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Transcript
Capital Structure: Limits to the Use of Debt Click here for title 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.