Capital structure limits to the use of debt

CAPITAL STRUCTURE
limits to the use of debt
4/30/2013
Dr. Md Mohan Uddin
http://lnkd.in/vvppcr
1

COSTS OF FINANCIAL DISTRESS
Bankruptcy risk or bankruptcy cost?
• Debt provides tax benefits
• However, debt also create the pressure of financial distress
• The ultimate distress is ‘bankruptcy’
– ownership of assets is legally transferred from stockholders to
bondholders
• Bankruptcy costs/ financial distress costs tend to offset the
advantages of debt (see following example).
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Dr. Md Mohan Uddin
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• Knight corporation and Day corporation will remain in business for one
more year
• Both has identical possible cash flows
– $100 with 50 percent probability (boom times)
– $50 with 50 percent probability (recession)
• These firms do not have any other asset
• They have different interest and principal obligations
– Knight: $49
– Day: $60
• Taxes are ignored
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Dr. Md Mohan Uddin
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• In case of recession, Day corporation cannot meet the financial obligations in full
• If bankruptcy occurs, bondholders will receive all the cash and stockholders will
receive nothing
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Dr. Md Mohan Uddin
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Knight Corporation Day Corporation
Boom times
(prob. 50%)
Recession
(prob. 50%)
Boom times
(prob. 50%)
Recession
(prob. 50%)
Cash flow $100 $ 50 $100 $ 50
Financial obligation on debt 49 49 60 50
Distribution to stock holders $ 51 $ 1 $ 40 $ 0

• Assuming
– Both bondholders and stockholders are risk neutral
– The interest rate is 10%
𝑽 𝑲𝑵𝑰𝑮𝑯𝑻 = 𝑺 𝑲𝑵𝑰𝑮𝑯𝑻 + 𝑩 𝑲𝑵𝑰𝑮𝑯𝑻
=
$𝟓𝟏×𝟎.𝟓𝟎+$𝟏×𝟎.𝟓𝟎
𝟏.𝟏𝟎
+
$𝟒𝟗×𝟎.𝟓𝟎+$𝟒𝟗×𝟎.𝟓𝟎
𝟏.𝟏𝟎
= $𝟐𝟑. 𝟔𝟒 + 𝟒𝟒. 𝟓𝟒 = $𝟔𝟖. 𝟏𝟖
𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀
=
$𝟒𝟎×𝟎.𝟓𝟎+$𝟎×𝟎.𝟓𝟎
𝟏.𝟏𝟎
+
$𝟔𝟎×𝟎.𝟓𝟎+$𝟓𝟎×𝟎.𝟓𝟎
𝟏.𝟏𝟎
= $𝟏𝟖. 𝟏𝟖 + $𝟓𝟎 = $𝟔𝟖. 𝟏𝟖
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Dr. Md Mohan Uddin
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• In case of bankruptcy, some additional costs associated with the bankruptcy would reduce the
value of the firm.
• In this example, if the bankruptcy costs are $15,
𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀
=
$𝟒𝟎 × 𝟎. 𝟓𝟎 + $𝟎 × 𝟎. 𝟓𝟎
𝟏. 𝟏𝟎
+
$𝟔𝟎 × 𝟎. 𝟓𝟎 + $𝟑𝟓 × 𝟎. 𝟓𝟎
𝟏. 𝟏𝟎
= $𝟏𝟖. 𝟏𝟖 + $𝟒𝟑. 𝟏𝟖
= $𝟔𝟏. 𝟑𝟔
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Dr. Md Mohan Uddin
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Knight Corporation Day Corporation
Boom times
(prob. 50%)
Recession
(prob. 50%)
Boom times
(prob. 50%)
Recession
(prob. 50%)
Cash flow $100 $ 50 $100 $ 50
Financial obligation on debt 49 49 60 5035
Distribution to stock holders $ 51 $ 1 $ 40 $ 0

• The yield or promised return to the bondholders of Day Corporation (without
considering bankruptcy costs)
$𝟔𝟎
$𝟓𝟎
− 𝟏 = 𝟐𝟎%
• The yield or promised return to the bondholders of Day Corporation (considering
bankruptcy costs)
$𝟔𝟎
$𝟒𝟑. 𝟏𝟖
− 𝟏 = 𝟑𝟗%
• Summary
– 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 the value. Rather, it is the costs associated
with bankruptcy that lower value.
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Dr. Md Mohan Uddin
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• Summary
– 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 the
value. Rather, it is the costs associated with bankruptcy that lower
value.
B
Fees and costs related to
bankruptcy procedure

DESCRIPTION OF FINANCIAL DISTRESS COSTS
Direct costs of financial distress
• Legal and administrative costs of liquidation or reorganization
– lawyers fee
– administrative and accounting fee
– expert witnesses fee
• Although large in absolute amount, these direct costs are actually
small as a percentage of firm value
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Dr. Md Mohan Uddin
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Indirect costs of financial distress
• Impaired ability to conduct business
– impaired service
– loss of trust
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Dr. Md Mohan Uddin
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Agency costs
• Conflict of interest arises between stockholders and bondholders of a
levered firm
• Stockholders are tempted to pursue selfish strategies
• In a financial distress situation, these conflicts are magnified and
impose agency costs
• There are three kinds of selfish strategies
– taking large risks
– underinvestment
– milking the property
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Dr. Md Mohan Uddin
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Agency costs: taking large risks
• When a firm is near bankruptcy, management may try to get the incentive from
taking large risks
– high risk projects increases firm value in a boom and its benefit is captured only by
stockholders
• Consider a levered firm considering two mutually exclusive projects to choose from:
a low-risk one and a high-risk one
• There are two equally likely outcomes: recession, and boom
• The firm promises to pay $100 to bondholders as principal and interest payment
• In case of a recession, The firm will
– come near to bankruptcy with the low-risk project
– actually fall into bankruptcy with the high-risk project
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Dr. Md Mohan Uddin
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• If the firm invests in the low risk project:
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Outcome Prob. Value = Stock + Bonds
Recession 0.50 $100 = $ 0 + $100
Boom 0.50 $200 = $100 + $100
Expected value of the firm: $𝟏𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟎𝟎
Expected value of the stock: $𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎
• If the firm invests in the high risk project:
Outcome Prob. Value = Stock + Bonds
Recession 0.50 $ 50 = $ 0 + $ 50
Boom 0.50 $240 = $140 + $100
Expected value of the firm: $𝟏𝟒𝟓 = 𝟎. 𝟓𝟎 × $𝟓𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟒𝟎
Expected value of the stock: $𝟕𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟒𝟎

Agency costs: underinvestment
• If there is a significant probability of bankruptcy, stockholders often
find that new investment only help bondholders at their expense
• Consider a firm considering the decision to accept or reject a new
project requiring investment of $1000.
• The project will generate a cash flow of $1700, if accepted
• The financial obligation to the bondholders is $4000.
• There are two equally likely outcomes: recession, and boom
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Dr. Md Mohan Uddin
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• Cash flows with and without the project:
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Without project With project
Boom Recession Boom Recession
Firm cash flows $5000 $2400 $6700 $4100
Bondholders’ claim 4000 2400 4000 4000
Stockholders’ claim $1000 $ 0 $2700 $ 100
Expected value of stockholder interest without the project (also without any cost):
$𝟓𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟎
Expected value of stockholder interest with the project (also with a $1000 cost):
$𝟏𝟒𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟐𝟕𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎
Thus, after spending $1000, stockholder interest rises by only:
$𝟗𝟎𝟎 = $𝟏𝟒𝟎𝟎 − $𝟓𝟎𝟎
Therefore, underinvestment brings incentive to the stockholders

Agency costs: milking the property
• If there is a significant probability of bankruptcy, the firm may
attempt higher cash distributions such as extra dividends to the
stockholders
• This strategy would result less assets to remain in the firm for
the bondholders.
4/30/2013
Dr. Md Mohan Uddin
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Agency costs
• Who pays for the cost of selfish investment strategies?
– it is ultimately stockholders
• Rational bondholders know that stockholders would not help them at
the time of financial distress, rather they will become selfish
• Hence, bondholders protects themselves by requiring higher interest
rate on the bonds, which is paid by the stockholders
• Thus, firms with greater probability of financial distress would find
debt costly
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Dr. Md Mohan Uddin
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CAN COSTS OF DEBT BE REDUCED?
Protective covenants
• Stockholders will have to pay higher interest as insurance against
their selfish strategy
• They often hope to lower the rate by agreeing several conditions
imposed by bondholders
• These conditions are called ‘protective covenants’
• Broken covenants can lead to default
• Two types of protective covenants
– negative covenants
– positive covenants
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Dr. Md Mohan Uddin
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Protective covenants
• Negative covenants limit or prohibit company actions
– limit of the amounts of dividend to pay
– Restriction on pledging assets to other lender
– Restriction on merger
– Restriction on selling or leasing of major assets
– Restriction on issuing additional debt
• Positive covenants specify an action that the company agrees to take
– Maintaining a minimum level of working capital
– Furnishing periodic financial statements to the lender
• Covenants reduce flexibility, but increase firm value and also can be the lowest cost
solution to stockholder-bondholder conflict
4/30/2013
Dr. Md Mohan Uddin
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Consolidation of debt
• If the financially distressed firm has many creditors, they may
contend with each other
• In this situation, negotiating costs increases
• This problem can be alleviated by proper arrangement of
bondholders and stockholders
– one, or perhaps a few lenders can shoulder the entire debt
– bondholders can purchase the stocks
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Dr. Md Mohan Uddin
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INTEGRATION OF TAX EFFECTS AND FINANCIAL
DISTRESS COSTS
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Debt (B)
Value of firm (V)
0
Present value of tax
shield on debt
Present value of
financial distress costs
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
V = Actual value of firm
VU = Value of firm with no debt
B*
Maximum
firm value
Optimal amount of debt

DISTRESS COSTS
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Dr. Md Mohan Uddin
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Debt (B)
Cost of capital (%)
0
R0
RWACC
B*
R0
Optimal amount of debt

DISTRESS COSTS
• A firm’s capital structure decision involves a trade-off between
the tax benefits of debt and the costs of financial distress.
• Thus, there is an optimal amount of debt for any individual firm
• This amount becomes the firm’s target level of debt
• This approach is frequently called the static trade-off theory of
capital structure.
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Dr. Md Mohan Uddin
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Dr. Md Mohan Uddin
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B
DISTRESS COSTS
G
L
S

DISTRESS COSTS
• The essence of the MM intuition is, firm’s capital structure merely cuts 𝑽 𝑻 into
slices, it does not affect the total value, 𝑽 𝑻
• The value of a firm equals the some of stockholders’ claim (S), bondholders’ claim
(B), taxes (G), and bankruptcy claims (L)
i.e., 𝑽 𝑻 = 𝑺 + 𝑩 + 𝑮 + 𝑳 = 𝑽 𝑴 + 𝑽 𝑵
Where, 𝑽 𝑴 represents marketable claims and 𝑽 𝑵 represents nonmarketable claims
• 𝑽 𝑴 can change with changes in the capital structure
• By the pie theory, any increase in 𝑽 𝑴 must imply identical decrease in 𝑽 𝑵
• Rational financial managers will choose a capital structure that maximizes 𝑽 𝑴 and
minimizes 𝑽 𝑵
4/30/2013
Dr. Md Mohan Uddin
25

SIGNALING
• The firm’s capital structure is optimized where the marginal subsidy
to debt equals the marginal cost.
• 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.
4/30/2013
Dr. Md Mohan Uddin
26

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.”
• 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.
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Dr. Md Mohan Uddin
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THE PECKING ORDER THEORY
• 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, 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
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Dr. Md Mohan Uddin
28

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 real world. As a result,
100% debt financing is sub-optimal.

PERSONAL TAXES
• Individuals, in addition to the corporation, must pay taxes. Thus,
personal taxes must be considered in determining the optimal
capital structure.

PERSONAL TAXES
• Dividends face double taxation (firm and shareholder), which
suggests a stockholder receives the net amount:
• (1-TC) x (1-TS)
• Interest payments are only taxed at the individual level since they are
tax deductible by the corporation, so the bondholder receives:
• (1-TB)

PERSONAL TAXES
• If TS= TB then the firm should be financed primarily by debt
(avoiding double tax).
• The firm is indifferent between debt and equity when:
(1-TC) x (1-TS) = (1-TB)

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.
• There is evidence that firms behave as if they had a target Debt-Equity ratio.

HOW FIRMS ESTABLISH CAPITAL STRUCTURE
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.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than equity if internal
financing is insufficient.

Capital structure limits to the use of debt

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