CH 17 Reading

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What is the relationship between a company's profitability and its debt level?

- A firm with low anticipated profits will likely take on a low level of debt -- a small interest deduction is all that is needed to offset all of this firm's pretax profits and too much debt would raise the firm's expected distress costs - A mroe successful firm would take on more debt as it could use the extra interest to reduce the taxes from its greater earnings. Being more financially secure, the firm would find its extra debt increasing the risk of bankruptcy only slightly. -rational firms raise debt levels (and the associated interest payments) when profits are expected to increase

Integration of Tax Effects and Financial Distress Costs -Other authors suggestions

- Bankruptcy and related costs reduce the value of the firm

MM Proposition

- In a world without taxes, the value of the levered firm is the same as the value of the unlevered firm -- The choice of D/E is unimportant -In a world with corporate taxes, the value of the firm increases with leverage, implying that firms should take on as much debt as possible

Figure 17.2 The pie model with real-world factors

- not an exhaustive list of financial claims to the firm's CFs -While VT is determined by the firm's CFs, the firm's capital structure merely cute VT into slices. Capital Structure does not affect the total value, VT.

Figure 17.1 The Optimal Amount of Debt and the Value of the Firm -Top half

- the diagonal straight line represents the value of the firm without bankruptcy - the upside down U curve represents the value of the firm with these costs -the curve rises as the firm moves from all equity to a small amount of debt. The PV of the distress costs is minimal since the probability of distress is so small -However, as more and more debt is added, the PV of these costs rises at an increasing rate -B* is the debt level maximizing the value of the firm. The increase in PV from an additional dollar of debt equals the increase in the PV of the tax shield -B* is the optimal amount of debt. -Bankruptcy costs increase faster than the tax shield beyond this point, implying a reduction in firm value from further leverage

Agency Cost in Equity

A manager-owner will greatly dilute his or her share of total equity when considering a large stock offering and a significant drop in work intensity or increase in fringe benefits is possible -Less likely for a large corporation with many stockholders --an additional offering is not likely to increase the temptation he has already experienced before.

Consolidation of debt

Bankruptcy costs are so high since the different creditors (and their lawyers) contend with each other -this problem can be alleviated by proper coordination between bondholders and stockholders -One lender or a few lender could should the entire debt and negotiating cost would be minimized if financial distress occurs. - Bondholders can purchase stock and now stockholders and bondholders are not pitted against each other.

Figure 17.6 Leverage Ratios of GM, IBM, Eastman Kodak over time

Capital Structures of individual firms often vary widely over time -large variations in individual firm leverage over time is evident that variations in individual firm investment opportunities and the need for financing are important determinants of capital structure and importance of financial slack. (firms borrow money when they have projects worth spending it on)

Marketable Claims

Claims that can be bought and sold in financial markets, such as those of stockholders and bondholders -stockholders pay cash to the firm to receive dividends later -bondholders pay cash to the firm to receive interest in the future

Nonmarketable Claims

Claims that cannot be easily bought and sold in the financial markets, such as those of the government and litigants in lawsuits. -the IRS says nothing to the firm for the privilege of receiving fees from the firm the future

Personal taxes

Corporations are not the only ones paying taxes; individuals must pay taxes on both the dividends and interest that they receive

Agency Costs -Summary of Selfish Strategies

The distortions occur only when there is a significant probability of bankruptcy or financial distress -they are unlikely to affect utilities regulated by state commissions because financial distress is rare among these firms -By contrast small firms in risky industries such as computer fields are more likely to experience financial distress and be affected by such distortions

Can costs of debt be reduced?

The sum of all these costs of financial distress is substantial and may well affect debt financing severely -managers have an incentive to reduce these costs -methods can reduce the costs of debt but cannot eliminate them entirely

Are there benefits to extra debt but no costs, implying that all firms will take on as much debt as possible?

There are costs as well. -If a firm issued debt to fool the public, the market will eventually learn that the company is not that valuable after all. At this time, the stock price will fall lower than what it would have been if the debt had never increased. Because the firm's debt level is now above the optimal level (the marginal tax benefit is now above the optimal level). -If the current stockholders plan to sell half of their shares no and retain the other half, an increase in debt will help them on immediate sales and hurt them on later ones

Free Cash Flow Hypothesis

We expect to see more wasteful activity in a firm with large CF than in one with small CFs -High CF firms will make more bad acquisitions than low CF firms - A manager can pad his expense account only if the firm has the CF to cover it

Static Trade-off model

Where a rise in debt increases both the tax shield and the costs of distress -change in value when debt is substituted for equity= tax shield on debt- increase in costs of financial distress including agency costs of debt -A note on agency cost of equity: an individual will work harder for a firm if he or she is one of its owners rather than if she is just an employee especially if she owns a large percentage.

Example 17.1 Bankruptcy Costs (ignore taxes) -Knight corporation will be in business for one more year -CF forecasted as either $100 or $50 with a 50% probability of each -Previously issued debt requires payments of $49 of interest and principal -Day corporation has identical CF but has $60 in interest and principal -Day Corporation Realistic set of CFs

Why do bondholders only receive $35 in a recession? -If CF is $50, bondholders will be informed that they will not be paid in full -these bondholders are likely to hire lawyers to negotiate or even to sue the company -the firm is also likely to hire lawyers to defend itself -further costs will be incurred if the case gets brought to a bankruptcy court -These fees are always paid before the bondholders get paid -In this example we assume that the bankruptcy costs = 50-35= $15

Leveraged Buyout (LBO)

a purchaser, usually a team of existing management, buys out the stockholders at a price above the current market -The company goes private and is now in the hands of only a few people -reduces the costs of equity because managers now own a big chunk of the business and will work harder

Protective covenants should reduce the....

costs of bankruptcy, ultimately increasing the firm. -stockholders are likely to favor all reasonable covenants -Even if bond covenants reduce flexibility, they can increase the value of the firm. --they can be the lowest-cost solution to the stockholder-bondholder conflict

Bankruptcy costs

increase with debt, offsetting the tax advantage of leverage Bankruptcy: ownership of the firm's assets are legally transferred from the stockholders to the bondholders

Negative Covenant

limits or prohibits actions that the company might take -Typical negative covenants include 1. limitations are placed on the amount of dividends a company may pay 2. the firm may not pledge any of its assets to other lenders 3. the firm may not merge with another firm 4. the firm may not sell or lease its major assets without approval by the lender 5. The firm may not issue additional long-term debt

Protective Covenants

part of the indenture or loan agreement that limits or requires certain actions by a company during the term of the loan to protect the lender's interest -because stockholders must pay higher interest rates as insurance against their own selfish strategies, they frequently make these agreements with bondholders in hopes of lower rates -a broken covenant can lead to default -agreements can include more than 30 covenants

Positive Covenant

specifies an action that the company agrees to take or a condition the company must abide by Examples include: 1. The company agrees to maintain its working capital at a minimum level 2. The company must furnish periodic financial statements to the lender

The result that essentially all firms should issue debt is extreme since...

- MM result that in a world without taxes, firms are indifferent to capital structure. - MM result that in a world with corporate taxes but no financial distress costs, all firms should be 100% debt-financed. -Timing is not the only consideration. Managers must also consider taxes, financial distress costs, and agency costs. -- A firm may issue debt only up to a point. if financial distress becomes a real possibility beyond that point, the firm may issue equity instead.

Figure 17.3 Stock Returns at the Time of Announcements of Exchange Offers

- The solid line indicates that stock prices rise substantially on the date when an exchange offering increasing leverage is announced (Day 0) - The dotted line indicates that stock price falls substantially when an offer decreasing leverage is announced -the market infers from an increase (decrease) in debt that the firm is better off, leading to a stock price rise (fall) -managers signal information when they change leverage

Pecking Order -Implications 1. There is no target amount of leverage:

- Trade off model balances the benefits of debt (tax shield) with the costs of debt (distress costs) and the optimal amount if when the marginal benefit of debt= marginal cost of debt - The pecking order does not have a target. -- Each firm chooses its leverage ratio based on financing needs. -- Projects are first funded with RE lowering the % of debt in capital structure raising BV and MV. --Additional projects are funded with debt, raising the debt level -- Debt capacity will become exhausted giving way to equity issuance at some point. --there is no target D/E ratio

-Both company's in a recession give out $50 to bond/stock -Bankruptcy does not reduce the firm's cash flows. The recession caused the reduction, not the bankruptcy

-Day Corporation faces the possibility of bankruptcy due to its greater leverage, while night Corporation does not -Total CF to investors is the same for both firms in a world without bankruptcy costs -However, once we introduce bankruptcy costs, total CF to investors is lower for the bankrupt company -In a recession Knight bondholders get $49 and stock get $1. In a recessions Day bondholders get $35 and stock gets $0 for only $35 total.

-For Knight Corporation in both types of economy the CF is greater than the interest and principal payments. --The bondholders are paid in full and the stockholders receive the residual -Day Corporation in a recession makes only $50 but needs $60 to pay bondholders --Bondholders cannot be satisfied in full as we assume the corporation has no other assets. Bankruptcy now occurs, implying the bondholders will receive all of the firms cash and stockholders will receive nothing --the stockholders do not have to come up with the additional $10 since corporations are limited liability meaning that bondholders cannot sue stockholders for the $10

Direct Costs of Financial Distress: legal and administrative costs of liquidation of organization

-Lawyers get involved in all stages before and during bankruptcy (very expensive) -Administrative and accounting fees can also add to the bill -Expert witnesses can be hired to testify the fairness of proposed settlement -bankruptcy in the private sector is often far larger than those in county's such as Orange County, CA. -Financial distress direct costs while large in absolute amount, are actually small as a percentage of firm value (3% of MV of the firm) -Legal fees are about 1.5% of total asset for bankrupt firms -Bankruptcy expenses are about 2-10% of asset values

-Leverage increases the likelihood of bankruptcy. However, bankruptcy does not, by itself, lower the CFs to investors. Rather, it is the costs associated with bankruptcy that lower CF (and value of firm) -In a world without bankruptcy costs, the bond and stockholders share the entire pie. However, bankruptcy costs eat up some of the pie in the real world, leaving less for stock and bondholders

Example 17.2 Agency Costs Firm is worth $1 million -She owns 100% of the firm -She must raise another $2 million -She can either issue $2 million of debt at 12% or issue $2 million in stock -Conclusions

-She is likely to work harder if she issues debt. She has more incentive to shirk (avoid responsibility) if she issues equity. Since she makes more with debt than equity. -She is likely to obtain more perquisites (big office, company car, etc) if she issues stock -- If she is 1/3 stockholder, 2/3 of thee costs are paid for by the other stockholder -- If she is sole owner, any additional perquisites reduce her equity stake alone. -She is more likely to take on capital budgeting projects with negative NPV even though stock price would fall. Managerial salaries rise with firm size which provides an incentive to accept some unprofitable projects after all the profitable ones are taken --The loss in stock value may be smaller than the increase in salary -losses from accepting bad projects are far greater than losses from shirking or excessive perquisites -unprofitable projects cab bankrupt a firm!

Free Cash Flow Hypothesis Implications

-Since dividends leave the firm, they reduce FCF. An increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. Dividends are not required. -Interest and principal also leave the firm making debt reduce FCF. These payments are required otherwise go bankrupt. --Bond payments should have a greater effect than dividends on the free-spending ways of managers -A shift from equity to debt will boost firm value. -debt reduces the opportunity for managers to waste resources.

The effect of personal taxes on capital structure 1. Ignoring costs of financial distress, what is the firm's optimal capital structure if dividends and interest are taxed at the same personal rate- that is, TS=TB?

-The firm should select the capital structure that gets the most cash into the hands of the investor -If TS=TB, then bondholders receive more than stockholders using the formula on the last flashcard. -The firm should then issue debt, not equity. -Equity Income is taxed twice: once at the corporate level and then at the personal level if it is paid to stockholders -Income is only taxed once at the personal level if it paid to bondholders -firms would issue debt in a world without personal taxes since they receive $1 and stockholder receive 1-TC.

Figure 17.5 Survey Results on the Use of Target D/E ratios

-The great majority of firms use targets, though the strictness of the targets varies across companies -large firms are more likely to employ these targets -did not rebalance in response to changes in their firm's stock price, suggesting flexibility in target ratios

Agency Costs -Summary of Selfish Strategies -Who pays for the cost of selfish startegies?

-The stockholders -Rational bondholders know that when financial distress is imminent, they cannot expect help from stockholders -stockholders are likely to choose investment strategies that reduce the value of the bonds and bondholders will protect themselves by raising the interest rate that they require on the bonds. - Because stockholders must pay these high rates, they ultimately bear the costs of these strategies -firms that face these distortions will have low leverage ratios as debt will be difficult and costly to obtain

Agency Costs -Selfish Investment Strategy 1: Incentive to Take Large Risks -Conclusion

-They key is that relative to the low risk project, the high risk project increases the firm value in a boom and decreases the firm value in a recession -the increase in value in a boom is captured by the stockholders because the bondholders are paid in full (they receive $100) regardless of which project is accepted -Conversely, the drop in value in a recession is lost by the bondholders because they were paid in full with the low risk project but receive only $50 with the high risk one. The stockholders will receive nothing in a recession anyway (high or low). -Financial economists argue that stockholders expropriate value from the bondholders by selecting high0risk projects

Figure 17.1 The Optimal Amount of Debt and the Value of the Firm -Bottom Half

-WACC falls as debt is added to the structure -After reaching B*, the WACC rises -the optimal amount of debt produces the lowest WACC -(Static) Trade-off theory: A firm's capital structure decision involves a trade-off between the tax benefits of debt and the costs of financial distress -there is an optimal amount of debt fro any individual form and is the firm's target debt level -However, no formula has been developed to determine the optimal level of debt since financial distress costs cannot be expressed in a precise way

Bankruptcy risk

-debt provides tax advantages to the firm, but it also puts pressure on the firm since interest and principal payments are obligations -If these obligations are not met, the firm may risk some sort of financial distress -the ultimate distress is bankruptcy -debt obligations are different from stock obligations --stockholders like and expect dividends, but bondholders are legally entitled to interest and principal payments

How Firms Establish Capital Structure -Empirical Regularities worth considering (5)

1. Most nonfinancial companies have low debt-asset ratios - corporations do not issue debt up to the point where tax shelters are completely used up. 2. A number of firms use no debt -managers will have high equity ownership. -managers of all-equity firms are less diversified than managers of similar levered firms. Significant leverage represents added risk that the managers of all equity firm are loath to accept 3. There are differences in the capital structures of different industries 4. Most corporations employ target D/E ratios 5. Capital Structures of individual firms can vary significantly over time

Pecking Order -Implications (3)

1. There is no target amount of leverage 2. Profitable Firms Use Less debt: profitable firms generate cash internally implying less need for outside financing and debt. -with the trade-off model profitable firms have a greater debt capacity to capture a greater tax shield 3. Companies like financial slack: pecking order is based on difficulties of finding financing at a reasonable cost -managers rely first on bonds then stocks because investors believe stocks are overvalued and will drive the price down -accumulate cash today for future, but not too much

3 Choices by stockholders to reduce bankruptcy costs:

1. issue no debt: because of the tax advantages to debt, this is a very costly way of avoiding conflicts 2. Issue debt with no restrictive and protective covenants: bondholders will demand high interest rates to compensate for the unprotected status of their debt 3. Write protective covenants into the loan contracts: if covenant is reasonable, the creditors receive protection without large costs being imposed on the shareholders.The creditors are likely to accept a lower interest rate than they would without the protective covenant.

3 Important factors affecting the D/E ratio

1. taxes: firms can deduct interest for tax purposes -highly profitable firms are more likely to have larger target ratios 2. types of assets: the costs of financial distress depends on the types of assets -large investment in land, buildings, and other tangible assets= smaller costs of financial distress than firm with large R&D. large investment in tangible assets= higher D/E ratios 3. uncertainty of operating income -firms with uncertain operating income have a high probability of experiencing financial distress, even without debt. Must finance with mostly equity

Rules of the Pecking Order -Rule #2: Issue Safe Securities First

Although investors fear mispricing of both debt and equity, the fear is much greater for equity. -Corporate debt still has little risk compared to equity because if financial distress is avoided then investors receive a fixed return. -The pecking order implies that if outside financing is required, debt should be issued before equity. Only when the firm's debt capacity is reached should the firm consider equity -Convertible debt is more risky than straight debt so straight debt should be issued first -Issue the safest securities first!

Agency Costs -Selfish Investment Strategy 1: Incentive to Take Large Risks -Example: can invest in a high risk project

Expected Value= (.5 x 50) + (.5 x 240)= $145 - this is lower than the expected value of the firm with the low risk project -the low risk project would be accepted if the firm were all equity -However, the expected value of the stock (.5 x 0) + (.5 x 100)= 70 with the high risk and only (.5 x 0) + (.5 x 100)= $50 for the low risk -Given the firm's present levered state, the stockholders will select the high risk project, even though the high risk has a lower NPV

Agency Costs -Selfish Investment Strategy 1: Incentive to Take Large Risks

Firms near bankruptcy often take great chances because they believe that they are playing with someone else's money

CF of a firm go to 4 different claimants

Gov= taxes Lawyers= help during bankruptcy process S=equity B= bonds G=gov taxes L= lawyers

Agency Costs -Selfish Investment Strategy 1: Incentive to Take Large Risks -Example: can invest in a low risk project

If a recession occurs, the value of the firm will be $100; if a boom occurs, the value of the firm will be $200. -expected value= (.5 x 100) + (.5 x 200)= $150 -Firm must pay bondholders $100 (prior claim) and shareholders will obtain the difference (residual claim)

Indirect Costs of Financial Distress

Impaired ability to conduct business -Bankruptcy hampers conduct with customers and suppliers -Sales are lost because of both fear of impaired service and loss of trust -difficult to measure these costs even though they clearly exist -both direct and indirect costs of financial distress are around 10- 20% of firm value

Agency Costs -Selfish Investment Strategy 2: Incentive toward Underinvestment -Table 17.1: Illustrating Incentive to Underinvest -The firm must decide whether to accept or reject a new project -Cost= $1000

In a recession without the project, the firm will go bankrupt. -The firm with the project would generate CF of $1,700 in either state bringing the firm's CF to 5000+1700= 6700 in a boom and 2400+1700= 4100 in a recession. -They would accept the project since their a positive NPV and bankruptcy is avoided.

Integration of Tax Effects and Financial Distress Costs -MM

MM says that the firm's value rises with leverage in the presence of corporate taxes and that all firms should choose maximum debt. The theory does not accurately predict the behavior of firms in the real world

Rules of the Pecking Order -Rule #1: Use Internal Financing

Managers cannot use special knowledge of their firm to determine if risk-less debt is mis-priced because the rate of interest is the same for all issuers of risk-less debt. -In reality, corporate debt has the possibility of default (risk). Just as managers tend to issue equity when they think it is overvalued, managers also tend to issued debt when they think it is overvalued. -If the public thinks the firm's prospects are rosy, but managers see trouble they would view debt and equity as being overvalued. --public sees risk free and firm sees strong possibility of default -Investors will price a debt issue with the same skepticism as pricing equity. Managers can avoid investor skepticism if you can avoid going to investors in the first place by using retained earnings (internal financing)

Agency Costs -Selfish Investment Strategy 3: Milking the Property

Milking the Property: Pay out extra dividends or other distributions in times of financial distress, leaving less in the firm for the bondholders. - Goes one step further than choosing not to raise new equity since the equity is actually withdrawn through the dividend

exchange offers

Occur when a firm offers to exchange stock for debt, or vice versa -firms can change the debt levels through exchange offers 2 types 1. Allows stockholders to exchange some of their stock for debt, thereby increasing leverage 2. Allows bondholders to exchange some of their debt for stock, decreasing leverage

How do investors react to an increase in debt?

Rational investors are likely to infer a higher firm value from a higher debt level. -investors are likely to bid up a firm's stock price after the firm has issued debt in order to buy back equity -investors view debt as a signal of value -Managers may fool the public. A manager may desire to increase the firm's stock price because he knows the stockholders want to sell their stock soon. He may increase the level of debt to make investors think the firm is more valuable than it really is. if this works, investors will push the price of the stock up.

Example 17.2 Agency Costs Firm is worth $1 million -She owns 100% of the firm -She must raise another $2 million -She can either issue $2 million of debt at 12% or issue $2 million in stock -CFS

She can choose to wrk a 6 or 10 hour day. -with debt and 10 hour work day she brings an extra $100,000 (160,000-60,000) home. -With the stock issue she retains only 1/3 interest in equity --The extra work of a 10 hour day brings only $33,333 extra (133,333-100,000) -As she issues more equity, she will increase leisure time, work related perquisites, and unprofitable investments (agency costs)

Figure 17.4 Median Leverage ratio of Sample Firms in 39 Different Countries

Shows the median D/E ratio, defined as BV of debt to MV of firm -ranges from 50% to 10% -US is the 4th lowest

Agency Costs -Selfish Investment Strategy 2: Incentive toward Underinvestment

Stockholders of a firm with a significant probability of bankruptcy often find that new investment helps the bondholders at the stockholder's expense

Effect of agency costs of equity on debt financing

The change in the value of the firm is now the tax shield on debt plus the reduction in the agency costs of equity minus the increase in the costs of financial distress (including agency costs of debt) -the optimal D/E ratio would be higher in a world with agency costs of equity than in a world without these costs -However, because costs of financial distress are so significant, the costs of equity do not imply 100% debt financing

The key is that the stockholders contribute the full $1000 investment, but the stockholders and the bondholders share the benefits -the stockholders take the entire gain if a boom occurs and the bondholders reap most of the CF from a project in a recession -leverage results in a distorted investment policy. An unlevered corporation always chooses projects with positive NPV, but the levered firm may deviate from this policy.

The new project hurts the stockholders of the levered firm. - If the old stockholders contribute $1000 themselves, the expected value without the project is (.5 x 1000) + (.5 x 0)= $500. The expected value with the project is (.5 x 2700) +(.5 x 100)= 1400. - The stockholders interest rises by only $900 (1400-500) while its cost them $1000

The Pecking-Order Theory

Timing! -Issue stock only when it is overvalued and you can make money. (price is high) -Issue bonds with little or no risk of default when the stock is undervalued. (price is too low) -Asymmetric information: the manager must know more about his firm's prospects than does the typical investor. If the manager does not have a better estimate, than any attempt by the manager to time will fail. -investors will not want to buy the stock as they know it is overvalued so they will wait for the price to fall. --No one will issue equity since only the most overvalued firms have any incentive to issue equity as the price will end up falling dramatically.

Agency Costs

When a firm has debt, conflicts arise between stockholders and bondholders -stockholders are tempted to pursue selfish strategies -Agency costs: costs of conflicts of interest among stockholders, bondholders, and managers - 3 strategies are used to hurt bondholders and help the stockholders and are costly because they will lower the MV of the whole firm.

Table 17.3 Capital Structure Ratios for Selected US industries

debt ratios tend to be quite low in high growth industries with ample future investment opportunities, such as drug and electronics industries - Industries with large investments in tangible assets such as construction tend to have high leverage

In a world where managers do not attempt to fool investors, valuable firms will...

issue more debt than less valuable ones. -Even when managers attempt to fool investors, the more valuable firms still will want to issue more debt than the less valuable ones. -While all firms will increase debt levels somewhat to fool investors, the costs of extra debt prevent less valuable firms from issuing more debt than the more valuable firms issue. -investors can still treat debt level as a signal of firm value; an announcement of debt is a positive sign for the firm.

There is a limit to...

the financial leverage a company can use and the risk of too much leverage is bankruptcy

For high levels of debt, the firm's capital structure is optimized where...

the marginal subsidy to debt equals the marginal cost -for low levels of debt, the marginal tax subsidy exceeds the distress costs

Value of the firm

the value of the firm refers to the value of Marketable claims (VM) not the value of the nonmarketable claims (VN) -According to the pie theory, any increase in VM must imply an identical decrease in VN -Rational financial managers will choose a capital structure to maximize the VM and minimize the VN.

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