corporate finance cap structure 1

8/20/2019 Corporate Finance Cap Structure 1

1/140

FINANCIAL DISTRESS, MANAGERIALINCENTIVES, AND INFORMATION

Corporate Finance


2/140

Default and Bankruptcy in a PerfectMarket• Financial Distress

• When a firm has difficulty meeting its debt obligations

• Default

• When a firm fails to make the required interest or principalpayments on its debt, or violates a debt covenant

• After the firm defaults, debt holders are given certain rights to the assetsof the firm and may even take legal ownership of the firm’s assetsthrough bankruptcy.

• An important consequence of leverage is the risk ofbankruptcy.

• Equity financing does not carry this risk. While equity holders hopeto receive dividends, the firm is not legally obligated to pay them.

2


3/140

Armin Industries:Leverage and the Risk of Default• Armin is considering a new project.

• While the new product represents a significant advance over Armin’s competitors’ products, the products success is uncertain.

• If it is a hit, revenues and profits will grow, and Armin will be worth $150

million at the end of the year.

• If it fails, Armin will be worth only $80 million.

3


4/140

Armin Industries: Leverage and the Risk of Default(cont'd)

• Armin may employ one of two alternativecapital structures.

• It can use all-equity financing.

• It can use debt that matures at the end of the year with a total of$100 million due.

4


5/140

Scenario 1: New Product Succeeds

• If the new product is successful, Armin is worth $150million.

• Without leverage, equity holders own the full amount.

• With leverage, Armin must make the $100 million debt payment,and Armin’s equity holders will own the remaining $50 million.

• Even if Armin does not have $100 million in cash available at the end ofthe year, it will not be forced to default on its debt.

5


6/140

Scenario 1:New Product Succeeds (cont'd)• With perfect capital markets, as long as the value of the

firm’s assets exceeds its liabilities, Armin will be able torepay the loan.

• If it does not have the cash immediately available, it can raise thecash by obtaining a new loan or by issuing new shares.

6


7/140

Scenario 1:New Product Succeeds (cont'd)• If a firm has access to capital markets and can issue new

securities at a fair price, then it need not default as longas the market value of its assets exceeds its liabilities .

• Many firms experience years of negative cash flows yet remainsolvent.

7


8/140

Scenario 2: New Product Fails

• If the new product fails, Armin is worth only $80 million.

• Without leverage, equity holders will lose $20 million.

• With leverage, Armin will experience financial distress and the firmwill default.

• In bankruptcy, debt holders will receive legal ownership of the firm’sassets, leaving Armin’s shareholders with nothing.

• Because the assets the debt holders receive have a value of $80 million, theywill suffer a loss of $20 million.

8


9/140

Comparing the Two Scenarios

• Both debt and equity holders are worse off if the productfails rather than succeeds.

• Without leverage, if the product fails equity holders lose $70 million.

• $150 million − $80 million = $70 million.• With leverage, equity holders lose $50 million, and debt holders

lose $20 million, but the total loss is the same, $70 million .

9


10/140

Table 16.1 Value of Debt and Equity with and withoutLeverage ($ millions)

10


11/140

Comparing the Two Scenarios (cont'd)

• If the new product fails, Armin ’ s investors are equallyunhappy whether the firm is levered and declaresbankruptcy or whether it is unlevered and the share pricedeclines .

• The decline in value is not caused by bankruptcy: thedecline is the same whether or not the firm has leverage.

• If the new product fails, Armin will experience economic distress,which is a significant decline in the value of a firm’s assets, whether

or not it experiences financial distress due to leverage.

11


12/140

Bankruptcy and Capital Structure

• With perfect capital markets, Modigliani-Miller (MM)Proposition I applies: The total value to all investors doesnot depend on the firm’s capital structure.

• There is no disadvantage to debt financing, and a firm willhave the same total value and will be able to raise thesame amount initially from investors with either choice ofcapital structure.

12


13/140

Textbook Example 16.1

13


14/140

Textbook Example 16.1 (cont'd)

14


15/140

The Costs of Bankruptcy and FinancialDistress• With perfect capital markets, the risk of bankruptcy is not

a disadvantage of debt, rather bankruptcy shifts theownership of the firm from equity holders to debt holderswithout changing the total value available to all investors.

• In reality, bankruptcy is rarely simple and straightforward. It is oftena long and complicated process that imposes both direct andindirect costs on the firm and its investors.

15


16/140

The Bankruptcy Code

• The U.S. bankruptcy code was created so that creditorsare treated fairly and the value of the assets is notneedlessly destroyed.

• U.S. firms can file for two forms of bankruptcy protection: Chapter 7or Chapter 11.

16

1


17/140

The Bankruptcy Code (cont'd)

• Chapter 7 Liquidation

• A trustee is appointed to oversee the liquidation of the firm’s assetsthrough an auction. The proceeds from the liquidation are used topay the firm’s creditors, and the firm ceases to exist.

17

18


18/140


• Chapter 11 Reorganization

• Chapter 11 is the more common form of bankruptcy for largecorporations.

• With Chapter 11, all pending collection attempts are automatically

suspended, and the firm’s existing management is given theopportunity to propose a reorganization plan.

• While developing the plan, management continues to operate thebusiness.

• The reorganization plan specifies the treatment of each creditor of

the firm.

18

19


19/140


• Chapter 11 Reorganization

• Creditors may receive cash payments and/or new debt or equitysecurities of the firm.

• The value of the cash and securities is typically less than the amount

each creditor is owed, but more than the creditors would receive if thefirm were shut down immediately and liquidated.

• The creditors must vote to accept the plan, and it must be approvedby the bankruptcy court.

• If an acceptable plan is not put forth, the court may ultimately forcea Chapter 7 liquidation.

19

20


20/140

Direct Costs of Bankruptcy

• The bankruptcy process is complex, time-consuming, andcostly.

• Costly outside experts are often hired by the firm to assist with thebankruptcy process.

• Creditors also incur costs during the bankruptcy process.

• They may wait several years to receive payment.

• They may hire their own experts for legal andprofessional advice.

20

21


21/140

Direct Costs of Bankruptcy (cont'd)

• The direct costs of bankruptcy reduce thevalue of the assets that the firm’s investors will ultimatelyreceive.

• The average direct costs of bankruptcy are approximately 3% to4% of the pre-bankruptcy market value of total assets.

• In the real world, there are several costs directly related tobankruptcy: legal expenses, court costs, advisory fees, theopportunity cost of the time the CEO and CFO spend talking with

creditors.

21

22


22/140

Direct Costs of Bankruptcy (cont'd)

• Given the direct costs of bankruptcy, firms may avoid filingfor bankruptcy by first negotiating directly with creditors.

• Workout• A method for avoiding bankruptcy in which a firm in financial

distress negotiates directly with its creditors to reorganize• The direct costs of bankruptcy should not substantially exceed the cost

of a workout.

• Prepackaged Bankruptcy (Prepack)

• A method for avoiding many of the legal and other direct costs of

bankruptcy in which a firm first develops a reorganization plan withthe agreement of its main creditors and then files Chapter 11 toimplement the plan

• With a prepackaged bankruptcy, the firm emerges from bankruptcyquickly and with minimal direct costs.

22

23


23/140

Indirect Costs of Financial Distress

• While the indirect costs are difficult to measure accurately,they are often much larger than the direct costs ofbankruptcy.

• It is estimated that the potential loss due to financial distress is 10% to

20% of firm value

• Agency Costs: conflicts between shareholders and debt holders(examples: Fire Sale of Assets; Delayed Liquidation; Costs toCreditors)

• Weakened ability to operate (examples: decrease in sales, loss ofcustomers; Loss of Customers; Loss of Suppliers; Loss ofEmployees; Loss of Receivables)

23

24


24/140

Overall Impact of Indirect Costs (cont'd)

• When estimating indirect costs, two important points mustbe considered.

• Losses to total firm value (and not solely losses to equity holders ordebt holders, or transfers between them) must be identified.

• The incremental losses that are associated with financial distress,above and beyond any losses that would occur due to the firm’seconomic distress, must be identified.

24

25


25/140

Financial Distress Costs and Firm Value

• Armin Industries: The Impact of FinancialDistress Costs

• With all-equity financing, Armin’s assets will be worth $150 million ifits new product succeeds and $80 million if the new product fails.

25

26


26/140

Financial Distress Costs and Firm Value

• Armin Industries: The Impact of FinancialDistress Costs

• With debt of $100 million, Armin will be forced into bankruptcy if thenew product fails.

• In this case, some of the value of Armin’s assets will be lost tobankruptcy and financial distress costs.

• As a result, debt holders will receive less than $80 million.

• Assume debt holders receive only $60 million after accounting for thecosts of financial distress.

26

27


27/140

Table 16.2 Value of Debt and Equity with and withoutLeverage ($ millions)

27

28


28/140

Financial Distress Costs and Firm Value(cont'd)• Armin Industries: The Impact of Financial

Distress Costs

• As shown on the previous slide, the total value to all investors isnow less with leverage than it is without leverage when the new

product fails.• The difference of $20 million is due to financialdistress costs.

• These costs will lower the total value of the firm with leverage, andMM’s Proposition I will no longer hold.

28

29


29/140


29

30


30/140


30

31


31/140

Who Pays for Financial Distress Costs?

• For Armin, if the new product fails, equity holders losetheir investment in the firm and will not care aboutbankruptcy costs.

• However, debt holders recognize that if the new product

fails and the firm defaults, they will not be able to get thefull value of the assets.• As a result, they will pay less for the debt initially (the present value

of the bankruptcy costs less).

31

32


32/140

Who Pays for Financial Distress Costs?(cont'd)• If the debt holders initially pay less for the debt, there is

less money available for the firm to pay dividends,repurchase shares, and make investments.

• This difference comes out of the equity holders’ pockets.

• When securities are fairly priced, the original shareholders of a firmpay the present value of the costs associated with bankruptcy andfinancial distress .

33


33/140


34


34/140


35


35/140

Optimal Capital Structure: The TradeoffTheory• Tradeoff Theory

• The firm picks its capital structure by trading off the benefits of thetax shield from debt against the costs of financial distress andagency costs.

36


36/140

Optimal Capital Structure: The TradeoffTheory (cont'd)• According to the tradeoff theory, the total value of a

levered firm equals the value of the firm without leverageplus the present value of the tax savings from debt, lessthe present value of financial distress costs.

(Interest Tax Shield) (Financial Distress Costs) L U V V PV PV

37


37/140

The Present Value of Financial DistressCosts

Three key factors determine the present value offinancial distress costs:

1. The probability of financial distress.

• The probability of financial distress increases with the amount of a

firm’s liabilities (relative to its assets).

• The probability of financial distress increases with the volatility of afirm’s cash flows and asset values.

2. The magnitude of the costs after a firm is in distress.

• Financial distress costs will vary by industry.• Technology firms will likely incur high financial distress costs due tothe potential for loss of customers and key personnel, as well as alack of tangible assets that can be easily liquidated.

• Real estate firms are likely to have low costs of financial distress sincethe majority of their assets can be sold relatively easily.

38


38/140

The Present Value of Financial DistressCosts (cont'd)

3. The appropriate discount rate for the distress costs.• Depends on the firm’s market risk

• Note that because distress costs are high when the firm does poorly,the beta of distress costs has the opposite sign to that of the firm.

• The higher the firm’s beta, the more negative the beta of its distresscosts will be

• The present value of distress costs will be higher for high betafirms.

39


39/140

Optimal Leverage

• For low levels of debt, the risk of default remains low andthe main effect of an increase in leverage is an increase inthe interest tax shield.

• As the level of debt increases, the probability of defaultincreases.

• As the level of debt increases, the costs of financial distressincrease, reducing the value of the levered firm.

40


40/140

Optimal Leverage (cont'd)

• The tradeoff theory states that firms should increase theirleverage until it reaches the level for which the firm valueis maximized.

• At this point, the tax savings that result from increasing leverage

are perfectly offset by the increased probability of incurring thecosts of financial distress.

• The tradeoff theory can help explain

• Why firms choose debt levels that are too low to fully exploit the

interest tax shield (due to the presence of financial distress costs)

• Differences in the use of leverage across industries (due todifferences in the magnitude of financial distress costs and thevolatility of cash flows)

41


41/140

Figure 16.1 Optimal Leverage with Taxesand Financial Distress Costs

42


42/140


43


43/140


44


44/140

Exploiting Debt Holders: The AgencyCosts of Leverage• Agency Costs

• Costs that arise when there are conflicts of interest between thefirm’s stakeholders

• Management will generally make decisionsthat increase the value of the firm’s equity. However, whena firm has leverage, managers may make decisions thatbenefit shareholders but harm the firm’s creditors andlower the total value of the firm.

45


45/140

Exploiting Debt Holders: The Agency Costs ofLeverage (cont'd)

• Consider Baxter, Inc., which is facingfinancial distress.

• Baxter has a loan of $1 million due at the end of the year.

• Without a change in its strategy, the market value of its assets willbe only $900,000 at that time, and Baxter will default on its debt.

46


46/140

Excessive Risk-Taking and Over-investment• Baxter is considering a new strategy

• The new strategy requires no upfront investment, but it has only a50% chance of success.

• If the new strategy succeeds, it will increase the value of

the firm’s asset to $1.3 million.

• If the new strategy fails, the value of the firm’s assets willfall to $300,000.

47


47/140

Excessive Risk-Taking and Over-investment (cont'd)• The expected value of the firm’s assets under the new

strategy is $800,000, a decline of $100,000 from the oldstrategy.

• 50% ! $1.3 million + 50% ! $300,000 = $800,000

• Despite the negative expected payoff, some within thefirm have suggested that Baxter should go ahead with thenew strategy.• Can shareholders benefit from this decision?

48


48/140

Excessive Risk-Taking and Over-investment (cont'd)• If Baxter does nothing, it will ultimately default and equity

holders will get nothing with certainty.• Equity holders have nothing to lose if Baxter tries the risky strategy.

• If the strategy succeeds, equity holders will receive

$300,000 after paying off the debt.• Given a 50% chance of success, the equity holders’ expected

payoff is $150,000.

49


49/140

Table 16.3 Outcomes for Baxter ’s Debt and Equity Under EachStrategy ($ thousands)

50


50/140

Excessive Risk-Taking and Over-investment (cont'd)• Equity holders gain from this strategy, even though it has

a negative expected payoff, while debt holders lose.

• If the project succeeds, debt holders are fully repaid and receive $1million.

• If the project fails, debt holders receive only $300,000.• The debt holders’ expected payoff is $650,000, a loss of $250,000

compared to the old strategy.

• 50% ! $1 million + 50% ! $300,000 = $650,000

51


51/140

Excessive Risk-Taking and Over-investment (cont'd)• The debt holders $250,000 loss corresponds to the

$100,000 expected decline in firm value due to the riskystrategy and the equity holder ’s $150,000 gain.

• Effectively, the equity holders are gambling with the debtholders’ money.

52


52/140

Excessive Risk-Taking and Over-investment• Over-investment Problem (or Asset Substitution)

• When a firm faces financial distress, shareholders can gain at theexpense of debt holders by taking a negative-NPV project, if it issufficiently risky.

• Shareholders have an incentive to invest in negative-NPVprojects that are risky, even though a negative-NPV project

destroys value for the firm overall.• Why? Think about option theory. Equity holders’ payoff is

equal to the payoff of a call option: unlimited upside, limiteddownside (if you assume limited liability!). • The value of equity increases if the firm selects risky investment

projects.

• Debt (a combination of the firm’s assets along with a shortposition in a call option on those assets) becomes less valuable ifthe firm’s investments become riskier.

• Anticipating this bad behavior, security holders will pay less for the firminitially.

53


53/140

Example: Howard Inc.

• Howard Inc. has 2 mutually exclusive investment opportunities, Rand S, which it plans to fund with debt. Each investment costs $50million. Project S pays off $60 million for certain, and Project R paysoff only $20 million when the economy is poor and $90 million whenthe economy is good. Assume risk neutral investors.• A) What is the NPV of each project, assuming the economy is

equally likely to be favorable or unfavorable and the discount rateis 0 percent?

• Suppose Howard can raise the $50m by issuing a bond with a facevalue of $50 million (because the lender naively think that thecompany will take the safe project)• B) Which project Howard’s shareholders prefer? • C) What is the expected payoff to the naïve lenders?

• Now assume that the debt holders are sophisticated.• D) What must the debt holders be promised, which project will the

company select, and what do the shareholders gain?


54/140

Howard: Solution

A) NPV S = 10 NPV R = 5

B) S R

Unfav. Fav.

CF 60 20 90

Debt Holders Payoff 50 20 50

Equity Holders Payoff 10 0 40

Expected payoff toEquity Holders

10 20

C) Expected payoff tonaïve debt holders

50 35

54

55


55/140

Howard: Solution

• D) Payoff to sophisticated debt holders:• Sophisticated debt holders know that equity holders

have an incentive to invest in project R. Thus, they willdemand a future payment of:

• (20+ x)/2 = 50 80• If debt holders require a payment of 80 in the

favorable state, the payoff to equity holder of project Ris 10 (90-80) in the favorable state and 0 in the

unfavorable state The expected payoff is 5.• Thus, shareholders are better off if they find a way to

commit themselves to select project S (10>5).

56


56/140

The reluctance to liquidate problem

• One of the most difficult decisions a firm must make is whether toremain in business.• It is optimal to liquidate if the net proceeds from liquidation exceed the

present value of the future cash flows that the firm would generate if itwere to continue operating.

• Bankruptcy and liquidation are not the same thing!• Bankruptcy doesn’t imply liquidation!

• There are many bankruptcy procedures under which firms are reorganized andcontinue operating (for example Chapter 11 in the U.S.)

• Liquidation costs are the difference between the firm’s going concern value(the present value of the future cash flows that the firm’s assets wouldgenerate if it were to continue operating), and its liquidation value, which iswhat the firm could collect by liquidating its assets and selling them.

• Capital structure can affect liquidation policy.

57


57/140

The reluctance to liquidate problem

• Managers of financially sounds firms, as representativesof their equity holders, have an incentive to continueoperating their firm even when the liquidation values ofthe firm exceed its going concern value. Why?• Because shareholders are residual claimants!

Shareholders are likely to receive nothing in aliquidation. Continuing to operate is the more riskyproject here!

• Managers are also interested in keeping the firmoperating because they are likely to lose their jobs if thefirm liquidates.

• Equity holders can also put more money into the firm ifthis means to keep the firm going and, thus, to extend thelife of their claims. In doing so, they hope to make a profitfrom the possible upside benefits that may be realized ifthe firm continues to operate.

58


58/140

Debt Overhang and Under-investment

• Now let’s go back to Baxter and assume does not pursuethe risky strategy but instead the firm is considering aninvestment opportunity that requires an initial investmentof $100,000 and will generate a risk-free return of 50%.

• If the current risk-free rate is 5%, this investment clearlyhas a positive NPV.

• What if Baxter does not have the cash on hand to make theinvestment?

• Could Baxter raise $100,000 in new equity to make theinvestment?

59


59/140

Table 16.4 Outcomes for Baxter ’s Debt and Equity with andwithout the New Project ($ thousands)

60


60/140

Debt Overhang and Under-investment(cont'd)• If equity holders contribute $100,000 to fund the project,

they get back only $50,000.

• The other $100,000 from the project goes to the debt holders,whose payoff increases from $900,000 to $1 million.

• The debt holders receive most of the benefit, thus this project is anegative-NPV investment opportunity for equity holders, eventhough it offers a positive NPV for the firm.

61


61/140

Debt Overhang and Under-investment• Under-investment Problem

• A situation in which equity holders choose not to invest in a positiveNPV project because the firm is in financial distress and the valueof undertaking the investment opportunity will accrue tobondholders rather than themselves.

• When a firm faces financial distress, it may choose not tofinance new, positive-NPV projects .

• This is also called a debt overhang problem.

62


62/140

The Balance Sheet of a Firm in Financial Distress

Assets BV MV Liability BV MVCash $200 $200 Debt $300 $200Fix. Assets $400 $0 Equity $300 $0Total $600 $200 Total $600 $200

What happens if you liquidate the firm today?

Debt holders get $200; Equity holders get nothing.

63


63/140

Example: Underinvestment

• Consider a project that guarantees $350 next year.• The project costs $300 and the firm only has cash for

$200. Thus, shareholders must finance the remaining$100.

• Assume that the discount rate for similar projects is10%

Should we accept or reject the project?

NPV = – $300 + $350

(1.10)

NPV = $18.18

64


64/140

Shareholders pass up positive NPV projects

Expected CF from the project: 350To Bondholders = $300

To Stockholders = ($350 – $300) = $50

PV of debt without project = $200

PV of equity without project= $0

(assume to put the $200 in bank deposit at 10%).

$272.73 =

$300

(1.10)

PV of debt with project:

– $100-$54.55 =

$50

(1.10) PV equity with project:

65


65/140


• Accepting the project implies a wealth transfer fromshareholders to bond holders of $54.55. Bond holdersalso obtain the project’s NPV of $18.18(54.55+18.18=$72.73).

• Shareholders will not accept the project even if NPV>0!!!

• We have assumed equity financing. What happens if theproject is paid for with debt?

Sh h ld iti NPV j t

66


66/140


• Let’s consider the debt seniority: • New debt is junior to existing debt: No way the project is financed!• The project generates 350, senior debt gets 300, new debt holders

get 50 after investing100!• New debt is senior to existing debt:

• New debt gets 100*(1+r), existing debt gets 350-100*(1+r). This is ok

with existing debt holders iff: [350-100*(1+r)]/(1.1)>200.• However, there are covenants that protect existing debt holders.

Covenants prevent the firm from issuing new debt with higher prioritythan the existing one.

• In this scenario, the debt contract has to be renegotiated. Easier saidthan done…

• To renegotiate a debt contract is particularly difficult when there aremany debt holders (free-rider problem).

Th Sh t i ht d I t t P bl

67


67/140

The Shortsighted Investment Problem

• During the LBOs golden era of the late 1980s, there wasa common claim that the increased use of debt financingby some firms worsened the shortsightedness of

American businesses.

• Debt can lead firms to prefer lower NPV projects that payoff quickly than higher NPV projects with lower initialcash flows.• The intuition for this is rooted in the debt overhang problem

(refinance the existing debt is very costly!).

68


68/140

An Example: Lester

• Lester Inc. has debt obligations that are due both nextyear ($100) and in two years ($40). Lester can choosebetween two projects:• Project A: short-term project generating cash flows of $50 in year

1 and 0 in year 2

• Project B: short-term project generating cash flows of $20 in year1 and $40 in year 2

• The risk-free rate is 0. All cash-flows are certain.

• The cash-flow from existing assets is $50 in year 1. In year 2, thecash flow is:

• In the favorable state (prob.= !), CF=$60,

• In the unfavorable state (prob.= !), CF=$10.

69


69/140

An example: Lester

• Year 1

• Lester chooses A: Lester is able to pay its $100 debtobligation in Year 1 ($50+$50).

• Lester chooses B: Lester cannot meet its debtobligation with its cash flows ($20+$50=$70). It needsadditional $30 of new debt. If it wants to issue juniordebt, Lester has to offer to pay the new lenders $50 inyear 2 to raise $30.

• Why? (Hint: compute the expected payoff for junior debtholders if the debt has a face value of $50).

L t

70


70/140

Lester

• Year 2• No project allows Lester to meet its debt obligation in the

unfavorable state.• Project A: cash for $10 but debt for $40

• Project B: cash for $50 (10+40) but debt for $90 (40+50).

• Equity is worth 0 in this state.

• Favorable state:• Project A: $20 (60-40-0)

• Project B: $10 (60-40+40-50)

• Thus, the firm’s equity holders are better off selecting theshort-term project even though it has a lower NPV. Why?

L t

71


71/140

Lester

• Why?• Because there is a wealth transfer from debt holders

whose debt is due in Year 2 and equity holders!

• These debt holders are paid in full in the unfavorable

state if the firm chooses the long-term project, but theyonly receive $10 if the short-term project is chosen.

• Thus, firms with large amounts of debt tend to pass uphigh NPV projects in favor of lower NPV projects that

pay off sooner.

72


72/140

Cashing Out

• When a firm faces financial distress, shareholders havean incentive to withdraw money from the firm, if possible.

• For example, if it is likely the company will default, the firm may sellassets below market value and use the funds to pay an immediate

cash dividend to the shareholders.• This is another form of under-investment that occurs when a firm faces

financial distress.

73


73/140

Estimating the Debt Overhang

• How much leverage must a firm have for there to be asignificant debt overhang problem?

• Suppose equity holders invest an amount I in a newinvestment with similar risk to the rest of the firm.

• Equity holders will benefit from the new investment only if:

D

E

NPV β D>

I β E

74


74/140


75


75/140

Textbook Example 16.5 (cont’d)

76


76/140

Agency Costs and the Value of Leverage

• Leverage can encourage managers and shareholders toact in ways that reduce firm value.

• It appears that the equity holders benefit at the expense of the debtholders.

• However, ultimately, it is the shareholders of the firm who bearthese agency costs.

77


77/140

Agency Costs and the Value of Leverage (cont'd)

• When a firm adds leverage to its capital structure, thedecision has two effects on the share price.

• The share price benefits from equity holders’ ability to exploit debtholders in times of distress.

• The debt holders recognize this possibility and pay less for the debtwhen it is issued, reducing the amount the firm can distribute toshareholders.

• Debt holders lose more than shareholders gain from these activities andthe net effect is a reduction in the initial share price of the firm.

78


78/140

Agency Costs and the Value of Leverage

• Agency costs of debt represent another cost of increasingthe firm’s leverage that will affect the firm’s optimal capitalstructure choice.

79


79/140


80


80/140


81


81/140

The Leverage Ratchet Effect

• Captures the observations that, once existing debt is inplace:

1. Shareholders may have an incentive to increase leverage evenif it decreases the value of the firm, and

2. Shareholders will not have an incentive to decrease leverageby buying back debt, even if it will increase the value of thefirm.

82


82/140


83


83/140


84


84/140

Debt Maturity and Covenants

• The magnitude of agency costs often depends on thematurity of debt.

• Agency costs are highest for long-term debt and smallest for short-term debt.

• Debt Covenants• Conditions of making a loan in which creditors place restrictions on

actions that a firm can take

• Covenants may help to reduce agency costs, however,

because covenants hinder management flexibility, theyhave the potential to prevent investment in positive NPVopportunities and can have costs of their own.

Motivating Managers:

85


85/140

Motivating Managers:The Agency Benefits of Leverage• Management Entrenchment

• A situation arising as the result of the separation of ownership andcontrol in which managers may make decisions that benefitthemselves at investors’ expenses

• Entrenchment may allow managers to run the firm in theirown best interests, rather than in the best interests of theshareholders.

86


86/140

Concentration of Ownership

• One advantage of using leverage is that it allows theoriginal owners of the firm to maintain their equity stake.

As major shareholders, they will have a strong interest indoing what is best for the firm.

87


87/140

Concentration of Ownership (cont'd)

• Assume Ross is the owner of a firm and he plans toexpand. He can either borrow the funds needed forexpansion or raise the money by selling shares in thefirm. If he issues equity, he will need to sell 40% of the

firm to raise the necessary funds.

88


88/140


• Suppose the value of the firm depends largely on Ross’spersonal effort.

• By financing the expansion with borrowed funds, Ross retains100% ownership in the firm. Therefore, Ross is likely to workharder, and the firm will be worth more since he will receive 100%

of the increase in firm value.

• However, if Ross sells new shares, he will only retain 60%ownership and only receive 60% of the increase in firm value.

89


89/140


• With leverage, Ross retains 100% ownership and willbear the full cost of any “perks,” like country clubmemberships or private jets.

• By selling equity, Ross bears only 60% of the cost; the

other 40% will be paid for by the new equity holders.• Thus, with equity financing, it is more likely that Ross will

overspend on these luxuries.

90


90/140


• By issuing new equity, the firm incurs the agency costs ofreduced effort and excessive spending on perks.

• As shown before, if securities are fairly priced, the original ownersof the firm will pay these costs.

• Using leverage can benefit the firm by preservingownership concentration and avoiding these agencycosts.

91


91/140

Reduction of Wasteful Investment

• A concern for large corporations is that managers maymake large, unprofitable investments.

• What would motivate managers to makenegative-NPV investments?

92


92/140


• Managers may engage in empire building .• Managers often prefer to run larger firms rather than smaller ones,

so they will take on investments that increase the size, but notnecessarily the profitability, of the firm.

• Managers of large firms tend to earn higher salaries, and they may alsohave more prestige and garner greater publicity than managers of smallfirms.

• Thus, managers may expand unprofitable divisions, pay too much foracquisitions, make unnecessary capital expenditures, or hire unnecessaryemployees.

93


93/140


• Managers may over-invest because theyare overconfident.

• Even when managers attempt to act in shareholders’ interests, theymay make mistakes.

• Managers tend to be bullish on the firm’s prospects and may believe

that new opportunities are better than they actually are.

94


94/140

Reduction of Wasteful Investment (cont'd)

• Free Cash Flow Hypothesis

• The view that wasteful spending is more likely to occur when firmshave high levels of cash flow in excess of what is needed aftermaking all positive-NPV investments and payments to debt holders

95


95/140


• When cash is tight, managers will be motivated to run thefirm as efficiently as possible.

• According to the free cash flow hypothesis,leverage increases firm value because it commits the firm to

making future interest payments, thereby reducing excess cashflows and wasteful investment by managers.

96


96/140


• Leverage can reduce the degree of managerialentrenchment because managers are more likely to befired when a firm faces financial distress.

• Managers who are less entrenched may be more concerned about

their performance and less likely to engage in wasteful investment.

• In addition, when the firm is highly levered, creditorsthemselves will closely monitor the actions of managers,providing an additional layer of management oversight.

97


97/140

Leverage and Commitment

• Leverage may also tie managers’ hands and commit themto pursue strategies with greater vigor than they wouldwithout the threat of financial distress.

• A firm with greater leverage may also become a fiercer

competitor and act more aggressively in protecting itsmarkets because it cannot risk the possibility ofbankruptcy.

Benefits of Financial distress with98


98/140

committed stakeholders

• There are situations where firms and stakeholders are nottransacting in a competitive market.• Example: negotiation with unions or a monopoly supplier.

• After specialized investments in human or physical capital havebeen made, the relationships between customers and suppliers,employees and employers, develop into bilateral monopolyrelationship. In these situations, the terms of trades (wages,prices) are open to negotiation.

• Financial distress may provide the firm with a negotiatingadvantage because suppliers and employees must consider howtheir demands affect the firm’s survival.• High debt levels may facilitate employee concessions during

business downturns.• Financial distress may be helpful to obtain government

subsidies, especially if the firm is large.

CS & Product Market Competition

99


99/140

CS & Product Market Competition

• CS can affect the competitiveness of an industry.We now examine how a firm’s leverage affects itscompetitors.

• CS can be used by a firm to credibly commit to agiven strategy. A credible signal that the firm iscommitted to a strategy (and cannot deviate fromit) can be a strategic advantage.

Debt & Product Market Competition

100


100/140

Debt & Product Market Competition

• Assume we are in an oligopoly.• Oligopoly: many customers, few firms.

• Debt can allow firms to commit to an aggressive outputpolicy that otherwise would not be able to carry out. Theaggressive output policy is necessary to repay the high

debt.• If there is no signal (debt), if the firm produced more

output, the additional production would reduce the price,and , thus, reduce profits for both the firm and itscompetitor.

• However, if the firm can send a credible signal, thecompetitors may accommodate the firm by reducing theiroutput instead of engaging in a price war. In this case, theaggressive policy does increase the firm’s profits.

Debt output and risk

101


101/140

Debt, output, and risk

• How does a high debt ratio help a firm send a crediblemessage?

• The answer is: risk. Higher leverage increases a firm’sincentive to invest in risky projects (we are only interestedin the upside of the investment project).

• Higher output can be seen as a risky investment project.Higher output increases risk because it leads to higherprofits when product demand is high, but lower profitswhen demand is low.

• If the firm has a high debt level, shareholders do not care aboutthe bad state of the world.

Debt & Product Market Competition – The other side

102


102/140

of the story

• However, this is not the full story. We know that debt financing canlead firms to reduce their level of investment, and thus, to act lessaggressively.

• Let’s consider a firm that can increase its market share loweringprices.

• This firm will have smaller profits in the short-run because of lowerprices, but it will realize greater profits in the long run because ofthe higher market share.

• Gaining market share is thus an investment that becomes more orless attractive as the relevant discount rate increases ordecreases. If the discount rate increases, the incentive to gainmarket share decreases.

• We already saw that highly levered firms use higher discount ratesto evaluate investments (because of the debt overhang problem).Thus, this implies that highly levered firms will compete lessaggressively in the product market.

Debt & Predation

103


103/140

Debt & Predation

• Debt will also affect rival firms’ strategies. In particular,highly leveraged firm might be vulnerable to predationfrom less leveraged competitors.

• Less leveraged competitors may try to drive a highly leverage firmout of business with a strategy of low prices (predation).

• This strategy is particularly effective in industry where customersand other stakeholders are concerned about the long-term viabilityof the firms with which they do business.

A C d h T d ff Th

104


104/140

Agency Costs and the Tradeoff Theory

• The value of the levered firm can now be shown to be

(Interest Tax Shield) (Financial Distress Costs)

(Agency Costs of Debt)+ (Agency Benefits of Debt)

L U V V PV PV

PV PV

Figure 16.2 Optimal Leverage with Taxes,105


105/140

Financial Distress, and Agency Costs

Th O ti l D bt L l

106


106/140

The Optimal Debt Level

• R&D-Intensive Firms• Firms with high R&D costs and future growth opportunities typically

maintain low debt levels.

• These firms tend to have low current free cash flows and risky

business strategies.• Low-Growth, Mature Firms

• Mature, low-growth firms with stable cash flows and tangible assetsoften carry a high-debt load.

• These firms tend to have high free cash flows with few goodinvestment opportunities.

D bt L l i P ti

107


107/140

Debt Levels in Practice

• Although the tradeoff theory explains how firms shouldchoose their capital structures to maximize value tocurrent shareholders, it may not coincide with what firmsactually do in practice.

D bt L l i P ti ( t'd)

108


108/140

Debt Levels in Practice (cont'd)

• Management Entrenchment Theory• A theory that suggests managers choose a capital structure to

avoid the discipline of debt and maintain their own job security

• Managers seek to minimize leverage to prevent the job loss that

would accompany financial distress, but are constrained from usingtoo little debt (to keep shareholders happy).

Asymmetric Information and Capital

109


109/140

Asymmetric Information and CapitalStructure• Asymmetric Information

• A situation in which parties have different information

• For example, when managers have superior information toinvestors regarding the firm’s future cash flows

L C dibl Si l

110


110/140

Leverage as a Credible Signal

• Credibility Principle• The principle that claims in one’s self-interest are credible only if

they are supported by actions that would be too costly to take if theclaims were untrue.

• “ Actions speak louder than words.”

L C dibl Si l ( t'd)

111


111/140

Leverage as a Credible Signal (cont'd)

• Assume a firm has a large new profitable project, butcannot discuss the project due to competitive reasons.

• One way to credibly communicate this positive information is tocommit the firm to large future debt payments.

• If the information is true, the firm will have no trouble making the debtpayments.

• If the information is false, the firm will have trouble paying its creditorsand will experience financial distress. This distress will be costly for thefirm.

L C dibl Si l ( t'd)

112


112/140

Leverage as a Credible Signal (cont'd)

• Signaling Theory of Debt• The use of leverage as a way to signal information to investors

• Thus a firm can use leverage as a way to convince investors that it doeshave information that the firm will grow, even if it cannot provideverifiable details about the sources of growth.

Debt as a credible signal113


113/140

• To be credible, a signal must be costly. Thus, for a capital structure decisionto credibly convey favorable information to investors, a firm with poorprospects must find it costly to mimic the decisions made by firms withfavorable prospects.• Good firms will use the less costly signal that permit them to separate themselves

from bad firms.

• The increase in the debt level satisfies this requirement because it

increases the probability of bankruptcy more for bad firms than good firms.• To convince investors, good firms often take on much more debt than itotherwise would have found optimal.

• The amount of debt that firms must use to send a credible signal dependson the manager’s incentive to increase the firm’s current stock price (to thedetriment of the future one).• If there is a big incentive to choose hit-and-run strategies, the amount of debt will

be higher.

Textbook Example 16 8

114


114/140


Textbook Example 16 8 (cont'd)

115


115/140


Issuing Equity and Adverse Selection

116


116/140


• Adverse Selection• The idea that when the buyers and sellers have different

information, the average quality of assets in the market will differfrom the average quality overall

• Lemons Principle• When a seller has private information about the value of a good,

buyers will discount the price they are willing to pay due to adverseselection.


117


117/140


• A classic example of adverse selection and the lemonsprinciple is the used car market.

• If the seller has private information about the quality of the car, thenhis desire to sell reveals the car is probably of low quality.

• Buyers are therefore reluctant to buy except at heavily discountedprices.

• Owners of high-quality cars are reluctant to sell because they knowbuyers will think they are selling a lemon and offer only a low price.

• Consequently, the quality and prices of cars sold in the used-carmarket are both low.

Textbook Example 16 9

118


118/140


Textbook Example 16 9 (cont'd)

119


119/140

Textbook Example 16.9 (contd)


120


120/140


• This same principle can be applied to the market forequity.

• Suppose the owner of a start-up company offers to sell you 70% ofhis stake in the firm. He states that he is selling only because hewants to diversify. You suspect the owner may be eager to sell such

a large stake because he may be trying to cash out before negativeinformation about the firm becomes public.

• Firms that sell new equity have private information aboutthe quality of the future projects.

• However, due to the lemon principle, buyers are reluctant to believemanagement’s assessment of the new projects and are only willingto buy the new equity at heavily discounted prices.


121


121/140


• Therefore, managers who know their prospects are good (andwhose securities will have a high value) will not sell new equity.

• Only those managers who know their firms have poorprospects (and whose securities will have low value) are willing

to sell new equity.• The lemons problem creates a cost for firms that need to raise

capital from investors to fund new investments (Myers andMajluf, 1984). As a result, firms can pass up good investmentprojects because they do not want to issue equity (and disclose

this information).• If they try to issue equity, investors will discount the price they are

willing to pay to reflect the possibility that managers have bad news.

Myers & Majluf (1984)

122


122/140

Myers & Majluf (1984)

• The firm will pass up an investment project ifthe intrinsic value of a firm’s share with theproject is lower than the value without theproject (P is the intrinsic value of one share, thetrue value known only by managers):

• P with project =(PV existing assets +PV newinvestment)/(# existing shares+#new shares)

• P without project= PV existing assets / # existing shares• These equations show that one firm can reduce the

intrinsic value of its shares if the PV of the newinvestment is low relative to the number of new sharesit must issue.

Example123


123/140

• A firm has assets whose value is $100m and 1m sharesoutstanding. A new project costs $70m and its value is $90m. Thecompany’s share is selling at $70 (Pm) on the market .

• P=100 without new investment project.• To raise $70m, the firm must issue one 1m shares.• P with investment project is: (100+90)/(1+1)= $95• The firm will reject a positive NPV project. Why?• Because if they issue new shares at $70, there is a wealth transfer

from old shareholders to new shareholders of $5 a share.• Old shareholders lose $25 million if they finance the project at these

conditions. The loss is only partially compensated by the NPV of theproject.• Managers (who run the firm on behalf of OLD shareholders) know

that they are giving the new shareholder a claim to $95m ($50existing assets +$45 from the new project) for the bargain price of$70m!!!

Debt financing to mitigate adversel ti

124


124/140

selection

• Managers can choose to issue debt and not equity when they believeequity is underpriced.

• With debt financing, the intrinsic value of a share is

• P with investment debt financing =(Existing value of assets+NPV ofthe new investment)/ #shares

• The value increases if the NPV of the project is greater than 0.• Results can change if debt is risky. In this case, we need to take

into account the possibility to incur the costs of financial distress.• Thus, firms finance some positive NPV project with debt (the ones

where NPV> costs of financial distress). They could become at leasttemporarily overleveraged.

What happens if equity is overvalued?125


125/140

• Firms have incentive to invest in negative NPVprojects and become underleverage if they canissue overvalued equity securities to financethese projects.

• Because of this incentive, the market reaction atthe announcement of a new equity issue isnegative. The announcement signals that the

stock is overpriced.

The Myers-Majluf model: A complete example

126


126/140

• Starting point: A firm needs $100 to finance a newinvestment project. The firm has no cash and it cannotuse debt-financing.

• Two states of the world are possible (good and bad).

They have the same probability (p=0.5). Managers knowthe state of the world, investors do not.

• In the good state, the value of existing assets is 150 andthe project NPV is 20.

• In the bad state, the value of existing assets is 50 andthe project NPV is 10.

Definition

127


127/140

• P’: market value of existing shares (old shares) if the firmissues shares and invest

• P: market value of existing (old) shares if the firm does notissue new shares (and thus it doesn’t invest).

• V: intrinsic value of the firm (true value, known only tomanagers)

• Va: intrinsic value of old shares

• Vn: intrinsic value of new shares

• E: amount raised issuing new shares (it is a market value)

Does it make sense to invest in both states?

128


128/140

• P’= 0.5(150+20)+0.5(50+10)=115

• Good state:• V=150+20+100=270

• 100 is the equity raised with the issue

• V=Va+Vn• The way value is shared among new and old

shareholders depends on market values, not intrinsicvalues.

• Va= [P’/(P’+E)] *V=[115/(115+100)]*270=144.42 • Vn= [E/(P’+E)] *V=[100/(115+100)]*270=125.58

Does it make sense to invest in both state?

129


129/140

Does it make sense to invest in both state?

• Bad State

• V=50+10+100=160

• Va= [P’/(P’+E)] *V=[115/(115+100)]*160=85.58

• Vn= [E/(P’+E)] *V=[100/(115+100)]*160=74.42

• So, the situation for the old shareholders is thefollowing:

Payoffs to old shareholders (Va)


130/140

Issue &Investment

No Issue & NoInvestment

Good State 144.42 150

Bad State 85.58 50

130

Shareholders’ decision

131


131/140

• Old shareholders will behave in this way:• Good state: No investment (and no issue)• Bad state: Issue & Investment.

•But if they choose “issue & investment”, then themarket knows that we are in the bad state!

• Rule: “Issue & Investment” only if we are in the badstate, but if the investors see the equity issue then

they realize we are in the bad state.• Therefore the situation becomes:

Shareholders’ decision

132


132/140

Shareholders decision

• V=160• P’=60

• Va= [P’/(P’+E)] *V=[60/(60+100)]*160=60

• Good state: Va=150

• Bad state: Va=60

What happens in the good state?

133


133/140

• Vn=125.58• E=100 (market value)

• There is a wealth transfer of 25.58 from oldshareholders to new ones!

• Old shareholders follow this rule:

Accept the project if the NPV of the project is

larger than the wealth transfer to newshareholders.

Implications for Equity Issuance

134


134/140

Implications for Equity Issuance

• The lemons principle directly implies that:• The stock price declines on the announcement of an equity issue .

• The stock price tends to rise prior to the announcement of an equityissue .

• Firms tend to issue equity when information asymmetries areminimized, such as immediately after earnings announcements .

Stock Returns Before and After an EquityI

135


135/140

Issue

Implications for Capital Structure

136


136/140


• Managers who perceive the firm ’ s equity is underpriced

will have a preference to fund investment using retainedearnings, or debt, rather than equity .

• The converse is also true: Managers who perceive the firm’s equity

to be overpriced will prefer to issue equity, as opposed to issuingdebt or using retained earnings, to fund investment.


137


137/140


• Pecking Order Hypothesis• The idea that managers will prefer to fund investments by first

using retained earnings, then debt and equity only as a last resort

• However, this hypothesis does not provide a clear prediction

regarding capital structure. While firms should prefer to useretained earnings, then debt, and then equity as funding sources,retained earnings are merely another form of equity financing.

• Firms might have low leverage either because they are unable to issueadditional debt and are forced to rely on equity financing or becausethey are sufficiently profitable to finance all investment using retainedearnings.

Figure 16.4 Aggregate Sources of Funding for CapitalExpenditures, U.S. Corporations

138


138/140

Source: Federal Reserve Flow of Funds.

Implications for Capital Structure (cont'd)

139


139/140

Implications for Capital Structure (cont d)

• Market Timing View of Capital Structure• The firm’s overall capital structure depends in part on the market

conditions that existed when it sought funding in the past.

Capital Structure: The Bottom Line

140


140/140

Capital Structure: The Bottom Line

• The optimal capital structure depends on marketimperfections, such as taxes, financial distress costs,agency costs, and asymmetric information.

corporate finance cap structure 1

Documents