L11-Capital Structure1

8/7/2019 L11-Capital Structure1

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Capital Structure Limits to the

Use of Debt

RWJ Chp 16


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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 withbankruptcy.

It is the shareholders who bear these

costs.


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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


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Balance Sheet for a Company

in DistressAssets 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?

The bondholders get RM200; the shareholders get nothing.

RM200

RM0


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Selfish Strategy 1: Take Large

RisksThe Gamble Probability Payoff

Win Big 10% RM1,000

Lose Big 90% RM0

Cost of investment is RM200 (all the firms cash)

Required return is 50%

Expected CF from the Gamble = RM1000 0.10 + RM0 = RM100

133$

50.1

100$200$

!

!

NPV

NPV


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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


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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 anadditional RM100 to finance the project

Required return is 10%

18.18$10.1

350$300$

!

!

NPV

NPV

yShould we accept or reject?


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Selfish shareholders Forego Positive

NPV Project

Expected CF from the government sponsored project:

To Bondholder = RM300

To Stockholder = (RM350 - RM300) = RM50

PVof Bonds Without the Project = RM200

PVof Stocks Without the Project = RM0

PVof Bonds With the Project = RM300 / 1.1 = RM272.73

PVof Stocks with the project = RM50 / 1.1 - RM100 = -

RM54.55


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Selfish Strategy 3: Milking the

Property Liquidating dividends

Suppose our firm paid out a RM200 dividend

to the shareholders. This leaves the firminsolvent, with nothing for the bondholders, but

plenty for the former shareholders.

Such tactics often violate bond indentures.

Increase perquisites to shareholders

and/or management


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Can Costs of Debt Be Reduced?

Protective Covenants

Debt Consolidation:

If we minimize the number of parties,contracting costs fall.


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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 payinglower interest rate.

Buy another companys 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.


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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.


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Integration of Tax Effects and Financial

Distress Costs

Debt (B)

Value of firm (V)

0

Present value of taxshield on debt

Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

VL

= VU

+ TCB

V= Actual value of firm

VU

= Value of firm with no debt

B*

Maximumfirm value

Optimal amount of debt


14/29

The Pie Model Revisited

Taxes and bankruptcy costs can be viewed as justanother claim on the cash flows of the firm.

Let G and L stand for payments to the government andbankruptcy lawyers, respectively.

VT= S + B + G + L

The essence of the M&M intuition is that VTdepends onthe cash flow of the firm; capital structure just slices the

pie.

S

G

B

L


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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 inperquisites, 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 reducingthe 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.


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17/29

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 realworld; as a result, 100% debt financing is

sub-optimal.


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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:

BT

TTVV

B

SC

UL v

v!

1)1()1(1

Where:

TS= personal tax rate on equity income

TB = personal tax rate on bond income

TC= corporate tax rate


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Personal Taxes: The Miller Model

The derivation is straightforward:

)1()1()(

receivefirmleveredainrsShareholde

SCBTTBrEBIT vv

)1(

receivesBondholder

BBTBr v

)1()1()1()(

isrsstakeholdealltoflowcashtotaltheThus,

BBSCB

TBrTTBrEBIT vvv

vvvvv

B

SC

BBSC

T

TTTBrTTEBIT

1

)1()1(1)1()1()1(

asrewrittenbecanThis

Continued


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Personal Taxes: The Miller Model (cont.)

vvvvv

B

SC

BBSC

T

TTTBrTTEBIT

1

)1()1(1)1()1()1(

The first term is the cashflow of an unlevered firm

after all taxes.

Its value = VU.

A bond is worth B.It promises topay r

BB(1- T

B) after taxes. Thus

the value of the second term is:

v

v B

SC

T

TTB

1

)1()1(

1

The total cash flow to all stakeholders in the leveredfirm is:

The value of the sum of these

two terms must be VL

T

TTVV

Lv

v!@

1

)1()1(1


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Personal Taxes: The Miller Model (cont.)

Thus the Miller Model shows that the value of alevered firm can be expressed in terms of an

unlevered firm as:

BT

TT

B

SCUL v

v! 1

)1()1(1

y In the case where TB = TS, we return to M&M withonly corporate tax:

BT!


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Effect of Financial Leverage on Firm Value

with Both Corporate and Personal Taxes

Debt (B)

VU

VL

= VU+T

CB when T

S=T

B

VL

< VU

+ TCB

when TS< T

B

but (1-TB

> (1-TC(1-T

S

VL

=VU

when (1-TB

= (1-TC(1-T

S

VL

< VU

when (1-TB

< (1-TC(1-T

S

BT

TTVV

B

SC

ULv

v!

1

)1()1(1


23/29

Integration of Personal and Corporate Tax Effects

and Financial Distress Costs and Agency Costs

Debt (B)

Value of firm (V)

0


Present value offinancial distress costs Value of firm under

MM with corporatetaxes and debt

VL

= VU

+ TCB


VU


B*

Maximumfirm value


VL

< VU

+ TCB

when TS< T

B

but (1-TB

> (1-TC(1-T

S

Agency Cost of Equity Agency Cost of Debt


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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 withtaxes.

Another interpretation is that firms signal good newswhen they lever up.

There are Differences in Capital Structure AcrossIndustries.

There is evidence that firms behave as if they had atarget Debt to Equity ratio.


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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 ofassets 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.


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Summary and Conclusions

Costs of financial distress cause firms to restrain theirissuance 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


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Because costs of financial distress can bereduced but not eliminated, firms will not

finance entirely with debt.

Debt (B)

Value of firm (V)

0


Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

VL= VU + TCB


VU


B*

Maximumfirm value



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Summary and Conclusions If distributions to equity holders are taxed at a lower

effective personal tax rate than interest, the tax advantageto debt at the corporate level is partially offset. In fact, the

corporate advantage to debt is eliminated if (1-TC) (1-TS) =

(1-TB)

Debt (B)

Value of firm (V)

0


Present value of

financial distress costs Value of firm underMM with corporatetaxes and debt

VL

= VU

+ TCB


VU= Value of firm with no debt

B*

Maximumfirm value


VL

< VU

+ TCB when T

S< T

B

but (1-TB

> (1-TC(1-T

S

Agency Cost of Equity Agency Cost of Debt


29/29


Debt-to-equity ratios vary across industries.

Factors in Target D/E Ratio

Taxes

If corporate tax rates are higher than bondholdertax 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 operatingincome have high probability of experiencingfinancial distress.

Documents

L11-Capital Structure1