Effects of Default and Bankruptcy in a Effects of Default and Bankruptcy in a Perfect Market (no costs of financial Perfect Market (no costs of financial

distress)distress)

There are no effects of default and bankruptcy There are no effects of default and bankruptcy on firm value in a perfect marketon firm value in a perfect market

Example: Armin IndustriesExample: Armin Industries Armin is introducing a new product.Armin is introducing a new product. If success, Armin’s value in one year = 150If success, Armin’s value in one year = 150 If failure, Armin’s value in one year = 80If failure, Armin’s value in one year = 80

Comparing two capital structures:Comparing two capital structures:All-equityAll-equityDebt that matures in one year with 100 dueDebt that matures in one year with 100 due

Scenario 1. SuccessScenario 1. Success Without leverage equityholders get 150Without leverage equityholders get 150 With leverage they get 50With leverage they get 50 What if there’s not enough cash to pay to What if there’s not enough cash to pay to

creditors? (150 can be a PV of future cash creditors? (150 can be a PV of future cash flows not available right now)flows not available right now)

No problem with perfect cap market. The No problem with perfect cap market. The money to repay can be raised by issuing new money to repay can be raised by issuing new debt or equity as claims against future cash debt or equity as claims against future cash flowsflows

Ex: selling equity for 100 and using the proceeds Ex: selling equity for 100 and using the proceeds to repay the debtto repay the debt

Scenario 2. FailureScenario 2. Failure Without leverage equityholders get 80Without leverage equityholders get 80 With leverage there will be default and bankruptcy. With leverage there will be default and bankruptcy.

The shareholders get 0 (limited liability). The creditors The shareholders get 0 (limited liability). The creditors suffer loss of 20.suffer loss of 20.

Comparing two scenarios:Comparing two scenarios:

The total value that goes to all investors in any state of The total value that goes to all investors in any state of nature is independent of the capital structure, hence the nature is independent of the capital structure, hence the ex-ante total firm value is independent of the cap ex-ante total firm value is independent of the cap structure too (MM proposition I)structure too (MM proposition I)

Introducing the costs of bankruptcy Introducing the costs of bankruptcy and financial distressand financial distress

Direct costsDirect costs Fees to lawyers, consultants, appraisers, Fees to lawyers, consultants, appraisers,

etc…etc…E.g., for Enron the total cost of fees was above E.g., for Enron the total cost of fees was above $750 mln = 10% of the assets value$750 mln = 10% of the assets value

Usually, 3-4% of the pre bankruptcy market value. Usually, 3-4% of the pre bankruptcy market value. But higher for small firms (e.g. 15%)But higher for small firms (e.g. 15%)

TimeTime

Indirect costs (difficult to measure but seem Indirect costs (difficult to measure but seem much larger than direct ones (10-20%))much larger than direct ones (10-20%)) Loss of customersLoss of customers Loss of suppliersLoss of suppliers Loss of employeesLoss of employees Loss of receivablesLoss of receivables Fire sales of assetsFire sales of assets Indirect costs to creditors (they can suffer distress too)Indirect costs to creditors (they can suffer distress too) Inefficient investment (NPV < 0) when in distress (see Inefficient investment (NPV < 0) when in distress (see

below)below) Inability to raise finance for positive NPV projects Inability to raise finance for positive NPV projects

when in distresswhen in distress

Armin Industries: The Impact of Armin Industries: The Impact of Financial Distress CostsFinancial Distress Costs

Assume in case of failure debt holders Assume in case of failure debt holders receive only 60 < 80 because they bear receive only 60 < 80 because they bear the bankruptcy costs.the bankruptcy costs.

MM I does not hold anymoreMM I does not hold anymore E.g. assuming that success and failure are E.g. assuming that success and failure are

equally likely, that the risk is diversifiable (or equally likely, that the risk is diversifiable (or that agents are risk-neutral), and that the risk-that agents are risk-neutral), and that the risk-free interest rate = 1.05, we get:free interest rate = 1.05, we get:

PV(financial distress costs) = ((1/2)*20 + PV(financial distress costs) = ((1/2)*20 + (1/2)*0)/1.05 = 9.52 – this is the difference (1/2)*0)/1.05 = 9.52 – this is the difference between the value of the unlevered firm and between the value of the unlevered firm and levered firmlevered firm((VVUU = ((1/2)*150 + (1/2)*80)/1.05 = 109.52; = ((1/2)*150 + (1/2)*80)/1.05 = 109.52;VVLL = ((1/2)*150 + (1/2)*60)/1.05 = 100) = ((1/2)*150 + (1/2)*60)/1.05 = 100)

New MM I:New MM I:

Who bears financial distress costs eventually?Who bears financial distress costs eventually?When securities are fairly priced, the original When securities are fairly priced, the original shareholders pay the whole PV(financial distress cost)shareholders pay the whole PV(financial distress cost)Suppose at the beginning of the year Armin has 10 mln Suppose at the beginning of the year Armin has 10 mln shares and no debt. It wants to issue one-year debt with shares and no debt. It wants to issue one-year debt with a face value of $100 mln and use the proceeds to a face value of $100 mln and use the proceeds to repurchase shares.repurchase shares.If there are no bankruptcy costs the total value that goes If there are no bankruptcy costs the total value that goes to equityholders should not change:to equityholders should not change:

Debt = ((1/2)*100 + (1/2)*80)/1.05 = 85.71 – this is how much Debt = ((1/2)*100 + (1/2)*80)/1.05 = 85.71 – this is how much the firm can raise through debt with face value 100.the firm can raise through debt with face value 100.

Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost.remaining shares will cost.

Hence, the total value that goes to equityholders = Equity + Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 109.52 – exactly the same as money paid in the repurchase = 109.52 – exactly the same as VVUU

If there are bankruptcy costs, the total value that If there are bankruptcy costs, the total value that goes to equityholders changes:goes to equityholders changes: Debt = ((1/2)*100 + (1/2)*60)/1.05 = 76.19 – this is Debt = ((1/2)*100 + (1/2)*60)/1.05 = 76.19 – this is

how much the firm can raise now through debt with how much the firm can raise now through debt with face value 100.face value 100.

Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the remaining shares will cost.much the remaining shares will cost.

Hence, the total value that goes to equityholders = Hence, the total value that goes to equityholders = Equity + money paid in the repurchase = 100 = Equity + money paid in the repurchase = 100 = VVUU – – PVPV(financial distress cost) – shareholders bear the (financial distress cost) – shareholders bear the whole costwhole cost

Optimal Capital Structure: The Tradeoff Optimal Capital Structure: The Tradeoff TheoryTheory

VVLL = = VVUU + + PVPV(Interest Tax Shield) + (Interest Tax Shield) + PVPV(Financial Distress Costs)(Financial Distress Costs)

Agency CostsAgency Costs

Remember: one of the key assumptions behind Remember: one of the key assumptions behind MM I was that they way the firm is financed has MM I was that they way the firm is financed has no effect on the cash flows it generatesno effect on the cash flows it generates

In reality this is not true due to conflicts of In reality this is not true due to conflicts of interest between debt holders and shareholders interest between debt holders and shareholders (( agency costs of debt) and between agency costs of debt) and between managers and shareholders (managers and shareholders ( agency costs of agency costs of equity)equity)

Hence, the capital structure will matterHence, the capital structure will matter

Agency Costs of DebtAgency Costs of Debt

Assume Baxter Inc. has a loan of $1 mln Assume Baxter Inc. has a loan of $1 mln due at the end of the year. Without due at the end of the year. Without changing strategy the market value of its changing strategy the market value of its assets will be only $900,000 assets will be only $900,000 default defaultWe will see how the following problems We will see how the following problems can arise:can arise: Overinvestment (asset substitution)Overinvestment (asset substitution) Underinvestment (debt overhang)Underinvestment (debt overhang) Cashing out (excessive dividends)Cashing out (excessive dividends)

Overinvestment (asset substitution Overinvestment (asset substitution (Jensen and Meckling (JFE, 1976))(Jensen and Meckling (JFE, 1976))

New strategy. Success with prob 50%New strategy. Success with prob 50% If success, assets value = $1.3 mln If success, assets value = $1.3 mln no no

defaultdefault If failure, assets value = $300,000 If failure, assets value = $300,000 default default

Assuming no discounting, expected assets Assuming no discounting, expected assets value value AA = $800,000 < $900,000 = $800,000 < $900,000

Why would the management follow a Why would the management follow a value reducing strategy?value reducing strategy?

If it cares If it cares onlyonly about the interest of the shareholders, it about the interest of the shareholders, it would, because the shareholders would, because the shareholders gaingain..

The debt holders lose and the firm value decreasesThe debt holders lose and the firm value decreasesHence, when a firm faces financial distress, Hence, when a firm faces financial distress, shareholders are tempted to gain by gambling at the shareholders are tempted to gain by gambling at the expense of debt holders, even if such gambles have expense of debt holders, even if such gambles have NPV < 0!NPV < 0!Note: this problem exists not only in distress, but in Note: this problem exists not only in distress, but in distress it becomes especially seriousdistress it becomes especially seriousEventually, the cost is again born by the initial Eventually, the cost is again born by the initial shareholdersshareholders

Underinvestment (debt overhang, Underinvestment (debt overhang, Myers (JFE, 1977))Myers (JFE, 1977))

Suppose instead of pursuing risky strategy, the manager considers Suppose instead of pursuing risky strategy, the manager considers a positive NPV opportunity that requires initial investment of 100 a positive NPV opportunity that requires initial investment of 100 and generates 150 in one year.and generates 150 in one year.

Could the firm raise 100 by issuing new equity? No.Could the firm raise 100 by issuing new equity? No.

End of year values:End of year values:

Equityholders receive only 50 – they will not agree to invest 100!Equityholders receive only 50 – they will not agree to invest 100!

Hence, when a firm faces financial distress, it Hence, when a firm faces financial distress, it may fail to implement projects with NPV > 0!may fail to implement projects with NPV > 0!

Note: this problem exists not only in distress, but Note: this problem exists not only in distress, but in distress it becomes especially seriousin distress it becomes especially serious

Note: the firm is unable to raise funds not only Note: the firm is unable to raise funds not only through selling equity, but through selling any through selling equity, but through selling any security that is junior to the existing debtsecurity that is junior to the existing debt

This cost is again born by the initial shareholdersThis cost is again born by the initial shareholders

Cashing out (excessive dividends)Cashing out (excessive dividends)

Suppose Baxter has equipment it can sell for 25 at the Suppose Baxter has equipment it can sell for 25 at the beginning of the year and pay out this cash as dividend.beginning of the year and pay out this cash as dividend.Assume without the equipment the firm will be worth only Assume without the equipment the firm will be worth only 800 at the year-end.800 at the year-end.This behavior reduces value by 100 – 25. But the This behavior reduces value by 100 – 25. But the shareholders do not care – the firm will default anyway shareholders do not care – the firm will default anyway and they are protected by limited liabilityand they are protected by limited liabilityAgain this cost would initially be born by the initial Again this cost would initially be born by the initial shareholders.shareholders.Note: this problem exists not only in distress, but in Note: this problem exists not only in distress, but in distress it becomes especially seriousdistress it becomes especially serious

Example: benefits of lower leverageExample: benefits of lower leverage

Debt maturity, Covenants and Convertible Debt maturity, Covenants and Convertible Debt as ways to mitigate the above Debt as ways to mitigate the above

problemsproblems

Short term debt leaves fewer possibilities Short term debt leaves fewer possibilities for shareholders to profit at the for shareholders to profit at the debtholders’ expense.debtholders’ expense.Covenants – restrictions in a debt contract:Covenants – restrictions in a debt contract: Limiting dividend paymentsLimiting dividend payments Limiting the scope for risky investmentsLimiting the scope for risky investments Limiting the ability to issue more senior debtLimiting the ability to issue more senior debt

Convertible bonds (e.g. in case stock price Convertible bonds (e.g. in case stock price reaches some level)reaches some level)

Agency Costs of Equity (benefits of Agency Costs of Equity (benefits of debt)debt)

Extracting private benefits at the expense Extracting private benefits at the expense of shareholders (Jensen and Meckling of shareholders (Jensen and Meckling (JFE, 1976))(JFE, 1976))

Free cash flowFree cash flow problem (Jensen (AER, problem (Jensen (AER, 1986))1986))

Extracting private benefits at the expense of Extracting private benefits at the expense of shareholders (Jensen and Meckling (JFE, shareholders (Jensen and Meckling (JFE,

1976))1976))

Managers do not fully internalize shareholder Managers do not fully internalize shareholder value because they own 100% of the sharesvalue because they own 100% of the sharesImagine an initial owner (entrepreneur) who Imagine an initial owner (entrepreneur) who needs to raise funds from outside but wants to needs to raise funds from outside but wants to keep managing the companykeep managing the company If he sells equity he is left with < 100% of shares If he sells equity he is left with < 100% of shares he he

can be tempted to do things that benefit him privately can be tempted to do things that benefit him privately at the expense of other shareholders (“pet” projects, at the expense of other shareholders (“pet” projects, perks, profit diversion, asset diversion, simply perks, profit diversion, asset diversion, simply underprovision of effort)underprovision of effort)

If he sells debt he still owns 100% and fully bears the If he sells debt he still owns 100% and fully bears the consequences of his actions for the equity valueconsequences of his actions for the equity value

Free cash flowFree cash flow problem problem

Managers can be tempted to use available cash Managers can be tempted to use available cash for projects that they like but are investments for projects that they like but are investments with NPV < 0 (e.g. with NPV < 0 (e.g. empire building empire building through through acquisitions)acquisitions)

Hence, the available cash should be reducedHence, the available cash should be reduced

The way to do it is trough debt financing. Then The way to do it is trough debt financing. Then the managers have lower discretion over cash the managers have lower discretion over cash because they because they mustmust pay part of it to creditors as pay part of it to creditors as interest.interest.

Agency Costs and the Tradeoff Agency Costs and the Tradeoff TheoryTheory

Tradeoff theory and observed Tradeoff theory and observed leverage for different types of firmsleverage for different types of firms

Young, R&D intensive firms usually have Young, R&D intensive firms usually have low leverage because:low leverage because: Low current free cash flow – little benefit from Low current free cash flow – little benefit from

tax shieldtax shield High human capital – large loss in case of High human capital – large loss in case of

bankruptcybankruptcy Easy to increase risk of business strategy – Easy to increase risk of business strategy –

danger of the asset-substitution problemdanger of the asset-substitution problem Often need to raise additional capital – debt Often need to raise additional capital – debt

overhang problemoverhang problem

Low-growth, mature firms usually have Low-growth, mature firms usually have high leverage because:high leverage because: Stable current free cash flow – benefit from Stable current free cash flow – benefit from

tax shieldtax shield Tangible asses – low loss in case of Tangible asses – low loss in case of

bankruptcybankruptcy Seldom need to raise additional capital – debt Seldom need to raise additional capital – debt

overhang problem is unlikelyoverhang problem is unlikely