CAPITAL STRUCTURE

: BASIC CONCEPTS
MUHAMMAD ISAMESAL
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CAPITAL STRUCTURE - OVERVIEW

Cost of Financial Distress

Desctription of Financial Distress Cost
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
Signaling
Shirking, Perquisites, and Bad Investments : a Note on Agency Cost of Equity
The Pecking-Order Theory
Growth and the Debt-Equity Ratio
Personal Taxes
How Firms Establish Capital Structure
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COST OF FINANCIAL DISTRESS

Bankruptcy risk or bankruptcy cost? Debt provides tax benefits to the firm. However, if debt obligations are
not met, it may put the firm into financial distress. If the firm can not recover from the distress position, it will
ultimately become bankrupt i.e. the ownership of the firm’s assets will be legally transferred from
stockholders to the bondholders of the firm.

In the following example it is shown that bankruptcy costs or more generally financial distress costs tend to
offset the advantages of using debt capital.
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DESCRIPTION • Di rect f i n a n ci a l d i s t res s co s t s

•Leg al an d ad mi n i s t r at i v e co s t s t h es e co s t s ar e l arg e i n ab s o l u t e t er m,
OF COSTS h o wev er, i n r el at i o n t o t h e f i r m v al u e t en d t o b e a s mal l p er cen t ag e.

• I n d i rect f i n a n ci a l d i s t res s co s t s
•I mp ai r ed ab i l i t y t o co n d u ct b u s i n es s ( e.G., Lo s t s al es ) t h es e co s t s ar e
p r act i cal l y d i ff i cu l t t o meas u r e.

• Ag en cy co s t s
•Th e co s t s o f co n f l i ct o f i n t er es t b et ween s t o ck h o l d er s an d
b o n d h o l d er s . Co n f l i ct o f i n t eres t s a re ma g n i f i ed d u ri n g f i n a n ci a l
d i s t res s a n d i mp o s e a g en cy co s t o n t h e f i rm. As s u ch , t h e
s t o ck h o l d er s ar e t emp t ed t o p u r s u e s el f i s h s t r at eg i es .
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THREE TYPES OF SELFISH STRATEGIES ARE
DISCUSSED BELOW:

SELFISH STRATEGY 1: SELFISH STRATEGY 2: SELFISH STRATEGY 3:

INCENTIVE TO TAKE LARGE INCENTIVE TOWARD MILKING THE PROPERTY
RISKS UNDERINVESTMENT
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CAN COSTS OF DEBT BE REDUCED ?

Because of their own strategies shareholders may pay

higher interest rates on borrowed capital. Therefore, Protective covenants can be of two types such as
they frequently make agreements with bondholders negative covenants and positive covenants as
with the hope of reducing interest rates. These follows:
agreements are called protective covenants and are
included as part of the detailed loan document or
indenture.
 PROTECTIVE COVENANTS
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Negative covenant: thou shall 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.
• Buy another company’s bonds.

Positive covenant: thou shall:

• Use proceeds from sale of assets to buy other assets.
• Allow redemption in the event of merger.
• Maintain good condition of assets.
• Provide audited financial information.
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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. THE FACT
RESULTS IN TRADE-OFF MODEL.

IT IS DIFFICULT TO EXPRESS THIS WITH A PRECISE AND

RIGOROUS FORMULA.
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INTEGRATION
OF TAX EFFECTS
AND FINANCIAL
DISTRESS
COSTS
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THE PIE
MODEL
REVISITED
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SIGNALING
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SHIRKING, PERQUISITES, AND BAD INVESTMENTS:

THE AGENCY COST OF EQUITY
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THE PECKING-
ORDER
THEORY

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NEXT…….
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THE ABOVE DISCUSSION FORMS THE BASIC IDEAS OF
PECKINGORDER THEORY. THE THEORY PRESCRIBES THE
FOLLOWING TWO RULES FOR THE REAL WORLD:

RULE 1 Use internal financing first.

RULE 2 Issue debt next, equity last.

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16 GROWTH AND THE DEBT-EQUITY RATIO

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PERSONAL
TAXES: THE
MILLER
MODEL
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PERSONAL
TAXES: THE
MILLER
MODEL
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EFFECT OF FINANCIAL LEVERAGE ON FIRM VALUE WITH BOTH

CORPORATE AND PERSONAL TAXES

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PERSONAL TAXES: THE MILLER MODEL

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HOW FIRMS ESTABLISH CAPITAL STRUCTURE

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HOW FIRMS ESTABLISH CAPITAL STRUCTURE

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24 HOW FIRMS ESTABLISH CAPITAL STRUCTURE

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TERIMA KASIH

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