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 Financial Distress Costs and Firm Value 3 Costs of Financial Distress Bankruptcy: When debt obligation is not met, the ultimate destination is bankruptcy, where ownership of the firm s assets is legally transferred from stockholders to bondholders. The possibility of bankruptcy has a negative effect on firm value. But it is not the risk of bankruptcy itself that lowers the value of the firm. Rather, it is the costs associated with bankruptcy that lower value. Costs of financial distress: Costs arising from bankruptcy or distorted business decisions when a firm is near bankruptcy. It is understood that the latter far exceeds the former in magnitude. Financial Distress Costs Direct Costs Legal and administrative costs Indirect Costs Impaired ability to conduct business (e.g., lost sales) Agency Costs Selfish Strategy 1: Incentive to take large risks ( overinvestment ) Selfish Strategy 2: Incentive to reject profitable investments ( underinvestment ) Selfish Strategy 3: Milking the property Selfish Strategy 4: Reluctance to liquidation
5 6 Direct Bankruptcy Costs Whey companies go bankruptcy, they have to pay a sizable amount of money to lawyers, accountants, and experts (sometimes including finance professors) Bankruptcies are to lawyers what blood is to sharks The problem worsens because bankruptcy process sometimes takes years, snowballing costs involved The process often accompanies serious moral hazard, which further inflates costs Some biggest direct costs of bankruptcy: $2 billion (Lehman Brothers), $1 billion (Enron), $600 million (Worldcom) All these costs are borne by bondholders Enron: Bankruptcy Case One of the largest energy firm Covered 20% of energy sales in Europe/U.S. combined $66 billion in assets; $100 billion in sales Selected as the most innovative firm in U.S. for six consecutive years by Fortune Aggressive business expansions lead to enormous losses. Management relied on fraudulent accounting to cover losses Stock price plummeted from near $90 to below 10 cents Arthur Anderson, who was responsible for accounting and auditing for Enron, were forced out of business in the wake of the scandal Enron Stock Enron s Bankruptcy is a Bankruptcy Advisors Windfall Name Fees Expenses
9 Enron: Bankruptcy Case Expenses and fees billed by Weil Gotshal during the first 120 days Lawyers billed 20 to 23 hours per day $300,000 on airline tickets $135,856 on hotel bills $62,000 on day-time working means and $21,000 on out-oftown meals $175 hourly wage for in-house librarians Expense to hire people in line for lawyers for entering Senate hearing committee Agency Costs of Debt Arise because of conflicts of interests between shareholders (and management representing them) and creditors Appear only in firms that have financial distress because of debt Selfish Strategy 1: Incentive to take large risks ( overinvestment ) Selfish Strategy 2: Incentive to reject profitable investments ( underinvestment ) Selfish Strategy 3: Milking the property Selfish Strategy 4: Reluctance to liquidation Example: Company in Distress We will use this example for the next two cases Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? $200 $0 1. Overinvestment Firms that are near bankruptcy often take great chances and invest in risky investments that have negative NPVs. This can happen because shareholders believe that they are playing with others money. Suppose that firm C considers two mutually exclusive investment projects, S and R, where S is a safe, positive NPV project while R is a risky, negative NPV project. If C is near bankruptcy, its shareholders are more likely to choose R over S. The reason is that if the investment succeeds, a significant portion of the payoffs will belong to shareholders. however, if it fails, it is not shareholders but bondholders who will suffer from the failed investment This problem arises because, when a firm is liquidated, shareholders have residual claim
Example: Overinvestment The 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 = $1000 0.1 + $0 0.9 = $100 Example: Overinvestment Expected CF from the Gamble To Bondholders = To Stockholders = PV of Bonds Without the Gamble = PV of Stocks Without the Gamble = PV of Bonds With the Gamble: PV of Stocks With the Gamble: Overinvestment Problem and Firm Value The tendency of firms near bankruptcy to prefer high risk investments lowers firm value because it causes firms to make mistakes of choosing inferior investments over superior, positive NPV investments 2. Underinvestment Underinvestment means that firms facing a significant chance of bankruptcy invest less than the optimal level or do not invest at all although they have profitable investment opportunities that can raise the value of the firm For example, firm A considers a new investment with a positive NPV. If the firm is near bankruptcy and if all of the payoffs from the investment belong to bondholders, the shareholders are unlikely to accept the project. New investments help bondholders at the expense of shareholders
Example: Underinvestment Consider a government-sponsored project that guarantees $350 in one period. Cost of investment is $300 (the firm only has $200 now), so the stockholders will have to supply an additional $100 to finance the project. Required return is 10%. Example: Underinvestment Expected CF from the government sponsored project: To Bondholder = To Stockholder = PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project: Should we accept or reject? PV of Stocks With the Project: Underinvestment Problem and Firm Value Underinvestment creates a problem because firms may deny investments with a high probability of success and positive payoffs. Thus, it lowers firm value Meanwhile, one cannot find the underinvestment problem in all-equity firms 3. Milking the Property If unchecked, shareholders of firms near bankruptcy might pay out extra dividends or other distributions, leaving less in the firm for bondholders The behavior, needless to say, will harm firm value To prevent this from happening, sometimes a dividend restriction clause is included as a protective covenant in bond indentures.
Example: Milking the Property Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. Such tactics often violate bond indentures. 4. Reluctance to Liquidation Reluctance to liquidation refers to the tendency of shareholders or managers to refuse liquidation although liquidation is the best option for firm value In principle, the decision to liquidate or let the firm continue operation should be based on the comparison of firm values under different decisions. If the liquidation value is greater than the value of the firm as a going concern, the firm should be liquidated. However, shareholders have an incentive to maintain the firm alive. 24 Things to Note One thing to note is that managers are shareholders agents (to work for shareholders). Hence, without effective protective mechanisms, it is possible that bondholder rights are violated Tax Effects and Financial Distress 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. II. Integration: of Tax Effects and Financial Distress Costs Now we have more slices of the pie. V T = E + D + G + L V = E + D = V T G L where V T = total size of the pie V = market value of the firm E = equity value D= debtvalue G = tax claims L = bankruptcy claims
25 26 What are the implications of financial distress costs to (1) the relationship between leverage and firm value and (2) the relationship between leverage and the cost of capital? The implications can be summarized in the following two graphs. Pie Model with Taxes and Financial Distress Costs (L) 27 28 Firm Value V L with tax Cost of Capital Max. Firm Value Cost of Financial Distress r E V U PV of Tax Shield of Debt V L witout tax Minimum WACC r U WACC r D (1-T C ) Optimal Capital Structure Leverage and Firm Value Debt to Equity Ratio Optimal Capital Structure WACC with financial distress costs Debt to Equity Ratio
Conclusions from the Capital Structure Theory: If we ignore taxes, capital structure is irrelevant. 29 III. Other Theories to explain capital structure policies 30 But with corporate taxes capital structure matters a great deal. This is because interest is tax deductible and generates a tax shield. The theory we have studied so far is called Static Theory of Capital Structure. It is not the only theory to explain capital structure policies, though. Other Theories Signaling Agency Cost Approach Pecking Order Theory Finally, financial distress costs reduce the attractiveness of debt financing. The above considerations imply that an optimal capital structure exists when the net tax savings from an additional dollar in interest just equal the increase in expected financial distress costs. This is the essence of the theory of capital structure. 1. Signaling Firm Value V L with tax 32 The firm s capital structure is optimized where the marginal subsidy to debt equals the marginal cost (optimal point). If, because of some changes in circumstances, the management revise their expectation of firm s future performance upward, the optimal point will shift right. Then, the firm will issue more debt Therefore, investors view debt as a signal of firm value. Firms with low anticipated profits will take on a low level of debt. Firms with high anticipated profits will take on a high level of debt. A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run. Max. Firm Value V U PV of Tax Shield of Debt Optimal Capital Structure New Optimal Capital Structure Debt to Equity Ratio
2. 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. In addition, he will work harder if he owns a large percentage of the firm than if he owns a small percentage. An entrepreneur who issues stock to expand his business has a smaller share of the firm. He gets a smaller share of any extra income and bears a smaller share of any perks. Thus he has more incentive to shirk and consume perks. He may also accept negative NPV projects because his salary will increase with firm size. If the expansion is financed through debt, he is unlikely to increase his leisure time, work related perks and unprofitable investments: percentage stake not affected. Agency cost of equity is one reason to issue debt. While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the 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. 3. The Pecking-Order Theory Issuing securities is not cheap! Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1 Use internal financing first Rule 2 Issue debt next, and then new equity last The pecking-order theory is at odds with the tradeoff theory: There is no target D/E ratio Profitable firms use less debt Companies like financial slack 36
How Firms Establish Capital Structure Most corporations have low Debt-Asset ratios. Changes in financial leverage affect firm value. Stock price increases with leverage and vice-versa; this is consistent with M&M with taxes. Another interpretation is that firms signal good news when they lever up. There are differences in capital structure across industries and even through time. There is evidence that firms behave as if they had a target Debt-Equity ratio (Consistent with M&M) Maybe, in the long-run, target D/E ratio, but in the shortrun, pecking order Factors in Target D/E Ratio Taxes Since interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit). 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 operating income have a high probability of experiencing financial distress.