Chapter 17
CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT
SLIDES
CHAPTER ORGANIZATION
17.1 Costs of Financial Distress
Bankruptcy Risk or Bankruptcy Cost?
17.2 Description of Financial Distress Costs
Direct Costs of Financial Distress: Legal and Administrative Costs of
Liquidation or Reorganization
Indirect Costs of Financial Distress
Agency Costs
17.3 Can Costs of Debt Be Reduced?
Protective Covenants
Consolidation of Debt
17.1 Key Concepts and Skills
17.2 Chapter Outline
17.3 Costs of Financial Distress
17.4 Description of Financial Distress Costs
17.5 Example: Company in Distress
17.6 Selfish Strategy 1: Take Risks
17.7 Selfish Strategy 1: Take Risks
17.8 Selfish Strategy 2: Underinvestment
17.9 Selfish Strategy 2: Underinvestment
17.10 Selfish Strategy 3: Milking the Property
17.11 Can Costs of Debt Be Reduced?
17.12 Tax Effects and Financial Distress
17.13 Tax Effects and Financial Distress
17.14 The Pie Model Revisited
17.15 Signaling
17.16 The Agency Cost of Equity
17.17 The Pecking-Order Theory
17.18 Personal Taxes
17.19 Personal Taxes
17.20 Personal Taxes
17.21 How Firms Establish Capital Structure
17.22 Factors in Target D/E Ratio
17.23 Quick Quiz
17.4 Integration of Tax Effects and Financial Distress Costs
Pie Again
17.5 Signaling
17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Effect of Agency Costs of Equity on Debt-Equity Financing
Free Cash Flow
17.7 The Pecking-Order Theory
Rules of the Pecking Order
Implications
17.8 Personal Taxes
The Basics of Personal Taxes
The Effect of Personal Taxes on Capital Structure
17.9 How Firms Establish Capital Structure
ANNOTATED CHAPTER OUTLINE
Slide 17.0 Chapter 17 Title Slide
Slide 17.1 Key Concepts and Skills
Slide 17.2 Chapter Outline
17.1. Costs of Financial Distress
Slide 17.3 Costs of Financial Distress
.A Bankruptcy Risk or Bankruptcy Cost?
In the MM model with corporate taxes there is no limit to the
increase in firm value and equity value from the use of financial
leverage. Common sense tells us that companies are not financed
100% by debt. What are some factors that hold back financial
managers from using financial leverage? Bankruptcy costs eat up
some of the corporate “pie.”
Lecture Tip: In 1997, the remaining assets of Fruehauf
Corporation, described by Barrons as “the once-dominant”
manufacturer of truck trailers, were sold off for a mere $50
million, bringing an end to the story of a great firm laid low by
over-reliance on debt financing.
Founded in the 1940’s, the firm controlled one-third of the
trailer market in the early 1980’s, but then went private in a
leveraged buyout in 1986 to avoid a hostile takeover bid. Saddled
with debt it found difficult to service, the firm went through a
number of restructurings until the firm filed for chapter 11 in 1996.
At that time its shares were delisted from the NYSE. And, as
Barrons notes, “… the shareholders had been wiped out, leaving
the carcass to be picked over by those with secure claims to
Fruehauf’s assets … [b]lood was in the water.” By 1997, the last
division was sold, and the remaining assets were sold to Wabash
National.
A more recent example may further highlight the potential
negative consequences of leverage. Specifically, consider financial
firms such as Lehman and AIG who were bankrupted or bailed out
as a result of the impact of excessive leverage, or exposure thereto.
17.2. Description of Financial Distress Costs
Slide 17.4 Description of Financial Distress Costs
.A Direct Costs of Financial Distress: Legal and Administrative Costs
of Liquidation or Reorganization
The key disadvantage of the use of debt is bankruptcy costs.
Direct bankruptcy costs are the legal and administrative expenses
directly associated with bankruptcy. Generally, these costs are
quantifiable and measurable.
.B Indirect Costs of Financial Distress
Indirect bankruptcy costs (e.g., difficulties in hiring and retaining good people
because the firm is in financial difficulty) are hard to measure and
generally take the form of forgone revenues, opportunity costs, etc.
.C Agency Costs
The selfish strategies represent agency costs between bondholders and
stockholders. These costs exist because stockholders enjoy limited
liability and payoffs to bondholders are limited. When a firm is in
financial distress, investment strategies that maximize firm value
may no longer maximize the value of stockholders.
To focus on the conflicts between bondholders and stockholders, assume that
there is only one stockholder, who is also the manager.
Therefore, he will always act in the best interests of the
stockholders (himself). An important characteristic of this example is that the
company is already in financial distress. The firm is not bankrupt
yet because the bonds are due tomorrow. The owner-manager can
make one last investment today.
Slide 17.5 Example: Company in Distress
Slide 17.6 –
Slide 17.7 Selfish Strategy 1: Take Risks
Selfish Investment Strategy 1: Incentive to take large risks
-The payoff structure for equity is asymmetric, which increases the
incentive to take on projects that have large possible payoffs, even
if the probability of the payoff is small.
Lecture Tip: This strategy is ideal for illustrating that equity,
particularly in bankruptcy, can be viewed as a call option on the
firm’s debt.
Slide 17.8 –
Slide 17.9 Selfish Strategy 2: Underinvestment
Selfish Investment Strategy 2: Incentive toward underinvestment
-Unless a project generates sufficient cash flow to cover any
existing shortfall, as well as a payoff for shareholders, the added
cost is not worth it.
Slide 17.10 Selfish Strategy 3: Milking the Property
Selfish Investment Strategy 3: Milking the property
-Owners could pay out cash as dividends prior to debt coming due;
however, this is likely controlled by protective covenants.
17.3. Can Costs of Debt Be Reduced?
Slide 17.11 Can Costs of Debt Be Reduced?
.A Protective Covenants
Covenants were discussed in a prior chapter. The point here,
though, is that these covenants can reduce bankruptcy costs.
.B Consolidation of Debt
When multiple creditors are involved, bankruptcy costs are higher
due to negotiating and legal fighting. With consolidated loans,
these costs are reduced.
17.4. Integration of Tax Effects and Financial Distress Costs
Slide 17.12 –
Slide 17.13 Tax Effects and Financial Distress
Firms borrow because tax shields are valuable.
Borrowing is constrained by the costs of financial distress.
The optimal capital structure balances the incremental benefits and costs of
borrowing.
With corporate taxes and bankruptcy costs, firm value is
maximized where the additional benefit from the interest tax shield
is just offset by the increase in expected bankruptcy costs, which
implies there is an optimal capital structure.
The direct costs of financial distress represent transaction costs.
The indirect costs result from information asymmetry and
transaction costs. Both are violations of the MM assumptions. The
value of a levered firm is:
VL = VU + PV(tax savings) – PV(costs of financial distress)
The optimal amount of debt is the point at the top of the curve.
Point out to students that this graph says nothing about how
quickly costs of financial distress enter at higher levels of debt for
a particular firm. This graph also does not tell us the exact value of
the optimal capital structure or the formula for computing the
optimal capital structure.
Meaning, it is difficult, if not impossible, to quantify this point.
A. Pie Again
Slide 17.14 The Pie Model Revisited
Cash Flow = Payments to stockholders (S) + Payments to creditors (B) +
Payments to the government (G) + Payments to bankruptcy courts
and lawyers (L)
Marketed claims – claims against cash flow that can be bought and sold
(bonds, stock)
Nonmarketed claims – claims against cash flow that cannot be bought and
sold (taxes)
VM = value of marketed claims
VN = value of nonmarketed claims
VT = value of all claims = VM + VN = S + B + G + L
Given the firm’s cash flows, the optimal capital structure is the one that
maximizes VM, or minimizes VN.
17.5. Signaling
Slide 17.15 Signaling
Debt involves bankruptcy costs. Thus, firms that take on debt may
effectively be signaling that they are of high enough quality to take
on debt.
17.6. Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
Slide 17.16 The Agency Cost of Equity
Agency costs refer to the separation of control between owners and
managers. Specifically, managers may take actions that are in their
own best interests, which is not necessarily the same as for the
owners of the firm. These costs may be highest when managers
have access to large amounts of free cash flow. Existing owners are
hurt by these costs.
.A Effect of Agency Costs of Equity on Debt-Equity Financing
Agency costs are an extension to the static model:
VL = VU + PV(tax savings) – PV(costs of financial distress) –
PV(agency costs)
where agency costs refer to those related to equity, as well as those
of bondholders.
.B Free Cash Flow
If greater free cash flow increases agency costs, then actions that
restrain free cash flow may decrease these costs. Paying larger
dividends is one way. But, issuing additional debt, which reduces
free cash flow as a result of interest payments, may be a better
choice for reducing these agency costs.
17.7. The Pecking-Order Theory
Slide 17.17 The Pecking-Order Theory
Asymmetric information between buyers and sellers means that
existing firm owners know more than potential investors. The view
is that existing owners will sell equity when it is overvalued, which
is a negative signal to investors. Thus, this is avoided at all costs.
.A Rules of the Pecking Order
#1: Use internal financing first
#2: Issue debt next, new equity last
.B Implications
The pecking-order theory is in contrast to the tradeoff theory in
that:
-there is no target D/E ratio
-profitable firms will use less debt
-companies like financial slack
17.8. Personal Taxes
Slide 17.18 –
Slide 17.20 Personal Taxes
To this point, only corporate taxes have been considered; however,
investors must pay individual income taxes as well, which will also
affect the optimal capital structure.
.A The Basics of Personal Taxes
Dividends face double taxation (firm and shareholder), which
suggests a stockholder receives the net amount:
(1-TC) x (1-TS)
Interest payments are only taxed at the individual level since they
are tax deductible by the corporation, so the bondholder receives:
(1-TB)
.B The Effect of Personal Taxes on Capital Structure
If TS= TB then the firm should be financed primarily by debt
(avoiding double tax).
The firm is indifferent between debt and equity when:
(1-TC) x (1-TS) = (1-TB)
17.9. How Firms Establish Capital Structure
Slide 17.21 How Firms Establish Capital Structure
Debt ratios are relatively low in the United States, with many firms
having no debt. Moreover, many firms have low debt ratios and
still pay large tax bills.
Changes in capital structure affect firm value. Typically,
announcements of increases in financial leverage increase value
and vice versa. This is true despite difficulty in identifying and
measuring financial distress costs.
Debt ratios vary among industry groups. Drug companies have low
debt ratios. Airlines have high debt ratios. Some patterns emerge,
including the fact that firms with high proportions of intangible
assets (e.g. drug companies) and growth opportunities use less
debt.
It appears firms target specific D/E ratios. Some factors that may
affect the target level include:
Taxes – tax shields are more important for firms with high
marginal tax rates
Financial distress – the lower the risk (or cost) of distress, the more likely
a firm is to borrow funds. This is affected by:
-the types of assets (tangible vs. intangible)
-uncertainty of operating income
While firms may employ a target, capital structures of individual
firms can vary significantly through time.
Slide 17.22 Factors in Target D/E Ratio
Lecture Note: In theory, the static model of capital structure described in this
chapter applies to multinational firms as well as to domestic firms.
The multinational firm should seek to minimize its global cost of
capital by balancing the debt-related tax shields across all of the
countries in which the firm does business against global agency
and bankruptcy costs. However, this assumes that worldwide
capital markets are well-integrated and that foreign exchange
markets are highly efficient. In such an environment, financial
managers would seek the optimal global capital structure. In
practice, of course, the existence of capital market segmentation,
differential taxes, and regulatory frictions make the determination
of the global optimum much more difficult than the theory would
suggest.
Slide 17.23 Quick Quiz