Capital structure limits to the use of debt rwj chp 16
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Capital Structure – Limits to the Use of Debt RWJ Chp 16. Costs of Financial Distress. Bankruptcy risk versus bankruptcy cost. 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 value.

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Costs of financial distress l.jpg
Costs of Financial Distress

  • Bankruptcy risk versus bankruptcy cost.

  • 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 value.

  • Rather it is the costs associated with bankruptcy.

  • It is the shareholders who bear these costs.


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Description of Costs

  • Direct Costs

    • Legal and administrative costs (tend to be a small percentage of firm value).

  • Indirect Costs

    • Impaired ability to conduct business (e.g., lost sales)

    • Agency Costs

      • Selfish strategy 1: Incentive to take large risks

      • Selfish strategy 2: Incentive toward underinvestment

      • Selfish Strategy 3: Milking the property


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Balance Sheet for a Company in Distress

Assets BV MV Liabilities BV MV

Cash RM200 RM200 LT bonds RM300

F.Asset RM400 RM0 Equity RM300

Total RM600 RM200 Total RM600 RM200

What happens if the firm is liquidated today?

RM200

RM0

The bondholders get RM200; the shareholders get nothing.


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Selfish Strategy 1: Take Large Risks

The Gamble Probability Payoff

Win Big 10% RM1,000

Lose Big 90% RM0

Cost of investment is RM200 (all the firm’s cash)

Required return is 50%

Expected CF from the Gamble = RM1000 × 0.10 + RM0 = RM100


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Selfish shareholders Accept Negative NPV Project with Large Risks

  • Expected CF from the Gamble

    • To Bondholders = RM300 × 0.10 + RM0 = RM30

    • To shareholders = (RM1000 - RM300) × 0.10 + RM0 = RM70

  • PV of Bonds Without the Gamble = RM200

  • PV of Stocks Without the Gamble = RM0

  • PV of Bonds With the Gamble = RM30 / 1.5 = RM20

  • PV of Stocks With the Gamble = RM70 / 1.5 = RM47


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Selfish Strategy 2: Underinvestment Risks

  • Consider a government-sponsored project that guarantees RM350 in one period

  • Cost of investment is RM300 (the firm only has RM200 now) so the shareholders will have to supply an additional RM100 to finance the project

  • Required return is 10%

  • Should we accept or reject?


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Selfish shareholders Forego Positive NPV Project Risks

  • Expected CF from the government sponsored project:

    • To Bondholder = RM300

    • To Stockholder = (RM350 - RM300) = RM50

  • PV of Bonds Without the Project = RM200

  • PV of Stocks Without the Project = RM0

  • PV of Bonds With the Project = RM300 / 1.1 = RM272.73

  • PV of Stocks with the project = RM50 / 1.1 - RM100 = -RM54.55


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Selfish Strategy 3: Milking the Property Risks

  • Liquidating dividends

    • Suppose our firm paid out a RM200 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.

  • Increase perquisites to shareholders and/or management


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Can Costs of Debt Be Reduced? Risks

  • Protective Covenants

  • Debt Consolidation:

    • If we minimize the number of parties, contracting costs fall.


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Protective Covenants Risks

  • Agreements to protect bondholders

  • Negative covenant: Thou shalt not:

    • Pay dividends beyond specified amount.

    • Sell more senior debt & amount of new debt is limited.

    • Refund existing bond issue with new bonds paying lower interest rate.

    • Buy another company’s bonds.

  • Positive covenant: Thou shall:

    • Use proceeds from sale of assets for other assets.

    • Allow redemption in event of merger or spinoff.

    • Maintain good condition of assets.

    • Provide audited financial information.


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Integration of Tax Effects and Financial Distress Costs Risks

  • 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.


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Integration of Tax Effects and Financial Distress Costs Risks

Value of firm underMM with corporatetaxes and debt

Value of firm (V)

Present value of taxshield on debt

VL = VU + TCB

Maximumfirm value

Present value offinancial distress costs

V = Actual value of firm

VU = Value of firm with no debt

0

Debt (B)

B*

Optimal amount of debt


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The Pie Model Revisited Risks

  • Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.

  • Let G and L stand for payments to the government and bankruptcy lawyers, respectively.

  • VT = S + B + G + L

  • The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.

S

B

G

L


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Shirking, Perquisites, and Bad Investments: The 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”.

  • Who bears the burden of these agency costs?

  • 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 shareholders 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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The Pecking-Order Theory of

  • Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

    • Rule 1

      • Use internal financing first.

    • Rule 2

      • Issue debt next, equity last.

  • The pecking-order Theory is at odds with the trade-off theory:

    • There is no target D/E ratio.

    • Profitable firms use less debt.

    • Companies like financial slack


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Growth and the Debt-Equity Ratio of

  • 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.


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Personal Taxes: The Miller Model of

  • The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:

Where:

TS = personal tax rate on equity income

TB = personal tax rate on bond income

TC = corporate tax rate


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Personal Taxes: The Miller Model of

The derivation is straightforward:

Continued…


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Personal Taxes: The Miller Model (cont.) of

The total cash flow to all stakeholders in the levered firm is:

The first term is the cash flow of an unlevered firm after all taxes.

Its value = VU.

A bond is worth B. It promises to pay rBB×(1- TB) after taxes. Thus the value of the second term is:

The value of the sum of these two terms must be VL


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Personal Taxes: The Miller Model (cont.) of

  • Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:

  • In the case where TB = TS, we return to M&M with only corporate tax:


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Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes

VL = VU+TCB when TS =TB

Value of firm (V)

VL < VU + TCBwhen TS < TB

but (1-TB) > (1-TC)×(1-TS)

VU

VL =VU

when (1-TB) = (1-TC)×(1-TS)

VL < VU when (1-TB) < (1-TC)×(1-TS)

Debt (B)


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Agency Cost of Equity Corporate and Personal Taxes

Agency Cost of Debt

Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs

Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

Value of firm (V)

Present value of taxshield on debt

VL = VU + TCB

VL < VU + TCBwhen TS < TB

but (1-TB) > (1-TC)×(1-TS)

Maximumfirm value

VU = Value of firm with no debt

V = Actual value of firm

0

Debt (B)

B*

Optimal amount of debt


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How Firms Establish Capital Structure Corporate and Personal Taxes

  • Most Corporations Have Low Debt-Asset Ratios.

  • Changes in Financial Leverage Affect Firm Value.

    • Stock price increases with increases in 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 to Equity ratio.


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Factors in Target D/E Ratio Corporate and Personal Taxes

  • Taxes

    • If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.

  • 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 high probability of experiencing financial distress.

  • Pecking Order and Financial Slack

    • Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.


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Summary and Conclusions Corporate and Personal Taxes

  • Costs of financial distress cause firms to restrain their issuance of debt.

    • Direct costs

      • Lawyers’ and accountants’ fees

    • Indirect Costs

      • Impaired ability to conduct business

      • Incentives to take on risky projects

      • Incentives to underinvest

      • Incentive to milk the property

  • Three techniques to reduce these costs are:

    • Protective covenants

    • Repurchase of debt prior to bankruptcy

    • Consolidation of debt


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Summary and Conclusions Corporate and Personal Taxes

  • Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt.

Value of firm underMM with corporatetaxes and debt

Value of firm (V)

Present value of taxshield on debt

VL = VU + TCB

Maximumfirm value

Present value offinancial distress costs

V = Actual value of firm

VU = Value of firm with no debt

0

Debt (B)

B*

Optimal amount of debt


Summary and conclusions28 l.jpg

Agency Cost of Equity Corporate and Personal Taxes

Agency Cost of Debt

Summary and Conclusions

  • If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB)

Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

Value of firm (V)

Present value of taxshield on debt

VL = VU + TCB

VL < VU + TCB when TS < TB

but (1-TB) > (1-TC)×(1-TS)

Maximumfirm value

VU = Value of firm with no debt

V = Actual value of firm

0

Debt (B)

B*

Optimal amount of debt


Summary and conclusions29 l.jpg
Summary and Conclusions Corporate and Personal Taxes

  • Debt-to-equity ratios vary across industries.

  • Factors in Target D/E Ratio

    • Taxes

      • If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.

    • 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 high probability of experiencing financial distress.


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