Download Chapter 13

Chapter 13
Capital Structure: Non-Tax
Determinants Of Corporate Leverage
Del Hawley
FIN 634
Fall 2003
Chapter 13: Overview
• 13.1. Costs of Bankruptcy and Financial Distress
– What Makes Bankruptcy Costs Matter?
– Asset Characteristics and Bankruptcy Costs
– Direct and Indirect Costs of Bankruptcy
– International Differences in Bankruptcy Costs
• 13.2. Agency Costs and Capital Structure
– Using Debt to Overcome the Agency Costs of Equity
– Agency Costs of Outside Debt
– The Agency Cost/Tax Shield Trade-Off Model
• 13.3. The Pecking Order Hypothesis of Corporate Debt
– Assumptions Underlying the Pecking Order Hypothesis
– Limitations of the Pecking Order Hypothesis
Chapter 13: Overview
• 13.4. Signaling Models of Corporate Leverage
– How Capital Structure Signaling Convey Information
– Empirical Evidence on Capital Structure Signaling
• 13.5. Developing a Checklist For CS Decision-Making
– Leverage & Operating / Financial Variables Relationships
– Leverage & Ownership Structure Variables Relationships
– Leverage & Macroeconomic / Country Variables
• 13.6. Summary
Bankruptcy Risk Doesn’t Impact Capital
Structure--Unless It Is Costly
• Two companies, Low-Debt and High-Debt, have one-year
contracts to manage identical convention centers.
• Contract value depends on economic conditions over next year.
– If expansion continues, both will have CF of $3,500,000.
– If recession, both have CF of $1,100,000.
– Both have borrowed money; Low-Debt will owe $930,000 in one
year, High-Debt will owe $1,600,000.
• Low-Debt stockholders require a return of 6% and the firm’s
bondholders require 4.5%
• High-Debt stockholders expect a return of 6.25% and the
bondholders are requiring an expected return of 4.8%
Costs Of Financial Distress
• Direct costs of bankruptcy (out-of-pocket cash expenses)
– Legal, auditing and administrative costs (include court costs)
– Large in absolute amount, but only 1-2% of large firm value
• Indirect costs: Usually much more important
– Impaired ability to conduct business (e.g., lost sales)
– Managerial distraction, loss of best (most mobile) personnel
• Financial distress also gives managers adverse incentives
– Asset substitution problem: Incentive to take large risks
– Under-investment problem: S/Hs refuse to contribute funds
• Trade-off Model of Corporate Capital Structure
– Trade off tax benefits of debt vs costs of Financial distress:
V L = V U + PV Tax Shields - PV Bankruptcy Costs
(Eq 13.1)
Game #1: The Asset Substitution Problem
• When a firm falls into financial distress, has incentive to
play two damaging “games”.
– First is known as asset substitution
• Assume Firm Substitute has debt with a face value of
$12,000,000 outstanding that will mature in one month.
– Only has $10,000,000 of cash on hand now, but firm still
controls investment policy until default actually occurs
– If firm defaults, bondholders take over all remaining assets
(including cash on hand)
• Substitute’s managers offered two projects, both requiring
$10,000,000 cash investment & both paying off in 30 days:
– Safe promises a certain $10,200,000 payoff (2% monthly
return)
– Lottery offers a 25% chance of $13,000,000 payoff, and a
75% chance of $7,500,000: expected value = $8,875,000.
Game #1: Asset Substitution (Continued)
• Safe has positive NPV and is preferred by bondholders,but
stockholders and managers rationally choose Lottery
– If gamble is successful (payoff = $13,000,000 million), pay
off maturing debt, keep remaining $1,000,000
– If gamble unsuccessful, stockholders are no worse off, since
B/H will take firm’s remaining assets in 30 days anyway
• Game is important because S/Hs (through managers) have
incentive to gamble with bondholders’ money
– Would not accept Lottery if all-equity financed firm
– Would not accept Lottery if company was a partnership;
limited liability means B/Hs have no recourse to S/Hs
Game # 2: The Under-Investment Problem
• Second problem caused by financial distress is refusal by
S/Hs to contribute funds for positive NPV projects
– Occurs if S/Hs must contribute cash, but all project’s benefits
accrue to bondholders.
• Assume, as before, firm has $10,000,000 cash on hand and a
bond worth $12,000,000 maturing in 30 days
– Suppose firm is offered chance to purchase a competitor at a
discount price of $11,000,000, but offer open only 30 days
– Merger would maximize firm value, and B/H would accept; but
S/Hs control firm’s investment policy until default occurs
• Firm’s managers, acting for the S/Hs, would reject merger
– Even though value-maximizing, S/Hs have to contribute
additional $1,000,000 cash, yet firm will still default in 30 days
– If firm all-equity financed, S/Hs would invest additional cash
U.S. Bankruptcy Practices And Costs
• In U.S., bankruptcy governed by Federal law and filings are
made in Federal bankruptcy courts.
– If filing accepted, Bankruptcy court halts further prosecution
of creditor claims and court becomes ultimate firm master
• Two types of B/R filings in US for corporations: Chapter 7
(Liquidation) and Chapter 11 (Reorganization)
– Filing can be voluntary (by firm) or involuntary (by creditors)
– If voluntary Chapter 11 filing accepted, firm’s management
continues to operate firm, can propose reorganization plan
– If liquidation is selected by court, a trustee is usually
appointed to liquidate firm’s assets
• Proceeds from liquidation should be distributed according
to Absolute Priority Rule, with S/Hs last in line
– Courts often deviate from APR, so B/R often unpredictable
The Agency Cost / Tax Shield Trade-Off
Model Of Corporate Leverage
• “Mainstream” theory of corporate capital structure models
optimal leverage as a firm-specific trade-off
– Companies trade off the tax and agency cost benefits of debt
against the costs of bankruptcy and the agency costs of debt
– Firm V maximized at a unique optimal debt level (Eq 13.2)
PV Tax PV Bankruptcy PV Agency Costs PV Agency Costs
+
V L =VU +
Shields
Costs
of Outside Equity of Outside Debt
• Trade-off model has garnered much empirical support,
though far from perfect in its predictions:
– Weaknesses lead to development of Pecking Order Theory
The Optimal Amount of Debt and the Value
of the Firm
Market value
of firm (V)
Present value of
expected bankruptcy costs
Present value of interest
tax shields on debt
VL = Value of levered firm in
the absence of
bankruptcy costs
Maximum
firm value
V=Value of levered firm
with bankruptcy costs
VU=Value of firm under al equity financing
0
B*
Optimal amount of debt
Debt (B)
How Important
Is R&D
Spending To
Modern
Economies?
The Pecking Order Theory Of Corporate
Capital Structure
• Trade-off theory cannot explain three empirical CS facts
(1) Most profitable firms in an industry use least debt;
(2) Stock market response to leverage-increasing events is
strongly positive; negative to leverage-decreasing events
(3) Firms issue debt frequently, but rarely issue equity
• Myers (1984), Myers & Majluf (1984) proposed Pecking
Order Theory of Corporate Leverage
– Assumes manager acts in best interests of existing S/Hs
– Assumes info asymmetry between managers and investors
– Managers won’t issue under-valued stock for +NPV projects
• Makes two key predictions about managerial behavior:
(1) Firms hold financial slack so don’t have to issue securities
(2) If firm must issue securities, will follow pecking order and
sell first low-risk debt, using equity only as last resort.
Signaling And Other Asymmetric
Information Models of Corporate Leverage
• Third group of models, based on A/I between managers and
investors, predict managers will use a costly signal
– A simple statement of high firm value is not credible
– Must take action that is too costly for weak firm to mimic
– Crude signal: burn $100 bills; only wealthy can afford to do
• If signaling can differentiate between strong and weak firms
based on signal, a signaling equilibrium results
– Investors identify stronger firms, assign higher market value
• If signaling cannot differentiate between strong and weak
firms, a pooling equilibrium results
– Investors assign low average value to all firms
• Models predict high value firms use high leverage as signal
– Makes sense, but empirics show the opposite—most
profitable & highest market/book firms use least leverage
A Checklist for Capital Structure
Decision-Making
Variable
Documented relationship
between variable and leverage
Profitability
Negative
Market-to-book ratio
Negative
Earnings volatility
Negative
Non-debt tax shields
Negative
Effective (marginal) corp tax rate
Positive
Regulation (regulated industry?)
Positive
Firm size
Positive
Asset tangibility
Positive
A Checklist for Capital Structure
Decision-Making
Variable
Documented relationship
between variable and leverage
Growth rate of firm’s assets
Ambiguous
Insider share ownership
Ambiguous
Managerial entrenchment
Negative
Creditor power in bankruptcy
Negative
Corporate income tax rate (c)
Positive
Personal tax rate, equity income (ps)
Positive
Personal tax rate, debt income (pb)
Negative
State ownership
Positive