Download Capital Structure II:

Capital Structure II:
Limits to the Use of Debt
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.
Description of Bankruptcy 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

Balance Sheet for a Company in
Distress
Assets
BV MV
Cash
$200 $200
Fixed Asset $400
$0
Total
$600 $200
Liabilities BV MV
LT bonds $300 $200
Equity
$300 $0
Total
$600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
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 +
(1.50)
NPV = –$133
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
(1.50)
PV of Stocks With the Gamble: $47 = $70
(1.50)
PV of Bonds With the Gamble: $20 =
The value of firm becomes: 67 = 20 + 47 = 200 - 133
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)
Should we accept or reject?
NPV = $18.18
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:
$300
$272.73 =
(1.10)
$50
– $100
$-54.55 =
(1.10)
The value of firm = 272.73 – 54.55 = 218.18=200 + 18.18
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
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.
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
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
0
Debt (B)
B*
Optimal amount of debt
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.
Shirking, Perquisites, and Bad Investments: The
Agency Cost 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”.
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.
The managers may decide to pursue a capital structure
which is less levered than that implied by maximized value,
trying to reduce the risk in bankruptcy, thus the risk in
losing his own job.
The Pecking-Order Theory

Theory stating 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, equity last.
The pecking-order Theory is at odds with the
trade-off theory:



There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial slack
Growth and the Debt-Equity Ratio

High growth firms face high operating risk; so
they adopt less risky financial strategy.

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.

Growth is an essential feature of the real world;
as a result, 100% debt financing is sub-optimal.
Capital Structure and
Operating Risk


Operating risk: a firm’s facing uncertainty in
product prices, variable and fixed costs. This
risk does not involves with debt financing. We
can measure operating risk by standard
deviation of operating income, i.e. EBIT.
Financial risk: a firm facing uncertainty
resulted from debt financing. Using debt
increases uncertainty in EPS (and ROE).
Analysis on Operating risk（Break-even
Analysis）
Sales  VC  FC  EBIT  0
p  Q  v  Q  FC  0
FC
Q 
pv
*
FC
Sales  p  Q 
1  ( v / p)
*
*
Break-even Analysis

One firm could have two ways to produce the same
product. The first is to employ $20,000 fixed cost
and thus incurs $1.50 variable cost per unit. The
second is to employ $60,000 fixed cost and incurs
$1.00 variable cost per unit. What are the breakeven volume for each production method? On
what level of production volume that both ways will
produce the same level of EBIT? The price for the
product is $2.00.
The first method
FC
20, 000
Q 

 40, 000units
p  v 2  1. 5
*
The second method Q* 
FC 60, 000

 60, 000units
pv
2 1
On what level of production volume that both ways will
produce the same level of EBIT?
Sales  20, 000  1. 5Q  60, 000  Q
Q  80, 000
Sales  $2  80, 000  $160, 000
EBIT
1st
40,000
2nd
60,000 80,000 Sales/Quantity
Financial Break-even Analysis
A firm currently has $2,000,000 bond outstanding, which has
8% coupon rate, in addition to its 100,000 shares common
stock. The firm is consider to undertake $1,000,000 expansion
plan, which could be financed by either of two alternatives:
(1)100% debt financed which is issued on par and 10% coupon
rate
(2)100% equity financed with issuance of new stock, and at a
price of $10.
The firm expects its operating income (EBIT) to be $800,000,
and corporate income tax rate is 25%. What will be the
financial break-even points for both alternatives? What will be
the EBIT/EPS indifferent point? Which financing alternative
leads to higher EPS if the expected EBIT is $800,000?
EPS 
E PS 1 
( EBIT  I )  (1  t )  Dpf
n
( E B IT  I )  (1  t )  D
n
( E B IT  $260,000)  (1  0.25)

 0,
100,000
E B IT  $260,000
EPS2 
( EBIT  I )  (1  t )  Dpf
n
( EBIT  $160, 000)  (1  0. 25)

 0,
200, 000
EBIT  $160, 000
( EBIT *  $260, 000)  (1  0. 25) ( EBIT *  $160, 000)  (1  0. 25)
EPS1 

 EPS2
100, 000
200, 000
EBIT *  $360, 000
EPS
Alt 1
Alt 2
EBIT
160,000
260,000
360,000
800,000
Degree of Operating Leverage
%EBIT
DOL 
%Sales
Sales  VC
Sales  VC EBIT  FC
DOL 


Sales  VC  FC
EBIT
EBIT
Degree of Financial Leverage
%EPS
DFL 
%EBIT
DFL 
EBIT
EBIT  I 
D pf
1 t
Degree of Combined Leverage; DCL
%EBIT %EPS
%EPS
DCL  DOL  DFL 


%Sales %EBIT %Sales
EBIT  FC
DCL 

EBIT
EBIT  FC

D pf
D pf
EBIT  I 
EBIT  I 
1 t
1 t
EBIT
Integrate operating and financial
risk with financing alternatives



Firms try to manage total risk (financial and
operating) to an acceptable level.
Firms with high operating risk, tend to adopt
less financial risk financing (equity financing
dominant) alternatives, to avoid high interest
payment.
Firms with low operating risk, tend to adopt
more financial risk financing (debt financing
dominant) alternatives, to increase ROE.