Corporate Borrowing and Leverage Effects

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1 FIN 614 Mixing Debt and Equity Professor Robert B.H. Hauswald Kogod School of Business, AU Corporate Borrowing and Leverage Effects Continue with deviations from ideal world of M&M taxes, financial and operating risks, etc. Homemade leverage - investors can create or adjust leverage how they see fit suppose the firm does not change its capital structure but investors want high debt: continue our example management might prefer low debt: why? Leverage mitigates and exacerbates conflicts of interests within the firm in the absence of full information managers vs. owners: mitigates managerial agency conflicts shareholders vs. debtholders: creates debt agency conflicts 3/22/2011 Debt and Equity Robert B.H. Hauswald 2

2 Operating Leverage The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs. Operating leverage increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicity on beta. The degree of operating leverage is given by: DOL = EBIT EBIT Sales Sales 3/22/2011 Debt and Equity Robert B.H. Hauswald 3 Operating Leverage $ Total costs EBIT Fixed costs Volume Fixed costs Volume Operating leverage increases as fixed costs rise and variable costs fall. 3/22/2011 Debt and Equity Robert B.H. Hauswald 4

3 Consequences of Operating Leverage Degree of operating leverage: sensitivity of operating cash flow to a percentage change in Q (quantity) Percentage change in OCF = DOL x percentage change in Q so that DOL = 1 + FC/OCF Selection of high risk projects: risk may increase with debt ratio gambling for resurrection: limited liability invites risk shifting ==> "go for broke since you will get nothing otherwise" A project can have a positive NPV for one group of claimants (investors), while its overall NPV is negative Examples: Hunt Brothers, S&Ls (Charles Keating) 3/22/2011 Debt and Equity Robert B.H. Hauswald 5 Financial Slack Amount of funds available for investment without external finance after paying interest essentially the amount of retentions before paying dividends + depreciation: cash at hand More equity (financial slack) or more debt? 2 factors likelihood of finding and exploiting good investment opportunities 1. Firm s track record: lemons problem firms may be willing to take risks and negative NPV projects because they are investing other peoples money 2. Financing available for good opportunities? small growing firms may have problems raising financing when they have positive NPV projects: convincing investors about projects merit out of a pool of potential investments 3/22/2011 Debt and Equity Robert B.H. Hauswald 6

4 Costs of Financial Slack: Managerial Agency Conflicts 1. Conflicts between managers and shareholders: uneconomic expansion: empire building, dotcoms, ATT-NCR debt can be a mechanism that "ties the manager's hands" 2. Conflicts between shareholders, managers and employees: high debt can also be a mechanism that reduces the pool of profits that labor can bargain over facilitates adjustment to a new economic environment helps managers avoid emotionally costly decisions reduces over-diversification: to protect themselves against bankruptcy managers might over-diversify (human capital) possible reversal of this trend: 1980s Focus on Core Competencies and debt reduction 3/22/2011 Debt and Equity Robert B.H. Hauswald 7 Asset Type Asset type is one of the most important factors in capital structure design determining differential growth opportunities, and differential agency costs, and differential information Example: Back to the Future old economy: assets in place might inhibit the exercise of growth opportunities new economy: assets are mainly human capital (technology, processes, ideas) and need incentives 3/22/2011 Debt and Equity Robert B.H. Hauswald 8

5 Asset Type and Debt-Equity Mix Factors arguing for more equity: human assets growth opportunities combined with differential information financial distress costs: higher for firms with intangible assets or assets that are hard to sell Factors favoring more debt: taxes and agency conflicts tax advantages: firms with stable cash flows will be able to use the tax advantages of debt (even tax credits) stable firms with high free cash flow from current operations without profitable investment opportunities will tend to increase debt - thus avoiding over-investment signalling: high debt may signal good stable opportunities 3/22/2011 Debt and Equity Robert B.H. Hauswald 9 The Store(s) around the Corner Two individuals want to open and operate a corner grocery store without sufficient funds: need $100,000 they must finance the store by raising money (external finance) Kelly finances the store with EQUITY sells 90% of the business to an investor for 90,000 Tom finances his store with DEBT 100% ownership, finances 90% of the store with a 90,000 loan By JUNE it becomes apparent that both stores have made 90,000. summer profit opportunities are 10,000: work is tough and it takes 2,500 to get owners to forego the beach who works, and who goes to the beach? 3/22/2011 Debt and Equity Robert B.H. Hauswald 10

6 Increased Effort and Incentives Tom knows that he will get all $10,000 of the PROFIT so he stays and works can you show this? Kelly realizes that she will only get $1,000 of the $10,000 so goes to the BEACH ==>Debt can produce higher efficiency and less waste: reduction in agency costs Other examples: desire to buy jet planes or other firms a fancy office costs $50,000 but adds only $25,000 to corporate profits: Tom would not buy! Kelly gets $25,000 of benefits but only costs her $5,000 of her money: Kelly installs the fancy office 3/22/2011 Debt and Equity Robert B.H. Hauswald 11 Cost of (too much) Debt: Debt Agency Conflict of interest between manager-shareholders and debtholders (banks, bondholders) risk-shifting: take risks that are beneficial to owners Examples: take bad risks Incentive to take large risks: gambling for resurrection Incentive toward underinvestment: fly to Rio Milking the property: asset stripping Consequences: shift costs to debtholders Impaired ability to conduct business (e.g., lost sales) Agency Costs 3/22/2011 Debt and Equity Robert B.H. Hauswald 12

7 Balance Sheet for a Company in Financial Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 $200 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 $0 What happens if the firm is liquidated today? Bondholders get $200; shareholders get nothing! 3/22/2011 Debt and Equity Robert B.H. Hauswald 13 Self-interested Owners 1: Gambling for Resurrection R&D Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm s cash) Required return is 50% Expected CF from the Gamble = $ $0 = $100 NPV = $200 + $100 (1.50) NPV = $133 3/22/2011 Debt and Equity Robert B.H. Hauswald 14

8 Negative NPV Project Selection Expected CF from the R&D Gamble To Bondholders = $ $0 = $30 To Stockholders = ($1000 $300) $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble: PV of Stocks With the Gamble: $20 = $30 (1.50) $47 = $70 (1.50) 3/22/2011 Debt and Equity Robert B.H. Hauswald 15 Self-interested Owners 2: Underinvestment Continue previous example of firm in distress but consider a government-sponsored project that guarantees $350 in one period: sure return with same balance sheet Cost of investment is $300 the firm only has $200 in cash so that stockholders will have to supply an additional $100 to finance the project Required return is 10% $350 NPV = $ = $ Accept or reject project? 3/22/2011 Debt and Equity Robert B.H. Hauswald 16

9 Selfish Shareholders Forego Positive NPV Project Expected CF from the government sponsored project: to bondholders = $300 to shareholders = ($350 $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project: $ = $300 (1.10) $50 PV of Stocks With the Project: - $54.55 = $100 (1.10) 3/22/2011 Debt and Equity Robert B.H. Hauswald 17 Self-interested Owners 3: Milking the Property Liquidating dividends: suppose our firm paid out a $200 dividend to the shareholders. payment leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders Such actions often violate bond indentures PG&E however used such extraordinary dividend payments to drive generating subsidiary into bankruptcy Equivalent strategies just increase perquisites to shareholders and/or management free products, housing, jets, etc. 3/22/2011 Debt and Equity Robert B.H. Hauswald 18

10 Costs of Financial Distress E[Costs] = Prob. of bankruptcy * Cost of Bankruptcy Direct costs: lawyers, accountants, consultants dividing up/redistributing the pie: enforcement costs generally thought to be small (Warner 1977: Journal of Financial Economics) but in some cases not: Eastern Airlines taxes: loss of PV of tax credits Indirect costs: matter most sales and customers (reliability): costs of switching suppliers, lost up-front relationship specific costs opportunities: cutback in R&D, advertising; higher charges operating costs: higher costs of labor or of investing in long term relationship flexibility: debt restrictions and covenants 3/22/2011 Debt and Equity Robert B.H. Hauswald 19 Forms of Increased Leverage All debt instruments: private and public debt, loans Debt securities: bonds rated by Moody s and S&P investment grade: rated at least Baa (Moody s) or BBB (S&P) high yield: bonds rated lower than investment grade (junk) Why do some borrowers have to pay a higher interest rate than others? caveat emptor! borrowers demand risk premium: promised vs. effective yield Promised yield (to maturity): ytm that is calculated assuming NO default risk Effective yield (to maturity): ytm that takes into account the bonds expected payments, i.e., incorporate default risk 3/22/2011 Debt and Equity Robert B.H. Hauswald 20

11 Pricing Default Risk (Default) risk free bonds have a 9% coupon, $1,000 par (face) value, 1 year to maturity Suppose a company has a 20% chance of default issues 1 year note at 9% bondholders receive nothing in the event of default they receive full payment + interest otherwise. Assume that default is not correlated with systematic market risk: bonds β = 0 What are the effective and promised yields? bondholders rationally anticipate on shareholder actions and price bond accordingly self-interested actions affect borrowing costs 3/22/2011 Debt and Equity Robert B.H. Hauswald 21 Solution Outcome Payoff Probability Full Payment $ No Payment $0 0.2 Expected Value of the Payment = 0.8 ($1,090) ($0) = $872 Note that investors require only 9% by assumption: no correlation with systematic risk PV of the bonds = $872 / 1.09 = $800 An investor who bought the notes at this price would receive a promised yield of: Promised yield: still 9% Effective yield: 1,090 y = 1 = 36.25% 800 3/22/2011 Debt and Equity Robert B.H. Hauswald 22

V T = S + B + G + L B S L G The essence of the M&M intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie. 3/22/2011 Debt and Equity Robert B.H.

12 The Firm as a Pie Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy lawyers, respectively. V T = S + B + G + L B S L G The essence of the M&M intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie. 3/22/2011 Debt and Equity Robert B.H. Hauswald 23 Capital Structure Design Maximum firm value Value of firm (V) Present value of tax shield on debt Present value of financial distress costs V L = V U + T C B Value of firm under MM with corporate taxes and debt V L < V U + T C B when T S < T B but (1-T B ) > (1-T C ) (1-T S ) V U = Value of firm with no debt V = Actual value of firm with bankruptcy costs Agency Cost of Equity Agency Cost of Debt 0 Debt (B) B* 3/22/2011 Debt and Equity Robert B.H. Hauswald 24

Summary and Conclusion Optimal capital structure trade off costs and benefits Advantages to debt: reduction of taxes through tax shield reduces managerial discretion when firm has few positive

13 Summary and Conclusion Optimal capital structure trade off costs and benefits Advantages to debt: reduction of taxes through tax shield reduces managerial discretion when firm has few positive investment opportunities Disadvantages of debt: bankruptcy costs may be significant and affect operations Advantages of equity: increased managerial discretion when firm has more positive investment opportunities and outside investors have poor ability to choose good firms 3/22/2011 Debt and Equity Robert B.H. Hauswald 25 Appendix: Industry D/E Ratios 3/22/2011 Debt and Equity Robert B.H. Hauswald 26

14 Market Default Risk Let default be related to the market: more likely to occur in a recession: investors will require an additional bond risk-premium Suppose the required premium is 2%: β = 0.25 R d = R f + β ( Ε(r m ) - R f ): the market risk premium is 8% ==> R d = 9% +.25( 8%) = 11% The notes will sell for: 872/ 1.11 = risk-adjusted yield: discounting expected value both numerator and denominator adjusted for risk! Effective yield: $1090 / = 38.8% Promised yield? 3/22/2011 Debt and Equity Robert B.H. Hauswald 27

Financial Distress Costs and Firm Value

Financial Distress Costs and Firm Value 1 2 I. Limits to Use of Debt According to MM Propositions with corporate taxes, firms should have a capital structure almost entirely composed of debt. Does it make sense in the real world? Why? Note 14