Finnes optimal gjeldsgrad

1
Optimal Gjeldsgrad og Egenkapital-/Gjeldshaver
konflikter
Finnes optimal gjeldsgrad? How can Firms
Minimize Debt Holder-Equity Holder Problems?
2
The Capital Structure Irrelevance (MM, 1958)
VTK - Selskapsverdi
kTK -WACC
VD/VE gjeldsgrad
0
3
The Capital Structure Irrelevance (MM, 1958)
k - Cost of Capital
kE -Cost of Equity
kTK -WACC
kD -Cost of Debt
VD/VE gjeldsgrad
0
? kE endres i et forhold som tilsier en konstant
kTK
4
Capital Structure effects from

• Taxes
• Dividends and Share Repurchases
• Direct and Indirect Cost of Bankruptcy and
  Financial Distress
• Stakeholder theory
• Dynamic Capital Structure Considerations

5
The Capital Structure Relevance
k - Cost of Capital
kD -Cost of Debt
kE -Cost of Equity
kTK -WACC
VD/VE gjeldsgrad
0
6
The Capital Structure Problem

• The debt-ratio becomes so high that the risk is
  transferred from equity holders to debt holders.
• Debt Holders must increase interest rates so the
  risk is properly reflected.
• The classical situation may be best illustrated
  in the recent examples
• Enitel A/S and
• Braathen Safe A/S

7
Direct Bankruptcy Cost relate to the legal
process involved in reorganization a bankrupt
firm.
Bankruptcy Costs and Debt Holder-Equity Holder
Conflict
The Indirect Bankruptcy Cost are not directly
related to the reorganization and can arise
among financially distressed firms, or those
firms that are close to bankruptcy, but which may
never actually go bankrupt.
Note, most indirect bankruptcy costs arise
because financial distress creates a tendency for
firms to engage in actions that are harmful to
their debt holders and non-financial stakeholders
such as customers, employees and suppliers.
8
The Direct Costs of Bankruptcy

• Costs related to bankruptcy (MM require
  costless bankruptcy)
• Management time spending on creditors
• Legal expenses and court costs
• Advisory fees

Example Mays department store went bankrupt in
1992. It spent an estimated 100 million on
lawers, accountants, investment bankers and
other highly paid advisors. Hence, 2 to 3 of the
firms estimated value was spent on direct
bankruptcy costs.
9
The Direct Costs of Bankruptcy
Who Bears the Bankruptcy Costs? Since the direct
costs diminish the value of the firm, most direct
bankruptcy costs are thus ultimately borne by the
firms debt holders. However, managers,
representing the interest of equity holders
should be concerned about bankruptcy because
lenders charge an interest premium that reflects
the expected costs they must bear in the event of
default. Therefore, shareholders indirectly bear
the expected costs of bankruptcy and must
consider these cost when choosing their optimal
capital structure.
10
Indirect Bankruptcy Cost (IBC) Equity Holder
Incentives

• Firms acting to maximize their stock prices make
  different decisions when they have debt in their
  capital structures than when they are financed
  completely with equity
• Equity holders of leveraged firms may implement
  strategies that decrease the value of the firms
  debt without reducing its total value increase
  the firms share price.
• ? Equity holders may also implement strategies
  that reduce the total value of the firms debt
  and equity claims if these strategies transfer a
  sufficient amount from the debt holder to the
  equity holders.

11
IBC Who Bears the Costs of the Incentive Problem

• Note, sophisticated lenders will anticipate the
  equity holders incentives to implement
  strategies of self-interest and will determine
  interest rates they charge on loans accordingly.
• ? Charge higher interest rates
• Consequently, equity holder bears the expected
  costs of their future adverse incentives in the
  form of higher interest rates at the time they
  borrow.
• Firms have an incentive to convince their lenders
  that they will not engage in such behavior
• ? Firms may have difficulty committing
  credibility to a policy of maximizing the firms
  total value rather than the value of there shares.

12
Indirect Bankruptcy Cost Equity Holder Incentives
How Equity Holders can Expropriate Debt-holder
Wealth Instruct the firms managers to sell all
of its assets and pay the proceeds of this
liquidation as a dividend to the shareholders,
leaving the debt-holders with valueless paper.
? Lenders demand covenants (contracts that
precludes such actions). However, covenants
cannot sole all of the potential conflicts.
13
Indirect Bankruptcy Cost Equity Holder Incentives
Distortions in investment strategies that might
arise because of conflicts of interest

• The Debt Overhang Problem (under investment)

• The Shortsighted Investment Problem

• The Asset Substitution Problem

• The Reluctance to Liquidate Problem

14
IBC The Debt Overhang Problem (under investment)
Selecting projects with positive net present
value can at times reduce the value of a
leveraged firms stock.
Ex. Lily Pharmaceuticals Research (Myers,
1977) The case is presented i Figure 1. Financing
by a bond with covenants specifying that any
additional debt the firm issues must have lower
priority in the event of bankruptcy. Assume risk
neutrality and zero expected rate of return on
bonds. The firm will default when markets look
unfavourable! Consequently, to raise the 100
million, the firm must promise to pay 110
million in the future to compensate investors for
the possibility that they may not be repaid.
15
Figure 1 Lily Pharmaceuticals Research
16
IBC The Debt Overhang Problem (under-investment)
In the less favorable situation The project show
a NPV 0. That is, the investment is 100
million and returns 150 million! The initial
100 is sunk cost!
However, given the 110 million senior debt
obligation, new investors will be unwilling to
provide more than 40 million (150 110
million) to fund the project. The firm therefore
may be unable to obtain financing when the
project is less successful ( default)! Firms
that have existing senior debt obligations may
not be able to obtain financing for positive NPV
investments!
Note (1) in the underinvestment problem we find
an implicit free-rider problem from original
lenders and (2) unprotected debt would have
allowed the firm to raise additional investment
(Stulz and Johnson, 1985)
17
IBC The Debt Overhang Problem (Dividend Policy)
What about internally generated funds? the
tendency to under invest become even more clearer!
Consider Chan Partners Ltd. which purchased a
100 million office building. They paid 20
million in cash an financed the rest with a
mortgage, requiring payment of 8 million per
year for 10 years with 80 million in principal
due at the end of 10 years. Annual rental income
is 12 million and maintenance cost is 3 million.
Suppose a downturn that reduce the office value
to 70 million, not influencing the rental
income. Now, since the partners believe that they
were quite likely to default on the final 80
million repayment of the principal, they have an
incentive to distribute (to the partners) as much
cash as possible before the final repayment date,
without regard to how their actions would affect
the buildings value.
The partners considered cutting annual
maintenance budget from 3 to 2
million. ? increased yearly dividend (1 million)
and reducing office value by 18 million in 8
years.
18
IBC The Debt Overhang Problem (Dividend Policy)
The partners would not normally considered this
alternative (8 vs. 18)! However, the 1 million
would be distributed directly to the owners while
the 18 million loss in value would be borne by
the holders of the mortgage!
With risky debt, equity holders have an incentive
to pass of internally financed positive NPV
projects when the funds can be paid to equity
holders as dividend!

• Solution applying covenants
• Specify the partners to maintain the building
  appropriately.
• ? impractical difficult to specify maintenance!
• 2. Restrict the payout to the partners.
• ? Most corporate loans and privately placed bonds
  have some kind of restriction on the amount of
  funds the firm can pay out as dividend
  repurchasing shares)

19
IBC The shortsighted investment problem
Debt may lead firms to favour lower NPV projects
that pay off quickly over higher NPV projects
with lower initial cash flows. ? rooted in the
debt overhang problem.
Firms with large debt obligations need to pay
high borrowing rates on new subordinated debt
used to refinance the proportion of their
existing debt that is maturing. Incentive to
generate cash quickly to minimize the amount of
debt that they will need to refinance at high
rates.
20
Figure 2. Applied Textronics Cash Flows
Example Applied Textronics has debt obligations
that are due both next year and in two years.
100 million next year and 40 million due the
following year. Considering two equally costly
projects (1) a long-term project and (2) a
short-term project (figure 2).
Risk-free rate is zero, both cash flow are
certain and long-term NPV short-term NPV. The
probability in each state of the economy is 50.
21
Applied Textronics (AT) Cash Flows

• Short Term Project AT is able to meet its
  obligation (5050100 million)
• Long Term Project AT is able to meet its
  obligation (502070 million) and therefore need
  an additional 30 million in new debt to meet its
  obligations in year 1.
• ? Subordinated new debt requires that the firm
  offer to pay the new lenders 50 million at the
  end of year 2 in order to raise 30 million (50
  0.5 10 0.5 30 million)
• ? AT will be unable to meet its obligations if
  the unfavourable state of the economy occurs
  regardless of long-term or short-term project.
  The firms equity will be worth zero.
• ? AT will in the favourable state of economy
  receive 10 million for the long term project (40
  60 (4050)10 million). For the short term
  reject 20 million (0 60 40 20 million).
• ? AT is better off selecting the short-term
  project even though it has lower NPV.
• Why? Since, the firms existing debt holders are
  made worse off when the firm selects the short
  term project, the gain to the equity holders
  comes at the expense of the original debt-holders
  whose debt is due at end of year 2. Note that the
  debt holders have been paid in full in the
  unfavorable state of the economy if the firm
  takes the long-term project, but they receive
  only 10 million of their 40 million obligation in
  the unfavorable state of the economy when the
  short-term project is selected.

Firm with high debt obligations tend to pass up
high NPV projects in favor of lower NPV projects
that pay of sooner.
22
IBC The Asset Substitution Problem
Option pricing theory provides one way to think
about the asset substitution problem. Note that
equity holder possess a call option on the firms
equity. Hence, the function max(CF-Debt
Obligations,0) defines their pay-off.
Therefore, increased volatility (more risky
investments) will show that the a firms equity
is more valuable.
However, a firms debt which can be viewed as a
combination of the firms assets and a short
position in a call option on those assets,
becomes less valuable if the firms investments
become riskier.
By increasing firms risk, equity holders
transfer wealth from the debt holders to
themselves.
23
IBC The Asset Substitution Problem the Case of
Unistar
Unistar manufacture memory chips. The management
have to decide on one of two production
processes. Unistar management knows that process
2 involves much more risk than process 1 (both
costs 70 million)! Lenders are aware of the two
alternatives and can forecast the possible payoff
of each, but they cannot observe which process
the firm will decide upon until after they lend
the money.
Assumptions Risk Neutrality and the Risk free
rate is zero. PV of the projects are their
Expected Payoffs. Figure 1.
All equity firm Process 1 is the better
alternative. 1 NPV5 (75-70) 2 NPV0 (70
70).
DebtEquity firm Assume 40 million of the 70
million invested is debt. Figure 2 below show a
summary of the payoffs to the firms equity
holders after repayment of the 40 million debt
obligation. Figure 1 and Figure 2 is equal except
for the equity holder pyoff in the unfavorable
state of the economy for process 2 is given as 0
instead of -15 million (25 40), because of
limited liability (zero worst case)!
24
Unistars Alternative Payoffs
25
IBC The Asset Substitution Problem the Case of
Unistar
The equity holders expected payoffs of 37.5
million from process 2 exceed their payoff of 35
million from process 1. Hence, the equity holders
of a levered firm may prefer a high risk, low (or
even negative) NPV project to a low-risk, high
NPV project.
Note however that if lenders are sophisticated
and anticipate that Unistar select the high risk
project, they will realize that they have default
risk. The loan has an expected value of 0.525
0.540 32.5 million. Hence, these sophisticated
lenders will be unwilling to provide 40 million
today for the uncertain promise of obtaining 40
million in the future!
With sophisticated lenders, equity holders must
bear the cost that arise because of their
tendency to substitute high-risk, low NPV
projects for low-risk, high NPV projects.
26
IBC The Asset Substitution Problem Enitel - CASE

• Enitel Industries has two mutually exclusive 50
  million investment projects , R and S, which it
  plan to fund with debt. Project S pays off 60
  million for certain and project R pays off only
  20 million when the economy is poor and 90
  million when the economy is good.
• What is the net present value of each project,
  assuming that the economy is equally likely to be
  favourable or unfavourable and the risk-adjusted
  discount rate is zero?
• Suppose Enitel can raise the 50 million by
  issuing a bond with a face value of 50 million
  (because the lender naively believes the company
  will take the safe project).
• b) Which project will Enitel shareholders prefer?
• c) What is the expected pay off to the naive
  lenders?
• Now suppose the lenders are sophisticated.
• d) Which project will the company select, and
  what do the shareholders gain?

27
IBC The Asset Substitution Problem Solution to
Enitel Exercise

• NPVS 0.5(60 million 60 million) - 50
  million 10 million
• NPVR 0.5(20 million 90 million) - 50
  million 5 million
• b) With naive lenders or bondholders, the pay off
  to equity holders with with project S is
• 0.5(60 million 60 million) - 50 million
  10 million
• The pay off to equity holders with with project R
  is
• 0.5(0 million) 0.5(90 million - 50 million)
  20 million
• Thus if the executives act in the best interest
  of shareholders, they will choose project R.
• c) The naive lenders do not receive full payment
  in the poor state of the economy they will
  receive only 0.5(20 million) 0.5(50 million)
  35 million, on average (loss of 50 35 15
  million).

28
IBC The Asset Substitution Problem Solution to
Enitel Exercise

• Sophisticated lenders aware of the both projects
  will realize that equity holders have an
  incentive to invest in the riskier project. For
  the 50 million loan, they will require a future
  payment of 80 million. With the selection of
  project R, they receive an expected pay off of
  0.5(20 million) 0.5(80 million) 50
  million, so they recover their investment. In
  this situation, the pay-off to equity holders
  selecting project R is 0.5(0 million) 0.5(90
  million - 80 million) 5 million. The payoff
  is zero if project S is selected because in
  neither state of the economy can the obligation
  be met. Thus equity holders will select project R
  despite its lower NPV. If they have been able to
  commit to taking project S, equity holders would
  have created 10 million in stead of 5 million
  in value.

29
IBC The Asset Substitution Problem Credit
Rationing
Some Economists have argued that because of the
tendency to increase risk, some banks ration
credit rather than increase borrowing rates when
credit conditions tighten (Stiglitz and Weiss,
1981). Stem from the lenders belief that
firms will respond to higher interest rate
obligations by choosing riskier investments.
The Olivin Corporation has an opportunity to take
on one of two 100 million projects which the
firms lenders cannot distinguish from one
another. For the analysis we assume risk
neutrality and the interest rate is initially
zero. The payoffs for the two projects are shown
in the figure below. The NPV(A)14 million (114
100). The NPV(B)-30 million (70 100). Now, if
the firm can convince the lender that it will
choose project A, then it will obtain the
required 100 million financing by issuing a
zero-coupon bond that pays 112.5 million at
year-end when the payoffs are realized. The
lender obtains 100 million 0.8 112.5 0.2
50. Zero interest rate The company prefers the
less risky project (A) as 0.8 (130 million
112.5 million) 14 million, while Project B 0.2
(150 112.5) 7.5 million. 12 interest rate
Lenders who believe that the company will take
the safe project (A) will now demand 127.5
million promised payment for a 100 million loan.
0.8 127.5 0.2 50 112 million. On average
the company now earn 12 return.
30
Olivins Project Payoffs
What happens to the equity holders return? With
12 being the debts expected return, the
expected payoff to the equity holders from
selecting A is 0.8 (130 127.5) 2.0
million.The expected payoff from B is 0.2 (150
127.5) 4.5 million. With a promised payment of
this magnitude, Olivin will prefer project B, the
more risky project, because it creates a higher
return for the equity holders. Realizing that
Olivin will select the more risky project in
these circumstances, the lender would not be
willing to offer a 100 million loan for a 127.5
million promised payment since it will not, on
average, achieve the 12 risk-free return on its
investment. In fact, there is no promised
interest payment that will induce the bank to
lend money to Olivin. The maximum debt obligation
Olivin possibly can pay, 150 million, is
insufficient to yield the lender an expected 12
return.
Firms with the potential to select high-risk
projects may be unable to obtain debt financing
at any borrowing rate when risk-free interest
rates are high.
31
IBC Credit Rationing Exercise
Norwegian Health is choosing between project A,
which introduces a traditional greasy hamburger,
and project B, which introduces a healthy,
low-fat emu burger. Project A costs 100 million
in marketing, training of cooks, and so forth and
yields a cash flow for the next year of 115
million with certainty. Project B also costs 100
million but, because of the controversial nature
of the meat, has only a limited probability of
success. The marketing experts at Norwegian
Health estimate that there is a 1 in 3 chance
that emu meat will be accepted and the project
will be successful. If project B is successful it
will generate cash flows over the next year of
142 million. If it fails cash flows will only be
60 million. a) Suppose the discount rate is zero.
What is the NPV of each project? b) Would lenders
be willing to make a 100 million loan for a bond
with a face value of 100 million? Which project
will Norwegian Health take? c) Suppose the
discount rate is 10, so that lenders require a
bond with face value of 110 million to make a
risk less loan of 100 million. Would rational
lenders make such a loan to Norwegian Health? d)
What would the face value need to be in order for
the bondholders to receive a fair return?
32
IBC Credit Rationing Solution to Exercise

• NPV(A) 115 100 15 million and
  NPV(B)1/3142 2/360 100 -12.667 million.
• With such a bond, the expected payoff to equity
  from project A is 115 100 15 million and
  project B is 1/3(142 - 100) 2/3 (0) 14
  million. The equity holders therefore choose
  project A and the lenders receive 100 million
  with certainty.
• With a bond having a face value of 100 million,
  the expected payoff to shareholder from project A
  is 115 100 5 million. The expected payoff to
  shareholders if Norwegian Health chooses project
  B is 1/3 (142 110) 2/3 (0) 10.667
  million. Thus, shareholders would select project
  B. The lenders will receive only 1/3 110 2/3
  60 76.667 million, which is less than the 110
  million they require for the loan of 100 million.
  Lenders will not make the loan.
• Given that Project B is chosen, the lender will
  require a payment of F in the good state for a
  loan of 100 million. F solve the following
  equation
• 1/3 F 2/3 60 110 F 210 million.
  Such a large payment is not feasible.
• With a 210 million loan obligation, Norwegian
  Health will always default and equity will
  receive nothing. Neither projects will be taken.
  Due to the increase in interest rates Norwegian
  Health cannot profit from the positive NPV
  project.

33
Indirect Bankruptcy Cost Contingent Claims
Analysis

• CCA highlights the IBC.
• Value of equity equals a long position in the
  assets cash flows, VCF, minus the risk free
  debt, VD with exercise price XD, plus a purchased
  put-option with exercise price XD.
• VE VF XD VP max (VF XD, 0)
• Value of debt equals the risk free debt, VD with
  exercise price XD, minus a written put option
  with exercise price XD.
• VD XD VP max (VF XD, 0)

34
Indirect Bankruptcy Cost Contingent Claims
Analysis
Shareholders equity as a call-option with
exercise price XD on the firms assets at
expiration date T where
35
Indirect Bankruptcy Cost Contingent Claims
Analysis
Substitution and Risk Shifting implies for equity
holders
Value of shareholders call option increases in
the riskiness of the underlying assets cash flow.
36
How Can Firms Minimize Debt Holder-Equity Holder
Problems?

• Protective Covenants
• ? Specify seniority of the debt plus specify the
  amount that can be distributed to shareholders as
  dividend or repurchase.
• ? Restrict various accounting ratios debt/equity
  ratio, interest coverage and working capital.
• ? Restrict the sale of assets

37
How Can Firms Minimize Debt Holder-Equity Holder
Problems?

• Bank and Privately Placed Debt
• ? Bank debt solves the free-rider problem that
  contributes to the debt overhang problem.
• ? Banks and other private providers of debt
  capital are better able to monitor the investment
  decisions of firms and enforce protective
  covenants.
• The conflict between debt and equity is less in
  Germany and Japan than in US.

38
How Can Firms Minimize Debt Holder-Equity Holder
Problems?

• The Use of Short-Term versus Long-Term Debt
• The conflicts between debt and equity holders are
  more severe when firms use long-term rather than
  short-term debt financing.
• ? The value of short-term debt is much less
  sensitive to changes in a firms investment
  strategy than the value of long term debt.

39
How Can Firms Minimize Debt Holder-Equity Holder
Problems?

• Security Design The Use of Convertibles
• ? Hence, the increase in the value of the option
  component can offset the decrease in the value of
  the convertible's straight bond component that
  occurs when the firms volatility increases.
• ? Some researchers have suggested that it may be
  possible to design a convertible bond so that its
  value is insensitive to changes in the volatility
  of the firms cash flow.

40
How Can Firms Minimize Debt Holder-Equity Holder
Problems?

• Management Compensation Contracts
• We normally assume that managers make investment
  choices that maximize their firms share price.
  However, managers have often other objectives.
  For example, sometimes that are under more
  pressure to please debt holders than equity
  holders.
• Moreover, some of the natural tendencies of
  managers are more aligned with the interest of
  debt holders than equity holders.
• ? More risk averse
• ? Prestige and Power
• To maximize the firms current value, a firm must
  commit managers to make future choices that are
  in the combined best interest of all claimants,
  maximizing the combined value of the firms debt
  and equity. must guide the compensation
  contract.

41
Empirical Implications for Financing Choices

• How Investment Opportunities Influence Financing
  Choices
• Since debt financing distorts investment
  incentives, firms with substantial investment
  opportunities should be more conservative in
  their use of debt financing.
• ? Empirical studies tend to support this
  hypothesis!

• How Financing Choices Influence Investment
  Choices
• Do highly leveraged firms invest less than firms
  with lower debt/equity ratios.
• ? Empirical studies conclude that more highly
  leveraged firms tend to invest less than firms
  with lower leverage ratios.

42
Empirical Implications for Financing Choices

• Firm Size and Financing Choices
• Two reasons explain why the debt holder equity
  conflict may be worse for small firms
• 1. Small firms may be more flexible and thus
  better able to increase the risk of their
  investment projects.
• 2. The top management of small firms are more
  likely to be major shareholders, which gives them
  a greater incentive to make choices that benefit
  equity holders at the expense of debt holders.
• Empirical studies
• Small firms should exhibit lower debt ratios,
  which does not seem to be the case. However,
  long-term debt tends to be convertible and a
  greater proportion of their total debt financing
  tend to be short-term debt.
• Moreover, use more banks ? short-term financing.

43
Empirical Implications for Financing Choices

• Evidence from Japan
• In Japan, banks play a much larger role in the
  financing of corporations.
• 1. Empirical studies show that the negative
  relationship between RD expenditures and
  leverage found to be strong in Anglo-American
  countries, is weak in Japan.
• 2. Moreover, Japanese firms having a
  banking-owner relationship, tend to be more
  levered than their counterparts without a banking
  relationship of this type. Therefore, because
  banks are able to exercise more control when they
  hold more shares, they can better protect their
  interests and can thus offer greater amounts of
  debt financing in situations where potential
  conflicts exists.