If the seller has private information about the quality of the car, then

his desire to sell reveals the car is probably of low quality.

Buyers are therefore reluctant to buy except at heavily discounted

Owners of high-quality cars are reluctant to sell because they know

buyers will think they are selling a lemon and offer only a low price.
Consequently, the quality and prices of cars sold in the used-car

market are both low.


Textbook Example 16.9


Textbook Example 16.9 (cont'd)


Issuing Equity and Adverse Selection

This same principle can be applied to the market for


Suppose the owner of a start-up company offers to sell you 70% of

his stake in the firm. He states that he is selling only because he

wants to diversify. You suspect the owner may be eager to sell such
a large stake because he may be trying to cash out before negative
information about the firm becomes public.

Firms that sell new equity have private information about

the quality of the future projects.

However, due to the lemon principle, buyers are reluctant to believe

managements assessment of the new projects and are only willing

to buy the new equity at heavily discounted prices.


Issuing Equity and Adverse Selection

Therefore, managers who know their prospects are good (and

whose securities will have a high value) will not sell new equity.
Only those managers who know their firms have poor

prospects (and whose securities will have low value) are willing
to sell new equity.
The lemons problem creates a cost for firms that need to raise
capital from investors to fund new investments (Myers and
Majluf, 1984). As a result, firms can pass up good investment
projects because they do not want to issue equity (and disclose
this information).
If they try to issue equity, investors will discount the price they are

willing to pay to reflect the possibility that managers have bad news.


Myers & Majluf (1984)

The firm will pass up an investment project if

the intrinsic value of a firms share with the

project is lower than the value without the
project (P is the intrinsic value of one share, the
true value known only by managers):

P with project =(PV existing assets +PV new

investment)/(# existing shares+#new shares)

P without project= PV existing assets / # existing shares
These equations show that one firm can reduce the
intrinsic value of its shares if the PV of the new
investment is low relative to the number of new shares
it must issue.


A firm has assets whose value is $100m and 1m shares

outstanding. A new project costs $70m and its value is $90m. The
companys share is selling at $70 (Pm) on the market .
P=100 without new investment project.
To raise $70m, the firm must issue one 1m shares.
P with investment project is: (100+90)/(1+1)= $95
The firm will reject a positive NPV project. Why?
Because if they issue new shares at $70, there is a wealth transfer
from old shareholders to new shareholders of $5 a share.
Old shareholders lose $25 million if they finance the project at these
conditions. The loss is only partially compensated by the NPV of the
Managers (who run the firm on behalf of OLD shareholders) know
that they are giving the new shareholder a claim to $95m ($50
existing assets +$45 from the new project) for the bargain price of


Debt financing to mitigate adverse

Managers can choose to issue debt and not equity when they believe

equity is underpriced.
With debt financing, the intrinsic value of a share is

P with investment debt financing =(Existing value of assets+NPV of

the new investment)/ #shares

The value increases if the NPV of the project is greater than 0.

Results can change if debt is risky. In this case, we need to take

into account the possibility to incur the costs of financial distress.

Thus, firms finance some positive NPV project with debt (the ones
where NPV> costs of financial distress). They could become at least
temporarily overleveraged.


What happens if equity is overvalued?

Firms have incentive to invest in negative NPV

projects and become underleverage if they can

issue overvalued equity securities to finance
these projects.
Because of this incentive, the market reaction at
the announcement of a new equity issue is
negative. The announcement signals that the
stock is overpriced.


The Myers-Majluf model: A complete example

Starting point: A firm needs $100 to finance a new

investment project. The firm has no cash and it cannot

use debt-financing.
Two states of the world are possible (good and bad).
They have the same probability (p=0.5). Managers know
the state of the world, investors do not.
In the good state, the value of existing assets is 150 and
the project NPV is 20.
In the bad state, the value of existing assets is 50 and
the project NPV is 10.


P: market value of existing shares (old shares) if the firm

issues shares and invest

P: market value of existing (old) shares if the firm does not
issue new shares (and thus it doesnt invest).
V: intrinsic value of the firm (true value, known only to
Va: intrinsic value of old shares
Vn: intrinsic value of new shares
E: amount raised issuing new shares (it is a market value)


Does it make sense to invest in both states?

P= 0.5(150+20)+0.5(50+10)=115
Good state:
100 is the equity raised with the issue
The way value is shared among new and old

shareholders depends on market values, not intrinsic

Va= [P/(P+E)] *V=[115/(115+100)]*270=144.42
Vn= [E/(P+E)] *V=[100/(115+100)]*270=125.58


Does it make sense to invest in both state?

Bad State
Va= [P/(P+E)] *V=[115/(115+100)]*160=85.58
Vn= [E/(P+E)] *V=[100/(115+100)]*160=74.42
So, the situation for the old shareholders is the


Payoffs to old shareholders (Va)

Issue &

No Issue & No

Good State



Bad State





Shareholders decision
Old shareholders will behave in this way:
Good state: No investment (and no issue)
Bad state: Issue & Investment.
But if they choose issue & investment, then the

market knows that we are in the bad state!

Rule: Issue & Investment only if we are in the bad

state, but if the investors see the equity issue then

they realize we are in the bad state.
Therefore the situation becomes:


Shareholders decision

[P/(P+E)] *V=[60/(60+100)]*160=60

Good state: Va=150

Bad state: Va=60


What happens in the good state?

E=100 (market value)

There is a wealth transfer of 25.58 from old

shareholders to new ones!

Old shareholders follow this rule:
Accept the project if the NPV of the project is
larger than the wealth transfer to new


Implications for Equity Issuance

The lemons principle directly implies that:
The stock price declines on the announcement of an equity issue.
The stock price tends to rise prior to the announcement of an equity

Firms tend to issue equity when information asymmetries are

minimized, such as immediately after earnings announcements.


Stock Returns Before and After an Equity



Implications for Capital Structure

Managers who perceive the firms equity is underpriced

will have a preference to fund investment using retained

earnings, or debt, rather than equity.
The converse is also true: Managers who perceive the firms equity

to be overpriced will prefer to issue equity, as opposed to issuing

debt or using retained earnings, to fund investment.


Implications for Capital Structure

Pecking Order Hypothesis
The idea that managers will prefer to fund investments by first

using retained earnings, then debt and equity only as a last resort
However, this hypothesis does not provide a clear prediction

regarding capital structure. While firms should prefer to use

retained earnings, then debt, and then equity as funding sources,
retained earnings are merely another form of equity financing.
Firms might have low leverage either because they are unable to issue

additional debt and are forced to rely on equity financing or because

they are sufficiently profitable to finance all investment using retained


Figure 16.4 Aggregate Sources of Funding for Capital

Expenditures, U.S. Corporations

Source: Federal Reserve Flow of Funds.


Implications for Capital Structure (cont'd)

Market Timing View of Capital Structure
The firms overall capital structure depends in part on the market

conditions that existed when it sought funding in the past.


Capital Structure: The Bottom Line

The optimal capital structure depends on market

imperfections, such as taxes, financial distress costs,

agency costs, and asymmetric information.