FINANCIAL ADMINISTRATION OF THE FIRM FIN 5043--930

1
Chapter 13
Capital Structure Non-Tax Determinants Of
Corporate Leverage
Del HawleyFIN 634
Fall 2003
2
Chapter 13 Overview

• 13.1. Costs of Bankruptcy and Financial
  Distress
• What Makes Bankruptcy Costs Matter?
• Asset Characteristics and Bankruptcy Costs
• Direct and Indirect Costs of Bankruptcy
• International Differences in Bankruptcy Costs
• 13.2. Agency Costs and Capital Structure
• Using Debt to Overcome the Agency Costs of Equity
• Agency Costs of Outside Debt
• The Agency Cost/Tax Shield Trade-Off Model
  
• 13.3. The Pecking Order Hypothesis of Corporate
  Debt
• Assumptions Underlying the Pecking Order
  Hypothesis
• Limitations of the Pecking Order Hypothesis

3
Chapter 13 Overview

• 13.4. Signaling Models of Corporate Leverage
• How Capital Structure Signaling Convey
  Information
• Empirical Evidence on Capital Structure Signaling
  
• 13.5. Developing a Checklist For CS
  Decision-Making
• Leverage Operating / Financial Variables
  Relationships
• Leverage Ownership Structure Variables
  Relationships
• Leverage Macroeconomic / Country Variables
• 13.6. Summary

4
Bankruptcy Risk Doesnt Impact Capital
Structure--Unless It Is Costly

• Two companies, Low-Debt and High-Debt, have
  one-year contracts to manage identical convention
  centers.
• Contract value depends on economic conditions
  over next year.
• If expansion continues, both will have CF of
  3,500,000.
• If recession, both have CF of 1,100,000.
• Both have borrowed money Low-Debt will owe
  930,000 in one year, High-Debt will owe
  1,600,000.
• Low-Debt stockholders require a return of 6 and
  the firms bondholders require 4.5
• High-Debt stockholders expect a return of 6.25
  and the bondholders are requiring an expected
  return of 4.8

5
Costs Of Financial Distress

• Direct costs of bankruptcy (out-of-pocket cash
  expenses)
• Legal, auditing and administrative costs (include
  court costs)
• Large in absolute amount, but only 1-2 of large
  firm value
• Indirect costs Usually much more important
• Impaired ability to conduct business (e.g., lost
  sales)
• Managerial distraction, loss of best (most
  mobile) personnel
• Financial distress also gives managers adverse
  incentives
• Asset substitution problem Incentive to take
  large risks
• Under-investment problem S/Hs refuse to
  contribute funds
• Trade-off Model of Corporate Capital Structure
• Trade off tax benefits of debt vs costs of
  Financial distress

(Eq 13.1)
6
Game 1 The Asset Substitution Problem

• When a firm falls into financial distress, has
  incentive to play two damaging games.
• First is known as asset substitution
• Assume Firm Substitute has debt with a face value
  of 12,000,000 outstanding that will mature in
  one month.
• Only has 10,000,000 of cash on hand now, but
  firm still controls investment policy until
  default actually occurs
• If firm defaults, bondholders take over all
  remaining assets (including cash on hand)
• Substitutes managers offered two projects, both
  requiring 10,000,000 cash investment both
  paying off in 30 days
• Safe promises a certain 10,200,000 payoff (2
  monthly return)
• Lottery offers a 25 chance of 13,000,000
  payoff, and a 75 chance of 7,500,000 expected
  value 8,875,000.

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Game 1 Asset Substitution (Continued)

• Safe has positive NPV and is preferred by
  bondholders,but stockholders and managers
  rationally choose Lottery
• If gamble is successful (payoff 13,000,000
  million), pay off maturing debt, keep remaining
  1,000,000
• If gamble unsuccessful, stockholders are no worse
  off, since B/H will take firms remaining assets
  in 30 days anyway
• Game is important because S/Hs (through managers)
  have incentive to gamble with bondholders money
• Would not accept Lottery if all-equity financed
  firm
• Would not accept Lottery if company was a
  partnership limited liability means B/Hs have no
  recourse to S/Hs

8
Game 2 The Under-Investment Problem

• Second problem caused by financial distress is
  refusal by S/Hs to contribute funds for positive
  NPV projects
• Occurs if S/Hs must contribute cash, but all
  projects benefits accrue to bondholders.
• Assume, as before, firm has 10,000,000 cash on
  hand and a bond worth 12,000,000 maturing in 30
  days
• Suppose firm is offered chance to purchase a
  competitor at a discount price of 11,000,000,
  but offer open only 30 days
• Merger would maximize firm value, and B/H would
  accept but S/Hs control firms investment policy
  until default occurs
• Firms managers, acting for the S/Hs, would
  reject merger
• Even though value-maximizing, S/Hs have to
  contribute additional 1,000,000 cash, yet firm
  will still default in 30 days
• If firm all-equity financed, S/Hs would invest
  additional cash

9
U.S. Bankruptcy Practices And Costs

• In U.S., bankruptcy governed by Federal law and
  filings are made in Federal bankruptcy courts.
• If filing accepted, Bankruptcy court halts
  further prosecution of creditor claims and court
  becomes ultimate firm master
• Two types of B/R filings in US for corporations
  Chapter 7 (Liquidation) and Chapter 11
  (Reorganization)
• Filing can be voluntary (by firm) or involuntary
  (by creditors)
• If voluntary Chapter 11 filing accepted, firms
  management continues to operate firm, can propose
  reorganization plan
• If liquidation is selected by court, a trustee is
  usually appointed to liquidate firms assets
• Proceeds from liquidation should be distributed
  according to Absolute Priority Rule, with S/Hs
  last in line
• Courts often deviate from APR, so B/R often
  unpredictable

10
The Agency Cost / Tax Shield Trade-Off Model Of
Corporate Leverage

• Mainstream theory of corporate capital
  structure models optimal leverage as a
  firm-specific trade-off
• Companies trade off the tax and agency cost
  benefits of debt against the costs of bankruptcy
  and the agency costs of debt
• Firm V maximized at a unique optimal debt level
  (Eq 13.2)

• Trade-off model has garnered much empirical
  support, though far from perfect in its
  predictions
• Weaknesses lead to development of Pecking Order
  Theory

11
The Optimal Amount of Debt and the Value of the
Firm
Market value of firm (V)
Present value ofexpected bankruptcy costs
Present value of interest tax shields on debt
Value of levered firm in the absence of
bankruptcy costs
VL
Maximumfirm value

VValue of levered firm with bankruptcy costs
VUValue of firm under al equity financing
0
Debt (B)
B
Optimal amount of debt
12
How Important Is RD Spending To Modern Economies?
13
The Pecking Order Theory Of Corporate Capital
Structure

• Trade-off theory cannot explain three empirical
  CS facts
• (1) Most profitable firms in an industry use
  least debt
• (2) Stock market response to leverage-increasing
  events is strongly positive negative to
  leverage-decreasing events
• (3) Firms issue debt frequently, but rarely issue
  equity
• Myers (1984), Myers Majluf (1984) proposed
  Pecking Order Theory of Corporate Leverage
• Assumes manager acts in best interests of
  existing S/Hs
• Assumes info asymmetry between managers and
  investors
• Managers wont issue under-valued stock for NPV
  projects
• Makes two key predictions about managerial
  behavior
• (1) Firms hold financial slack so dont have to
  issue securities
• (2) If firm must issue securities, will follow
  pecking order and
• sell first low-risk debt, using equity only as
  last resort.

14
Signaling And Other Asymmetric Information Models
of Corporate Leverage

• Third group of models, based on A/I between
  managers and investors, predict managers will use
  a costly signal
• A simple statement of high firm value is not
  credible
• Must take action that is too costly for weak firm
  to mimic
• Crude signal burn 100 bills only wealthy can
  afford to do
• If signaling can differentiate between strong and
  weak firms based on signal, a signaling
  equilibrium results
• Investors identify stronger firms, assign higher
  market value
• If signaling cannot differentiate between strong
  and weak firms, a pooling equilibrium results
• Investors assign low average value to all firms
• Models predict high value firms use high leverage
  as signal
• Makes sense, but empirics show the oppositemost
  profitable highest market/book firms use least
  leverage

15
A Checklist for Capital StructureDecision-Making
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A Checklist for Capital StructureDecision-Making