Capital Structure ± Limits to the Use of Debt

RWJ Chp 16

Costs of Financial Distress
‡ Bankruptcy risk versus bankruptcy cost. ‡ The possibility of bankruptcy has a negative effect on the value of the firm. ‡ However, it is not the risk of bankruptcy itself that lowers value. ‡ Rather it is the costs associated with bankruptcy. ‡ It is the shareholders who bear these costs.

lost sales) ± Agency Costs ‡ Selfish strategy 1: Incentive to take large risks ‡ Selfish strategy 2: Incentive toward underinvestment ‡ Selfish Strategy 3: Milking the property ..g.Description of Costs ‡ Direct Costs ± Legal and administrative costs (tend to be a small percentage of firm value). ‡ Indirect Costs ± Impaired ability to conduct business (e.

the shareholders get nothing.Asset Total BV MV RM200 RM200 RM400 RM0 RM600 RM200 Liabilities BV LT bonds RM300 Equity RM300 Total RM600 MV RM200 RM0 RM200 What happens if the firm is liquidated today? The bondholders get RM200. .Balance Sheet for a Company in Distress Assets Cash F.

000 RM0 Cost of investment is RM200 (all the firm¶s cash) Required return is 50% Expected CF from the Gamble = RM1000 × 0.Selfish Strategy 1: Take Large Risks The Gamble Win Big Lose Big Probability 10% 90% Payoff RM1.50 NPV ! $133 .10 + RM0 = RM100 $100 NPV ! $200  1.

Selfish shareholders Accept Negative NPV Project with Large Risks ‡ Expected CF from the Gamble ± To Bondholders = RM300 × 0.10 + RM0 = RM30 ± To shareholders = (RM1000 .RM300) × 0.10 + RM0 = RM70 ‡ PV of Bonds Without the Gamble = RM200 ‡ PV of Stocks Without the Gamble = RM0 ‡ PV of Bonds With the Gamble = RM30 / 1.5 = RM20 ‡ PV of Stocks With the Gamble = RM70 / 1.5 = RM47 .

Selfish Strategy 2: Underinvestment ‡ Consider a government-sponsored project that guarantees RM350 in one period ‡ Cost of investment is RM300 (the firm only has RM200 now) so the shareholders will have to supply an additional RM100 to finance the project ‡ Required return is 10% $350 NPV ! $300  1.18 yShould we accept or reject? .10 NPV ! $18 .

1 .RM100 = RM54.Selfish shareholders Forego Positive NPV Project ‡ Expected CF from the government sponsored project: ± To Bondholder = RM300 ± To Stockholder = (RM350 .1 = RM272.73 ‡ PV of Stocks with the project = RM50 / 1.RM300) = RM50 ‡ PV of Bonds Without the Project = RM200 ‡ PV of Stocks Without the Project = RM0 ‡ PV of Bonds With the Project = RM300 / 1.55 .

‡ Increase perquisites to shareholders and/or management .Selfish Strategy 3: Milking the Property ‡ Liquidating dividends ± Suppose our firm paid out a RM200 dividend to the shareholders. ± Such tactics often violate bond indentures. This leaves the firm insolvent. but plenty for the former shareholders. with nothing for the bondholders.

Can Costs of Debt Be Reduced? ‡ Protective Covenants ‡ Debt Consolidation: ± If we minimize the number of parties. contracting costs fall. .

‡ Positive covenant: Thou shall: ± Use proceeds from sale of assets for other assets.Protective Covenants ‡ Agreements to protect bondholders ‡ Negative covenant: Thou shalt not: ± Pay dividends beyond specified amount. ± Sell more senior debt & amount of new debt is limited. ± Refund existing bond issue with new bonds paying lower interest rate. . ± Maintain good condition of assets. ± Allow redemption in event of merger or spinoff. ± Buy another company¶s bonds. ± Provide audited financial information.

. ‡ It is difficult to express this with a precise and rigorous formula.Integration of Tax Effects and Financial Distress Costs ‡ There is a trade-off between the tax advantage of debt and the costs of financial distress.

Integration of Tax Effects and Financial Distress Costs Value of firm (V) Present value of tax shield on debt Value of firm under MM with corporate taxes and debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt 0 B* Optimal amount of debt Debt (B) .

respectively. ‡ Let G and L stand for payments to the government and bankruptcy lawyers. capital structure just slices the pie. .The Pie Model Revisited ‡ Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. ‡ VT = S + B + G + L S B L G ‡ The essence of the M&M intuition is that VT depends on the cash flow of the firm.

‡ The free cash flow hypothesis says that an increase in dividends should benefit the shareholders by reducing the ability of managers to pursue wasteful activities. Free cash flow provides this opportunity. they also need opportunity. ‡ The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases. and Bad Investments: The Agency Cost of Equity ‡ An individual will work harder for a firm if he is one of the owners than if he is one of the ³hired help´. ‡ Who bears the burden of these agency costs? ‡ While managers may have motive to partake in perquisites.Shirking. . Perquisites.

± Profitable firms use less debt. ± Rule 2 ‡ Issue debt next.The Pecking-Order Theory ‡ Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. ± Rule 1 ‡ Use internal financing first. equity last. ± Companies like financial slack . ‡ The pecking-order Theory is at odds with the trade-off theory: ± There is no target D/E ratio.

‡ Thus. ‡ Growth is an essential feature of the real world.Growth and the Debt-Equity Ratio ‡ Growth implies significant equity financing. . high-growth firms will have lower debt ratios than low-growth firms. as a result. 100% debt financing is sub-optimal. even in a world with low bankruptcy costs.

Personal Taxes: The Miller Model ‡ The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: « (1  TC ) v (1  TS ) » VL ! VU  ¬1  ¼vB 1  TB ­ ½ Where: TS = personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate .

the total cash flow to all stakeholde rs is ( EBIT  rB B) v (1  TC ) v (1  TS )  rB B v (1  TB ) This can be rewritten as « (1  TC ) v (1  TS ) » EBIT v (1  TC ) v (1  TS )  rB B v (1  TB ) v ¬1  ¼ 1  TB ­ ½ Continued« .Personal Taxes: The Miller Model The derivation is straightforward: Shareholde rs in a levered firm receive ( EBIT  rB B ) v (1  TC ) v (1  TS ) Bondholder s receive rB B v (1  TB ) Thus.

A bond is worth B. Its value = VU.TB) after taxes.) The total cash flow to all stakeholders in the levered firm is: « » (1  TC ) v (1  TS ) EBIT v (1  TC ) v (1  TS )  rB B v (1  TB ) v ¬1  ¼ 1  TB ­ ½ The first term is the cash flow of an unlevered firm after all taxes. Thus the value of the second term is: « (1  TC ) v (1  TS ) » B v ¬1  ¼ 1  TB ­ ½ The value of the sum of these two terms must be VL (1  T ) v (1  T ) v @VL ! V  1  1 T . It promises to pay rBB×(1.Personal Taxes: The Miller Model (cont.

) ‡ Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: L ! U « (1  TC ) v (1  TS ) »  ¬1  ¼vB 1  TB ­ ½ y In the case where TB = TS. we return to M&M with only corporate tax: ! T B .Personal Taxes: The Miller Model (cont.

Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes « (1  TC ) v (1 TS ) » VL ! VU  ¬1  ¼v B 1 TB ­ ½ VL = VU+TCB when TS =TB V L < V U + TC B when TS < TB but (1-TB > (1-TC ×(1-TS VL =VU when (1-TB = (1-TC ×(1-TS VU VL < VU when (1-TB < (1-TC ×(1-TS Debt (B) .

Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Value of firm (V) Present value of financial distress costs Present value of tax shield on debt Maximum firm value Value of firm under MM with corporate taxes and debt VL = VU + TCB V L < V U + TC B when TS < TB but (1-TB > (1-TC ×(1-TS VU = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt 0 B* Optimal amount of debt Debt (B) .

± Stock price increases with increases in leverage and vice-versa. ‡ There are Differences in Capital Structure Across Industries. ± Another interpretation is that firms signal good news when they lever up.How Firms Establish Capital Structure ‡ Most Corporations Have Low Debt-Asset Ratios. ‡ There is evidence that firms behave as if they had a target Debt to Equity ratio. ‡ Changes in Financial Leverage Affect Firm Value. . this is consistent with M&M with taxes.

‡ Uncertainty of Operating Income ± Even without debt. ‡ Types of Assets ± The costs of financial distress depend on the types of assets the firm has. ‡ Pecking Order and Financial Slack ± Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. . there is an advantage to debt. firms with uncertain operating income have high probability of experiencing financial distress.Factors in Target D/E Ratio ‡ Taxes ± If corporate tax rates are higher than bondholder tax rates.

Summary and Conclusions ‡ Costs of financial distress cause firms to restrain their issuance of debt. ± Direct costs ‡ Lawyers¶ and accountants¶ fees ± Indirect Costs ‡ Impaired ability to conduct business ‡ Incentives to take on risky projects ‡ Incentives to underinvest ‡ Incentive to milk the property ‡ Three techniques to reduce these costs are: ± Protective covenants ± Repurchase of debt prior to bankruptcy ± Consolidation of debt .

firms will not finance entirely with debt. Value of firm (V) Present value of tax shield on debt Value of firm under MM with corporate taxes and debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt 0 B* Optimal amount of debt Debt (B) .Summary and Conclusions ‡ Because costs of financial distress can be reduced but not eliminated.

the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB) Value of firm (V) Present value of financial distress costs Present value of tax shield on debt Maximum firm value Value of firm under MM with corporate taxes and debt VL = VU + TCB VL < VU + TCB when TS < TB but (1-TB > (1-TC ×(1-TS VU = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt 0 B* Optimal amount of debt Debt (B) .Summary and Conclusions ‡ If distributions to equity holders are taxed at a lower effective personal tax rate than interest. the tax advantage to debt at the corporate level is partially offset. In fact.

firms with uncertain operating income have high probability of experiencing financial distress. .Summary and Conclusions ‡ Debt-to-equity ratios vary across industries. ± Types of Assets ‡ The costs of financial distress depend on the types of assets the firm has. there is an advantage to debt. ‡ Factors in Target D/E Ratio ± Taxes ‡ If corporate tax rates are higher than bondholder tax rates. ± Uncertainty of Operating Income ‡ Even without debt.

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