CF Chapter 17: Limits to the Use of Debt

What is the result of the optimal capital structure?

• Maximize firm value

• Minimize cost of capital WACC

What begins to happen when you deploy too much debt? (Cost of Using Debt)

• Value of the firm begins to decrease (after previously increasing)

• WACC begins to increase (after previously decreasing)

• The rate of debt (R_D) begins to increase

Firms do not use an infinite amount of debt, why not?

• Bankruptcy costs, financial distress costs

• Debt puts pressure on the firm since interest and principal payments are obligations

• If these obligations are not met, bondholders can force bankruptcy

What happens in a bankruptcy?

• Bondholders take over

• Ownership of the firm is legally transferred from stockholders to bondholders

If a company experiences $0 to stockholders in a market state, stockholders of that corporation enjoy _______ _______ in that state

limited liability

You MUST consider _________ costs

Bankruptcy costs

Why would the prospect of bankruptcy further diminish cash flows?

• Lawyers Fees: If bondholders are not paid in full, they will hire lawyers to negotiate or to sue the company. The firm will hire lawyers to defend itself

• Further costs will be incurred: Loss in consumer confidence, managers may not take care of equipment

How to translate a bankruptcy cost of $15 into a sentence

“In a default, assume costs are $15”

T/F With bankruptcy, the change in the value of the firm (decrease) is equal to the change debt (decrease)

TRUE

Who bares the cost of the decrease in debt/value of the firm?

Shareholders

The possibility of bankruptcy has a ________ effect on the value of the firm

negative

T/F the risk of the bankruptcy itself is what lowers the value of the firm

FALSE

• it is the costs associated with bankruptcy

Who bares the costs of bankruptcy?

Almost ALWAYS equity/shareholders

• Bankruptcy Costs are borne by equity holders since debtholders pay fair price for debt by anticipating bankruptcy costs

T/F Equity holders lose value for what they can sell debt for due to bankruptcy costs

TRUE

What are the two kinds of bankruptcy costs?

1. Direct Costs

2. Indirect Costs

3. Agency Costs

Examples of direct costs

• Legal expenses

• Expert witnesses

• Administrative and accounting fees

How large are direct costs

• Large firms: on average 3% of market value of firm

• Direct bankruptcy costs are larger for smaller firms

Examples of indirect costs

Impaired ability to conduct business

• Sales are loss because of impaired service and loss of trust drive customers and suppliers away

• Costs can amount to 20% of firm value

Which costs are almost always greater? (Direct, indirect, or agency)

Indirect

Side: Case 2 is about what aspect of bankruptcy costs?

Impaired ability to conduct business

Definition: Agency Costs

When a firm has debt, conflicts of interest arise between stockholders and bondholders. These conflicts are magnified when financial distress (high leverage, debt-agency cost) is incured and impose agency costs on the firm

When a company has high leverage & debt agency cost, what begins to happen?

Debt & Equity begin to impact assets (by increasing R_WACC) even though they should be independent

Who has a conflict of interest with the agency cost of equity?

Conflict of interest between managers and shareholders

What are the three agency cost “Strategies”

1. Incentive to take on excessive risk

2. Incentive toward underinvest

3. Milking the property

Taking on Excessive Risk: Explain the two kinds of projects, the projects impact on company value, and which parties would pick each projects (managers, equity holders, debtholders)

• Projects: Low Risk and High Risk

• Impact

  • Low Risk project increases the value of the firm more than the high risk project (technically the more optimal project)

  • The high risk project does not increase the value of the company as much as the low risk project, BUT it increases the value of EQUITY more

• What parties choose

  • Debtholders choose the less risky project because it increases the value of the firm

  • Managers and equity holders choose project two because it increases the value of equity (equity holders choose the higher risk even though it has less firm value than the other project)

Why are equity holders willing to take on more risk/ier projects?

Because of limited liability

Taking on Excessive Risk: T/F - If debt = 0 then firm value is equal to equity value and there is no preference for which project to take

TRUE

Strategy 2: Incentive towards underinvestment in basic terms

Firm rejects a positive NPV project (because equity holders do not want the project), agency cost of debt

Strategy 2: Incentive towards underinvestment scenario

A firm has $4,000 in debt due next year

• Can invest in project that costs $1,000 and pays of $1,700 (NPV = +700, must accept)

• KEY ASSUMPTION: Project must be financed by stockholders

When must a project be financed by stockholders?

Happens when a company has too much leverage, debt market refuses to finance the firm, so the firm issues more shares to equity holders

• Directly covered in case study

Explaining this picture

If equity holders must cover the cost of $1,000, and their increase in equity is 900, that leaves them with a negative net: -$100, so they will reject the project even though the NPV is negative

This negative 100, gets added onto the positive NPV for debtholders as an asset buffer with NPV, so debtholders like the positive NPV project

• Change in debt = NPV - EH net (so if EH net is negative, will get added onto change in debt)

Strategy 3: Milking the property

Managers or shareholders would have incentives to pay out large extra dividends, especially in times of financial distress, leaving less in the firm for bondholders. This is known as “milking the property”

Example of Milking the Property: Liquidating dividends

• Suppose a firm pays out a large dividend to the shareholders and this leaves the firm insolvent, with nothing for bondholders, but plenty for the former shareholders

• Such tactics often violate bond indentures

How to reduce milking the property from a bondholder’s perspective

A debt covenant

(**Note: there is no perfect covenant)

Definition: Covenant

Clauses in debt contracts to avoid inefficient behavior

• Difficult to write the “perfect” contract, both comes with cost

• 
  

Examples of negative covenants

• Restrictions on dividends

• Restriction on using assets for new collateral

• Restrictions on mergers

  • Why? → Mergers hare high risk projects (agency cost #1: take on excessive risk)

• Restriction on asset sales

• Restrictions on new borrowing

Examples of positive covenants

• Must maintain certain financial ratios indicating financial health

• Provide financial statements to lender

Graph with considerations of perfect world, with tax, with bankruptcy costs

Optimal Capital structure considering M&M propositions with taxes in Chapter 16

A firm will borrow because the interest tax shield is valuable

Optimal Capital Structure Considering Bankruptcy Costs

• At relatively low debt levels, the probability of bankruptcy is low, and the benefit from debt outweighs the cost

• At very high debt levels, the probability of financial distress/bankruptcy is very high, so the bankruptcy costs outweigh the benefit from debt financing

• An optimal capital structure would exist somewhere in between these extremes

Trade off theory of firm value with debt

Evidence related to tradeoff theory (4 pieces)

1. Strong industry trends in capital structure (highest leverage, lowest cost of debt)

2. Firms/industries with high costs of debt financing tend to use less debt

3. Firms/industries with high benefits of debt financing tend to use more debt

4. Evidence that firms behave as if they had a target debt-equity ratio

Expansion: Firms/industries with high costs of debt financing tend to use less debt

• firms with lots of tangible assets (ex: employee talent, growth opportunities)

• firms with unique or specialized assets (cannot easily sell in market → ex: pharm, IT)

Expansion: Firms/industries with high benefits of debt financing tend to use more debt

• Firms with lots of tangible assets (hotel, real estate)

• Firms with very stable cash flow

Expansion: There is evidence that firms behave as if they had a target debt-equity ratio

Ex: Firms experiencing “shocks” to their debt ratios due to major issuance activity or change in stock price subsequently rebalance

• 2008 Market Collapse: Wanted to go back to old cost of debt means that it was believed that the prior cost of debt was the optimal cost of debt

Who has a conflict of interest with agency cost of debt? What are the three kinds?

Debt and equity holders have conflicting interest

• Take on excessive risk

• Underinvestment

• Milking property

Who has a conflict of interest with cost of equity?

Managers and equity holders

• Diffuse of ownership

How do you reduce the agency cost of equity

Reduce by using debt

Two Agency costs of equity scenarios

• Choice 1: Issue $2 million in bonds at 12%. Employee who owns stock retains 100% of equity

• Choice 2: Issue $2 million in stock. Employee who owns stock retains only 33% of firm’s equity

With the two choices, what happens with the employee’s incentive to work hard?

• Choice 1: Issue $2 million in bonds at 12%. Employee who owns stock retains 100% of equity

  • More incentive to work hard

  • 100,000 equity increase (full amount)

• Choice 2: Issue $2 million in stock. Employee who owns stock retains only 33% of firm’s equity

  • Less incentive to work hard

  • equity increase is 100,000(1/3) = $33,333

Agency cost of debt scenario conclusion

Incentive for a manager/employee with stock to work hard is higher with debt financing

Other than less motivation to work hard, what is another problem with equity financing?

Prerequisite consumption

• Ex: Big office, a company car, more expense account meals

Who pays for the agency cost of equity?

The manager/management

What may help reduce the agency cost of equity problem?

Leverage Buyout (LBO) may help reduce the agency cost of equity problem

What kind of companies are a target of a private equity takeover and why?

Companies that are doing poorly because they are a lot cheaper to buy into

• Private Equity holders takeover poor management

• Once they take over, captures all profit (choice one from previous scenario)

Definition: Free Cash Flow

Excessive Cash left over after projects are taken on

Hypothesis for the question: Can the agency costs of equity be reduced?

Free Cash Flow Hypothesis

2 statements from the Free Cash Flow Hypothesis

1. An increase in dividends should benefit stockholders by reducing the ability of managers to pursue wasteful activities

2. An increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases

**Additional side: Also argues that can waste FCF on negative NPV projects (and take on unreasonably risky projects?)

Recap of the Free Cash Flow Hypothesis

Increasing dividends and debt both use up FCF and require managers to not be wasteful because they are obligated to pay back holders (makes it effective)

What is more expensive?

A personal tax on a dividend gain OR a tax on debt interest

A tax on debt interest

(Personal Taxes) Investors ultimately care about…

the money that ends up in their pocket

Personal Taxes: Dividends vs. Capital Gains

• Many firms do not pay out all earnings as dividends

• Allows investors to take equity return as a capital gain

• Allows investors to defer personal taxes into the future

What does T_e mean

Effective personal tax on each dollar of earnings

What does T_D mean?

Effective personal tax rate on each dollar of interest

Will personal taxes result in companies using more or less debt?

Less (because the tax on debt is more expensive than the personal tax on a dividend gain)

• Value of debt also decreases

What would happen if the personal tax rate decreased?

• Equity holders would pay less tax

• 
  

How to convert annual cash flows into firm values (equation)

Equation for firm value if T_D = T_E

V_L = V_U + T_CD

Equation for firm value if T_D = T_E = T_C

V_L = V_U

Value gain from leverage decreases as T_D - T_E _________

increases

• Can use this to predict how tax changes corporate tax structure

If you are in favor of personal tax, which kind of financing should you go for?

Equity financing

If not in favor of personal tax, which kind of financing should you go for

Debt financing

If corporate taxes increase, should you use more or less debt?

Use more debt

What are the two sides of the equation

(1-T_C )(1 - T_E) = (1 - T_D )

Goes to EH = Goes to DH

(1-T_C )(1 - T_E) = (1 - T_D ) when firm value…

V_L = V_U

(1-T_C )(1 - T_E) > (1 - T_D ) when firm value…

• Money going to equity financing is greater, so equity financing is better…

V_L < V_U

(1-T_C )(1 - T_E) < (1 - T_D ) when firm value…

V_L > V_U

Graph visual of the different inequality scenarios

Do examples on slides 23-24

ok

If you do not have a well developed stock market, what do you use?

The bank

If the US government raises personal tax rate…

• Value of the company decreases due to leverage

If T_E = 0 what does the government want to do?

Help the stock market & drive more investment into equity

Most corporations have high or low debt-asset ratios?

low

The market likes or dislikes increases in leverage?

LIKES

• Leverage increase is met with a positive market reaction

• Leverage decrease is met with a negative market reaction

Why might leverage vary substantially across industries?

Depending on their assets/products are tangible (high leverage, hard assets) vs intangible (low leverage, products/ideas are a lot harder to sell if takeover occurs)

Practical considerations (5)

1. Corporations that have lots of taxable income should have a preference for debt

2. Firms with intangible assets such as R&D, talented employees, will have higher bankruptcy costs → should use less debt

3. Firms in risky industries have a high probability of financial distress → should use less debt

   1. If stable, then use more debt

4. If firms prefer internal finance (like retained earnings) to external finance (like new debt issues, new equity issues). New issues are costly

5. Following industry norms in capital structure decisions may be a very safe strategy