Download Debt (B) Value of firm (V)

Capital Structure:
Limits
to
the
Use
of
Debt
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12-1
Financial Distress
• What will happen if firms borrow too much?
• Value of firm = value of all-equity financing +
PV(tax shield) – PV(cost of financial distress)
• PV(cost of financial distress) = Probability of
financial distress * amount of cost if distress occurs
• Financial distress vs. bankruptcy
• What kind of costs of financial distress?
12-2
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)
• growth opportunity
• suppliers and customers relationship
• human capital
– Agency Costs
• Selfish strategy 1: Incentive to take large risks
• Selfish strategy 2: Incentive toward underinvestment
• Selfish Strategy 3: Milking the property
12-3
Balance Sheet for a Company in Distress
Assets
Cash
Fixed Asset
Total
BV
$200
$400
$600
MV
$200
$0
$200
Liabilities
LT bonds
Equity
Total
BV MV
$200
$300
$0
$300
$600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
12-4
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
Accept?
$100
NPV  $200 
1.50
NPV  $133
Selfish Stockholders Accept Negative NPV
Project with Large Risks
12-5
• 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
• PV of Bonds With the Gamble = $30 / 1.5 = $20
• PV of Stocks With the Gamble = $70 / 1.5 = $47
12-6
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?
Selfish Stockholders Forego Positive NPV
Project
12-7
• 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 = $300 / 1.1 = $272.73
• PV of Stocks with the project = $50 / 1.1 - $100 = -$54.55
12-8
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
12-9
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
Debt (B)
0
B*
Optimal amount of debt
12-10
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.
12-11
Trade-off theory
• Tradeoff- between cost of financial distress and tax
shield
• It explains
– Stable firms use higher debt, growth firms with
huge intangible assets use small debts
– High tech firms use little debts.
• It does NOT explain
– the most profitable firms borrows the least!
12-12
The Pecking-Order Theory
• Information Asymmetry of external financing
• Theory stating that firms prefer internal financing,
followed by debt issues, and then equity financing
• The pecking-order Theory implies:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack ( cash buildup and
low leverage)
TABLE 14-1 Sources and uses of funds in nonfinancial corporations expressed as percentage of each
12-13
year's total investment.
1988
1989
1990
1991
1992
1993
1994
1995
1996
Uses.'
1. Capital expenditures
74
87
87
98
73
89
92
77
81
2. Investment in net
26
13
13
2
27
19
20
23
19
working capital and other
usesa
3. Total investment
100
100
100
100
100
100
100
100
100
Sources:
4. Internally generated
81
87
90
112
88
88
86
78
89
cash b
5. Financial deficit
19
13
10
-12
12
12
14
22
11
(5 - 4); equals required
external financing
Financial deficit covered
by:
6. Net stock issues
-26
-27
-14
3
6
4
-7
-8
-9
7. Net increase in debt
45
40
24
-14
7
8
21
30
20
1997
83
17
100
85
15
-14
30
a Changes in short-term borrowing are shown under net increase in debt. "Other uses" are net of any increase in
miscellaneous liabilities and any statistical discrepancy.
b Net income plus depreciation less cash dividends paid to stockholders
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds
Accounts, various issues.
12-14
Pecking order theory
• It explains:
– Debt financing is more frequently observed than
equity financing
– The most profitable firms borrows least
• It does NOT explain:
– High tech firms usually have low debt ratio
– Mature firms do not use earnings to payoff debt, and
instead, pay for dividends.
12-15
Capital Structure and Firm Value
• Changes in financial leverage affect firm value.
– Stock price increases with increases in leverage and vice-versa;
this is consistent with M&M with taxes.
– Another interpretation is that firms signal good news when
they lever up.
– Evidence of exchange offer and Leverage Buy-Out
• There are differences in capital structure across
Industries.
• There is evidence that firms behave as if they had a
target Debt to Equity ratio.
12-16
Factors in Target D/E Ratio
• 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.
12-17
The Agency Cost of Free Cash Flow
• Keeping large of internal funds make it easier for
firms to responds to growth opportunities,
• Agency costs of managers
• Who bears the burden of these agency costs?
• Free cash flow provides opportunity for managers
for pursuing private interests.
• To reduce agency costs of free cash flow
– increase in dividends
– increase in debt: even more effectively than
dividend increases.