1. Effects of Default and Bankruptcy in a Perfect Market (no costs of financial distress) There are no effects of default and bankruptcy on firm value in a perfect market Example: Armin Industries Armin is introducing a new product. Armin is introducing a new product. If success, Armin’s value in one year = 150 If success, Armin’s value in one year = 150 If failure, Armin’s value in one year = 80 If failure, Armin’s value in one year = 80 Comparing two capital structures: Comparing two capital structures:All-equity Debt that matures in one year with 100 due

2. Scenario 1. Success Without leverage equityholders get 150 Without leverage equityholders get 150 With leverage they get 50 With leverage they get 50 What if there’s not enough cash to pay to creditors? (150 can be a PV of future cash flows not available right now) What if there’s not enough cash to pay to creditors? (150 can be a PV of future cash flows not available right now) No problem with perfect cap market. The money to repay can be raised by issuing new debt or equity as claims against future cash flows No problem with perfect cap market. The money to repay can be raised by issuing new debt or equity as claims against future cash flows Ex: selling equity for 100 and using the proceeds to repay the debt

3. Scenario 2. Failure Without leverage equityholders get 80 Without leverage equityholders get 80 With leverage there will be default and bankruptcy. The shareholders get 0 (limited liability). The creditors suffer loss of 20. With leverage there will be default and bankruptcy. The shareholders get 0 (limited liability). The creditors suffer loss of 20. Comparing two scenarios: The total value that goes to all investors in any state of nature is independent of the capital structure, hence the ex-ante total firm value is independent of the cap structure too (MM proposition I)

4. Introducing the costs of bankruptcy and financial distress Direct costs Fees to lawyers, consultants, appraisers, etc… Fees to lawyers, consultants, appraisers, etc… E.g., for Enron the total cost of fees was above $750 mln = 10% of the assets value Usually, 3-4% of the pre bankruptcy market value. But higher for small firms (e.g. 15%) Time Time

5. Indirect costs (difficult to measure but seem much larger than direct ones (10-20%)) Loss of customers Loss of customers Loss of suppliers Loss of suppliers Loss of employees Loss of employees Loss of receivables Loss of receivables Fire sales of assets Fire sales of assets Indirect costs to creditors (they can suffer distress too) Indirect costs to creditors (they can suffer distress too) Inefficient investment (NPV < 0) when in distress (see below) Inefficient investment (NPV < 0) when in distress (see below) Inability to raise finance for positive NPV projects when in distress Inability to raise finance for positive NPV projects when in distress

6. Armin Industries: The Impact of Financial Distress Costs Assume in case of failure debt holders receive only 60 < 80 because they bear the bankruptcy costs.

7. MM I does not hold anymore E.g. assuming that success and failure are equally likely, that the risk is diversifiable (or that agents are risk-neutral), and that the risk- free interest rate = 1.05, we get: E.g. assuming that success and failure are equally likely, that the risk is diversifiable (or that agents are risk-neutral), and that the risk- free interest rate = 1.05, we get: PV(financial distress costs) = ((1/2)*20 + (1/2)*0)/1.05 = 9.52 – this is the difference between the value of the unlevered firm and levered firm PV(financial distress costs) = ((1/2)*20 + (1/2)*0)/1.05 = 9.52 – this is the difference between the value of the unlevered firm and levered firm (V U = ((1/2)*150 + (1/2)*80)/1.05 = 109.52; V L = ((1/2)*150 + (1/2)*60)/1.05 = 100) New MM I: New MM I:

8. Who bears financial distress costs eventually? When securities are fairly priced, the original shareholders pay the whole PV(financial distress cost) Suppose at the beginning of the year Armin has 10 mln shares and no debt. It wants to issue one-year debt with a face value of $100 mln and use the proceeds to repurchase shares. If there are no bankruptcy costs the total value that goes to equityholders should not change: Debt = ((1/2)*100 + (1/2)*80)/1.05 = 85.71 – this is how much the firm can raise through debt with face value 100. Debt = ((1/2)*100 + (1/2)*80)/1.05 = 85.71 – this is how much the firm can raise through debt with face value 100. Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost. Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost. Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 109.52 – exactly the same as V U Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 109.52 – exactly the same as V U

9. If there are bankruptcy costs, the total value that goes to equityholders changes: Debt = ((1/2)*100 + (1/2)*60)/1.05 = 76.19 – this is how much the firm can raise now through debt with face value 100. Debt = ((1/2)*100 + (1/2)*60)/1.05 = 76.19 – this is how much the firm can raise now through debt with face value 100. Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost. Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost. Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 100 = V U – PV(financial distress cost) – shareholders bear the whole cost Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 100 = V U – PV(financial distress cost) – shareholders bear the whole cost

10. Optimal Capital Structure: The Tradeoff Theory V L = V U + PV(Interest Tax Shield) + PV(Financial Distress Costs)

11. Agency Costs Remember: one of the key assumptions behind MM I was that they way the firm is financed has no effect on the cash flows it generates In reality this is not true due to conflicts of interest between debt holders and shareholders (  agency costs of debt) and between managers and shareholders (  agency costs of equity) Hence, the capital structure will matter

12. Agency Costs of Debt Assume Baxter Inc. has a loan of $1 mln due at the end of the year. Without changing strategy the market value of its assets will be only $900,000  default We will see how the following problems can arise: Overinvestment (asset substitution) Overinvestment (asset substitution) Underinvestment (debt overhang) Underinvestment (debt overhang) Cashing out (excessive dividends) Cashing out (excessive dividends)

13. Overinvestment (asset substitution (Jensen and Meckling (JFE, 1976)) New strategy. Success with prob 50% If success, assets value = $1.3 mln  no default If success, assets value = $1.3 mln  no default If failure, assets value = $300,000  default If failure, assets value = $300,000  default Assuming no discounting, expected assets value A = $800,000 < $900,000 Why would the management follow a value reducing strategy?

14. If it cares only about the interest of the shareholders, it would, because the shareholders gain. The debt holders lose and the firm value decreases Hence, when a firm faces financial distress, shareholders are tempted to gain by gambling at the expense of debt holders, even if such gambles have NPV < 0! Note: this problem exists not only in distress, but in distress it becomes especially serious Eventually, the cost is again born by the initial shareholders

15. Underinvestment (debt overhang, Myers (JFE, 1977)) Suppose instead of pursuing risky strategy, the manager considers a positive NPV opportunity that requires initial investment of 100 and generates 150 in one year. Could the firm raise 100 by issuing new equity? No. End of year values: Equityholders receive only 50 – they will not agree to invest 100!

16. Hence, when a firm faces financial distress, it may fail to implement projects with NPV > 0! Note: this problem exists not only in distress, but in distress it becomes especially serious Note: the firm is unable to raise funds not only through selling equity, but through selling any security that is junior to the existing debt This cost is again born by the initial shareholders

17. Cashing out (excessive dividends) Suppose Baxter has equipment it can sell for 25 at the beginning of the year and pay out this cash as dividend. Assume without the equipment the firm will be worth only 800 at the year-end. This behavior reduces value by 100 – 25. But the shareholders do not care – the firm will default anyway and they are protected by limited liability Again this cost would initially be born by the initial shareholders. Note: this problem exists not only in distress, but in distress it becomes especially serious

18. Example: benefits of lower leverage

19. Debt maturity, Covenants and Convertible Debt as ways to mitigate the above problems Short term debt leaves fewer possibilities for shareholders to profit at the debtholders’ expense. Covenants – restrictions in a debt contract: Limiting dividend payments Limiting dividend payments Limiting the scope for risky investments Limiting the scope for risky investments Limiting the ability to issue more senior debt Limiting the ability to issue more senior debt Convertible bonds (e.g. in case stock price reaches some level)

20. Agency Costs of Equity (benefits of debt) Extracting private benefits at the expense of shareholders (Jensen and Meckling (JFE, 1976)) Free cash flow problem (Jensen (AER, 1986))

21. Extracting private benefits at the expense of shareholders (Jensen and Meckling (JFE, 1976)) Managers do not fully internalize shareholder value because they own 100% of the shares Imagine an initial owner (entrepreneur) who needs to raise funds from outside but wants to keep managing the company If he sells equity he is left with < 100% of shares  he can be tempted to do things that benefit him privately at the expense of other shareholders (“pet” projects, perks, profit diversion, asset diversion, simply underprovision of effort) If he sells equity he is left with < 100% of shares  he can be tempted to do things that benefit him privately at the expense of other shareholders (“pet” projects, perks, profit diversion, asset diversion, simply underprovision of effort) If he sells debt he still owns 100% and fully bears the consequences of his actions for the equity value If he sells debt he still owns 100% and fully bears the consequences of his actions for the equity value

22. Free cash flow problem Managers can be tempted to use available cash for projects that they like but are investments with NPV < 0 (e.g. empire building through acquisitions) Hence, the available cash should be reduced The way to do it is trough debt financing. Then the managers have lower discretion over cash because they must pay part of it to creditors as interest.

23. Agency Costs and the Tradeoff Theory

24. Tradeoff theory and observed leverage for different types of firms Young, R&D intensive firms usually have low leverage because: Low current free cash flow – little benefit from tax shield Low current free cash flow – little benefit from tax shield High human capital – large loss in case of bankruptcy High human capital – large loss in case of bankruptcy Easy to increase risk of business strategy – danger of the asset-substitution problem Easy to increase risk of business strategy – danger of the asset-substitution problem Often need to raise additional capital – debt overhang problem Often need to raise additional capital – debt overhang problem

25. Low-growth, mature firms usually have high leverage because: Stable current free cash flow – benefit from tax shield Stable current free cash flow – benefit from tax shield Tangible asses – low loss in case of bankruptcy Tangible asses – low loss in case of bankruptcy Seldom need to raise additional capital – debt overhang problem is unlikely Seldom need to raise additional capital – debt overhang problem is unlikely