Topic 9

Financial Distress, Managerial Incentives, and Information.

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Figure 18.2 Value of the Firm
Figure 18.3 Default Payoff Scenarios
 Figure 18.4 Ace Limited
Total payoff to Ace Limited security holders. There is a
$200 bankruptcy cost in the event of default (shaded
area).
 Debt and Incentives
Circular File Company has $50 of 1-year debt
 Risk Shifting: The First Game
Suppose that Circular has $10 cash. The following
investment opportunity comes up:
 Conflicts of Interest
Circular File Company value (post project)

Firm value falls by $2, but equity holder gains $3

 Refusing to Contribute Equity Capital: The Second
Game
Circular File Company value (assumes a safe project with NPV = $5)

The stockholder loses what the bondholder gains.

 And Three More Games, Briefly

Cash In and Run

• “Refusing to contribute equity capital” run in
reverse
Playing for Time
• Stockholders use delay tactics with creditors

Bait and Switch

• Start with conservative policy, then later switch
and issue a lot more.
Example 18.1 Ms. Ketchup Faces Credit Rationing

• Henrietta Ketchup has two possible

investment projects
The Trade-Off Theory of Capital Structure

Trade-Off Theory
• Theory that capital structure is based on
trade-off between tax savings and distress
costs of debt
The Pecking Order of Financing Choices

Pecking-Order Theory
• Theory stating firms prefer to issue debt over
equity if internal finances are insufficient
• Starts with asymmetric information, meaning
that managers know more about their
companies’ prospects, risks, and values than do
outside investors.
 Implications of the Pecking Order

1.Firms prefer internal finance

2.Adapt target dividend payout
ratios to investment opportunities
while avoiding changes in
dividends
Implications of the Pecking Order Continued
3. Internally generated cash flow is sometimes
more than capital expenditures, other times
not
• Due to dividend policies, plus fluctuations in profitability
and investment opportunities
• If more, firm pays off debt or invests in marketable
securities
• If less, firm first draws down cash balance or sells
holdings of marketable securities
4. If external finance is required, firms issue
the safest security first
• They start with debt, then possibly hybrid securities,
such as convertible bonds, then equity as a last resort
Trade-Off Theory vs. Pecking-Order Theory—
Some Evidence
1. Size. Large firms tend to have higher
debt ratios.
2. Tangible assets. Firms with high ratios of
fixed assets to total assets have higher
debt ratios.
3. Profitability. More profitable firms have
lower debt ratios.
4. Market to book. Firms with higher ratios
of market-to-book value have lower debt
ratios
 Stylized Facts

From
Frank, M. Z., & Goyal, V. K. (2008). Trade-off and
pecking order theories of debt. Handbook of
empirical corporate finance, 135-202.

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 Stylized Facts
1. Over long periods of time, aggregate leverage is stationary.
2. Over the past half century, the aggregate market-based leverage ratio has been about 0.32. There have
been surprisingly small fluctuations in this ratio from decade to decade.
3. At the aggregate level, capital expenditures are very close to internal funds. This is true for large public
firms and private firms; this is not true for small public firms.
4. At the aggregate level, the financing deficit is very close to debt issues. This holds for large public firms
and for private firms; this does not hold for small public firms. For small public firms, financing deficits very
closely match equity issues.
5. Aggregate dividends are very smooth and almost flat as a fraction of total assets for all classes of firms.
There has been remarkable stability in the aggregate dividend rate over time. Large public firms pay higher
dividends than do small public firms. Many small firms pay no dividends.

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 Stylized Facts
6. Over the past half century, there has been a large decrease in direct holding of corporate securities by
households, and a corresponding huge increase in financial intermediation of such claims.
7. Households have been net suppliers of corporate equity since the 1960s. Corporations have been net
buyers of equity since the 1980s. Most equity is no longer
held directly. Insurance companies, mutual funds, and pension funds now hold more equity and debt than
households hold directly.
8. There is a core set of six reliable factors that are correlated with cross-sectional differences in leverage.
Leverage is positively related to median industry leverage, collateral, log of assets, and expected inflation.
Leverage is negatively related to market-to-book and profits.
9. Firms frequently adjust their debt. The financing deficit plays a role in these decisions. The traditional
cross-sectional factors are, however, more important than the financing deficit.

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 Stylized Facts
10. After an IPO, equity issues are more important for small firms than for
large firms. Many large firms infrequently issue significant amounts of
equity. When larger firms do issue, the issues can be large. Many small
firms issue equity fairly often.
11. Corporate leverage is mean reverting at the firm level. The speed at
which this happens is not a settled issue.
12. At the aggregate level, mean reversion of leverage mainly happens
through debt market actions.
13. Mergers and acquisitions are more common reasons for exit than are
bankruptcies and liquidations.

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 Stylized Facts
14. Market conditions have some effect on leverage decisions. The
magnitude and durability of these effects are not settled issues.
15. Announcements of corporate debt issues and debt repurchases have
little, if any, effect on the market value of the firm.
16. Announcements of equity issues are generally associated with a drop
in the market value of the firm. Announcements of equity repurchases
are generally associated with an increase in the market value of the firm.
17. The natural experiments papers are generally easy to understand
from the perspective of trade-off theory.

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 Leverage Ratios of GM, IBM and Eastman Kodak: 1926 to 2008

Book leverage is the ratio of

total book debt to total assets.
Market leverage is total book
debt divided by the sum of total
book debt and the market value
of common stock. Leverage
data are from company annual
reports, Moodys manuals, and
Compustat. Market values are
from CRSP.

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 Time Series Range and Standard Deviation (σ) of Book Leverage, Market Leverage,
and Net Debt Ratios of Publicly Held Industrial Firms

Book leverage is the ratio of total debt to total assets.

Market leverage is the ratio of debt to the sum of debt plus the market value of
common stock.

The net-debt ratio equals debt minus cash, divided by total assets.

The sample is restricted to industrial firms in the CRSP/Compustat file over

1950 to 2008. It excludes firms

(i) with SIC codes in the ranges 4900 to 4949 (utilities) or 6000 to 6999
(financials),

(ii) (ii) incorporated outside the U.S., or

(iii) (iii) without CRSP security codes of 10 or 11.

The constant- composition sample contains 157 firms that are included in the
sample in 1950 and remain until at least 2000. The time-series standard
deviation of leverage, σ, is based on the maximum likelihood estimator, which
uses a divisor equal to the number of observations, N, in each firm’s time
series, not N-1.

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Conservatively Levered v Highly Levered Publicly Held Industrial Firms: 1950 - 2008

Leverage is measured as the ratio of the

book value of total debt to the book value
of total assets (Debt/TA). The constant-
composition sample contains 157 firms with
non-missing total assets on Compustat in
1950 that remained listed through at least
2000. Conservatively levered firms are
defined as those with no debt outstanding,
while highly levered firms are defined as
those with Debt/TA > 0.400.

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 Stable Leverage Regimes

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 Stable Leverage Regimes

To generate the data in panel A, we first take a given firm and identify its longest stable
leverage regime (based on each Debt/TA range specified in the rows). For example, to generate
the data in the first row, we take a firm that has been listed at least 20 years and calculate the
longest number of consecutive years that its Debt/TA ratio remained within a range of values
that differ by no more than 0.050. We repeat this process for all firms in the sample, and
report the resulting histogram, with the sample median number of years given in the far-right
column.
In the first and second rows of panel B, we consider situations in which the firm’s book-
leverage ratio (Debt/Total Assets) continuously remains within a range no wider than 0.050. In
the third and fourth rows, we consider situations in which Debt/TA remains within a range no
wider than 0.100. The columns sort firms according to the median value of the Debt/TA ratio
during its longest stable regime, and report the percentage of firms (in the sample for the
subject row) that falls within each leverage category. N.m. indicates non-meaningful.

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 Firm Expansion and Departures from Stable Leverage Regimes

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 Firm Expansion and Departures from Stable Leverage Regimes

Departures from leverage stability generally reflected significant increases in leverage and the dollar
amount of outstanding debt, as shown in rows 1 and 2 3.
However, they were not associated with significant changes in industry leverage, company profitability, or
other leverage determinants traditionally emphasized in the literature, as shown in rows 6 through 12 .
At the same time, departures from leverage stability typically were associated with significant increases in a
company’s asset growth and capital expenditures, and with a material funding deficit, which indicates that,
net of pay outs to shareholders, external funds were raised in the current period. The latter facts can be
seen in rows 3 through 5.
The findings strongly suggest that, in academic analysis of capital structure, too much emphasis has been
placed on traditionally posited leverage determinants, and not enough on the importance of meeting the
funding needs of a company’s operating/investment policy.

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 Implications for Theories of Capital Structure
Although episodes of capital structure stability do sometimes arise, the leverage ratios of publicly held nonfinancial firms
generally vary widely over time.

This is inconsistent with the view that companies keep leverage close to a particular target leverage ratio. It is fully
consistent with weak notions of leverage targeting as would arise, for example, with a target-zone model in which financial
distress costs discourage companies from allowing leverage to remain at high levels.

At the same time, however, we would caution that target zone and other muted target-rebalancing models miss numerous
important factors that plausibly affect the capital structures of real-world companies.

Most notably, our findings on departures from stability indicate a significant connection between leverage instability and the
funding of investment policy. Such a relationship is ruled out by the assumption of standard trade-off models of capital
structure that focus solely on the attainment of a target (optimal) leverage ratio while holding constant a firm’s investment
policy.

To understand capital structure, it is important to view investment policy as a first order influence on leverage dynamics and
to take into account considerations of payout policy and financial flexibility, as well as a number of other (often more
nuanced) factors related to company-specific operating environments.

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