Download Taxes and Bankruptcy Costs

BRN482
Corporate Financial Policy
Clifford W. Smith, Jr.
Summer 2007
Overhead 2
* Covers readings on course outline through Barclay/Smith/Watts (1997)
M/M (1958)
D
E
M/M (1958)
D
E
Historical Evidence
From Barclay/Smith/Watts (1997)
“
just wrap my arms
around the whole
backfield and peel
’em off one by one
until I get the ball
carrier. Him I keep”.
Gene “Big Daddy” Lipscomb
Relaxing the M/M Assumptions
Interest payments to bondholders are
deductible for tax purposes while
payments to equity holders are not.
Corporate Tax Liabilities
Tc
D
E
M/M (1963)
Corporate Tax Liabilities
Tc
D
E
M/M (1963)
Taxes and Bankruptcy Costs
BC Tc
D
E
Kraus/Litzenberger (1973)
Taxes and Bankruptcy Costs
BC
D
Tc
E
Kraus/Litzenberger (1973)
Bankruptcy Costs
 Warner examined the bankruptcies of 11
railroads to estimate the costs of bankruptcy.
 The bankruptcy proceedings typically lasted
many years. The average was 13 years, and
the longest was 23 years.
 On average these firms spent approximately
$2 million on the bankruptcy proceedings
Measuring Bankruptcy Costs
We can measure the bankruptcy costs in relation to
firm value at various points in time
0 - Filing date
T - Settlement date
(T = 13 years)
BC
= 5.3%
V0
BC
V-7
= 1.0%
Taxes and Bankruptcy Costs
 Merton Miller
– A case of horse and rabbit stew
– Analysis so far ignores personal
taxes and the effect of issuing debt on
the equilibrium in the bond market
Miller's Debt and Taxes
 Both corporations and individuals pay taxes.
 When corporations pay interest on debt, they
reduce their own taxes, but increase the
taxes of individuals.
 Ultimately, the corporation must bear all of
the taxes associated with its activities either
directly, or indirectly through higher required
rates of return on the securities that it issues.
Corporate and Personal Taxes
T p Tc
D
E
Miller (1977)
Corporate and Personal Taxes
Tp
D
Tc
E
Miller (1977)
DeAngelo and Masulis
Debt and Taxes
As corporations increase their debt, they
reduce the probability that they will pay the
highest marginal tax rate and be able to fully
utilize all tax credits and deductions.
Default
Zero taxes,
deductions not
fully utilized
Positive taxes,
tax credits not
fully utilized
Taxes paid
at the highest
marginal rate
Income
DeAngelo and Masulis
Debt and Taxes
In equilibrium, there is an optimal
capital structure for the economy as
a whole and for each individual firm.
DeAngelo and Masulis
Debt and Taxes
 In equilibrium, there is an optimal capital
structure for the economy as a whole and for
each individual firm
 Optimal leverage
B/V = B/V(tax credits, non-interest deductions
- + s2, BC, tc, tp)
What's Wrong With This Story?
 Large industrial firms with many physical
assets typically have many noninterest
deductions (like depreciation), large tax
credits (the investment tax credit), and also
high leverage.
 Firms with high dividend yields (like
regulated utilities) typically have high
leverage.
The DeAngelo/Masulis Capital
Structure Model with Taxes
 Holding other things constant, the logic of
the model is sound; it provides useful
information about optimal capital structure.
 The problem is that there are important
variables that are not included in the model.
As we examine firms in the real world, there
seems to be important determinants of
capital structure that are not captured by
this model.
The Effect of Capital Structure on
Real Investment Decisions
 The owner of an all equity firm will take all
positive NPV projects to maximize firm value.
 When a firm has both debt and equity, the
debt and equity holders sometimes disagree
about the optimal investment policy.
 Since equity holders have ultimate authority
over investment decisions, we have to be
concerned about how adding debt to the
capital structure affects equity holders'
investment incentives.
Agency Theory
 Jensen and Meckling
― An agency relationship is a contract under
which one or more persons (the principal)
engage another person (the agent) to perform
some service on their behalf which involves
delegating some decision making authority to
the agent.
― Often there is a blurred distinction between the
principal and the agent
― Agent responds to incentives and will not
always act in the best interests of the principal
Agency Theory
Jensen and Meckling provide a
definition of agency costs that
divides these costs into their
individual components:
Agency Theory
Jensen and Meckling provide a definition of
agency costs that divides these costs into
their individual components:
Agency
Monitoring
Bonding
Residual
+ Costs + Loss
Costs = Costs
Agency Theory
Jensen and Meckling provide a definition of
agency costs that divides these costs into
their individual components:
Agency
Costs
=
Monitoring
Costs
+
Bonding
Costs
Out-of-Pocket
Costs
+
Residual
Loss
Agency Theory
Jensen and Meckling provide a definition of
agency costs that divides these costs into
their individual components:
Agency
Costs
=
Monitoring
Costs
+
Bonding
Costs
Out-of-Pocket
Costs
+
Residual
Loss
Opportunity
Costs
Agency Theory
 Before Jensen and Meckling, it was common
to focus only on the out-of-pocket costs (M/M
theory focused on fixed investment policy)
 Contracts affect incentives for current and
future investments
 Private incentives exist within the contracting
process for the firm to maximize its current
market value as well as the "welfare" of
society
The Nexus of Contracts
Theory of the Firm
Lessors
Lessees
Suppliers
Customers
Shareholders
Firm
Bondholders
Board of
Directors
Managers
Employees
The Nexus of Contracts
Theory of the Firm
Lessors
Lessees
Suppliers
Customers
Shareholders
Firm
Bondholders
Board of
Directors
Managers
Employees
Conflicts of Interest
+ - + + + +
V = E(V, F, T, σ², r, DIV)
+ + - - - + B(V, F, T, σ², r, DIV)
Dividend payout
Claim dilution
Asset substitution
Underinvestment
A Simple Example
 Assume that capital markets are
competitive and that the appropriate
discount rate for all cash flows is zero.
 There are no taxes or transactions costs.
Project
A
B
0
-50
–
Time
1
100
-75
NPV
2
50
100
A Simple Example
 Assume that capital markets are
competitive and that the appropriate
discount rate for all cash flows is zero.
 There are no taxes or transactions costs.
Project
A
B
0
-50
–
Time
1
100
-75
NPV
2
50 = 100
100 = 25
A Simple Example
 Assume that capital markets are competitive
and that the appropriate discount rate for all
cash flows is zero.
 There are no taxes or transactions costs.
 Dividends can be paid in a period so long as
that period's promised payment to the
bondholders is made first.
Project
A
B
Bond
0
-50
–
?
Time
1
100
-75
-20
NPV
2
50 =
100 =
-100
100
25
A Simple Example
Project
A
B
0
-50
–
Bond
120
Time
1
100
-75
-20
NPV
2
50 = 100
100 = 25
-100
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
Bond
120
-20
70
5
DIV (A&B)
NPV
2
50
100
-100
50 = 125
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
NPV
Bond
120
-20
DIV (A&B)
70
5
50 = 125
DIV (A-)
70
80
– = 150
2
50
100
-100
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
Bond
120
-20
DIV (A&B)
70
5
DIV (A-)
70
80
NPV
2
50
100
-100
50 = 125
–
=
150
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
Bond
?
-20
NPV
2
50
100
-100
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
Bond
70
-20
NPV
2
50
100
-100
A Simple Example
Project
A
B
0
-50
–
Time
1
100
-75
Bond
70
-20
DIV (A&B)
20
5
NPV
2
50
100
-100
50 = 75
A Simple Example
Time
1
100
-75
2
50
100
-100
Project
A
B
0
-50
–
Bond
70
-20
DIV (A&B)
20
5
DIV (A-)
20
80
NPV
50 =
75
– = 100
The Underinvestment Problem
 Do I want to issue this bond?
 Who bears the agency costs of
increased leverage in this case? In
general?
 Equity holders have strong incentives to
structure debt contracts in a way that
minimizes the adverse incentive costs.
Less Leverage
Project
A
B
0
-50
–
Time
1
100
-75
Bond
?
-10
NPV
2
50
100
-50
Less Leverage
Project
A
B
Bond
0
-50
–
60
Time
1
100
-75
-10
NPV
2
50
100
-50
Less Leverage
Project
A
B
0
-50
–
Time
1
100
-75
2
50
100
-50
Bond
60
-10
DIV (A&B)
10
15
NPV
100 =
125
Less Leverage
Project
A
B
0
-50
–
Time
1
100
-75
NPV
2
50
100
-50
Bond
60
-10
DIV (A&B)
10
15
100 =
125
DIV (A-)
10
90
– =
100
Less Leverage
Project
A
B
0
-50
–
Time
1
100
-75
NPV
2
50
100
-50
Bond
60
-10
DIV (A&B)
10
15
100 =
125
DIV (A-)
10
90
– =
100
Which Bond Do I Want to Issue?
 High Leverage
Bond
70
-20
-100
DIV(A -)
20
80
–
= 100
 Low Leverage
Bond
60
-10
-50
DIV(A+B)
10
15
100
= 125
Investment Opportunity Set
Assets in
Place
Growth
Opportunities
Cost of Debt
(Underinvestment)
Low
High
Predicted Leverage
High
Low
Benchmarking
Corporate Leverage
Growth Options (Merck)
Impact on
Leverage
Lower
From Barclay/Smith/Watts (1997)
Economic Significance
From Barclay/Smith/Watts (1997)
Regulation
From Barclay/Smith/Watts (1997)
Benchmarking
Corporate Leverage
Impact on
Leverage
Growth Options (Merck)
Lower
Credence Goods (Eastern)
Lower
Product Warranties (Yugo)
Lower
Future Product Support (Yugo/Wang)
Lower
Benchmarking
Corporate Leverage
Impact on
Leverage
Growth Options (Merck)
Lower
Credence Goods (Eastern)
Lower
Product Warranties (Yugo)
Lower
Future Product Support (Yugo/Wang)
Lower
Supplier Financing (Campeau)
Lower
Closely Held Firm
Higher
Regulation
Higher
From Barclay/Smith/Watts (1997)
Benchmarking
Corporate Leverage
Impact on
Leverage
Growth Options (Merck)
Lower
Credence Goods (Eastern)
Lower
Product Warranties (Yugo)
Lower
Future Product Support (Yugo/Wang)
Lower
Supplier Financing (Campeau)
Lower
Closely Held Firm
Higher
Regulation
Higher
Tax Credits
Lower
Marginal Corporate Tax Rate
Higher
Marginal Personal Tax Rate
Lower
From Barclay/Smith/Watts (1997)
Benchmarking
Corporate Leverage
Impact on
Leverage
Growth Options (Merck)
Lower
Credence Goods (Eastern)
Lower
Product Warranties (Yugo)
Lower
Future Product Support (Yugo/Wang)
Lower
Supplier Financing (Campeau)
Lower
Closely Held Firm
Higher
Regulation
Higher
Tax Credits
Lower
Marginal Corporate Tax Rate
Higher
Marginal Personal Tax Rate
Lower
Information Costs
Higher
From Barclay/Smith/Watts (1997)
Signaling
From Barclay/Smith/Watts (1997)
Management Implications
 Benchmarking
– Rochester Gas & Electric
– Eastman Kodak
 Responding to change
– Frontier Communications
– Southern Company
Capital Structure Management
 Trade Off Hypothesis
 Pecking Order Hypothesis
 Market Timing Hypothesis
Don’t let the information age article
Pecking Order Hypothesis
 There is an important information asymmetry
between stockholders and managers
 “What you don’t know CAN hurt you”.
 If firm issues securities, those value depends on
firm value investors price-protect themselves.
 This cost is largest for equity, then risky debt;
internally generated capital is least expensive.
Pecking Order
 If there is an “optimal” capital structure,
the firm spends a lot of time away from it.
 Extreme Version: There is no optimal
capital structure – observed capital
structure is just the result of a sequence
of myopic financing choices.
Pecking Order
 Regression results are strong and
robust.
 Look at tails of distribution.
Market Timing
 Firm only issues equity when it’s
overvalued
 There is no optimal capital structure
Strategic Capital
Structure Management
 Determine the optimal capital structure
for the economic balance sheet.
 Look at the trajectory of capital structure.
 Whenever the costs of deviating from
target exceed the cost of adjustment adjust.
Adjustment Costs
Firm Value
Target
Leverage
Leverage
Adjustment Costs
Leverage
Target
Leverage
Time
Adjustment Costs
 Differ by transaction
─ Costs of share issues are higher than that for debt
─ Costs of share issues are higher than that of share
repurchases
 Exhibit fixed costs and scale economics
─ Equity offers are rare while bank loans are common
─ Optimal adjustment frequently involves
overshooting
─ Most companies spend considerable time away
from their target
Strategic Capital
Structure Management
 But investment opportunities are not
smooth – they are lumpy and episodic.
 Suppose you have a large growth option
– it will increase firm value by 50% and
take three years to exercise.
 How do you finance this project?
Table 1 All Firms
Mean INV/V of All Firms
0.07
0.06
0.05
0.04
0.03
0.02
0.01
14
16
18
20
14
16
18
20
14
16
18
20
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Mean D/V of All Firms
0.25
0.2
0.15
0.1
0.05
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Mean Cash/V of All Firms
0.12
0.1
0.08
0.06
0.04
0.02
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Table 1 All Firms [cont.]
Mean INV/A of All Firms
0.25
0.2
0.15
0.1
0.05
20
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Mean D/A of All Firms
0.3
0.25
0.2
0.15
0.1
0.05
14
16
18
20
14
16
18
20
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Mean Cash/A of All Firms
0.3
0.25
0.2
0.15
0.1
0.05
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
0
-1
2
0
Quarter relative to the quarter of SEO
Strategic Capital
Structure Management
 Pecking Order Hypothesis
 Market Timing Hypothesis
 Tradeoff Hypothesis
Table 2 Assets-In-Place Firms (28%) and Growth Firms (72%)
Mean INV/V
20
18
16
14
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
2
-1
0
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
Mean D/V
16
18
20
16
18
20
14
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
2
-1
0
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
Mean Cash/V
0.12
0.1
0.08
0.06
0.04
0.02
14
12
10
8
6
4
2
0
-2
-4
-6
-8
-1
2
-1
0
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
Table 2 Assets-In-Place Firms (28%) and Growth Firms (72%) [cont.]
Mean INV/A
0.25
0.2
0.15
0.1
0.05
18
15
12
9
6
3
0
-3
-6
-9
-1
2
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
Mean D/A
16
18
20
16
18
20
14
12
8
10
6
4
2
0
-2
-4
-6
-8
-1
2
-1
0
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
Mean Cash/A
14
12
8
10
6
4
2
0
-2
-4
-6
-8
-1
2
-1
0
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Quarter relative to the quarter of SEO
AIP Firms
Growth Firms
"Form Ever Follows Function"
Louis Henri Sullivan, 1896