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16-0
Chapter Sixteen
Corporate Finance
Capital Structure:
Ross Westerfield Jaffe
Limits to the Use of Debt


16
Seventh Edition
Seventh Edition
McGraw-Hill/Irwin
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
16-1
Chapter Outline
16.1
Costs of Financial Distress
16.2
Description of Costs
16.3
Can Costs of Debt Be Reduced?
16.4
Integration of Tax Effects and Financial Distress Costs
16.5
Signaling
16.6
Shirking, Perquisites, and Bad Investments:
A Note on Agency Cost of Equity
16.7
The Pecking-Order Theory
16.8
Growth and the Debt-Equity Ratio
16.9
Personal Taxes
16.10
How Firms Establish Capital Structure
16.11
Summary and Conclusions
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16-2
16.1 Costs of Financial Distress
• Bankruptcy risk versus bankruptcy cost.
• 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.
• It is the stockholders who bear these costs.
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16-3
16.2 Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a small
percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)
– Agency Costs
• Selfish strategy 1: Incentive to take large risks
• Selfish strategy 2: Incentive toward underinvestment
• Selfish Strategy 3: Milking the property
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16-4
Balance Sheet for a Company in Distress
Assets
Cash
Fixed Asset
Total
BV MV
$200 $200
$400
$0
$600 $200
Liabilities
LT bonds
Equity
Total
BV
$300
$300
$600
MV
$200
$0
$200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
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16-5
Selfish Strategy 1: Take Large Risks
The Gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
$100
NPV = –$200 +
(1.10)
NPV = –$133
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Selfish Stockholders Accept Negative NPV
Project with Large 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)
•PV of Stocks With the Gamble:
McGraw-Hill/Irwin
$70
$47 =
(1.50)
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16-7
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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16-8
Selfish Stockholders Forego Positive NPV
Project
Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
PV of Bonds With the Project:
PV of Stocks With the Project:
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$300
$272.73 =
(1.10)
$50
$54.55 =
– $100
(1.10)
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16-9
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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16-10
16.3 Can Costs of Debt Be Reduced?
• Protective Covenants
• Debt Consolidation:
– If we minimize the number of parties, contracting costs
fall.
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16-11
Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– Pay dividends beyond specified amount.
– Sell more senior debt & amount of new debt is limited.
– Refund existing bond issue with new bonds paying lower
interest rate.
– Buy another company’s bonds.
• Positive covenant: Thou shall:
–
–
–
–
Use proceeds from sale of assets for other assets.
Allow redemption in event of merger or spinoff.
Maintain good condition of assets.
Provide audited financial information.
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16-12
16.4 Integration of Tax Effects and
Financial Distress Costs
• There is a trade-off between the tax advantage of
debt and the costs of financial distress.
• It is difficult to express this with a precise and
rigorous formula.
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Integration of Tax Effects and Financial
Distress Costs
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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16-14
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.
• VT = S + B + G + L
S
B
L
G
• The essence of the M&M intuition is that VT depends on the
cash flow of the firm; capital structure just slices the pie.
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16-15
16.5 Signaling
• The firm’s capital structure is optimized where the
marginal subsidy to debt equals the marginal cost.
• Investors view debt as a signal of firm value.
– Firms with low anticipated profits will take on a low level
of debt.
– Firms with high anticipated profits will take on high
levels of debt.
• A manager that takes on more debt than is optimal
in order to fool investors will pay the cost in the
long run.
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16-16
16.6 Shirking, Perquisites, and Bad
Investments: The Agency Costs of Equity
• An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help”.
• Who bears the burden of these agency costs?
• While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
• The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
• The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
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16-17
16.7 The Pecking-Order Theory
• The pecking order theory states that firms prefer to
issue debt rather than equity if internal finance is
insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next. Issue equity last.
• The pecking-order theory is at odds with the tradeoff theory:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack.
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16-18
16.8 Growth and the Debt-Equity Ratio
• Growth implies significant equity financing, even in
a world with low bankruptcy costs.
• Thus, high-growth firms will have lower debt ratios
than low-growth firms.
• So: high growth firms have high equity.
• Growth is an essential feature of the real world; as a
result, 100% debt financing is sub-optimal.
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16-19
16.9 Personal Taxes: The Miller Model
• The Miller Model shows that the value of a levered firm
can be expressed in terms of an unlevered firm as:
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
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16-20
Personal Taxes: The Miller Model (cont.)
• Thus the Miller Model shows that the value of a levered
firm can be expressed in terms of an unlevered firm as:
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


 In the case where TB = TS, we return to MM with only
corporate tax:
VL  VU  TC B
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16-21
Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


VL = VU+TCB when TS =TB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VU
See example p. 459.
VL < VU when (1-TB) < (1-TC)×(1-TS)
Debt (B)
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16-22
Integration of Personal and Corporate Tax Effects
and Financial Distress Costs and Agency Costs
Present value of
financial distress costs
Value of firm (V)
Present value of tax
shield on debt
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum
firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
Agency Cost of Debt
Debt (B)
0
B*
Optimal amount of debt
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16-23
16.10 How Firms Establish Capital Structure
• Most Corporations Have Low Debt-Asset Ratios.
• Changes in Financial Leverage Affect Firm Value.
– Stock price increases with increases in leverage and
vice-versa; this is consistent with MM with taxes.
– Another interpretation is that firms signal good news
when they lever up.
• There are differences in capital structure across
Industries.
• There is evidence that firms behave as if they had
a target Debt to Equity ratio.
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Factors in Target D/E Ratio
• Taxes
– If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt.
• Types of Assets
– The costs of financial distress depend on the types of
assets the firm has.
• Uncertainty of Operating Income
– Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
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16-25
16.11 Summary and Conclusions
• Costs of financial distress cause firms to restrain
their issuance of debt.
– Direct costs
• Lawyers’ and accountants’ fees
– Indirect Costs
• Impaired ability to conduct business
• Incentives to take on risky projects
• Incentives to underinvest
• Incentive to milk the property
• Three techniques to reduce these costs are:
– Protective covenants
– Repurchase of debt prior to bankruptcy
– Consolidation of debt
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16-26
16.11 Summary and Conclusions
• Since the costs of financial distress can be reduced
but not eliminated, firms will not finance entirely
with debt.
Value of firm (V)
Present value of tax
shield on debt
Maximum
firm value
0
McGraw-Hill/Irwin
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
B*
Optimal amount of debt
Debt (B)
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16-27
16.11 Summary and Conclusions
• If distributions to equity holders are taxed at a lower effective
personal tax rate than interest, the tax advantage to debt at the
corporate level is partially offset. In fact, the corporate
advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB)
Value of firm (V)
Present value of
financial distress costs
Present value of tax
shield on debt
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum
firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
0
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Agency Cost of Debt
B*
Optimal amount of debt
Debt (B)
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16-28
16.11 Summary and Conclusions
• Debt-to-equity ratios vary across industries.
• Factors in Target D/E Ratio
– Taxes
• If corporate tax rates are higher than bondholder tax
rates, there is an advantage to debt.
– Types of Assets
• The costs of financial distress depend on the types of
assets the firm has.
– Uncertainty of Operating Income
• Even without debt, firms with uncertain operating
income have a high probability of experiencing
financial distress.
McGraw-Hill/Irwin
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