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Unformatted text preview: CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT Ross, Westerfield & Jaffe “Corporate Finance” 7th ed. Chapter 16 MM Propositions: No Taxes In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: VL = VU Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders rE rA D ( rA rD ) EL MM Propositions: With Taxes In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: VL = VU + TC D Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of taxes, M&M Proposition II states that leverage increases the risk and return to D stockholders. rE rA EL (1 TC ) ( rA rD ) Prospectus: Bankruptcy Costs So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt. In the real world, most executives would not like a capital structure of 100% debt because it will endanger them to “bankruptcy”. When debt increases so does the probability that the firm will be unable to pay its bondholders When a firm is declared bankrupt, ownership of firm’s assets are transferred from stockholders to bondholders and equity value is 0. Bankruptcy Process 5 Financial distress can be defined in several ways: Business failure – business has terminated with a loss to creditors Legal bankruptcy – petition federal court for bankruptcy. Bankruptcy is a legal process for liquidating or reorganizing a business. Technical insolvency – firm is unable to meet debt obligations Accounting insolvency – book value of equity is negative Liquidation and Reorganization 6 Liquidation: Chapter 7 of the Federal Bankruptcy Reform Act of 1978 A petition voluntarily or petitions may be filed against the corporation by several of its creditors. Trustee takes over assets, sells them, and distributes the proceeds according to the absolute priority rule Reorganization: Chapter 11 of the Federal Bankruptcy Reform Act of 1978. In most cases the corporation continues to run the business and restructure the corporation and a provision to repay creditors. For some length of time, the firm operates according to the provisions of the reorganization plan Costs of Financial Distress In an ideal world there are no costs associated with this transfer of ownership. In reality, there are both direct and indirect costs associated with bankruptcy However, it is not the risk of bankruptcy itself that lowers value. Rather it is the costs associated with bankruptcy. It is the stockholders who bear these costs. Description of Costs Direct Costs Legal and administrative costs (tend to be a smaller 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 Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? Selfish Strategy 1: Take Large Risks The Gamble Win Big Lose Big Probability 10% 90% Payoff at t=1 $1,000 $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Selfish Strategy 2: Underinvestment Consider a government‐sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10% $350 NPV = –$300 + (1.10) NPV = $18.18 Should we accept or reject? Selfish Strategy 3: Milking the Property Liquidating dividends Suppose our firm paid out a $200 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 Can Costs of Debt Be Reduced? Protective Covenants Debt Consolidation: If we minimize the number of parties, contracting costs fall. Protective Covenants Agreements to protect bondholders Negative covenant: You shall not: Pay dividends beyond specified amount. Sell more senior debt & amount of new debt is limited. Sell or lease major assets without approval by the lender. Buy another company’s bonds. Positive covenant: You shall: Use proceeds from sale of assets for other assets. Maintain working capital at or above a minimum level Maintain good condition of assets. Provide audited financial information. Integration of Tax Effects and Financial Distress Costs 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 As leverage increases: Higher value of tax shield Probability of bankruptcy and higher expected costs of bankruptcy The Static Theory of Capital Structure What is the optimal capital structure? The static theory of capital structure: a firm will borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress Integration of Tax Effects and Financial Distress Costs Value of firm under MM with corporate taxes and debt Value of firm (V) Present value of tax shield on debt VL = VU + TCB Present value of financial distress costs Maximum firm value V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt Some Qualifications 18 The tax benefit is only important if the firm has a large tax liability. Firms with large accumulated losses will get little value from interest tax shields. Similarly for firms that have substantial tax shields from other sources like depreciation, the value of the tax shield from debt will be low. The higher the tax rate, the greater the incentive to borrow. Some Qualifications 19 The greater the risk of financial distress, the less debt will be optimal for the firm The easier it is to transfer assets without loss in asset value, the lower the bankruptcy costs All other things being equal, firms with a lot of variability in cash flows and EBIT should borrow less Some Qualifications 20 The formal proofs of MM propositions depend on the assumption complete markets MM’s opponents argue that market imperfections make personal borrowing excessively costly and inconvenient This creates a natural demand and premium for the shares of levered firms Proposition I is violated when there is an unsatisfied clientele for levered equity and financial managers satisfy it by issuing some new and different The Pie Model Revisited 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 = E + D + G + L E D L G The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie. 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 stockholders 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. Eliminating Agency: Monitoring 23 Reviewing the actions of managers to make sure they maximize shareholder value Optimal level of monitoring is where the last dollar spent on monitoring equals the reduction in agency costs Delegated to the Board of Directors External auditors can issue a qualified opinion Lenders monitor to protect their loans Free Rider Problem : When owners rely on the efforts of others to monitor the company. Eliminating Agency: Compensation 24 Compensation : Designed to incentivize i.e. pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value The compensation package of Eisner, CEO of Walt Disney Company had three components: Base salary of $750,000, an annual bonus of 2% of the value of above normal profits, 10 year stock option for 2 million shares at $14/share In six‐years the value of Eisners’ shares had increased sixfold Signaling The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. Investors view debt as a signal of firm value. Firms with low anticipated profits will take on a low level of debt. Firms with high anticipated profits will take on high levels of debt. A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run. 26 Signaling Firm Quality: the Pecking Order of financing choices The Pecking Order Theory by Myers and Majluf (1984) is one of the most important and successful explanations of capital structure decisions Asymmetric information effects the choice between internal and external financing methods Key assumptions: Managers act in the interest of the existing shareholders Asymmetric information: managers have more information than external investors 27 Signaling Firm Quality: the Pecking Order of financing choices Consider two identical firms, Smith & Co. and Jones, Inc. Current expectations price both firms shares at $100, but the true value could be higher, say $120, or lower, say $80 Suppose both firms want to raise new money for investments. They can issue debt or new shares of stock 28 Signaling Firm Quality: the Pecking Order of financing choices One financial manager thinks: Sell stock for $100? Its worth at least $120. Our new factories make us the world’s lowest producer. We’ve painted a rosy picture for the press and security analysis but it just doesn’t seem to be working. Our equity is ridiculously underpriced, especially considering the underwriting fees. The other financial manager feels that: Our latest product was a hit for a while but looks like the fad is fading. Export markets are ok for now but how are we to compete with the new low cost products coming in? Fortunately the stock price has held up well‐ we’ve had some good short term news for the press and security analysis. 29 Signaling Firm Quality: the Pecking Order of financing choices Now suppose there are two press releases: Jones, Inc. will issue $120 million of 5 year senior notes Smith & Co. announced plans today to issue 1.2m new shares of stock. The company expects to raise $120m Can you infer management position based on these announcements and manager opinions? True value = $ 120 Jones, Inc. True value = $ 80 Smith & Co. 30 Signaling Firm Quality: the Pecking Order of financing choices Rational investors look unfavorably upon new issues: A smart, pessimistic manager at Smith will issue debt as well, knowing that an attempt to issue equity will force the equity price down and eliminate any advantage Debt ranks higher than equity in the pecking order Companies might issue equity when there are forces other than asymmetric information at play: e.g. the firm has already borrowed heavily The announcement will highlight manager’s concern about financial distress but not the quality of investments. 31 Signaling Firm Quality: the Pecking Order of financing choices High‐tech, high‐growth companies can also be credible issuers of stock With intangible assets bankruptcy costs can be very high Conservative financing requires conservative debt to equity ratio A fall in price does not necessarily follow The bulk of financing in the developed world comes from debt, even though equity markets are highly efficient 32 The Implications of the Pecking Order Profitable firms borrow less Less profitable firms borrow if internal financing is insufficient Tax shields are considered a second‐order effect Highly profitable firms with few investment opportunities have low debt ratios Helps to predict changes in debt ratios of mature firms: Increase when they have deficits and decrease when they have surpluses 33 The Implications of the Pecking Order Financial slack : includes cash, marketable securities, readily available real assets, easy access to debt and bank financing 34 The Implications of the Pecking Order 1. 2. 3. 4. Firms prefer internal finance They try to avoid sudden changes in dividends If internal financing is not enough then the firm draws on its cash balances or sells marketable securities If external finance is required, firms start with the safest security first: 1. Debt 2. Hybrid securities such as convertible bonds 3. Equity as a last resort The Pecking‐Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1 Rule 2 Use internal financing first. 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 36 Resolving Commitment Problems: Takeover markets What if there isn’t a large enough shareholder who is capable of monitoring the firm and influencing its actions directly? US: investor protection laws, in creating liquid market and protecting these small holdings, reduce investor incentives to maintain large block holdings Reduced investor scrutiny of managerial actions Dispersed investors or owners can create the right incentives for a third party to punish the managers , thereby creating the right incentives for the manager as well Incentivize managers via third parties is the opportunity to purchase the firm and replace its managers How Firms Establish Capital Structure 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. Factors in Target D/E Ratio Taxes Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. 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. Observed Capital Structure 39 Capital structure does differ by industries Differences according to Cost of Capital 2004 Yearbook by Ibbotson Associates, Inc. Lowest levels of debt Drugs with 6.39% debt Electrical components with 6.97% debt Highest levels of debt Airlines with 64.35% debt Department stores with 46.13% debt 40 Financial Management and the Bankruptcy Process The right to go bankrupt can be very valuable At times, due to the fact that bankruptcies are a lengthy and costly process, creditors and managers enter into voluntary agreements to restructure or reschedule the company debt Trump Hotels and Casinos was a successful, prepackaged bankruptcy with agreements with creditors prior to the filing to cut equity share in exchange of new bonds with lower coupon rate. 41 Financial Management and the Bankruptcy Process Often reorganization can result in removal of cost inefficiencies (Andrade and Kaplan (1998)): removal of poor management operating improvements sales of poorly performing assets In 1983, Continental Airlines strategically filed for bankruptcy, using it as an opportunity for renegotiating labor contracts and reducing labor costs. ...
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This note was uploaded on 04/09/2012 for the course FINN 321 taught by Professor Farahsaid during the Spring '12 term at Alvin CC.

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