HAME510: Raising Capital: The Process, the Players, and Strategic Considerations

Transcription

1 HAME510: Raising Capital: The Process, the Players, and Strategic Considerations Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 1

2 This course includes Seven self-check quizzes Three discussions One tool to download and use on the job One course project Completing all of the coursework should take about five to seven hours. What you'll learn View the process of raising capital in a broad context regarding the mix of capital and the process of entering into capital markets Understand why changes in the industry and in the economy are important to investment and financing decisions in your organization Contribute to decisions in your own firm more meaningfully with a more complete understanding of corporate restructuring, mergers, acquisitions, and bankruptcy Course Description The capital projects your firm undertakes need to be funded. You need to know how to choose between debt and equity funding and when to consider acquiring funds from capital markets. These outside funding sources will have their own expectations for rates of return, and the cost of this funding is driven by a number of external factors such as the state of Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 2

3 the economy and the industry. Making sound capital budgeting and funding decisions is a vital part of your role as a manager, and this course shows you how characteristics of capital markets impact the process and prospects of raising capital. We show you how to observe external economic data and develop strategies to balance debt and equity at your firm and how decisions regarding corporate restructuring, mergers, acquisitions, and bankruptcy are made. These concepts, when put into action, will help ensure that you are maximizing the value of your firm using the correct balance of debt and equity. Steven Carvell Professor and Associate Dean for Academic Affairs, School of Hotel Administration, Cornell University Steven Carvell has taught finance courses at Cornell University since Professor Carvell is the co-author of In the Shadows of Wall Street (Prentice-Hall, Inc. Strebel, Paul and Steven Carvell, 1988). Carvell has worked for professional money managers in applied strategy in the equity market and served as a consultant to the Presidential Commission on the 1987 stock market crash. Professor Carvell has conducted numerous specialized Executive Education seminars for some of the largest hotel companies in the world. Carvell holds a Ph.D. from the State University of New York, Binghamton. Scott Gibson Zollinger Professor of Finance, Mason School of Business, College of William and Mary Scott Gibson is the Zollinger Professor of Finance at the College of William and Mary Mason School of Business and previously held academic appointments at Cornell University and the University of Minnesota. He holds a B.S. and Ph.D. in Finance from Boston College. Prior to his academic career, he worked as an analyst with Fidelity Investments and as a credit team leader serving Fortune 500 clientele with HSBC Bank. He's won outstanding teaching awards on numerous occasions, including being named an outstanding faculty member in BusinessWeek Guide to the Best Business Schools. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 3

4 His finance research has appeared in top academic journals and has been featured in the financial press, including the Wall Street Journal, Financial Times, New York Times, Barron's, BusinessWeek, and Bloomberg. Start Your Course Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 4

5 Module Introduction: Financing Choices and the Debt-Irrelevance Proposition In this module, you will examine financing choices as well as some of the complex considerations that finance managers take into account when they consider how best to raise capital. You will examine the question of how we think about the optimal mix of debt and equity, and you will examine some of the types of financing that are available to firms, including stock, preferred equity, and debt. You will have an opportunity to discuss some of your initial questions with your peers in a discussion forum, and you will get to confirm your mastery of key learning points. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 5

6 Read: The Assumptions of the Debt-Irrelevance Proposition Key Points The debt-irrelevance proposition: the value of a firm is unaffected by its capital structure if certain assumptions are true It assumes we live in a world with no taxes It assumes we have no direct or indirect financial distress costs To begin the examination of raising capital, let's explore a key theory. Franco Modigliani and Merton Miller, two researchers studying capital structure in the 1950s, formulated what is known as the debt-irrelevance proposition (or the MM debt-irrelevance proposition), which states that the value of a firm is unaffected by its capital structure if certain assumptions are true. Five of the key assumptions required by the MM debt-irrelevance proposition include that the firm exists in a world with: No taxes No direct financial distress costs (that is, no costs associated with bankruptcy) No indirect financial distress costs (In other words, the firm's financing decisions do not affect its investment decisions, and there are no conflicts of interest between its debt holders and stockholders.) No direct transaction costs (For example, there are no investment-banking commissions on debt or equity issuances.) No information advantages for managers about the firm's prospects relative to outside investors Franco Modigliani and Merton Miller Modigliani and Miller knew full well that the five assumptions are not true in the real world. Their point was not to show that the value of a firm is unaffected by its capital structure, but to show that if capital structure does matter, then it must be because of these assumptions. The importance of the MM debt-irrelevance proposition is that it laid the groundwork for Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 6

7 the rigorous study of how value can be created through capital-structure decisions. It provided a framework for academics and practitioners to use to focus their efforts. In the decades that followed, insights were gained as each of the five assumptions was relaxed. This course presents information you can use to gain an understanding of the intuition behind the MM debt-irrelevance proposition. Then you can turn your attention to learning what relaxing each of the five assumptions indicates in terms of optimal capital structure. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 7

8 Watch: The Optimal Mix of Debt and Equity When you think about capital structure, you're thinking about the mix of debt and equity that a firm uses to finance its activities. In this video, Professors Carvell and Gibson introduce the concept of the optimal mix of debt and equity for a firm. They'll also discuss how financial professionals look at both equity and debt when making strategic decisions. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 8

9 Read: Strategic Financing Considerations at Four Firms Here are a few brief scenarios and questions to get you thinking about the strategic considerations of raising capital. Here you will examine types of financing that are available to firms, as well as some of the advantages of each. Types of Financing Type Issued by Description Security Corporations, governments, or other organizations Securities are investment instruments and are broadly categorized into debt from banks and bonds; equity securities, which include common stocks; and Common Stock Corporations Gives the holder a residual claim on the firm's assets and cash flows (net of l Debt Corporations, governments, or other organizations For our purposes, debt is any financial claim issued by a firm that has a fixed make at a specified time if it is to avoid default. Preferred equity and preferred stock Corporations Preferred shareholders are senior to common shareholders and junior to eve not have the same voting rights as common stock shareholders. Consider, for example, Firm One. It has a high proportion of debt in its capital structure. Firm Two is a competitor of Firm One. It possesses similar capital such as trucks, equipment, etc., and similar competitive dynamics and cash-flow projections. However, Firms One and Two have very different levels of debt and equity in their capital structures. Even so, the two firms appear to enjoy the same level of consumer confidence. How is it possible that Firm One and Firm Two are so similar and yet one carries so much more debt than the other? Is one firm smarter than the other? Aren't there significant risks involved with carrying greater debt? In fact, why would either of these firms continue to maintain a positive debt balance; why wouldn't they just pay off their debt? Meanwhile, across town, Firm Three currently has a significant amount of debt outstanding and is concerned about meeting its payment obligations. One of its managers has proposed a negative NPV project that is clearly high risk-it's the sort of project your intuition tells you to avoid. Yet Firm Three's executive management, which has a reputation for smart, savvy decision making, just approved it! Under what circumstances would this decision make sense? Finally, let's examine a fourth firm: Firm Four is facing financial distress. Management there has recently rejected a Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 9

10 positive NPV project that, to the outside observer, looks very likely to produce significant profits in the future. Why do you think this firm would reject a positive NPV project? These are the considerations that we will examine as we move through the concepts in this course. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 10

11 Read: Slicing the Cash Flow Pie Key Points Consider the source underlying value in a company Cash flows and combined NPV in projects = total value When considering the impact of a company's choice of financing mix between debt and equity, it is useful to begin with an understanding of the source underlying value in a company. Economic value in a company is created when investments are made in projects that generate cash flows in excess of their cost of required funds. When we consider the cash flows and the combined net present value of the company's projects, that gives us the company's total value. For the purposes of illustration, let's think of a company's value as a pizza pie. Yours may be small, medium, large, or even an extra-large pie. But the size of the pie, for our example here, is a consequence of the size or amount of our company's total value. The issue now is, does it matter how we slice up the cash flow value of the pie, or does debt matter? These projects just mentioned that are generating cash flows were financed by some mix of debt and equity. Does it matter whether we finance the company's project with all equity or some mix of debt and equity? Will the company's value change or be affected depending on the financing mix? Let's take our pie and split it up. We'll show three different examples to make the point. In this first example, the cash flow value goes to all equity. This is simply a case where the company has no debt at all and all cash flows over time go to the equity providers of the company's capital. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 11

12 In this second example, one-half of the pie goes to equity, and one-half of the pie goes to our debt providers. The pie hasn't changed...just that we now have half going to a different group of capital providers. In the third example, most of the pie goes to debt and just a little to equity. Again, the pie is the same size, just most of it is now going to the debt providers. In all of these examples, the cash flow from the projects that we've invested in are going to providers of capital. Those providers of capital may be equity, debt, or some combination of the two. But again, the size of the pie, which is related to the cash flows coming in from the projects, remains unchanged. We can refer to this example as the "debt-irrelevance proposition." Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 12

13 Watch: Debt vs. Equity Does it really matter what you think of as debt and what you think of as equity, or is the critical consideration only, how much value is there in my firm? In this video, Professors Gibson and Carvell discuss an intuitive way to think about debt and equity and what they mean to you. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 13

14 Module Wrap-up: Financing Choices and the Debt-Irrelevance Proposition In this module, you explored the debt-irrelevance proposition and how the valuation of a company is not impacted by its capital structure based on this theory. You examined key assumptions to this proposition that are necessary for it to apply. You also identified what you need to focus on when thinking about capital structure. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 14

15 Module Introduction: Factoring Taxes into the Financing Decision Are there benefits to a corporation in carrying debt? And what are the some of the implications of taxes? In this module, you will examine the way that debt can work to a firm's advantage. Professors Carvell and Gibson will lead you on an examination of the role of debt in firm valuation. You will review a case study that demonstrates how debt affects a fictional company, and you will have an opportunity to participate in a discussion with your peers about the tax shield. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 15

16 Watch: MM's Modified Theory In this video, Professor Carvell will explain the relevance of "MM's Modified Theory," and how it relates to this exploration of raising capital. It may seem counterintuitive at first, but as Professor Carvell explains here, you can add value to a company when you add to its debt. Let's find out the rationale for this theory. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 16

17 Read: The Unlevered Firm The first of the assumptions of MM's debt-irrelevance proposition is this: no taxes. Do taxes make a difference in the value of the firm, and if so, how? To find out the answer, let's take a look at FlatCorp. Case Study FlatCorp Limited FlatCorp currently has no debt outstanding-that is, it is an unlevered firm. Its tax rate is 40% and its earnings before interest and taxes (EBIT) are expected to average $10 million per year indefinitely. All net income is paid to stockholders as dividends. FlatCorp's stockholders currently require an expected return of 15% on their shares. FlatCorp's expected net income is the earnings before interest and taxes minus the amount paid in taxes: Expected net income = $10m - (.40)($10m) = $6m/year (perpetuity) FlatCorp's equity value is the expected net income divided by the required return on equity: Equity value = (expected net income)/(required return on equity) = ($6m) / (.15) = $40 million Thus, when FlatCorp is financed entirely by equity, its investors as a group value the cash flows its operations are expected to produce at $40 million. FlatCorp's Market-Value Balance Sheet ($ Millions) Assets Present value of unlevered cash flows (V ) UA Liabilities and Equity 40 Equity 40 We refer to the market value of the firm on an all-equity basis as the or V. We can think of V value of unlevered assets, UA Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 17

18 UA as the present value of future cash flows that goes to investors of an all-equity financed firm. As we continue to explore the significance of the assumption no taxes, we need to explore what happens when FlatCorp takes on debt. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 18

19 Consider the Role of Taxes In this video, Professors Carvell and Gibson explore the ways that taxes influence our thinking about capital structure, and they explain what it means that corporations can accrue tax benefits by writing off, on their taxes, the interest paid on the debt to creditors. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 19

20 Read: How Debt Creates Benefits for the Firm Key Points When debt is introduced, net income goes down An unlevered firm carries no debt Now you will examine the ways that debt can create benefits for a firm. The debt-irrelevance proposition states that the value of a firm is unaffected by its capital structure if, among other things, there are no taxes. Annual Cash Flows ($ Millions) "Unlevered" $10 Million (No Debt) EBIT Less: Interest EBT Less: Taxes (40%) Net Income Case Study FlatCorp Limited We are exploring how taxes are important to the value of a firm and we are using FlatCorp as an example. What if FlatCorp, currently unlevered, adds debt to its mix of capital? Specifically, assume it issues $10 million in debt at an interest rate of 10% and pays the $10 million out to equity holders as a dividend. In this scenario, FlatCorp's operations are unaffected, and so earnings before interest and taxes (EBIT) remains the same as before it issued debt: $10 million. However, it would now pay 10%, or $1 million in interest, on its $10 million debt. This payment would reduce FlatCorp's earnings before taxes (EBT) to $9 million and, subsequently, reduce the tax payment FlatCorp must make. At 40%, the tax payment on $9 million is $3.6 million. FlatCorp's net income would be $9 million - $3.6 million = $5.4 million. "Unlevered" $10 Million Debt (No Debt holders receive Equity holders receive Total for investors is Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 20

21 The first table shown here presents a comparison of the levered and unlevered cases. When debt is introduced, net income goes down. But as you can see in the second table, the total payment to investors, both debt holders and equity holders, goes up! It changes from $6 million to $6.4 million. An unlevered firm carries no debt, so the value of the firm can be represented in two pieces: expected net income and tax payments. We can look at this scenario in terms of the cash flow pie. In the unlevered firm, a large slice of the value pie goes to the government as a tax payment. In a firm that carries debt (a levered firm), the government and net income slices are both reduced in order to create a third slice for debt payment. The value of a firm carrying debt can be represented in three pieces: expected net income, tax payments, and debt payments. While the size of the cash flow pie isn't changing, the slice sizes do change. With more debt, the government slice shrinks because more of FlatCorp's taxable earnings are shielded from taxation. As the government slice shrinks, the combined size of the debt holder and equity holder slices increases. This means more pie (i.e., more value) for investors as a group. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 21

22 Read: The Value of the Levered Firm Key Points When debt is introduced to the unlevered firm, net income goes down Interest paid out on debt is tax deductible, whereas stock dividends and additions to retained earnings are not Recall that FlatCorp was an unlevered firm with an EBIT of $10 million year after year. Before FlatCorp took on debt, investors as a group valued the cash flows its operations are expected to produce at $40 million. Let's take a look at what happens to FlatCorp's value at the point at which the firm acquires debt. Case Study FlatCorp Limited When debt is introduced to the unlevered firm, net income goes down. But the total payment to investors, both debt holders and equity holders, goes up! This is due to the debt tax shield-the reduction in taxes realized by deducting interest expense. FlatCorp's value now consists of expected net income, tax payments, and debt payments. FlatCorp's annual tax shield is the product of three values: the tax rate for the corporation, T ; the amount of the debt, D; c and the rate on the debt, r. The annual tax shield is: D T c(r DD) = (.40)($1.0 million) = $0.4 million If the risk of the tax shield is roughly the same as the risk of the debt itself, these cash flows should be discounted at rate r D. Furthermore, if the debt is always rolled over and not expected to grow, the tax shield can be treated as a perpetuity. In this special case, the present value of the tax shields is shown to the right. PV (tax shields) = T (r D)/r c D D = T D c = (0.40)($10 million) Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 22

23 = $4.0 million FlatCorp's equity value is the expected net income divided by the required return on equity: Equity value = ($6m)/(.15) = $40 million FlatCorp's market value to its investors after the debt issue is: $40 million + $4 million = $44 million (This is the market value of FlatCorp to its investors, both debt and equity, as a group.) The market value consists of the value of the all-equity financed firm (in this case, $40 million) and the present value of the interest tax shields (in this case, $4 million). Remember, interest paid out on debt is tax deductible, whereas stock dividends and additions to retained earnings are not. This fact creates a tax advantage for debt. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 23

24 Watch: Taxes Matter In this video, Professors Carvell and Gibson place the content of this section into a helpful context for the non-financial manager by explaining how it will help you perform better in your position and what it means for you. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 24

25 Module Wrap-up: Factoring Taxes into the Financing Decision In this module, you explored how taxes can change our approach to capital structure. You examined the levered firm and the unlevered firm. You also identified some of the advantages debt can have for a company. You examined the ramifications of taxes and financial distress costs to the value of the firm. You also explored the factors that motivate companies to take on debt, as well as some reasons that firms may choose to limit the amount of debt they carry. You also had an opportunity to discuss the ramifications of the fact that the U.S. government allows interest payments to be deducted from taxes. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 25

26 Module Introduction: Financial Distress Costs In this module, you will examine key concepts related to financial distress. You will look at liquidation and reorganization and will examine the real-life example provided by the U.S. savings and loan industry. You will investigate the difference between a fixed rate and a floating rate and begin an exploration of risk. You will have an opportunity to participate in a discussion with your peers on the strategic implications of cost. You will also get to demonstrate your mastery of critical concepts by completing quizzes related to direct costs, indirect costs, and how much debt is too much. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 26

27 Debt Funding Now that we know that there are tax advantages to corporations taking on debt, do we assume that all corporations are taking advantage? No, say Professors Carvell and Gibson. They explore the reasons for that in this video. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 27

28 Read: Costs Due to Liquidation, Reorganization, and Shareholder Perceptions Let's explore the reasons why companies may incur costs due to liquidation, reorganization, and shareholder perceptions. Click each icon below to learn more. Use the embedded scroll bar within each screen to see all relevant content. Liquidation In the United States, bankruptcy that leads to liquidation of the firm's assets in the settlement of creditors' claims is called a c hapter 7 bankruptcy, named for its chapter in the Federal Bankruptcy Code. Chapter 7 bankruptcy can be initiated by the firm itself or by creditors if the firm does not make required contractual payments. A chapter 7 bankruptcy is overseen by a federal bankruptcy trustee under the supervision of a federal bankruptcy court. The federal bankruptcy trustee liquidates the firm's assets and distributes proceeds to claim holders according to the absolute priority rule. This rule specifies that claims are paid in the following order: Collateral to secured creditors. Secured creditors have first ("prior") claim on their collateral or its value, regardless of their seniority in other respects. If more than one claimant has claim to the same collateral, the claimant that registered ("perfected") its collateral rights first has priority. Administrative expenses incurred as the result of the bankruptcy process: court costs, lawyers' fees, the trustee's expenses, and any debts incurred (with the court's permission) after the bankruptcy filing. Debts of the latter sort are often referred to as debtor in possession financing. Various claims singled out for priority, including: unpaid employee wages and benefits accrued before the bankruptcy filing, consumer deposits (for example, security deposits on apartments), and taxes. Claims by unsecured creditors (bondholders, trade creditors, banks, etc.). These creditors have equal status unless their credit agreements specifically give them senior or junior status, in which case they are paid according to order of seniority. Dividends to preferred shareholders. Dividends to common shareholders. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 28

29 In liquidation, claims that have higher priority must be paid in full before claims with lower priority are paid at all. Reorganization If the firm's value as an ongoing concern exceeds its liquidation value, then it is in all claimants' interests to attempt to reorganize the firm. In this case, the firm would be an economically viable entity, and the presumption is that its current capital structure is not conducive to continued operations. Bankruptcy that allows the firm to reorganize its debt and equity claims and continue to operate is called a c hapter 11 bankruptcy, named for its chapter in the Federal Bankruptcy Code. Like a chapter 7 bankruptcy, a chapter 11 bankruptcy can be initiated by the firm itself or by creditors if the firm does not make required contractual payments. A chapter 11 bankruptcy is overseen by a federal bankruptcy trustee under the supervision of a federal bankruptcy court. In a successful reorganization, the firm continues operating and claim holders receive new financial claims in exchange for their old ones. All old claims (including equity) are null and void afterward, so those holding shares in the firm prior to its reorganization must secure shares in the reorganized firm or lose their investments. Steps in the reorganization process: Management has 120 days (often extended by the judge) to submit a reorganization plan. Claimants vote. The judge determines whether at least half the number and two-thirds the dollar amount of each claimant class (including equity) accepted the plan. If If yes, the plan is adopted no, the judge may take one of three actions: Instruct management to devise a new reorganization plan (then return to another round of voting). Instruct claimants to devise their own reorganization plan or plans (then return to another round of voting). Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 29

30 Force a "cramdown." A cramdown plan must give all claimants at least as much as they would get under a chapter 7 liquidation. Shareholder When a firm with significant debt in its capital structure experiences a downturn in its operations, non-financial stakeholders may take actions that adversely affect the firm's operations. Let's consider the actions of three key non-financial stakeholder groups: consumers, suppliers, and employees. Consumers Suppose you're shopping for a new car. You've narrowed it down to two similar cars offered by two different firms: Crystal Motors and Fjord. Crystal is financed by a high ratio of debt-to-equity. Fjord has a low debt-to-equity ratio. The economy is currently in recession, and you've seen news headlines expressing concerns that weak firms may be heading for bankruptcy. The two cars offer similar features and warranties and are currently priced the same. However, the weaker company may need to cut prices to raise cash quickly in the short term. From which company do you buy? Fjord would be your best bet. Buying from Crystal is risky. Given the possibility of the financial distress at Crystal caused by their high debt ratio, operating budgets may be adversely affecting quality controls. Moreover, if Crystal declares bankruptcy, there's a possibility that its car warranties will be voided. There is also a possibility that spare parts and service may be difficult to find. If Crystal is going to sell cars, it's going to have to cut prices relative to Fjord, which will impair the profitability of operations. Even if it never declares bankruptcy, these are revenues that are lost forever. What we have now is capital structure affecting the operations of the firm. When a firm with significant debt in its capital structure experiences a downturn in its operations, it may have to lower prices to attract customers or it may lose its customers outright. Financial distress leads to particularly severe customer revenue losses for Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 30

31 firms that sell products with quality that is important yet hard to observe, and for firms that sell products that require future servicing. Suppliers Let's now suppose you're the CEO of Elle and Dee's Bakery, a supplier of individually wrapped cupcakes, fruit pies, cream-filled sponge cakes, and other delectable confections to convenience stores and grocery stores. Once you've delivered the product to the store, you offer net-30 trade credit terms (that is, you require full payment within 30 days). Snack-N-Gas, one of the convenience store chains you supply, has significant debt in its capital structure and of late has been experiencing a downturn in its operations. You become concerned that Snack-N-Gas may have difficulty making contractual payments to its creditors. As CEO of Elle and Dee's, what might you do? You may decide to do nothing because terminating trade credit makes a bad operating situation considerably worse for Snack-N-Gas. However, there are good reasons to terminate their trade credit. In the event of bankruptcy, recall that absolute priority dictates the order in which claims are satisfied. Trade credit is far enough down the absolute priority list that it is seldom repaid more than a few cents on the dollar. Of course, you'll be willing to sell Elle and Dee's delectable confections for cash, but Snack-N-Gas is unlikely to have the cash given its financial difficulties. Clearly Snack-N-Gas will have difficulty restocking its shelves once Elle and Dee's and other suppliers terminate their trade credit, which makes a bad operating situation considerably worse for Snack-N-Gas. In fact, suppliers terminating their trade credit is often a strong sign that bankruptcy is imminent, as the business will not last long without an ability to restock and sell products. Again, we have the firm's capital structure affecting its operations. When a firm with significant debt in its capital structure experiences a downturn in its operations, it increases the likelihood that trade credit will be terminated. Financial distress leads to severe supplier problems for firms that rely heavily on trade credit. Employees Let's now suppose that you're an employee of a firm with significant debt in its capital structure that experiences a downturn in its operations. You grow concerned that your employer may be heading for bankruptcy. What might you do? Doing nothing is not a good idea. It would be wise to look for another job. In fact, everybody at the the firm would be wise to look for another job. What will happen? Most employees will look for other jobs. The most competent, highly motivated employees will likely find jobs. The less competent, less motivated employees will likely not. Will the loss of its best employees adversely affect the firm's operations? Absolutely. Even if the firm never actually declares bankruptcy, it will be left with only the employees who were unable to find work, and those employees will run the firm. Again, we have the firm's capital structure affecting its operations. When a firm with significant debt in its capital structure experiences a downturn in its operations, it increases the likelihood that it will lose its best employees. Financial distress leads to severe problems for firms that rely on Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 31

32 highly trained, specialized employees. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 32

33 Read: The Risk-Shifting Problem Case Study Ace Widgets Consider Ace Widget Company. Let's take a look at Ace's market value balance sheet. As of January 1, 2015, Ace has cash of $20 million and operating assets of $80 million. The operating assets consist of the property, plant, and equipment to manufacture a widget. That's their key product. Let's see how it's financed. Ace has debt of $48 million and equity of $52 million. A little bit more about the debt: the debt matures June 30 in five years. It pays an 8.33% coupon rate, or $2 million every six months. Ace has been around successfully manufacturing widgets for a decade or so now, doing quite well. Market Balance Sheet ($ millions) for Ace Widget on January 1, 2015 Assets Liabilities and Equity Cash 20 Operating Assets 80 Debt 48 Equity 52 Total 100 Total 100 Debt matures June 30 in five years. Pays 8.33% coupon rate or $2 million every six months. Let's jump five years into the future. Ace Widget has actually fallen on some difficult times. A competitive product is taking over the market. Widgets are quickly fading out. Ace has a problem. Currently, it has only $10 million of cash left. The operating assets are only worth $10 million now. Basically, it's scrap value. All the equipment they have to manufacture widgets is outdated. Total assets are worth $20 million. Market Balance Sheet ($ millions) for Ace Widget on June 1, 2020 Assets Liabilities and Equity Cash 10 Operating Assets 10 Debt? Equity? Total 20 Total 20 At the end of the month, recall that the $48 million in debt is due, plus they're going to owe a $2 million interest payment on top of that. As of June 30, Ace is going to owe the debt holders $50 million. Frank Ace Jr., son of the founder of Ace Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 33

34 Widget, has a dilemma. If he sits and does nothing, what happens? Well, the debt holders are going to ask for their $50 million. Ace only has $20 million. He'll just have to pay off the debt holders the $20 million and say, "Sorry about the other $30 million." Equity holders will be left with nothing. But Frank gets an idea. How about if he heads off to Las Vegas? What he's going to do is walk up to the roulette table. He's going to put it all down on 17 black-all $10 million in cash that Ace has left. Let's think of the roulette gamble as a project. Well, one in 38 times, 17 black is going to hit. If you've ever been to Vegas, the payoff is 36 to 1. That $10 million will turn into $360 million. Now, the 37 of the 38 times, Frank's basically going to walk away with a free cocktail. He gets nothing. Of course, Frank puts all of Ace's $10 million on the line. If we calculate the net present value, we get minus.53 million, or a loss of $530,000. Clearly, this is a negative NPV project. Capital budgeting teaches us that we don't want to take negative NPV projects. But recall: what is management's goal? What is the objective of the firm? Well, it's to maximize the value of equity or maximize shareholder wealth. So let's think about Frank's position here-not a great one. Remember, if Frank sits and does nothing, the equity holders get nothing. One in 38 times, 17 black is going to come in. Let's look at the balance sheet as of June 30. Well, Ace now has cash of $360 million. The operating assets are still $10 million. Remember that's the scrap value of the equipment. Debt holders come to Ace at the end of the month. They demand the $50 million they're due. No problem. Ace has the $50 million to pay the debt holders in full. That leaves equity holders with $320 million. The other 37 of 38 times, Frank is going to lose and walk away with his free cocktail. Let's look at the balance sheet in that instance. Well, Frank has lost the $10 million, so Ace Widget has no cash left, a zero balance. Again, we have the operating assets worth $10 million. Debt holders come to Ace at the end of the month. They ask for their $50 million. Frank can only send his apologies and the $10 million. Debt holders take a $40 million loss. Of course, we have nothing left for equity-it's worth zero. Let's take a look at their expected payoff. One in 38 times, equity holders will get the $320 million-that's when 17 black hits. The other 37 of 38 times, they get zero. The expected payoff to the equity holders is $8.42 million. How about the debt holders' perspectives? What can they expect? One in 38 times, they'll get paid off in full the $50 million when 17 black hits. The other 37 of 38 times, they'll get their $10 million-basically the scrap value of the equipment. Their expected payoff is $11.05 million. When Frank Wins vs. When Frank Loses When Frank Wins When Frank Loses Equity holders $320 million Expected payoff is 1/38 ($320) + 37/38 ($0) = $8.42 million if Vegas. $0 Expected payoff is $0 if nothing. Debt holders $50 million Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 34

35 Expected payoff is 1/38 ($50) + 37/38 ($10) = $11.05 million if Vegas. $10 million Expected payoff is $20 million if nothing. How are equity holders and debt holders going to feel about Frank heading off to Vegas? Well, equity holders will like it. If Frank stays home, equity holders get zero for sure. Frank heads off to Vegas, equity holders, at least now they're in the game. Their expected payoff is $8.42 million. Debt holders, however, want Frank to stay home; they don't want him going off to Vegas. If Frank stays home, they get $20 million for sure. If Frank heads off to Vegas, their expected payoff drops to $11.05 million. What should Frank do? Well, the goal of the firm is to maximize the value of equity, so Frank should head off to Vegas despite the fact that it's a negative NPV project. This is the idea of risk shifting. If the project comes in, equity holders get all of the upside. Debt holders have a fixed payment. It's a fixed contract. However, if the project doesn't come in, if Frank doesn't hit 17 black, the debt holders have all the downside risk. Equity holders get all the upside; debt holders get all the downside. Another way to put it-heads, equity holders win; tails, debt holders lose. This creates a perverse incentive. When we get a lot of debt, operations hit a rough patch, the firm finds itself in a position where it will take risky projects even if they're negative NPV. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 35

36 Read: The Debt-Overhang Problem Case Study Ace Widgets Recall that as of 2015, Ace was making widgets and had $20 million in cash. The operating assets-primarily property, plant, and equipment to manufacture the widgets-worth $80 million, total assets of $100 million. That was financed with debt of $48 million and equity of $52 million. Recall the debt matures June 30, 2020; it pays a coupon of 8.33%, or $2 million every six months. Market Balance Sheet ($ millions) for Ace Widget on January 1, 2015 Assets Liabilities and Equity Cash 20 Operating Assets 80 Debt 48 Equity 52 Total 100 Total 100 Debt matures June 30 in five years. Pays 8.33% coupon rate or $2 million every six months. Let's fast forward to June 1, The debt is now due. Frank's friend comes along and has a great idea. He says, "Why don't we upgrade the factory to the manufacture of a more competitive product?" Let's take a look at the numbers. If Frank upgrades the factory, it's going to cost $12 million in cash. The present value of the future cash flows will be $25 million. Let's calculate the net present value of the factory updates. Twenty-five million dollars is the present value of the future cash flows. Twelve million dollars is the cash required to convert the factory. Ten million dollars is the opportunity cost of the factory that he could have sold for scrap. The net is a positive $3 million. So the net present value is a positive $3 million. But where does the $12 million come from? NPV = PV - cost of upgrading factory - opportunity cost of factory for scrap = $25 million - $12 million - $10 million = $3 million Well, Ace Widgets has $10 million cash on hand, so there's $2 million needed. Let's think about trying to raise it from the equity holders. Let's look at it from equity holders' perspective. They put up the $2 million. Ace combines that with their $10 million cash and upgrades the factory. What do they have left? The cash is a zero balance. The operating assets are now worth $25 million. That's the present value of the future cash flows for the manufacture of upgraded widgets. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 36

37 So what will Frank's debt holders receive? They come and ask for their $50 million. Well, Frank has $25 million for them. Equity holders receive nothing. So will equity holders want to provide $2 million if they will get zero for sure? No. Even though this is a positive NPV project, it is not in the interest of the firm to undertake the investment. Recall that the objective of management, the goal of the firm, is to maximize the value of the equity or maximize its shareholder wealth. Market Balance Sheet ($ millions) for Ace Widget on June 30, 2020 Assets Liabilities and Equity Cash 0 Operating Assets 25 Debt 25 Equity 0 Total 25 Total 25 Consider the debt-overhang problem. Here equity holders put up the $2 million, but debt holders have first claim on the assets. With the debt overhang, equity holders will not fund the project, even though it is a positive net present value. Well, could the firm raise money from additional debt? Typically not. Typically, debt that's already in place will have a claim that is senior to any debt that follows on. We call this subordinate debt-this debt that follows on. What that means, in the case of a bankruptcy, is the debt that is already in place that is senior will have first claim on the assets. The subordinated debt that follows on will have a second claim. In this case, if the subordinated debt holders provide the $2 million, again, they will receive nothing, just like the equity holders. So a firm that finds itself with a debt overhang, even though it has positive net present value projects to undertake, it is shut off from funding. It cannot raise equity, and it cannot raise debt. When a firm gets debt in its capital structure, considerable amounts of debt, and hits a rough patch with its operations, the debt-overhang and the risk-shifting problems combine. With a debt-overhang problem, it cannot fund positive net value present projects. With the risk-shifting problem, it has an incentive to take high-risk projects even though they might be negative net present value. This destroys the value of the operating assets. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 37

38 Read: The Savings and Loan Industry Example Key Points Without knowledge of risk shifting, the actions of savings-and-loan management that contributed to the losses in the early 1980s make little sense. But once you understand risk shifting, the rationale becomes clear. Real-world examples of the risk-shifting and debt-overhang problems are not rare, particularly during economic recessions. Consider the collapse of the savings-and-loan industry that cost U.S. taxpayers more than $100 billion. An understanding of risk shifting makes clear the motives for otherwise puzzling S&L management actions. Imagine that you are a CEO of a savings-and-loan institution in the early 1970s. You, like other CEOs in the savings-and-loan business, have successfully followed a simple business model for years: originate and hold 30-year mortgages at a fixed rate of roughly 7% and raise capital primarily by taking in short-term deposits paying roughly 4%. The 3% difference between the 7% you are taking in on long-term mortgages and the 4% you are paying out on short-term deposits leaves your savings and loan with a handsome profit year after year! Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 38

39 Now fast forward a few years to 1980 and a very different world. Oil embargoes, Federal Reserve policies designed to fight unemployment rather than inflation, and other factors have resulted in an inflation rate of 13.5%. What does this mean for you? Your savings and loan assets are mostly the long-term 7% mortgages originated over past decades. Your savings and loan finances those assets primarily with short-term deposits that now pay double-digit interest to compensate depositors for inflation. If, as CEO, you take no action, how long will your savings and loan stay in business? The answer is not very long; you'll go out of business and your stockholders will receive nothing. But what can you do? Actual CEOs of the savings-and-loan industry found an option in 1980: they bought high-risk junk bonds and made high-risk loans. Assuredly, many of these "projects" had a negative net present value. Under normal circumstances, buying these high-risk junk bonds and making high-risk loans would not have made sense. But, savings-and-loan management was doing its job. If management had done nothing, stockholders would have lost everything. By gambling on the high-risk junk bonds and loans, management gave its stockholders a chance. If the gamble had paid off, depositors could have been paid and money would have been left for stockholders. Unfortunately, the gamble did not pay off, with many of the junk bonds and loans later proving worthless. Without knowledge of risk shifting, the actions of savings-and-loan management that contributed to the losses in the early 1980s make little sense. But once you understand risk shifting, the rationale becomes clear. When you sit down to catch up on the financial news, keep risk shifting in mind. It may help you to assess the motives behind management's actions. Copyright 2012 ecornell. All rights reserved. All other copyrights, trademarks, trade names, and logos are the sole property of their respective owners. 39