Chapter 16 Limits to the Use of Debt

1
Chapter 16Limits to the Use of Debt
2
Objectives

• Understand the reasons why firms do not maximize
  debt usage.
• Apply the concepts to making capital structure
  decisions.

3
Many Different Models of Capital Structure

• Static Trade-off Models
• Corporate taxes v
• Costly financial distress
• Agency costs models
• Asymmetric Information Model
• Pecking Order Theory
• Personal taxes
• Other factors

4
What is Financial Distress?

• A firm is financially distressed when it is
  unable to meet its debt obligations
• Interest
• Principal
• Financial distress could result from
• Poor sales / high costs
• Unwise expansions / intense competition
• Inefficient management
• Heavy reliance on debt
• Massive litigation
• Etc.

5
Options for a Financially Distressed Firm
Private Workout
Reorganization
Financial Restructuring
Legal Bankruptcy (Chapter 11)
Merger
Liquidation
6
Payoffs to Firms Securityholders
7
Cost of Financial Distress

• Direct Costs
• Legal and administrative costs
• Indirect Costs
• Managerial time devoted to restructuring
• Impaired ability to do business
• Lost sales
• Inability to get additional credit

8
Effect of Costs of Financial Distress

• Consider two firms (L H) with identical assets.
• Ignore corporate taxes.
• End of year cash flows (for both firms) are given
  in the table.
• Firms will be liquidated at end of the year.

9
Two Firms With Different Leverage

• Firm L
• Debt payment at end of year 106
• rB 6 and rS 11
• Firm H
• Debt payment at end of year 270
• rB 8 and rS 11.541

10
Cash Flows Without Distress Costs
11
Cash Flows Without Distress Costs
12
Cash Flows Without Distress Costs
13
Firm Values Without Distress Costs
14
Firm Values Without Distress Costs
15
Cash Flows With Distress Costs
Costs of financial distress 80
16
Firm Values With Distress Costs
Costs of financial distress decrease firm value.
17
Firm Values With Distress Costs
Costs of financial distress decrease firm value.
18
Who Pays the Costs of Financial Distress?

• Stockholders pay the cost ex-ante
• They get less from the bondholders, given a
  promised payment.
• Bondholders pay the cost ex-post
• They pay if and only if firm is in financial
  distress
• But they will demand a higher return ex-ante to
  compensate for the loss due to financial distress
  costs.

19
Agency Costs of Debt

• Conflict of interest between stockholders and
  bondholders impose Agency Costs on the firm.
• Three strategies whereby stockholders can hurt
  the bondholders (i.e. expropriate wealth from the
  bondholders).
• Overinvestment
• Milking the property
• Underinvestment

20
Balance Sheet for a Company in Distress

• Assets BV MV Liabilities BV MV
• Cash 200 200 Bonds 300
• Fixed Asset 400 0 Equity 300
• Total 600 200 Total 600 200
• What happens if the firm is liquidated today?

200
0
The bondholders get 200 the shareholders get
nothing.
21
The Overinvestment Strategy
Project Cost 200 (all of the firms
cash) Required return 50
Expected cash flow 100
22
Should the Firm Accept the Project?
23
Summary of the Overinvestment Strategy

• Projects with negative NPV would never be
  accepted by all-equity financed firms or by
  firms not in financial distress.
• Firms in financial distress may invest in high
  risk projects with negative NPV if there is some
  chance that the stockholders will gain.
• Doing so reduces overall firm value.
• Stockholders gain at the expense of the
  bondholders.

24
Milking the Property

• Recall that the financially distressed firm has
  200 in cash.
• If it does nothing, bondholders will get all of
  the 200 and the stockholders will get nothing
  (at the end of the year).
• Stockholders can pay themselves a dividend of
  200 today, and thereby take money away from the
  bondholders!

25
The Underinvestment Strategy
Project Cost 200 (all of the firms
cash) Required return 5
26
Should the Firm Accept the Project?
27
Summary of the Underinvestment Strategy

• Projects with positive NPV would always be
  accepted by all-equity financed firms or by
  firms not in financial distress.
• Firms in financial distress may forego
  investments in positive NPV projects if
  bondholders get all of the gains.

28
Who Pays for these Selfish Strategies?

• Bondholders recognize that if the firm ends up in
  financial distress, stockholders may play games
  that will hurt the bondholders.
• They requires a higher return ex ante.
• Stockholders will have to sell debt at a lower
  price (for a fixed promised future payment) than
  they otherwise could have.

29
Can the Deadweight Costs of Debt be Eliminated?

• Since stockholders pay the costs of debt, there
  is an incentive to try and reduce these costs.
• Make agreements with bondholders that they will
  not play games.
• Impossible to write a contract that anticipates
  all future events that would expropriate
  bondholders wealth to the benefit of the
  stockholders.
• Deadweight costs of debt can be reduced, but not
  eliminated.

30
Reducing the Deadweight Costs of Debt

• Protective covenants in the bond indenture.
• Agreements to protect bondholders
• Debt Consolidation
• Less costly to negotiate contracts with fewer
  parties.

31
Positive Protective Covenants

• The firm will
• Maintain adequate liquidity
• Use proceeds from sale of assets for other
  assets.
• Allow redemption in event of merger or spinoff.
• Limit the amount of new debt issued.
• Maintain good condition of assets.
• Provide audited financial information.

32
Negative Protective Covenants

• The firm will not
• Pay dividends beyond specified amount.
• Sell more senior debt.
• Buy another companys bonds.

33
Debt Covenants are Costly

• They may limit legitimate actions that could be
  taken, absent these covenants.
• Foregoing these could reduce firm value and
  shareholder wealth.
• Costs are incurred in monitoring and ensuring
  that the firm adheres to the provisions of the
  covenants.
• These costs are paid by the owners of the firm
  (stockholders).

34
Summary of Deadweight Debt Costs

• Deadweight Costs of Debt
• Direct costs of bankruptcy / financial distress
• Indirect costs of bankruptcy / financial distress
• Unresolved agency costs of debt
• The present value of the expected deadweight
  costs of debt affect firm value. Expected costs
  depend on
• Magnitude of the costs
• Probability of incurring these costs

35
Firm Value, Leverage, and Debt Costs

• For low levels of debt usage, the probability of
  financial distress is zero or near zero.
• Little or no impact of debt costs
• As debt usage increases, the probability of
  financial distress increases at an increasing
  rate.
• The magnitude of some debt costs may increase as
  well.
• The present value of these costs increases at an
  increasing rate.

36
Optimal Level of Debt
VL VU TCB
Firm Value with taxes and distress costs
VU
VL (no taxes)
Optimal Debt (B)
37
Optimal Level of Debt

• The optimal amount of debt is where firm value is
  maximized.
• This occurs when the marginal benefit of the
  present value of the tax shelter of debt is
  exactly offset by the marginal costs of the
  present value of the financial distress and
  agency costs of debt.
• Since financial distress costs cannot be
  expressed in a precise manner, no magic formula
  for the optimal level of debt exists!
• Use rules of thumb

38
Agency Costs of External Equity

• Like debt, agency costs are also associated with
  external equity.
• These arise due to conflict of interest between
  managers and shareholders.
• Examples of managerial self-interested behavior
• Shirking (less than best effort)
• Perquisite consumption (fancy offices)
• Empire building (firm size and salary are
  generally positively correlated)

39
Managerial Self-Interested Behavior

• Impact on firm value
• Reduces firm value
• Motivation
• All shareholders bear the costs, but managers get
  all of the benefit
• Opportunity
• Firms with high free cash flows
• FCF cash flow after payment of all costs,
  interest, taxes, new positive NPV capital
  projects, and investments in net working capital.

40
Managerial Self-Interested Behavior

• Mitigating the costs of managerial
  self-interested behavior
• Make managers part owners in the firm
• Performance based compensation
• Threat of takeovers (LBOs in particular)
• Impact on optimal level of debt
• Pushes optimal debt level higher

41
Optimal Level of Debt
VU
Optimal Debt (B)
42
Empirical Evidence of Capital Structure

• In virtually every industry, more profitable
  firms have lower debt ratios.
• Corporate tax argument implies more profitable
  firms should use more debt.
• Leverage increasing (decreasing) events are
  generally associated with an increase (decrease)
  in the stock price.
• The average effect should be zero since some
  firms may be below the optimal debt level and
  others above.

43
Empirical Evidence of Capital Structure

• Firms issue debt frequently, but equity only
  infrequently.
• The static tradeoff model makes no predictions
  about the relative frequencies of either.
• While the static tradeoff model provides valuable
  insights, theres more explaining to do!

44
Pecking Order Theory of Capital Structure

• Based on asymmetric information between insiders
  (managers) and outsiders (investors).
• Managers know more about the firms future
  prospects than do outsiders.
• Assumes that managers act in the best interest of
  existing stockholders.

45
Actions Convey Information

• Suppose management believes that stock is
  overpriced in the market.
• Issue equity
• Suppose management believes that the stock is
  under priced in the market.
• Issue debt
• When investors sees a new equity issue, they
  infer that the stock must be over priced.
• Stock price falls and this hurts existing
  stockholders.

46
Actions Convey Information (Contd.)

• But why dont debt issues face the same problem?
• Debt imposes mandatory obligations on the firms
  cash flows.
• Only firms with a strong future can take on these
  obligations.
• Issuance of new debt signals managerial optimism
  to the market.
• Faking it can get the firm into financial trouble
  in the future (cost associated with the signal).

47
The Pecking Order

• Use internal funds first
• Issue debt before equity
• Issue less risky debt before more risky debt
• Secured debt before unsecured
• Straight debt before convertible debt
• Issue equity as a last resort

48
Implications of the Pecking Order Theory

• There is no optimal capital structure for a firm.
• All else being the same, firms with more internal
  funds (financial slack) will use less debt
  financing.
• Debt financing will be limited by the costs of
  debt discussed earlier.
• Profitable firms will use less leverage
• They have more internal funds.
• Debt is issued more frequently than equity
• The model also explains the markets reaction to
  leverage increasing and leverage decreasing
  events.

49
Personal Taxes

• Debtholders income is taxed at rate TB
• Interest income taxed at marginal personal tax
  rates.
• Stockholders income is taxed at rate TS
• Dividend income is taxed at marginal personal tax
  rates.
• Capital gains are taxed at a lower marginal rate,
  and only when recognized

50
After-Personal-Tax Investor Cash Flows

• After personal taxes, bondholders receive

• After personal taxes, stockholders receive

51
After-Personal-Tax Investor Cash Flows

• Total cash flow to all investors is

Which can be rearranged to
52
After-Personal-Tax Investor Cash Flows
Debt worth B dollars provide a return of rB(1
TB) after taxes
Cash Flow of an unlevered firm after all taxes
53
Levered Firm Value (after all taxes)
54
Case 1

• TC TB TS 0

55
Case 2

• TB TS or both 0 (symmetric or no personal
  taxes)

56
Cases 3, 4 and 5

• (1 TB) (1 TC)(1 TS)

57
Tax Rates and Gain per Dollar of Debt
58
Other Factors Affecting Leverage

• Profitability
• Uncertainty of Operating Income
• Type of Assets (tangible vs. intangible)
• Effective Tax Rate
• Non-debt Tax Shields

59
Other Factors Affecting Leverage

• Firm Size
• Regulation in Industry
• Insider Ownership of Shares
• Managerial Entrenchment
• Creditor Power in Bankruptcy