Presentation on theme: "Chapter 17 Limits to the Use of Debt"— Presentation transcript:
1Chapter 17 Limits to the Use of Debt Topics:17.1 Costs of Financial Distress17.2 Agency costs of debt17.4 Integration of Tax Effects and Financial Distress Costs17.7, How Firms Establish Capital Structure
2Bankruptcy Risk vs. Bankruptcy Costs The possibility of bankruptcy has a negative effect on the value of the firmHowever, it is not the risk of bankruptcy that lowers value, but rather the costs associated with bankruptcy (and, more generally, financial distress)
3Example—firm bears costs of financial distress A firm borrows $1M for one year. There is a 90% chance of repayment and a 10% chance of bankruptcy. If bankruptcy occurs, the firm’s assets can be sold for $600,000. Suppose the bank charges interest so to earn an average return of 10% from similar companies.(1) What’s the expected cost of bond on the firm?(2) Now assume bankruptcy costs are $100,000. What’s the expected cost of bond on the firm?
4Financial Distress Costs Direct costs: Legal and other deadweight costsWhile large in absolute amounts, they are usually small in terms of overall firm value (5%)Indirect Costs (20%)Impaired ability to conduct businessCosts of negotiating and obtaining creditor approval for taking actionsUnderinvestment in research and developmentSelling off assets at fire sale pricesFailure to perform needed maintenanceAgency costs of debtThe firm bears the costs of financial distress
517.2 Agency cost of debtAn agency cost arises whenever you hire someone else to do something for you. It arises because your interests (as the principal) may deviate from those of the person you hired (as the agent).Stockholders interests are different from bondholders interests, becauseYou (as lender) are interested in getting your money backStockholders are interested in maximizing their wealthThis conflict of interest is more pronounced when the firm is in distress and both parties want to recover
6Three Types of Agency Costs of debt: Selfish Strategies by Equityholders in Distressed firms Incentive to take large risksIncentive toward underinvestmentMilking the Property
7Example $200 $0 Assets BV MV Liabilities BV MV Balance Sheet for a Company in DistressAssets BV MV Liabilities BV MVCash $200 $200 LT bonds $300Fixed Asset $400 $0 Equity $300Total $600 $200 Total $600 $200What happens if the firm is liquidated today?$200$0
8Selfish Strategy 1: Take Large Risks Example cont’dThe Gamble Probability PayoffWin Big % $1,000Lose Big % $0Cost of investment is $200 (all the firm’s cash); Required return is 50%What is the NPV the gamble?
92. However, equityholder will do the project. Why? Cont’d:2. However, equityholder will do the project. Why?Expected CF from the GambleTo BondholdersTo StockholdersPV of Bonds Without the GamblePV of Stocks Without the GamblePV of Bonds With the GamblePV of Stocks With the Gamble
10Selfish Strategy 2: Underinvestment (Selfish Stockholders Forego Positive NPV Project) Example cont’d:Consider a government-sponsored project that guarantees $350 in one periodCost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the projectRequired return is 10%.What is the NPV of the project? Should equityholder accept the project?
11Cont’d:Expected CF from the government sponsored project:To BondholderTo StockholderPV of Bonds Without the ProjectPV of Stocks Without the ProjectPV of Bonds With the Project = = $272.73PV of Stocks With the project = = -$54.55
12Selfish Strategy 3: Milking the Property Example cont’d:Liquidating dividendsSuppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.Such tactics often violate bond indentures.Increase perquisites to shareholders and/or management
13Agency Costs of Debt: Summary Conflicts of interest between stockholders and bondholders result in:poor decisions about investments and operationshigher interest rates to compensate lenders for potential problemCan these costs be reduced?debt consolidation (if we minimize the number of parties involved, negotiation costs will be lowered)bond covenants can also be seen as a means of reducing costsConsider the following three alternatives: (i) issue no debt (but this can be costly due to the foregone debt tax shield); (ii) issue debt without covenants (but this will result in much higher interest rates being charged on debt); or (iii) issue debt with covenants
14Integration of Tax Effects and Financial Distress Costs: Summarizing the Trade Off of Debt Advantage of BorrowingDisadvantage of BorrowingTax Benefits:Higher tax rate Higher tax benefitsBankruptcy cost:Higher business risk higher cost2. Added Discipline:Greater the separation between managers and stockholders Greater the benefit2. Agency cost:Greater the separation between stockholders and lenders higher cost3. Loss of future financing flexibility: Greater the uncertainty about future financing needs higher cost
15Integration of Tax Effects and Financial Distress Costs Value of firm under MM with corporate taxes and debtValue of firm (V)Present value of tax shield on debtVL = VU + TCBMaximum firm valuePresent value of financial distress costsV = Actual value of firmVU = Value of firm with no debtDebt (B)B*Optimal amount of debt
16MM propositions with distress We can update MM Prop. 1 with taxes as:VL = VU + PV(interest tax shields) - PV(FDC)where FDC (financial distress costs) is a very general increasing function of the amount of debt.MM Prop. 2
17The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.Let G and L stand for payments to the government and bankruptcy parties, respectively.VT = S + B + G + LSThe essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.BGL
18Static Tradeoff Theory of Capital Structure In the Pie modelHow much debt you take depends on the tradeoff between G and Lmaximizing the total value of the marketed claims (S+B) is equivalent to minimizing the total value of the non-marketed claims (G+L)The static tradeoff hypothesis says that the change in firm value when equity is replaced by debt is the PV of the debt tax shield minus the PV of increased costs of financial distressMore generally, the tradeoff theory says the capital structure is determined by the tradeoff between the benefits and costs of debtThe optimal amount of debt is when the marginal benefit equals marginal cost of debt
19Another school of Capital Structure: The Pecking Order Theory Recap: Theory states that firms prefer to issue debt rather than equity if internal finance is insufficient.Rule 1Use internal financing first.Rule 2Issue debt next, equity last.This theory focuses on the timing of security issuance, and relies on asymmetric informationAsymmetric information assumes one party possesses more information than another. e.g., equityholders vs. bondholders on the value of the firmConsider a manager of a firm which needs new capital (debt or equity)If the manager believes that the stock is currently undervalued, debt would be better (instead of selling shares for less than their true worth)If the manager believes that the stock is currently overvalued, equity would be better
20Pecking order cont’d Now consider the investor if the investor observes the firm issuing equity, this can be taken as a signal that the stock is currently overvalued (“signalling”)conversely, a firm issuing debt may be sending a signal that the stock is currently undervaluedIf the manager takes the investor’s inference into account, then the choice should always be debt (since if a firm tries to sell equity, investors will think it is overpriced and won’t buy it unless the price falls)Similarly, investors might be reluctant to buy bonds if they think that managers are issuing debt because it is currently overvaluedThis leads to the pecking order.
21Comparing tradeoff theory with pecking order theory The pecking-order theory is at odds with the trade-off theory:There is no target B/S ratio.Profitable firms use less debt.“Financial slacks” are valuable.The pecking order is also consistent with avoiding issue costs and a desire by managers to avoid publicity
22Empirical evidence Tradeoff theory Pecking order theory: Empirical evidence which is consistent with the tradeoff theory:changes in financial leverage affect firm valuespersistent differences in capital structures across industrieshighly leveraged firms tend to invest lessViolations: The tradeoff theory fails to explain why many very profitable firms have low debtPecking order theory:Consistent with the observed negative correlation between operating profits and leverageConsistent with profitable firms using less debt
23How Firms Establish Capital Structure Survey evidence on some of the factors that affect the decision to issue debt. The survey is based on the responses of 392 CFOs, conducted by John Graham and Campbell Harvey. (Paper is enclosed as an optional reading.)
24Review QuestionsDoes the following increase or decrease the use of debt:1. Agency costs of debt2. Governments often step in to protect large companies that get into financial trouble and bail them out. If this were an accepted practice, what effect would you expect it to have on the debt ratios of firms? Why?