Capital Structure – Limits to the Use of Debt RWJ Chp 16

1. Capital Structure – Limits to the Use of DebtRWJ Chp 16

2. 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 shareholders who bear these costs.

3. 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

4. Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash RM200 RM200 LT bonds RM300 F.Asset RM400 RM0 Equity RM300 Total RM600 RM200 Total RM600 RM200 What happens if the firm is liquidated today? RM200 RM0 The bondholders get RM200; the shareholders get nothing.

5. Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% RM1,000 Lose Big 90% RM0 Cost of investment is RM200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = RM1000 × 0.10 + RM0 = RM100

6. Selfish shareholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble • To Bondholders = RM300 × 0.10 + RM0 = RM30 • To shareholders = (RM1000 - RM300) × 0.10 + RM0 = RM70 • PV of Bonds Without the Gamble = RM200 • PV of Stocks Without the Gamble = RM0 • PV of Bonds With the Gamble = RM30 / 1.5 = RM20 • PV of Stocks With the Gamble = RM70 / 1.5 = RM47

7. Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees RM350 in one period • Cost of investment is RM300 (the firm only has RM200 now) so the shareholders will have to supply an additional RM100 to finance the project • Required return is 10% • Should we accept or reject?

8. Selfish shareholders Forego Positive NPV Project • Expected CF from the government sponsored project: • To Bondholder = RM300 • To Stockholder = (RM350 - RM300) = RM50 • PV of Bonds Without the Project = RM200 • PV of Stocks Without the Project = RM0 • PV of Bonds With the Project = RM300 / 1.1 = RM272.73 • PV of Stocks with the project = RM50 / 1.1 - RM100 = -RM54.55

9. Selfish Strategy 3: Milking the Property • Liquidating dividends • Suppose our firm paid out a RM200 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

10. Can Costs of Debt Be Reduced? • Protective Covenants • Debt Consolidation: • If we minimize the number of parties, contracting costs fall.

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.

12. 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.

13. Integration of Tax Effects and Financial Distress Costs Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Maximumfirm value Present value offinancial distress costs V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt

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 • The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie. S B G L

15. 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”. • 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 shareholders 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.

16. 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

17. 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. • Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal.

18. 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: Where: TS = personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate

19. Personal Taxes: The Miller Model The derivation is straightforward: Continued…

20. Personal Taxes: The Miller Model (cont.) The total cash flow to all stakeholders in the levered firm is: The first term is the cash flow of an unlevered firm after all taxes. Its value = VU. A bond is worth B. It promises to pay rBB×(1- TB) after taxes. Thus the value of the second term is: The value of the sum of these two terms must be VL

21. 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: • In the case where TB = TS, we return to M&M with only corporate tax:

22. Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes VL = VU+TCB when TS =TB Value of firm (V) VL < VU + TCBwhen TS < TB but (1-TB) > (1-TC)×(1-TS) VU VL =VU when (1-TB) = (1-TC)×(1-TS) VL < VU when (1-TB) < (1-TC)×(1-TS) Debt (B)

23. Agency Cost of Equity Agency Cost of Debt Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Present value offinancial distress costs Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB VL < VU + TCBwhen TS < TB but (1-TB) > (1-TC)×(1-TS) Maximumfirm value VU = Value of firm with no debt V = Actual value of firm 0 Debt (B) B* Optimal amount of debt

24. 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 M&M 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.

25. 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.

26. 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

27. Summary and Conclusions • Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt. Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Maximumfirm value Present value offinancial distress costs V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt

28. Agency Cost of Equity Agency Cost of Debt 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) Present value offinancial distress costs Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB VL < VU + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) Maximumfirm value VU = Value of firm with no debt V = Actual value of firm 0 Debt (B) B* Optimal amount of debt

29. 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 high probability of experiencing financial distress.