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Capital structure II
Bankruptcy cost
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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Costs of Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or
distorted business decisions before bankruptcy.
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
 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.
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Example: Company in Distress
Firm A(debt=0)
Assets
Boom Rec
Cash flow
$150 $80
BH
$0
$0
SH
$150 $80
Firm B ( debt=100 in 1 year)
Boom
Rec
$150
$80
$100
$80
$50
$0
Boom and Rec occur with prob=50%. No taxes
Debt due in one year with Interest rate=5%, assume debt and
equity bear the same risk(same discount factor)
The value of the two firms are still the same:
the risk of bankruptcy itself will not lower value.
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Example: Company in Distress
Assets
Cash flow
BH
SH
Firm B ( debt=100)
there is bankruptcy
Boom
Rec
cost=$20 in 1 year
$150
$80
$100
$ 60
$50
$0
PV(FDC) = (20*0.5)/1.05=9.52
S= (50 * 0.5 +0)/1.05=23.81
B= (100* 0.5 +60 *0.5)/1.05 = 76.19
V = S+B= 23.81+76.19=100
It is the costs associated with bankruptcy which
reduces the firm value !
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Where come the Financial Distress Costs
 Direct Costs
 Legal and administrative costs
 Indirect Costs
 Impaired ability to conduct business (e.g., lost sales)
 Agency Costs
 Mangers/stockholders may take selfish strategies to the
detrimental of the interest of bondholders or the firm.
 These strategies are costly because they may lower the market
value of the whole firm.
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Direct costs
 Direct cost can be born by creditors in case of default.
 Legal fees and lawyers appointments



Enron: $30 milliion/month on legal and accounting fees ≈$1b
in total, 10% of asset value.
WorldCom: $600m,
Lehman brother: nearly $ 2 billion.
 Time spent to renegotiate the debt repayment schedule

Creditors often wait several years for a reorganization plan to
be approved.

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Indirect costs
 Sales are frequently lost because of both fear of
impaired service and loss of trust.
 Difficulties in hiring and retaining good people often
result in forgone revenues, opportunity costs, etc.
 Reluctance of bankruptcy by government,
bondholders may cause further damage.
 Total cost of financial distress can range from 3-20% of
the firm value.
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Who pays for bankruptcy costs?
 Apparently, BH bears the bankruptcy cost, why should
SH care about costs borne by BH?
 BH are not foolish: anticipating they will get less in case
of bankruptcy, pay less for the debt initially.
 How much less?
 Precisely =PV (bankruptcy costs)
 BH asks for a higher interest payment to compensate the
costs before bankruptcy occurs.
 Less money available for SH.
=> Ultimately, these costs are shifted to stockholders.
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What happens to the MVBS?
Firm A (unlevered)
Firm B (debt=100 in 1 year)
Assets 109.52 | Equity 109.52
| Debt 0
Total 109.52 | B+S 109.52
Assets 100
Total
100
| Equity 23.81
| Debt 76.19
| B+S 100
• The firm sells a bond for 76.19 but has to pay 100 in 1 year.
• Assume firm A has 100 shares outstanding, what will be the
price change if the firm announce a change in capital structure
to that of firm B (issue debt, repurchase shares)?
True or False: If bankruptcy costs are only incurred once the
firm is in bankruptcy and its equity is worthless, then these
costs will not affect the initial value of the firm.
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Agency cost (SH vs BH)
 The selfish strategies represent agency costs between
bondholders and stockholders.
 These costs exist because stockholders enjoy limited
liability and payoffs to bondholders are limited.
 When a firm is in financial distress, investment
strategies that maximize firm value may no longer
maximize the value of stockholders.
 Selfish Strategy 1: Incentive to take large risks
 Selfish Strategy 2: Incentive toward underinvestment
 Selfish Strategy 3: Milking the property
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Selfish Strategy 1: Take Risks
The Gamble
Probability
Payoff in 1 year
Win Big
10%
$1,000
Lose Big
90%
$0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Debt payment due next year =$ 300
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
$100
NPV = –$200 +
(1.50)
NPV = –$133
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Selfish Strategy 1: Take Risks
 Expected CF from the Gamble
 To Bondholders = $300 × 0.10 + $0 = $30
 To Stockholders = ($1000 – $300) × 0.10 + $0 = $70
 PV of Bonds Without the Gamble = $200
 PV of Stocks Without the Gamble = $0
$30
• PV of Bonds With the Gamble: $20 =
(1.50)
$70
• PV of Stocks With the Gamble: $47 =
(1.50)
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Selfish Strategy 2: Underinvestment
 Consider a government-sponsored project that guarantees
$350 in one period.
 Cost of investment is $300 (the firm only has $200 now), so
the stockholders will have to supply an additional $100 to
finance the project.
 Required return is 10%.
$350
NPV = –$300 +
(1.10)
NPV = $18.18
Should we accept or reject?
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Selfish Strategy 2: Underinvestment
Expected CF from the government sponsored
project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50
PV of Bonds With the Project:
PV of Stocks With the Project:
$300
$272.73 =
(1.10)
– $54.55
=
$50
(1.10)
– $100
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
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Selfish Strategy 3: Milking the Property
 Liquidating dividends
 Suppose 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
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Can Costs of Debt Be Reduced?
 Short-term debt
 With
long-term debt, equity holders have more
opportunities to ripe the bond holders’ interests.
 Agency costs are smallest for short-term debt.
 Protective Covenants
 SHs make agreements with BHs in hopes of lower rates.
 A broken covenant leads to default.
 Examples: prohibit to pay large dividends , restrict the
types of investment, limit the issue of new debt.
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The 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 lawyers, respectively.
 The essence of the M&M intuition is that VT
depends on the cash flow of the firm; capital
structure just slices the pie.
S
 VT = S + B + G + L
B
 The role of manager is to
Max the marketable claims(S+B)
G
L
Min the non marketable claims (L+G)
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Tax Effects VS Financial Distress
 There is a trade-off between the tax advantage of
debt and the costs of financial distress.
 The optimal capital structure should be such that the
marginal benefit from tax shield equals the marginal
cost of financial distress.
 It is difficult to express this with a precise and
rigorous formula.
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Trade-off theory of capital
structure
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on 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
Debt (B)
B*
Optimal amount of debt
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Other benefit of leverage—
agency benefits
 Agency costs arises also between managers and the
firm
Managers with higher ownership concentration are
more likely to work hard to the shareholder’s interest.
Debt financing avoid the dilution of ownership.
 However, ownership becomes diluted overtime as a
firm grows.
Conflict of interest between managers and shareholders

Taking large, unprofitable investments, pay too much for
acquisitions, hire unnecessary employess…
Reducing free cash to discipline managers: issuing debt
(use free cash to pay interest and principal)
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Other benefit of leverage
—Debt Signaling
 Under information asymmetry: investors may not know the
firm’s profitability.
 Debt can be viewed as a signal of firm value.
 Firms with high anticipated profits will take on a high level of debt.
 The signal is credible because high leverage is too costly for low
profitable firms.
Problem: Suppose that Beltran currently uses all-equity financing,
and that Beltran’s market value in one year’s time will be either $100
million or $50 million depending on the success of business.
Currently, investors does not know which value the firm will end, but
the manger has information that success is virtually certain. Will
leverage of $25 million make the manager’s claims credible? How
about leverage of $55 million?
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Can trade-off theory explain the
company’s behavior?
 Yes:
 Most of the companies have a target debt ratio.
 Which company has higher debt ratio?



Company with risky and intangible assets v.s. with tangible and
safe assets.
Company paying heavy taxes v.s. low taxes
Profitable firm v.s. less profitable firm
 No:
 Some successful firms still run with little debt: Google.
 Debt ratios today are no higher than they were in the
early 1900s, when tax rates are low.
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Debt or Equity under Information
asymmetry
 The manager must know more about his firm than
investors.
 Equity value is unknown to investors (Lemon problem)
 If the firm is overvalued, the stock price will fall in the future. Then
the manager can make profit for the current shareholders by selling
it at a high price.
 However, investors anticipating this will not purchase the stock,
until the price falls. (adverse selection problem)
=>Better to issue debt, the value of which is less sensitive
to managers’ private information!
 However, issue debt may also suffer from information
problem, especially risky debt.
=> Better use the firm’s own money, i.e. retained earning.
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Implication for capital structure
—The Pecking-Order Theory
 Rule 1: Use internal financing first
 Using cash can avoid the cost of financial distress
 Firms first fund their project with retained earnings
(target div/ payout ratio)
 Rule 2: Issue debt next, new equity last
 Information asymmetry is less for Debt than for Equity:
issue debt up to the debt capacity (the level which just
leads to financial distress)
 Issue the safest securities first
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Implication of the Pecking-order theory
 There is no target D/E ratio
 Two kinds of equity: internal (1st order) and external
(last order).
 Debt to equity ratio may be lower if large internal funds
are used.
 Profitable firms use less debt
 The attraction of interest tax shield is at 2nd order
 Companies like financial slack
 Firms will accumulate cash today in order to fund
profitable projects in the future.
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Choice of capital structure
 According to the POT, what are the most likely capital
structures?
 Highly profitable firms with lots of investment
opportunities
 Highly profitable firms with limited investment
opportunities
 Less profitable firms with little investment
opportunities.
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Bright side and dark side of financial slack
 Bright side:
 having cash, marketable securities, readily salable real
assets, and ready access to debt markets or to bank
financing.
 Most valuable to firms with plenty of positive NPV
growth opportunities.
 Dark side: free cash flow hypothesis
 Managers may attempt to pursue wasteful activities:
investing too much (agency cost: manager v.s. company)
 Discipline managers: issuing debt (use free cash to
interest and principal)
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Average leverage by industrial
sectors
(source BMA p. 750, data 2008)
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International Comparison of
Capital Structure

Fan, J. P., Twite, G. J., & Titman, S. (2011). An International Comparison of Capital Structure and Debt
Maturity Choices. Journal of Financial and Quantitative Analysis, 47(1), 23-56.
 Corporate financing choices are determined by firm characteristics and
institutional environment
 Institution environment:
 Ability of creditors to enforce legal contracts:



Strength of legal system
Corruption
Bankruptcy code
 Tax treatment: are corporate profits double taxed?
 Supplies of capital: Large banking sector or not
Firm characteristics:

Asset tangibility , profitability, firm size, market-to-book ratio
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Median Leverage ratio
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Source: lecture notes of Damodaron
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