AppliedCorporateFinanceWeek4

Capital StructureCapitalStructure

References:References:BerkandDeMarzo Ch.16

Lecture OutlineLectureOutlineC it l St t Ch iCapitalStructureChoices

MeasuringtheEffectsofLeverageonaBusinessg g

CostsofFinancialDistress

TheTradeoffTheory

A C t f LAgencyCostsofLeverage

AgencyBenefitsofLeverageg y g

InformationBenefitsofLeverage

CapitalStructureChoices Whenraisingfundsfromoutsideinvestors,afirmmust choose what type of security to issue andmustchoosewhattypeofsecuritytoissueandwhatcapitalstructuretohave

Capital structureCapitalstructure thecollectionofsecuritiesafirmissuestoraisecapitalfrominvestors

Firmsconsiderwhetherthesecuritiesissued: Willreceiveafairpriceinthemarket Havetaxconsequences Entailtransactionscosts Changefutureinvestmentopportunities

Afirmsdebttovalueratioisthefractionofthefirmstotalvaluethatcorrespondstodebtp D/(E+D)

Figure15.6DebttoValueRatio[D/(E+D)]ofU.S.Firms,19752011

Source:Compustat andFederalReserve,FlowofFundsAccountsoftheUnitedStates,2012.

Figure15.7DebttoValueRatio[D/(E+D)]forSelectIndustries

Source:CapitalIQ,2012.

MeasuringtheEffectsofLeverageonaBusiness

d i li i LeveragedRecapitalization: Achangeincapitalstructureorownership

iti i l i b t ti l d bt fi icompositioninvolvingsubstantialdebtfinancing Examples:

IssuingdebtandusingtheproceedstofinancealargeprojectoracquisitionI i d b d i h d di id d IssuingdebtandusingtheproceedstopayadividendtoequityholdersIssuing debt and using the proceeds to repurchase Issuingdebtandusingtheproceedstorepurchaseshares

Capital Structure in Perfect Capital Markets

A perfect capital market is a market in which: SecuriNes are fairly priced No tax consequences or transacNons costs Investment cash ows are independent of nancing choices

Leverage will increase the risk of the rms equity and raise its equity cost of capital

M&M

Modigliani and Miller (MM) ProposiNon I: In a perfect capital market, the total value of a rm is equal to the market value of the free cash ows generated by its assets and is not aected by its choice of capital structure. VL= E + D =VU

MM ProposiNon I (with taxes): The total value of the levered rm exceeds the value of the rm without leverage due to the present value of the tax savings from debt: VL= VU + PV(Interest Tax Shield)

Valuing a rm in the presence of tax shields

We can explicitly model the tax shields: With an assumpNon of permanent debt:

Non-permanent/changing debt: model tax shields as an addiNonal cash ow

Discount using unlevered cost of capital This method is a bit more labor-intensive, but is much more exible

PV (Interest Tax Shield) = c Interestrd

= c (rd D)

rd= c D

Valuing a rm in the presence of tax shields

We can also use the aler-tax WACC and evaluate the cash ows without the interest tax shields: This assumes that capital structure is staying at a given target (Say D/V=50%) and not changing (for the life of the rm or project

(1 ) wacc E D cE Dr r r

E D E D= +

+ +rwacc = rU

Pretax WACC

DE + D

rD cReduction Due

to Interest Tax Shield

ExampleExample

Midco Industriescurrentlyhas20millionsharesoutstandingwithamarketpriceof$15g ppershareandnodebt.Midco hashadconsistently stable earnings and pays a 35%consistentlystableearnings,andpaysa35%taxrate.Managementplanstoborrow$100million on a permanent basis and they will usemilliononapermanentbasisandtheywillusetheborrowedfundstorepurchaseoutstandingshares.

The Tax BenefitTheTaxBenefit

Withoutleverage VU =(20millionshares) ($15/share)=$300V (20millionshares) ($15/share) $300million

IfMidco borrows$100millionusingpermanentdebt,thepresentvalueofthep , pfirmsfuturetaxsavingsis

PV(i t t t hi ld) D 35% $100 illi PV(interesttaxshield)=cD =35% $100million=$35million

Thusthetotalvalueoftheleveredfirmwillbe VL = VU + cD = $300 million + $35 million = $335V V + cD $300million+$35million $335million

Becausethevalueofthedebtis$100million,thevalueoftheequityisq y E= VL D =$335million$100million=$235millionmillion

Althoughthevalueofthesharesoutstandingdropsto$235million,shareholderswillalsopreceivethe$100millionthatMidco willpayout through the share repurchaseoutthroughthesharerepurchase.

Intotal,theywillreceivethefull$335million,yagainof$35millionoverthevalueoftheirshares without leverageshareswithoutleverage.

The Share RepurchaseTheShareRepurchase

AssumeMidco repurchasesitssharesatthecurrentpriceof$15/share.Thefirmwillprepurchase6.67millionshares.

$100 million $15/share = 6 67 million shares $100million $15/share=6.67millionshares It will then have 13 33 million sharesItwillthenhave13.33millionsharesoutstanding. 20million6.67million=13.33million

Thetotalvalueofequityis$235million;thereforethenewsharepriceisp$17.625/share.

$235 million 13 33 million shares = $17 625 $235million 13.33millionshares=$17.625 Shareholders that keep their shares earn aShareholdersthatkeeptheirsharesearnacapitalgainof$2.625pershare.

$ $ $ $17.625 $15=$2.625

Thetotalgaintoshareholdersis$35million. $2.625/share 13.33millionshares=$35million$2.625/share 13.33millionshares $35million

Ifthesharesareworth$17.625/shareaftertherepurchase,whywouldshareholderstender their shares to Midco at $15/share?tendertheirsharestoMidco at$15/share?

No Arbitrage PricingNoArbitragePricing Ifinvestorscouldbuysharesfor$15immediatelyy $ ybeforetherepurchase,andtheycouldsellthesesharesimmediatelyafterwardatahigherprice,y g p ,thiswouldrepresentanarbitrageopportunity.

Realistically, the value of the Midcos equity willRealistically,thevalueoftheMidco s equitywillriseimmediatelyfrom$300millionto$335millionaftertherepurchaseannouncement.p

With20millionsharesoutstanding,theshareprice will rise to $16.75 per share.pricewillriseto$16.75pershare. $335million 20millionshares=$16.75pershare

Witharepurchasepriceof$16.75,theshareholderswhotendertheirsharesandtheshareholders who hold their shares both gainshareholderswhoholdtheirsharesbothgain$1.75pershareasaresultofthetransaction.

$16 75 $15 $1 75 $16.75$15=$1.75 Thebenefitoftheinteresttaxshieldgoestoall20 million of the original shares outstanding for a20millionoftheoriginalsharesoutstandingforatotalbenefitof$35million. $1.75/share 20millionshares=$35million

Whensecuritiesarefairlypriced,theoriginalshareholdersofafirmcapturethefullbenefitoff f p f f ftheinteresttaxshieldfromanincreaseinleverage.

RelaxingMoreAssumptions:CostsofFinancialDistress

Ifincreasingdebtincreasesthevalueofthefirm,whynotshiftto100%debt?y

Withmoredebt,thereisagreaterchancethatthe firm will default on its debt obligationsthefirmwilldefaultonitsdebtobligations.

Afirmthathastroublemeetingitsdebtobligationsisinfinancialdistress.

TheCostsofBankruptcyandFinancialDistress

With f t it l k t th i k f Withperfectcapitalmarkets,theriskofbankruptcyisnotadisadvantageofdebt: Bankruptcyshiftstheownershipofthefirmfromequityholderstodebtholderswithoutchangingth t t l l il bl t ll i tthetotalvalueavailabletoallinvestors.

Bankruptcy is rarely simple andBankruptcyisrarelysimpleandstraightforward.

It is often a long and complicated process that Itisoftenalongandcomplicatedprocessthatimposesbothdirectandindirectcostsonthefirmanditsinvestors.

The Bankruptcy CodeTheBankruptcyCode

TheU.S.bankruptcycodewascreatedsothatcreditorsaretreatedfairlyandthevalueofytheassetsisnotneedlesslydestroyed.

S fi fil f f f b k U.S.firmscanfilefortwoformsofbankruptcyprotection:Chapter7orChapter11.

QuitesimilarforAustralianfirms,eitherliquidation (Chapter 7 in US) or administrationliquidation(Chapter7inUS)oradministration(Chapter11)

Chapter 7 LiquidationChapter7Liquidation

Atrusteeisappointedtooverseetheliquidationofthefirmsassetsthroughanq gauction.

Theproceedsfromtheliquidationareusedtopaythefirmscreditors,andthefirmceasestop yexist

Chapter 11 ReorganizationChapter11Reorganization

Ch t 11 i th f f Chapter11isthemorecommonformofbankruptcyforlargecorporations.

WithChapter11,allpendingcollectionattemptsareautomaticallysuspended,andthefirmsexistingmanagementisgiventheopportunitytoproposeareorganizationplan. Whiledevelopingtheplan,managementcontinuestooperatethebusiness.

Thereorganizationplanspecifiesthetreatmentofeachcreditorofthefirm.

C dit i h t d/ Creditorsmayreceivecashpaymentsand/ornewdebtorequitysecuritiesofthefirm.

Th l f th h d iti i t i ll l Thevalueofthecashandsecuritiesistypicallylessthantheamounteachcreditorisowed,butmorethanthecreditorswouldreceiveifthefirmwereshutdownimmediatelyandliquidated.

Thecreditorsmustvotetoaccepttheplan,anditp p ,mustbeapprovedbythebankruptcycourt.

If an acceptable plan is not put forth the courtIfanacceptableplanisnotputforth,thecourtmayultimatelyforceaChapter7liquidation

Direct Costs of BankruptcyDirectCostsofBankruptcy

Thebankruptcyprocessiscomplex,timeconsuming, and costly.consuming,andcostly.

Costlyoutsideexpertsareoftenhiredbythefirmtoassistwiththebankruptcyprocess.

Creditors also incur costs during the bankruptcyCreditorsalsoincurcostsduringthebankruptcyprocess. They may wait several years to receive payment Theymaywaitseveralyearstoreceivepayment. Theymayhiretheirownexpertsforlegalandprofessional adviceprofessionaladvice.

Thedirectcostsofbankruptcyreducethevalueoftheassetsthatthefirmsinvestorswillultimatelyreceive.

h di f b k Theaveragedirectcostsofbankruptcyareapproximately3%to4%oftheprebankruptcy

k l f lmarketvalueoftotalassets.

Giventhedirectcostsofbankruptcy,firmsmayavoidfilingforbankruptcybyfirsty g p y ynegotiatingdirectlywithcreditors.

Workout Workout Amethodforavoidingbankruptcyinwhichafirminfinancialdistressnegotiatesdirectlywithitscreditorstoreorganize Thedirectcostsofbankruptcyshouldnotsubstantiallyexceedthecostofaworkout.

PrepackagedBankruptcy(Prepack)A method for avoiding many of the legal and other Amethodforavoidingmanyofthelegalandotherdirectcostsofbankruptcyinwhichafirmfirstdevelops a reorganization plan with thedevelopsareorganizationplanwiththeagreementofitsmaincreditorsandthenfilesChapter 11 to implement the planChapter11toimplementtheplan Withaprepackagedbankruptcy,thefirmemergesfrombankruptcy quickly and with minimal direct costsbankruptcyquicklyandwithminimaldirectcosts.

Indirect Costs of Financial DistressIndirectCostsofFinancialDistress

Whiletheindirectcostsaredifficulttomeasureaccurately,theyareoftenmuchlargerthanthedirectcostsofbankruptcybankruptcy. LossofCustomers

f S li LossofSuppliers

LossofEmployees

LossofReceivables

FireSaleofAssets

DelayedLiquidation

CoststoCreditors

Th i di t t f fi i l di t Theindirectcostsoffinancialdistressmaybesubstantial.

It is estimated that the potential loss due to financial Itisestimatedthatthepotentiallossduetofinancialdistressis10%to20%offirmvalue

When estimating indirect costs two important points Whenestimatingindirectcosts,twoimportantpointsmustbeconsidered. Losses to total firm value (and not solely losses to equityLossestototalfirmvalue(andnotsolelylossestoequityholdersordebtholders,ortransfersbetweenthem)mustbeidentified.

Theincrementallossesthatareassociatedwithfinancialdistress,aboveandbeyondanylossesthatwouldoccurduetothefirmseconomicdistress,mustbeidentified.,

Example:Moon IndustriesExample:Moon IndustriesC id th f ll i t b th f thConsiderthefollowingoutcomesbothforthefollowingscenarioswithandwithoutleverageforMoon Industries new venture:MoonIndustries newventure:

With t L With L

ValueofDebtandEquitywithandwithoutLevearge($million)

Success Failure Success FailureDebtvalue $150 $90

WithoutLeverage WithLeverage

Equityvalue $250 $90 $100 $0Totaltoallinvestors $250 $90 $250 $90

Assume: Moonsnewventureisequallylikelytosucceedortofail.

Theriskfreerateis4%.

Theventurehasabetaof0andthecostofcapitalisequaltotheriskfreerate.q

.5($250) .5($90)Equity (unlevered) $163.46 million1 04

UV

5($100) 5($0)

1.04

.5($100) .5($0)Equity (Levered) $48.08 million1.04

LV

.5($150) .5($90)Debt $115.38 million1 04

1.04

VL = $48.08 + $115.38 = $163.46V $48.08+$115.38 $163.46

AsstatedbyMMPropositionI,thetotalvalueofthefi i ff t d b lfirmisunaffectedbyleverage.

assumenowthatthecostsoffinancialdistressare$15million:

ValueofDebtandEquitywithandwithoutLevearge($million)

Success Failure Success FailureWithoutLeverage WithLeverage

($million)

Debtvalue $150 $75Equityvalue $250 $90 $100 $0Total to all investors $250 $90 $250 $75Totaltoallinvestors $250 $90 $250 $75

Compute the value of Moons securities at theComputethevalueofMoon ssecuritiesatthebeginningoftheyearwithandwithoutleveragegiventhatfinancialdistressiscostly.

.5($250) .5($90)Equity (unlevered) $163.46 million1 04

UV 1.04

.5($100) .5($0)Equity (Levered) $48 08 millionLV Equity (Levered) $48.08 million1.04

V

5($150) 5($75).5($150) .5($75)Debt $108.17 million1.04

VL =$48.08+$108.17=$156.25

VL VU in the presence of financial distress costsV V inthepresenceoffinancialdistresscosts.

Thedierence,($163.46$156.25=$7.21),isthepresentvalueofthe$15millioninfinancialdistresscosts:

.5($0) .5($15)PV(Financial Distress Costs) $7 21million PV(Financial Distress Costs) $7.21 million1.04

Who Pays for Financial Distress Costs?WhoPaysforFinancialDistressCosts?

if h f il i h ld l ifthenewventurefails,equityholderslosetheirinvestmentinthefirmandwillnotcareaboutbankruptcycosts.

However debt holders recognize that if the However,debtholdersrecognizethatifthenewventurefailsandthefirmdefaults,theywill not be able to get the full value of thewillnotbeabletogetthefullvalueoftheassets.

l h ll l f h d b ll Asaresult,theywillpaylessforthedebtinitially(thepresentvalueofthebankruptcycostsless).

f h d b h ld i i i ll l f h Ifthedebtholdersinitiallypaylessforthedebt,thereislessmoneyavailableforthefi t di id d h hfirmtopaydividends,repurchaseshares,andmakeinvestments. Thisdifferencecomesoutoftheequityholderspockets.

Whensecuritiesarefairlypriced,theoriginalshareholdersofafirmpaythepresentvalueofthecostsassociatedwithbankruptcyandfinancialdistress

OptimalCapitalStructure:TheTradeoffTheory

The firm picks its capital structure by trading off thebenefits of the tax shield from debt against the costs offi i l di d

The total value of a levered firm equals the value of the

financial distress and agency costs.

f f q ffirm without leverage plus the present value of the taxsavings from debt, less the present value of financialdistress costs.

(Interest Tax Shield) (Financial Distress Costs)L UV V PV PV

Determinants of financial distress costsDeterminantsoffinancialdistresscosts

1 Th b bilit f fi i l di t1. Theprobabilityoffinancialdistress. Theprobabilityoffinancialdistressincreaseswiththe

amountofafirmsliabilities(relativetoitsassets).( ) Theprobabilityoffinancialdistressincreaseswiththe

volatilityofafirmscashflowsandassetvalues.

2. Themagnitudeofthecostsafterafirmisindistress. Financialdistresscostswillvarybyindustry.

Technology firms will likely incur high financial distress costs due Technologyfirmswilllikelyincurhighfinancialdistresscostsduetothepotentialforlossofcustomersandkeypersonnel,aswellasalackoftangibleassetsthatcanbeeasilyliquidated.

Realestatefirmsarelikelytohavelowcostsoffinancialdistressysincethemajorityoftheirassetscanbesoldrelativelyeasily.

3.Theappropriatediscountrateforthedistresscosts. Dependsonthefirmsmarketrisk

Notethatbecausedistresscostsarehighwhenthefirmdoespoorly,thebetaofdistresscostshastheoppositesigntothatofthefirm.

The higher the firms beta, the more negative the beta of itsThehigherthefirm sbeta,themorenegativethebetaofitsdistresscostswillbe

Thepresentvalueofdistresscostswillbehigherforhighbetafirms.

Optimal LeverageOptimalLeverage

l l l f d b h i k f d f l Forlowlevelsofdebt,theriskofdefaultremainslowandthemaineffectofanincreaseinleverageisanincreaseintheinteresttaxshield.

Asthelevelofdebtincreases,theprobabilityof default increasesofdefaultincreases. Asthelevelofdebtincreases,thecostsoffinancialdistressincrease,reducingthevalueoftheleveredfirm.

Th t d ff th t t th t fi h ld i th i Thetradeofftheorystatesthatfirmsshouldincreasetheirleverageuntilitreachesthelevelforwhichthefirmvalueismaximized. Atthispoint,thetaxsavingsthatresultfromincreasingleverage

areperfectlyoffsetbytheincreasedprobabilityofincurringthecosts of financial distresscostsoffinancialdistress.

Thetradeofftheorycanhelpexplain Whyfirmschoosedebtlevelsthataretoolowtofullyexploity y p

theinteresttaxshield(duetothepresenceoffinancialdistresscosts)Differences in the use of leverage across industries (due to Differencesintheuseofleverageacrossindustries(duetodifferencesinthemagnitudeoffinancialdistresscostsandthevolatilityofcashflows)

OptimalLeveragewithTaxesandFinancialDistressCosts

ExploitingDebtHolders:TheAgencyCostsofLeverage

C AgencyCosts Coststhatarisewhenthereareconflictsofinterestbetweenthefirmsstakeholders

ManagementwillgenerallymakedecisionsManagement will generally make decisionsthatincreasethevalueofthefirmsequity.

H h fi h l However,whenafirmhasleverage,managersmaymakedecisionsthatbenefitshareholdersbutharm the firms creditors and lower the totalharmthefirm screditorsandlowerthetotalvalueofthefirm.

ConsiderBaxter,Inc.,whichisfacingfinancial distressfinancialdistress. Baxterhasaloanof$1milliondueattheendoftheyear.

Withoutachangeinitsstrategy,themarketvalueofitsassetswillbeonly$900,000atthattime,andBaxterwilldefault on its debtdefaultonitsdebt.

Anewstrategyrequiresnoupfrontinvestment,butithasonlya50%chanceofsuccess. Ifthenewstrategysucceeds,itwillincreasethevalueofthefirmsassetto$1.3million.

Ifthenewstrategyfails,thevalueofthefirmsassetswillfallto$300,000

The expected value of the firms assets under the Theexpectedvalueofthefirmsassetsunderthenewstrategyis$800,000,adeclineof$100,000fromtheoldstrategy.gy

50% $1.3million+50% $300,000=$800,000 IfBaxterdoesnothing,itwillultimatelydefaultand equity holders will get nothing with certaintyandequityholderswillgetnothingwithcertainty. EquityholdershavenothingtoloseifBaxtertriestheriskystrategy.y gy

Ifthestrategysucceeds,equityholderswillreceive $300,000 after paying off the debt.receive$300,000afterpayingoffthedebt. Givena50%chanceofsuccess,theequityholdersexpectedpayoffis$150,000.

E it h ld i f thi t t Equityholdersgainfromthisstrategy,eventhoughithasanegativeexpectedpayoff,while debt holders losewhiledebtholderslose. Iftheprojectsucceeds,debtholdersarefully

d d $ llrepaidandreceive$1million.

Iftheprojectfails,debtholdersreceiveonlyp j , y$300,000. Thedebtholdersexpectedpayoffis$650,000,alossof$$250,000comparedtotheoldstrategy. 50% $1million+50% $300,000=$650,000

ExcessiveRiskTakingandOverinvestment

Th d bt h ld $250 000 l d t Thedebtholders$250,000losscorrespondstothe$100,000expecteddeclineinfirmvaluedueto the risky strategy and the equity holderstotheriskystrategyandtheequityholder s$150,000gain.E it h ld i ll f th t ti l b fit Equityholdersgainallofthepotentialbenefits,butdebtholdersfaceallofthepotentialcosts.Overall this is negative NPV for the firm but forOverallthisisnegativeNPVforthefirm,butforequityitispositiveNPV

Effectively the equity holders are gambling with Effectively,theequityholdersaregamblingwiththedebtholdersmoney.

OverinvestmentProblemWhen a firm faces financial distress shareholders Whenafirmfacesfinancialdistress,shareholderscangainattheexpenseofdebtholdersbytakinga negative NPV project if it is sufficiently riskyanegativeNPVproject,ifitissufficientlyrisky.

Anticipatingthisbadbehavior,securityholderswillpaylessforthefirminitially.

Debt Overhang and Under investmentDebtOverhangandUnderinvestment

N B t d t th i k NowassumeBaxterdoesnotpursuetheriskystrategybutinsteadthefirmisconsideringaninvestment opportunity that requires an initialinvestmentopportunitythatrequiresaninitialinvestmentof$100,000andwillgenerateariskfreereturnof50%.

Ifthecurrentriskfreerateis5%,thisinvestmentclearlyhasapositiveNPV. WhatifBaxterdoesnothavethecashonhandtomaketheinvestment?

CouldBaxterraise$100,000innewequitytomaketheinvestment?

OutcomesforBaxtersDebtandEquitywithandwithouttheNewProject($thousands)

Ifequityholderscontribute$100,000tofundtheproject,theygetbackonly$50,000.g y

Theother$100,000fromtheprojectgoestothedebtholders,whose payoff increases from $900 000 to $1 millionwhosepayoffincreasesfrom$900,000to$1million.

Thedebtholdersreceivemostofthebenefit,thusthisprojectis a negative NPV investment opportunity for equity holdersisanegativeNPVinvestmentopportunityforequityholders,eventhoughitoffersapositiveNPVforthefirm

UnderinvestmentProblemA situation in which equity holders choose not to AsituationinwhichequityholderschoosenottoinvestinapositiveNPVprojectbecausethefirmisin financial distress and the value of undertakinginfinancialdistressandthevalueofundertakingtheinvestmentopportunitywillaccruetobondholders rather than themselvesbondholdersratherthanthemselves.

Alsocalledadebtoverhangproblem(cashingoutisanexample)

Estimating the Debt OverhangEstimatingtheDebtOverhang

Howmuchleveragemustafirmhavefortheretobeasignificantdebtoverhangproblem?

SupposeequityholdersinvestanamountIinanewinvestmentwithsimilarrisktotherestofthefirm.

Equityholderswillbenefitfromthenewinvestmentonlyif:o y

NPV DDE

NPV D>I E

Debt Maturity and CovenantsDebtMaturityandCovenants

hi h f l Agencycostsarehigherforlongertermmaturities

DebtCovenants Conditionsofmakingaloaninwhichcreditorsplace

h f krestrictionsonactionsthatafirmcantake

Mayhelptoreduceagencycostsy p g y

Mayhindermanagementflexibilityandpreventinvestment in positive NPV opportunities and caninvestmentinpositiveNPVopportunitiesandcanhavecostsoftheirown.

The Agency Benefits of LeverageTheAgencyBenefitsofLeverage

h ll h Entrenchmentmayallowmanagerstorunthefirmintheirownbestinterests,ratherthaninthebestinterestsoftheshareholders.

Allows Concentration of Ownership AllowsConcentrationofOwnership Manager/ownershaveskininthegame,lesspotential agenc problemspotentialagencyproblems

Concentratedownersbettermonitors Creditorswillcloselymonitorafirmsmanagers,providingmoremonitoring

Reducewastefulinvestmentbyreducingfreecashflow Empirebuilding(managerswanttorunlargefirmsmore than small firms)morethansmallfirms)

ManagersmaybeoverconfidentP t j t d ti t Petprojects,donations,etc

Wh h i ti ht ill b ti t d t Whencashistight,managerswillbemotivatedtorunthefirmasefficientlyaspossible.

f f CommitsthefirmtomakingfutureinterestpaymentsthusreducescashforbadinvestmentsReduces managerial entrenchment as managers are more Reducesmanagerialentrenchmentasmanagersaremorelikelytobefiredwhenafirmfacesfinancialdistress.

Managers more concerned about their performance andManagersmoreconcernedabouttheirperformanceandlesslikelytoengageinwastefulinvestment.

Firmbecomeafiercercompetitorandactsmoreaggressivelyinprotectingitsmarketsbecauseitcannotriskthepossibilityofbankruptcy.

The Information Benefits of LeverageTheInformationBenefitsofLeverage

C dibl i l f iti i f ti Crediblesignalofpositiveinformation Signaling theoryofdebtI i E it d Ad S l ti IssuingEquityandAdverseSelection

AdverseSelectionTh id th t h th b d ll h Theideathatwhenthebuyersandsellershavedifferentinformation,theaveragequalityofassetsinthemarketwilldifferfromtheaveragequalityoverall

LemonsPrinciple When a seller has private information about the valueWhenasellerhasprivateinformationaboutthevalueofagood,buyerswilldiscountthepricetheyarewillingtopayduetoadverseselection

d Eg UsedCars Ifsellerknowsthecarisgood,theywillkeepit.Ifitadud,theywillsellit

Buyersknowthisandonlywillpaypriceofbadcar Equityasalemon:

Managers who know their prospects are good willManagerswhoknowtheirprospectsaregoodwillnotissueequity(andsharethesegains)

Will fund internally or issue debtWillfundinternallyorissuedebt PeckingOrderHypothesis

AgencyCostsandtheTradeoffTheory

Thevalueoftheleveredfirmcannowbeshowntobe:

V L VU PV (I T Shi ld) PV VL =VU +PV(InterestTaxShield)+PV(FinancialDistressCosts)+PV(AgencyCostsofDebt)+PV(AgencyBenefitsofDebt)+PV(Information Benefits of Leverage)(InformationBenefitsofLeverage)

The Optimal Debt LevelTheOptimalDebtLevelR&D I t i Fi R&DIntensiveFirms FirmswithhighR&Dcostsandfuturegrowth

t iti t i ll i t i l d bt l lopportunitiestypicallymaintainlowdebtlevels. Thesefirmstendtohavelowcurrentfreecashflows

d i k b i t t iandriskybusinessstrategies. LowGrowth,MatureFirms

Mature,lowgrowthfirmswithstablecashflowsandtangibleassetsoftencarryahighdebtload.

Thesefirmstendtohavehighfreecashflowswithfewgoodinvestmentopportunities.

HomeworkHomework

Chapter15:Problems8,10,16 Chapter 16 : Problems 1, 6, 8, 12, 13, 20, 21,Chapter16:Problems1,6,8,12,13,20,21,24,26,28,33R d Ch 12 ReadChapter12