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The Miller & Modigliani theorem. Turning to capital structure. The two key questions in corporate finance: Valuation : How do we distinguish between good investment projects and bad ones? Financing : How should we finance the investment projects we choose to undertake?

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turning to capital structure
Turning to capital structure

The two key questions in corporate finance:

  • Valuation: How do we distinguish between good investment projects and bad ones?
  • Financing: How should we finance the investment projects we choose to undertake?
  • We now turn to the second question.
some facts about capital structure
Some facts about capital structure
  • Firms finance themselves through retained earnings (internal financing) and selling securities in the market (external financing)
  • Internal financing (retained earnings) biggest source of financing for firms
    • Firms in countries with less developed financial markets use particularly little external financing

3. The external financing is done by issues of debt, equity and hybrid securities (such as convertible debt and preferred equity)

4. External financing is raised both in private and public markets
  • Private sources: Private equity, bank debt, private placements of bonds and equity
  • Public sources: IPOs, Seasoned equity issues; public bond issues

5. Sources of financing vary over time and over business cycle

  • Equity issues increase when stock market returns have been high for some period of time
  • Debt/borrowing issues less cyclical
4. Capital structures vary across different industries and countries
  • High leverage industries: Utilities, airlines, cars
  • Low leverage industries: biotech, software/internet, hardware
  • High leverage countries: Korea, Thailand, Indonesia, India
  • Low leverage countries: UK, Australia, US
industries vary in their capital structures
Industries Vary in Their Capital Structures

*D/(D+E), Debt in book value, Equity in market value

U.S. data

debt vs equity
Debt vs. equity
  • Equity and debt (and other corporate securities) differ along two dimensions:
  • Division of value

- Debt is senior to equity → get the value of the firm until debt paid off

    • Equity gets whatever is left after debt has been paid

(2) Division of control

    • Equity holders control firm as long as not bankrupt
    • Debt holders control firm when firm is bankrupt
equity is a call option
Equity is a call option
  • Equity gets max (0, V - D), i.e. a call option with strike D
  • Debt gets V – max (0. V – D) = min (V,D)


Payment to debt holders, D(V).

Payment to Equity holders, E(V).


Face of debt



Face of debt

questions we will try to answer
Questions we will try to answer:
  • Is there an “optimal” capital structure, i.e., an optimal mix between debt and equity?
  • More generally, can you ad value to existing owners (equity and debt holders) through decisions on the RHS of the balance sheet?
  • If yes, does the optimal financial policy depend on the firm’s operations (Real investment policy), and how?
the miller and modigliani mm capital structure irrelevance theorem
The Miller and Modigliani (MM) capital structure irrelevance theorem
  • MM (1958) maybe the most important paper in finance
    • Not only for corporate finance, but also for investments Black Scholes option pricing, for example, relies on arbitrage arguments introduced in this paper
  • One way to thing about it: what role does capital structure have in a neoclassical fully competitive model with frictionless markets
    • Like the CAPM
  • Answer: None!
why is mm so important
Why is MM so important?
  • We don’t believe it, literally
    • Since markets are not perfect, frictionless, and fully competitive
  • Strength of theorem is that by showing when capital structure is irrelevant, it also implies when it is relevant.
to get some perspective pre mm views
To get some perspective: pre-MM views
  • Typical pre-MM view: debt is typically cheaper than equity
    • Interest rate on debt is lower than the investors’ required return on equity
    • Equity issues are dilutive: decrease earnings per share, which hurts shareholders
  • But we can’t have too much debt, because then we go bankrupt

→ Optimal capital structure

the mm theorem shows that such arguments are flawed
The MM theorem shows that such arguments are flawed
  • The value of the firm is given by expected cash flows and the investors discount rate (or required rate of return) for these cash flows
  • V = E(FCF) / (1+R)
  • In “efficient markets” (i.e. the MM assumptions) capital structure affects neither of these.
V = E(FCF)/(1+R)
  • Capital structure is just one way of splitting cash flows between different investors, but the total value of the firm remains the same
  • Although the required returns of debtholders and equityholders may differ, the weighted average cost of capital to the firm will always equal R
the miller modigliani irrelevance proposition
The Miller Modigliani Irrelevance Proposition
  • Suppose the NPV of a new issue is zero.
  • Suppose the free cash flow to a levered firm is the same as to an all equity financed firm.
  • Then, financing does not matter! Value is maximized by taking all +NPV as before.
Intuition: (Yogi Berra).
    • The firm finances its projects by promising free cash flow from operations to different types of investors (debt and equity holders).
    • The size of the pie is the sum of the free cash flows – it depends on the investment policy, not the way the pizza is divided between investors.

When is it true that financing is irrelevant?

original mm 1958 home made leverage proof
Original MM (1958) home-made leverage proof:
  • “Twin” firms A and B with identical cash flows of CF
    • A is all-equity financed, value of equity = EA = VA
    • B has debt of D, value of equity = EB; VB = EB + D,
  • Miller and Modigliani claim that VA = VB, otherwise there would be an arbitrage opportunity
Suppose debt D is risk less. If buy all of B’s equity, you get:
    • CR – D(1 + RD) = company’snet profits after interest
    • This costs you EB.
  • Instead suppose you buy all of A’s equity, but borrow on own account D of the purchase pries.
    • So cost to you is EA – D.
    • You get CF – D(1+RD) = company’s whole cash flow less personal interest you owe.
  • Since strategies yield same net cash flow to you, must cost the same to assemble: EB = EA – D, of VB = VA.
    • Otherwise there would be an arbitrage opportunity.
NOTE: We have not assumed anything about how NPV is calculated.
    • MM does not rely, for example, on CAPM being true.
    • What is essential is that there are no arbitrage opportunities (financial markets are competitive and complete).
  • Does all this seem a bit esoteric…?
    • Capital structure arbitrage is currently a popular hedge fund strategy.
mm and the cost of capital
MM and the cost of capital
  • We have seen that when a firm levers up (finances with debt), it increases the risk ness of its equity. The weighted average cost of capital remains the same:
  • In our example:
  • D/(D+E)*rD + E/(D+E)*rE = rA
  • (10/11)*(10%)+(1/11)*(100%)= 18.18%
  • It is true that debt requires a lower return.
  • However, when you lever up, the equity becomes riskier and requires an even higher return. These two effects exactly cancel.
effect of leverage on returns in the mm world
Effect of leverage on returns in the MM world

return on assets

  • Return on equity (“MM proposition II”):

rE = rA + (D/E)(rA-rD)

  • Risk of equity:

βE = βA + (D/E)(βA – βD)

returns and leverage
Returns and leverage

Expected Returns




Debt becomes risky


do we believe the mm assumptions
Do we believe the MM assumptions?
  • MM irrelevance theorem holds if
    • NPV of a new issue of debt or equity is zero.
    • The free cash flow to a levered firm is the same as to an all equity financed firm.
  • Do we believe that these assumptions are true in the real world?
      • If not, this gives us a role for capital structure!
a is new issuance zero npv
(A) Is new issuance zero NPV?
  • There are 3 conditions for this to be true.
  • The first two are:
  • Financial markets are competitive.
    • New investors just demand fair return on their investment.
  • Financial markets are complete:
    • Investors can choose any consumption pattern by borrowing, lending, and hedging.
      • If not, the firm may be able to make money by offering a cash flow stream with attractive risk characteristics to certain clientele.
For a typical corporation, these two conditions probably hold
    • It is hard to think that a corporation could make money by issuing some new, eotic security that did not exist before
      • There are close substitutes available for any security that a company can issue
    • Making profits from pure financial engineering is better left to the investment banks than regular corporations!
But there is a third condition as well:

3. Prices reflect all existing information (strong form efficiency)

    • BUT: if the manager has private information about prospects of the firm, MM does not hold!

→ Could potentially issue misvalued securities and make money!

2 are fcf levered fcf all equity
(2) Are FCF Levered = FCF All Equity?
  • The assumptions for this to be true are:
    • No taxes (or no asymmetric tax treatments)
    • There are no extra costs of financial distress.
    • There are no transaction costs from issuing securities (or the same costs for debt and equity)
    • Managers and employees always work to maximize the value of the firm
  • As we will see, all of these assumptions may not always hold in real world.
using m m sensibly
Using M-M Sensibly
  • M-M is not a literal statement about the real world. It obviously leaves important things out.
  • But it gets you to ask the right question: How is this financing move going to change the size of the pie?
  • Helps you avoid making the wrong arguments, such as the cost of capital argument above.
  • Lets go back to some logical fallacies that MM can address.
“Debt is cheaper than equity because it has a low interest rate”
    • What matters for the value of the firm is RA, the opportunity cost of capital for the firms assets
    • In an MM world, when you take on more leverage, your RE will increase to keep RA constant
mm applies to all corporate finance decisions
MM applies to all corporate finance decisions
  • M-M Theorem was initially meant for capital structure, but applies to all aspects of financial policy:
    • capital structure is irrelevant.
    • long-term vs. short-term debt is irrelevant.
    • dividend policy is irrelevant.
    • buying back shares is irrelevant.
    • risk management is irrelevant.
    • purely diversifying acquisitions are irrelevant.
    • etc.
  • Indeed, the proof applies to all financial transactions because they are all zero NPV transactions.
(dividends) – (net proceeds from new financing) = (cash flow from operations) – (new investment)
  • In other words: think about the choice of whether to pay a dividend or not.
    • If we increase our dividend we can always issue new equity (or debt) to offset this shortfall
    • If we decrease our dividend we can always repurchase some shares (or pay down some debt) to offset.
  • We know that value is given by discounting the right hand side Free Cash Flows
    • LHS does not matter for value, if RHS given
As long as excess cash retained earns a market return, net payments to financial markets do not matter.
    • $ 100 of excess cash today is worth $ 100 regardless of whether pay out now or later.
    • Although the return on the firm’s assets may go down if you keep cash on your balance sheet, required return also goes down since firm cash flows become less risky
    • Total payout policy does not matter either under MM, as long as retained cash flow earns a fair market return and is paid out at some future point.
Essentially the payout policy argument is the same as the debt irrelevance argument.
  • Important principle: Deciding how much debt to take on and deciding how much cash to pay out is essentially the same decision

Cash = Negative debt!

  • This is why we should consider Net Debt =

Debt – Excess Cash when we evaluate capital structure and unlever betas.

bottom line
Bottom line
  • Using the MM theorem, we can understand what does (and doesn’t) matter for financial policy.
  • To understand capital structure and payout policy in the real world we will now see what happens when we relax some of the MM assumptions:
    • What if there are corporate and personal taxes?
    • Costs of financial distress?
    • Conflicts of interest among managers, equity holders, and debt holders?
    • Managers are better informed than investors?
financial policy plan of attack
Financial policy: Plan of Attack
  • Modigliani-Miller Irrelevance Proposition (1958):
    • In a world with out frictions, financial policy is completely irrelevant – does not change value of firm.
  • Now: How does the M world differ from the real world?
    • Taxes
    • Costs of financial distress
    • Other Frictions
relaxing the assumptions of mm
Relaxing the Assumptions of MM
  • New investors get zero NPV.
  • Financial markets are competitive.
  • Markets are strong form efficient.
  • Markets are complete.
  • The financial policy does not change the free cash flow from real investment policy.

4. No differential tax treatment.

5. No costs of financial distress.

6. No issuance costs.

7. Managers and employees do not have an incentive to deviate from +NPV rule.

Almost true

Not true

the effect of corporate taxes
The effect of corporate taxes
  • The importance of taxes was first noted by MM
  • Problem is not taxes per se, but that interest and dividends have a different tax treatment
  • In the U.S. (and for most other countries), the interest payments of corporations are tax-deductible, while dividends are not
  • Hence, there is a strict tax advantage to financing with debt rather than equity
    • As a matter of fact, implies firms should have 100% debt!
        • Which we clearly don’t observe…
example debt tax shield
Example: Debt tax shield
  • A firm generates $ 100M in profits for sure every period in perpetuity. This is the only cash flow the firm has.
  • Risk-free rate is 10%
  • Corporate tax rate (TC) is 40%.
  • If the firm is 100% equity financed, what is the value of the firm?
Every period, FCF = (1 – 0.40)*100= 60
  • V = E = 60/0.10 = 600
  • Now the firm takes of $ 500M of debt. What is the coupon of the debt?
The debt is risk-free → debt holders require 10% → $ 50M coupon
  • What is the value of the equity?
  • Each period equity holders get the Net Income of the firm: (1-0.40)*(100–50) = 30
  • Value of equity = 30 / 0.10 = 300
Since the value of debt is $ 500, firm value is V = E + D = $ 500 + $ 300 = $ 800
  • The firm value has increased by $ 200!
  • Another way to think about this:
    • VL = VU + PVTS
      • VL = value of the levered firm
      • VU = value of the unlevered firm
      • PVTS = PV of the Interest Tax Shield
  • In this case PVTS = $ 200M. Why?
Each period the firm saves TC*I in taxes where TC is the corporate tax rate and I is the interest payment
    • I.e. yearly tax savings are 40%*$50 = $20M
  • Hence, the Present Value of the Tax Shield is PVTS - $ 20 / 0.10 = $ 200M.
This is also equal to TC*D = 40%*$500 = $200
    • the PVTS = TC*I/RD
    • But the interest payment I D*RD
    • The PVTS becomes TC*D*RD/RD=TC*D
  • PVTS = TC*D is a “back of the envelope” formula. It assumes that
    • D is constant (ta shield is a perpetuity)
    • Taz shield and debt payments have same systematic risk → can discount the tax shield at RD
  • What is the optimal level of debt for this company?
who gains from taking on the debt
Who gains from taking on the debt?
  • Say that the firm has 1000 shares outstanding
  • Before taking on any debt, each share is worth $600/100=$0.60/share
  • Now the firm takes on $500 of debt, and buys back $500 worth of shares
  • Think about this as happening in two steps:
The firm raises $500 in debt. Firm now consist of the PV of future firm cash flows plus $500 in cash

The value of firm is Cash + VU + PVTS= $500 + 600 + 200 = $1300

The value of equity is

E = $1300 - $500 = $800

Share price increased from $0.60 to $0.80

→equity gets the whole $200 gain of the new debt tax shield!

(2) Firm does a share repo of $500 → buys back $500/0.8 = 625 shares.

Value of the firm is now $1300 - $500 = $800

E = V – D = $800 - $500 = $300

The equity market cap is lower, but equity holders wealth consist of $300 in stock + $500 in cash = $800

same argument applies to payout policy
Same argument applies to payout policy
  • Keeping excess cash of C in the company gives you a “negative” tax shield of t*C
  • Assume you keep $100 of excess cash in the firm and invests it in T-bonds @ 10%, say

→ Pre-tax profits increase by $10M/yr (perpetuity) if TC=40%, after tax profits are $6M/yr

  • What is the PV of this $100 T-bond investment?
PV = CF/r = $6/0.1 = $60

→ Keeping $100 of excess cash in the firm, rather than paying it out, reduces value of cash to $60!

  • if we keep excess cash of C in the firm rather than paying it out, this cash is only worth (1- TC)*C
  • I.e. cash has a “negative tax shield” of TC*C!
  • Here (and in general) keeping excess cash in firm is like having negative debt!
where do we stand now
Where do we stand now?
  • Adding corporate taxes to MM’s world suggest firms should be 100% debt financed and keep 0% excess cash!
  • Seems extreme:

- Average debt ratio has been around 35% in last decades.

- Many firms (Microsoft, Intel) hoard large amount of cash.

 Either CFO’s are missing something, or something must be missing from our analysis.

Firm’s value


in addition most firms effectively pay less than the statutory rate in corporate taxes
In addition, most firms effectively pay less than the statutory rate in corporate taxes
  • Will not make profits every year
  • Net operating losses (NOLs) can be carried back and forward to offset profits in other years.
  • Some firms have large non-debt tax shields, such as depreciation, investment tax credits, etc.
Firms have a lower tax benefit of debt if
    • Profits more volatile
    • firm already has a lot of debt
    • Have NOLs and substantial non-debt tax shields

→ less likely to have profits left to shield with additional debt

  • John Graham (Journal. of Fin. -00) estimated the U.S. effective corporate tax rate at about 30%
Bottom line: the effect of personal taxes and NOLs on the value of the interest tax shield is complex.

Depends on

      • % of firm’s securities held by institutions and individuals
      • whether investors adjust portfolios in a tax-efficient way
      • the volatility of the firm’s profits, NOLs, and tax shelters
  • Still, clear that even after accounting for personal taxes and effective corporate tax rate, a substantial debt tax shield remains in the U.S.
      • Back-of-the envelope calculations of T in the U.S. typically come in around 10-20%
      • Will vary from company to company, however
        • As low as 2% vs. as high as 35%
debt tax shield calculation note
Debt Tax Shield Calculation – Note!
  • Formula T*D assumes constant, perpetual debt.
  • More generally, can value PV (debt tax shields) as the discounted cash flow streamfrom the tax shield:
  • What should the discount rate rdts be?
      • We have used rd which is true if the risk of the tax shield is the same as the risk of the debt.
      • In many instances, e.g. highly levered firms, the tax shield is likely to be riskier than the debt → makes sense to use a higher discount rate, closer to rA
to summarize
To summarize
  • If the only MM assumption we relax is taxes, we get the following
    • Firm should finance themselves with 100% debt
    • All excess cash should be paid out to shareholders
  • Does not seem to match very well what we observe in reality…
the dark side of debt cost of financial distress
The Dark Side of Debt:Cost of Financial Distress
  • If taxes were the only issue, (most) companies would be 100% debt financed.
  • Common sense suggests otherwise: If the debt burden is too high, the company will have trouble paying.
  • The result: financial distress.

 Can lead to value destruction that would not have happened in the absence of debt

mm and bankruptcy
MM and bankruptcy
  • Note: the possibility that a firm defaults on its debt obligations does not in itself violate MM – as long as this does not impose any additional costs on the business!
  • In the MM world, when the value of equity falls to zero, debt holders take over the firm. There should be no costs to bankruptcy – no reduction in cash flows generated by the company.
what are the costs of financial distress and how big are they
What are the costs of financial distress and how big are they?
  • Most obvious: Direct costs of bankruptcy
    • Legal expenses, court costs, advisory fees…

Example: K-Mart spent more than $ 100 million on lawyers, accountants, investment bankers, and other advisors wile in bankruptcy.

direct costs of financial distress
Direct costs of financial distress
  • Direct costs represent (on average) some 2-5% of total firm value for large companies and up to 20-25% for small ones.
  • But this needs to be weighted by the probability of bankruptcy: (/07% per year for NYSE-AMEX firms).
  • Overall, expected direct costs tend to be very small: about .02% of firm value!
direct costs are too small
Direct costs are too small
  • The tax shield represents gain of 10-35 cents for a dollar of debt
  • Direct costs of bankruptcy are too small to account for the low debt ratios we see in reality.
  • But there are other, indirect costs of financial distress that could potentially be much more important
    • And that would be incurred even if the distressed firm is able to avoid outright bankruptcy or default!
what could these indirect costs be
What could these indirect costs be?
  • Inability to invest in the right projects
  • Inefficient liquidation of assets
  • Inability to respond to competition
  • Losing valuable customers, employees, and suppliers
  • Time and focus wasted negotiating with creditors rather than running the business
the importance of liquidity constraints
The importance of liquidity constraints
  • I.e. when firm’s not being able to access enough funds to be able to make the optimal operating decisions and still service the debt.
  • But why do firms become liquidity constrained when they have too much debt?
    • E.g. why can’t the firm just issue more equity, to both service the debt and cover investments?
  • Well, would you invest money in a firm on the verge of bankruptcy? Why/why not?
a simple example
A simple example
  • Firm has assets in place which will pay off next period:
    • Boom: Worth 100 with Probability = 0.5
    • Bust: Worth 20 with Probability = 0.5
  • Assume everyone risk neutral, discount rates are zero, and there are no taxes
    • This is not important, but makes things simple
    • The value of the firm is then simply expected cash flows next period
  • So: firm value V = 60
Assume this firm has debt outstanding with a face value F = 50
  • What is the value of equity and debt?
  • The payoffs for debt and equity:
    • Debt = min(V,F), Equity = max(V-F,0)
  • So in the boom, the debt will be paid off in full, in the bust the firm will default
    • Boom: D = F = 50, E = 50
    • Bust: D = V = 20, E = 0
    • So today: D = 35, E = 25
  • Debt is under water: trading below par
the debt overhang problem
The debt overhang problem
  • Assume that this firm has a new investment:
    • Invest 10 today
    • Worth 15 tomorrow for sure (both in boom and bust)
    • Positive NPV = 5 → optimal to invest
  • The firm’s cash flows would not be
    • Boom: cash flows increase to 115
    • Bust: cash flows increase to 35
    • Firm value increases from 60 to 75
  • Assume firm has no liquid assets and needs to raise cash to invest
  • Will equity-holders put in the money to invest?
If invests: V = 75
    • The firm increases in value by 15, which is more than the 10 the equity holders put in → good thing!
  • But how is value split between equity and debt?
    • Boom: D = 50, E = 65
    • Bust: D – 35, E = 0
  • Today:
    • D = 42.5, increased by 7,5
    • E = 32,5, increased by 7,5
  • Equity will NOT invest, since would lose 7.5 – 10 = -2.5
  • Wealth transfer to debt holders!
      • Debt is senior and will get part of surplus → junior claimants will not contribute capital
  • Problem arises because debt is risky
      • Risk-less debt → no wealth transfer, since debt is already as safe as it can be
      • E.g. if F=20 → D=20, regardless of investment
  • I.e. the debt overhang the problem arises when there is a significant probability that the debt will not be paid off = firm is in financial distress!
what about raising capital in other ways than equity
What about raising capital in other ways than equity?
  • As long as the new securities issued are junior to the existing debt, this problem will arise.
  • A solution would be to finance the new investment with debt that is senior to the existing debt.
      • Then we could issue risk-free debt with a face value of 10 to finance the investment.
      • Boom: Cash flows of 115. New D = 10, Old D = 50, E = 55
      • Bust: Cash flows of 35. New D= 10, Old D = 25, E = 0
  • Equity worth 27.5, Old debt worth 37.5 → everyone gains!
In the real world, debt typically has covenants preventing issues of new debt of the same (“pari passu”) or higher seniority
  • Although one would think that the existing creditors would be willing to renegotiate these terms since the investment makes everyone better off, this may be hard and take time
      • Why do you think this is? We will get back to this question.
  • the “Debtor in possession” (DIP) financing rule in U.S. chapter 11 bankruptcy is meant to alleviate the debt overhang problem
      • Allows a bankrupt firm to issue new senior debt.
indirect costs of financial distress
Indirect Costs of Financial Distress
  • So we understand why firms have a hard time getting new funds in financial distress. What are the costs when this happens?
  • Having to cut profitable new investment
      • As in the example above
      • This is probably the most common and obvious problem firms experience in distress.
  • Lots of evidence that financially distressed firms cut capital expenditures and R&D while in distress
      • Harder to say how much value was permanently lost as a result.
      • Or maybe this could even be a good thing in some cases?
        • E.g. GM and Ford?
financial distress product market competition
Financial distress & product market competition
  • Firms that are financially constrained may have a harder time responding to competition
  • There is evidence that highly levered firms can lose market share to competitors with lower leverage, cannot respond to competitors price changes, etc.
    • E.g. studies of the supermarket industry, trucking industry
financial distress customer supplier employee relationships
Financial distress & customer, supplier, employee relationships
  • Firms in financial distress have a harder time keeping customers, employees, suppliers
    • Would you want to work for a firm that is about to go bust?
  • Especially costly when long-term relationships are valuable
    • Firms with high-skilled labor that is hard to retrain
    • Firms with long-term supplier relationships
    • Firms with durable goods
      • Customers rely on firm being there for warranties, service, etc.
assets sold at fire sale prices
Assets sold at fire-sale prices
  • Firms in financial distress are often forced to sell off assets
    • To avoid default and bankruptcy
    • As part of a bankruptcy proceeding/liquidation
  • Problem: price obtained is often less than what the assets are worth to firm
    • Firm’s assets are often highly specific, with a limited number of other buyers that could use them
      • E.g. semiconductor wafers, oil rigs, telecom assets
    • Some assets, like R&D and intangibles, that may be so specific that not possible to sell them
    • Can explain why tech firms (semiconductor, software, biotech) have extremely low leverage
Especially problematic when have to sell assets fast, and other industry firms are also facing problems
    • Other industry firms are also constrained and cannot pay as much → Have to sell to a non-industry, financial buyer
    • As a result, cyclical industries face higher fire-sale costs for this reason (airlines, cars)
      • E.g. airlines sell aircraft at a 15% discount when the average airline is in financial distress
  • Often used as an argument to have a bankruptcy code that allows firms to reorganize rather than liquidate assets (such as the U.S. Chapter 11 code)
    • Bankruptcy liquidations experience fire-sale discounts of 30-50%
managerial loss of focus attention
Managerial loss of focus/attention
  • Resolving bankruptcy takes considerable effort, time, and attention of managers and employees
    • Negotiate with creditors, informing shareholders dealing with media, etc.

→ Less time and ability to run regular operations!

    • Often, firms in financial distress often hire a new management team
      • Original managers responsible for current problems
      • Some types of managers better at handling financial distress and “turnarounds”
games played by shareholders at the expense of creditors
“Games” played by shareholders at the expense of creditors


Suppose a levered firm is choosing between two projects with equal NPV, one of which is riskier than the other. Are equity- and debt holders indifferent between the two?

an option analogy
An option analogy
  • Equity’s claim: a call option with a strike price equal to the face value of debt, F.
    • Equity gets man(V-F,0)
    • Equity gets the upside, but does not bear the full downside
  • Debt’s claim: risk free bond minus put option
    • Debt gets F-max(F-V,0)=min(V,F)
  • Options 1.01: option value increases in risk
    • E value increases in risk, D value decreases in risk


  • Suppose firm consists of one risky cash flow in a year:
  • Equity is like a call option on the value of the firm

Value in a year



Cash flow in a year

Face Value

  • Equity holders prefer riskier projects, even when they may have negative NPV: Overinvestment / Asset substitution / Risk shifting

2. Equity holders are reluctant to contribute capital to safe projects, even when they have positive NPV: Underinvestment / Debt overhang

3. Anything that increases risk of debt without destroying value decreases value of debt and increases value of equity

let s return to our previous example
Let’s return to our previous example
  • Firm has payoffs next period:
    • Boom: Worth 100 with Probability = 0.5
    • Bust: Worth 20 with Probability = 0.5
    • Firm value V = 60
  • Firm has debt with a face value F = 50
    • Boom: D = F = 50, E = 50
    • Bust: D = V = 20, E = 0
    • So today: D = 35, E = 25
  • Debt is under water: trading below par
Assume there is a second investment project
    • Costs 10 as before, but pays off 18 in good state, 0 in bad state
    • Negative NPV = 9-10 = -1 → should not invest!
  • In addition, assume that firm has 10 in cash sitting around
    • Would go to debt holders in bad state
  • What if usus up 10 in cash and invests in this project?
    • Boom: V = 100 – 10 + 18 = 108, D = 50, E = 58
    • Bust: V = 20 – 10 + 0, D = 10, E = 0
    • Today:
      • D = 30, decrease by 5; E = 29, increase by 4
      • V – 59, decrease by 1
    • Wealth transfer from debt to equity!
  • Risk-shifting problem: shareholders like risky projects where they get upside, and debt holders pay on the downside.
What if firm did not have any cash “lying around,” but that there was no covenant preventing the firm from issuing senior debt.
  • Equity holders decide to issue 10 in senior debt to invest in project. New debt has face value of 10.
    • Boom: V = 100 + 118 = 108, new D = 10, old D = 50, E = 58
    • Bust: V = 20, new D = 10, old D = 10, E = 0
    • Same thing happens:
      • New D = 10. They get their money back.
      • Old D = 30, decrease by 5;
      • E = 29, increase by 4
  • Again, wealth transfer from debt to equity!
This explains why creditors demand seniority covenants
    • Although such covenants make the debt overhang problem worse, it curbs the risk-shifting problem
  • This is also a reason why the U.S. Chapter 11 code has been criticized:
    • Allows equity to continue the firm for too long in bankruptcy, in the hope that firm is luck and equity gets “in the money”
    • Famous example of this: Eastern Airlines bankruptcy.
the risk shifting problem in practice
The risk-shifting problem in practice
  • Maybe hard to find evidence of firms literally taking on “risky projects” in distress
  • But we do observe instances where firms take more ”subtle” actions that dilute their debt
      • Spin-offs of safer part of business (Marriott)
      • Play for time: Postpone efficient liquidation in hope of a miracle (Eastern Airlines).
      • Making excessive dividends or share repurchases
        • KB Toys and Bain Capital article
      • Using cash or senior debt to take over a (risky) firm.
        • In 1988, RJR Nabisco announced intention to acquire company in a leveraged buyout with new debt.
        • Value of public debt sank by $298M (>10%)
who pays for this risk shifting behavior
Who pays for this risk-shifting behavior?
  • If equity holders gain from diluting debt holders, isn’t this a benefit of debt (to equity)?
  • “Problem” is that creditors aren’t stupid…

→ Will demand higher interest rates when firm borrows in the firms place

→ Will impose covenants restricting firm behavior

    • Impose restrictions on investment, payout policy, spin-offs and asset sales.
    • Etc. “Browse” Smith & Warner (packet) for examples.
why can t we avoid costs of financial distress by renegotiating with creditors
Why can’t we avoid costs of financial distress by renegotiating with creditors?
  • If a firm faces liquidity problems, this does not necessarily mean that the firm would have to incur deadweight costs of distress
      • Could negotiate with creditors to write down debt, postpone interest, or ease covenants in exchange for additional interest or some equity in the company
  • Although such debt restructuring occur, they costly and sometimes not feasible
      • How can creditors know whether funds will be used for a “good” project? What if the firm is really risk-shifting?
      • In addition, creditors are often dispersed and face conflicts of interest among themselves
the problem of measuring costs of financial distress
The problem of measuring costs of financial distress
  • Although we believe that financial distress costs can be substantial, it is very hard to measure exactly how big they are.
  • The problem is how to distinguish value loss due to financial distress from economic distress
    • E.g. U.S. Airlines files for bankruptcy in August 2002 (and then again in September 2004)
Andrade & Kaplan (Journal of Fin. 1997) look at a sample of financially distressed firms
    • That had previously undergone leveraged buyouts (LBOs) and recapitalizations,
    • But operations were still generating positive cash flows
  • They estimate indirect costs of financial distress of up to 20% of firm value.
    • Probably best estimates we have.
    • So if these firms expected a 10% chance of going into distress, say: E(COFD) = 10%*20%=2%
    • Seems low, still, relative to tax benefits.
  • Problems with these estimates?
    • Which kind of firms are likely to undergo highly leveraged transactions, such as LBOs?
we now have a trade off theory of capital structure
We now have a trade-off theory of capital structure
  • The value of a leveraged firm is:

V(with debt) = V(all equity) + PV(tax shield) – PV(costs of distress)

PV (costs of distress) =

Probability of distress increases with leverage and decreases with excess cash.

PV (costs of distress) increases with leverage and decreases with excess cash.

practical implications
Practical Implications
  • Companies with “low” expected distress costs and high tax benefits should load up on debt to get tax benefits.
  • Companies with “high” expected distress costs should be more conservative.
attention commerce students