LSH Capital Structure - Wharton Finance

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1Copyright © Michael R. Roberts

Capital Structure

Finance 100

Prof. Michael R. Roberts


Topic Overview

Capital structure in perfect capital markets» M&M I and II

Capital structure with imperfect capital markets» Taxes

– Optimal Capital Structure» Bankruptcy costs

– Optimal Capital Structure» Agency costs (benefits)

– APV» Asymmetric information

– APV

22


The Intuition Behind M&M

Buy a house today for $100,000 and sell one year laterAssume mortgage rate is 10%

E.g., [145,000 – (50,000 + 5,000)]/50,000 - 1 = 80%

House Price Size of Mortgage

Prob Change 0% 50% 90%

1/3 -10% -10% -30% -190%1/3 10% 10% 10% 10%

1/3 45% 45% 80% 360%

Avg. 15% 15% 20% 60%

SD 23% 23% 45% 227%

(New Price) (What we owe) (What we paid)


Questions

Does the value of the house depend on the size of the mortgage?

What does change with the size of the mortgage?

33


Financing InvestmentExample

All equity firm considers a project:» Invest $800 today, date 0» Payoff next period, date 1:

– $1400 if strong economy w.p. 50%– $900 if weak economy w.p. 50%

» Risk-Free Rate (Rf) = 5%» Project Risk Premium (Rp-Rf) = 10%

Date 0Strong

EconomyWeak

EconomyDebt (D) 0 0 0Equity (E) ? 1400 900Firm 1000 1400 900

Date 1


All Equity FinancingExample (Cont.)

What is the project NPV

How much equity can we raise

What are the entrepreneur’s profits

What are returns to shareholders (in both states and expectation)

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?

44


Debt and Equity FinancingExample (Cont.)

Now suppose borrow $500, in addition to selling equity» Note: Project Cash Flows > Debt Owed in each state

Payoffs to Debt and Equity

M&M I Value of firm is independent of capital structure in perfect capital markets E = 500» Cash flows of D and E sum to Project cash flows D and E must sum to value

of firm (Law of One Price)» M&M I says that V = D + E, regardless of what D and E are!

Date 0Strong

EconomyWeak

EconomyDebt (D) 500 525 525Equity (E) ? 875 375Firm 1000 1400 900

Date 1

?


Effect of Leverage on Risk and ReturnExample (Cont.)

Why isn’t the value of equity

Look at the returns to shareholders now

Levered equity carries a higher risk premium than unlevered equity rE≠15% anymoreLevered equity = higher risk = higher return (25%)» This is not due to default risk! (Debt is risk-free)» Project risk is the same 15%

( )1 0.5 875 0.5 375 5431.15

× + × =

Date 0Strong

EconomyWeak

EconomyStrong

EconomyWeak

EconomyExpected

ReturnDebt (D) 500 525 525 5% 5% 5%Equity (E) 500 875 375 75% -25% 25%Firm 1000 1400 900 40% -10% 15%

Date 1 Returns

55


Homemade LeverageReplicating Levered Equity

Imagine entrepreneur creates all-equity firm, but investor wants levered equity» Investor just needs to borrow to replicate cash flows to levered equity

Loan is risk-free (Rf = 5%) since cash flows on equity serve as collateralWe just replicated the payoffs to the levered equity & law of one price value of levered equity = $500

Date 0Strong

EconomyWeak

EconomyUnlevered E 1000 1400 900Margin Loan -500 525 525Levered Equity 500 875 375

Date 1


Homemade LeverageReplicating Unlevered Equity

Imagine entrepreneur creates levered firm, but investor wants unlevered equity» Investor just has to buy both debt and equity in the firm

We just replicated the payoffs to the unlevered equity & law of one price value of unlevered equity = $1000

** With perfect capital markets, different capital structures don’t benefit investors don’t affect firm value

Date 0Strong

EconomyWeak

EconomyDebt 500 525 525Levered Equity 500 875 375Levered Equity 1000 1400 900

Date 1

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M&M I: Synopsis

In a “perfect capital market,” the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure» Value of Firm (V) = Value of Debt (D) + Value of Equity (E) (No

matter what D and E are since investors can undo anything the firm does with perfect capital markets, so capital structure doesn’t matter.)

» Only thing that matters for value (size of the pie) is the PV of the cash flows…doesn’t matter how you divide them up (slice the pie)

EquityEquity

Debt Equity

Debt


The Cost of Capital

Recall (from the last slide!) M&M I implies: Vl = E + D = Vu ( = Va)

» All values are “market” as opposed to “book” or “accounting”» Vl=Vu comes from homemade leverage

Return on a portfolio equals weighted average of returns to the securities in the portfolio:

But this implies:E D U A

E DR R R RE D E D

+ = =+ +

Risk withoutleverage Additional risk

due to leverage

( )E U U DDR R R RE

= + −

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M&M IILeverage, Risk, and the Cost of Capital

M&M Proposition II says:» The cost of capital of levered equity is equal to the cost of capital of

unlevered equity plus a premium that is proportional to the market value debt-equity ratio

The WACC,

is a constant function of leverage in perfect capital markets because as D/E changes, rE changes to compensate» For really high leverage, rD will change as well (rD=rA in limit)

( )E A A DDr r r rE

= + −

WACC A E D UE Dr r r r r

E D E D= = + =

+ +


WACC & Leverage in Perfect Capital Markets

VU=1000; rA = 15%; rD=5%Shape of rE and rD dictated by response of cash flows to leverage

88


Reducing Leverage and the Cost of CapitalExample

El Paso’s initial WACC =

After the Debt for Equity Swap:» What is the WACC (rA)» What is the firms leverage ratio (D/D+E) =» What is rE =

?

??

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Levered and Unlevered Betas

Everything we did with returns (rD, rE, rA), we can do with betas (βD, βE, βA):

Unlevering beta refers to the process of removing the effects of financial leverage from βE to obtain a beta that captures only asset risk, βA

( )E A A DDE

β β β β= + −

WACC A E D UE D

E D E Dβ β β β β= = + =

+ +

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Levered and Unlevered BetasExamples from the Airline Industry


Leverage and EPS

A fallacy:» Leverage can increase stock prices via its affect on EPS» Rationale: Leverage leads to higher earnings per share, which in turn

lead to higher stock prices» Error: Ignores the impact of leverage on risk

Example: Levitron Industries (LVI)» Currently:

– All equity with 10mil shares with $7.50/share– Next year: EBIT = $10mil

» Considering:– borrowing $15mil @ 8% and use proceeds to repurchase 2mil shares @

$7.50/share» What are the consequences of this transaction assuming perfect capital

markets?

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Implications of Leverage for EPSExample (Cont.)

Initial EPS:» LVI’s earnings (EBIT) = » LVI has no debt » Perfect markets » Initial EPS =

EPS after debt issuance & share repurchase:» Creates Annual Interest Payments =» Earnings after interest = » Share Repurchase:

– # of shares after repurchase = – EPS after debt issue & repurchase =

???

?

??

??


Leverage and EPS: A Closer LookExample (Cont.)

M&M tells us that there can be no benefit so something must give...Imagine that EBIT was only $4mil (instead of $10mil)» Before debt issuance EPS =» After debt issuance and share repurchase EPS =

?

??

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Leverage and EPS: A Picture

Average EPS is higher for levered firmRisk is higher (steeper line) for levered firm


Leverage and Stock PriceExample (Cont.)

Assume:» LVI’s EBIT is constant in the future (10mil)» All earnings are paid out in dividends» If we increase EPS, what will happen to the share price?

Unlevered:» Recall: Earnings = $10mil & Shares = 10mil EPS = $1» Dividends/Share (DPS) =» Value the company as a perpetuity to get the WACC

– Recall: Price/Share = $7.50 =– Market Cap =

?

??

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Levered:» Recall: Issue $15mil debt to repo $15mil of equity @ $7.50/shr

buyback $15mil/$7.50/shr = 2mil shr 10mil – 2mil = 8mil shares remaining after buyback

» M&M I New Market Cap =New D/E ratio =

» M&M II: New rE =» Earnings – Interest =

– New EPS =» New Share Price =

Intuition:

Leverage and Stock Price (Cont.)Example (Cont.)

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Equity Issuances and

According to CFOs in the US, what is the most important consideration when issuing equity

Fallacy:» Issuing equity will dilute existing shareholders’ ownership» Rationale: more shares mean the firm must be divided among a larger # of

shares, thereby reducing the value of each individual share» Error: Ignores the fact that cash raised by issuance increases the firm’s assets.

Example: Jet Sky Airlines (JSA)» Currently:

– No debt– 500mil shares trading @ $16/shr Market cap = $8bil

» Considering:– Expanding operations by buying $1bil new planes with new equity @ current price

$16/share» What are the implications for the stock price?

?

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Effect of Equity Issuances on Stock Prices

The firm issues 62.5mil new shares @ $16/share to get $1bilFirm grows by $1bil, which offsets increase in sharesAny gain or loss from issuance comes from project NPVKey assumption:» Sell the shares at a fair price!


Capital Structure in Perfect Capital MarketsSumming it Up

Conservation of Value Principle for Financial Markets» With perfect capital markets, financial transactions neither add nor

destroy value, but instead represent a repackaging of risk (and therefore return).

– This implies that any financial transaction that appears to be a good deal may be exploiting some type of market imperfection.

M&M I: V = E + D» Value of the firm is just the sum of E & D, regardless of what they are

M&M II: rE = rA + D/E(rA - rD)» Leverage increases risk of equity (not value according to M&M I)

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What are Perfect Capital Markets

What are the assumptions behind M&M? That is, when are the M&M propositions true?

1. no taxes, 2. no bankruptcy costs, 3. no agency costs/benefits, 4. no information asymmetry, and5. no transaction costsWhat the !@#$% ? What’s the point of this?

» If financial policy is to matter, it must be that it mitigates (or takes advantage of) one or more of these frictions

» Devise financial strategies around minimizing (maximizing) the adverse (beneficial) effects of these frictions


Debt and Taxes

Corporations pay taxes on their profits after interest payments are deducted interest expense reduces taxesExample: Safeway, Inc.:

Safeway’s 2005 net income is lower with leverage than without and…

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Debt and Taxes (Cont.)

…equity is lower with leverage than withoutBut, Safeway has greater value with leverage!

What’s going on?» With leverage, Safeway is worth an additional $140mil» This difference is just the value of the interest tax shield

Interest Tax Shield Corporate Tax Rate Interest Payments 35% $400 $140mil mil

= ×= × =


Interest Tax Shield

The interest tax shield is:» Corporate Tax Rate x Interest Payments

What is the benefit for firm value?» Present value of the interest tax shield!

In a perfect market, we had: VL = VU.M&M I with Taxes:» VL = VU + PV(Interest Tax Shield).

To get at PV(Interest Tax Shield) we need:» Forecast of firm’s debt forecast of interest payments» With forecasted interested payments interest tax shield» Discount the interest tax shield at the “appropriate” risk-adjusted rate

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Present Value of Interest Tax ShieldExample

Annual Interest tax shield =PV(Interest Tax Shield) = (Hint: The stream of interest tax shields looks like an

?

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Permanent Debt

In practice, future tax savings is uncertain:» Debt usage, interest rates, default risk, and marginal tax

rates will vary

A special case:» Keep debt amount constant forever

– Perpetuity or roll over short term debt indefinitely

» Then

» Implication: For every $1 of debt issues, firm value ↑ τC

( )(Interest Tax Shield) C DCC

D D

r DInterestPV Dr r

ττ τ× ××

= = =

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Leverage Recapitalization RevisitedExample

Midco Industries:» Currently:

– 20mil shares outstanding @ $15/share– Stable earnings– 35% tax rate

» Plan: – Borrow $100mil (on permanent basis) – Use proceeds to repurchase shares

What happens after the share repurchase?


Before Recap:» VA = VU = E =

After Recap:» PV(interest tax shield) = τCD =» VL = VU + τCD =» E = VL – D =

Leverage Recapitalization Revisited Example (Cont.)

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Assume Midco repurchases shares @ current price $15/share» Repurchase $100mil ÷ $15/share = 6.67mil shares

After repurchase» New # of shares outstanding = » New share price after repo = » Shareholders that keep their shares gain

–– Total gain =

Leverage Recapitalization Revisited Example (Cont.)

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Leverage Recapitalization RevisitedA Problem

Why would anyone tender their shares for $15 if they know that after the recap their shares will be worth $17.63?» I would buy shares @ $15 before the repo, and then sell after the repo

@ $17.63 for an arbitrage profit?It is precisely this arbitrage activity that will drive up the price before the recap!» The announcement of the recap will drive up the stock price to

incorporate the PV (interest tax shield) ex ante» So Midco’s equity will rise from $300mil to $335mil before the repo» Price per share will increase to $335mil / 20mil = $16.75» Tax shield surplus will be split evenly between those who tender their

shares and those who keep their shares– Original shareholders capture all of the surplus: $1.75 x 20mil = $35mil

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The WACC with Taxes

Tax deductibility of interest effectively lowers the cost of debt, rD, to rD(1-τC)Example:» Firm with 35% MTR borrower $100,000 @ 10% pa» Interest expense = rD x $100,000 = $10,000» Tax savings = - τC x rD x $100,000 = -$3,500» After-tax cost of debt = rD(1-τC) x $100,000 = $6,500

WACC with taxes:( )

Pre-tax WACC Reduction due toInterest Tax Shield

1A E D C E D D CE D E D Dr r r r r r

E D E D E D E D E Dτ τ= + − = + −

+ + + + +


The WACC with and Without Corporate Taxes

2020


Personal Taxes

Double taxation of equity income:» Cash flows to firm taxed at τC and then again at the personal rate τP when

distributed to investors– Debt holders pay taxes on interest payments (as ordinary income)– Equity holders pay taxes on dividends and capital gains

The amount of money an investor will pay for a security depends on the cash flows the investor will receive after all taxes have been paid.

Personal taxes reduce the cash flows to investors and can offset some of the corporate tax benefits of leverage.

The actual interest tax shield depends on both corporate and personal taxes that are paid.» To determine the true tax benefit of leverage, the combined effect of both

corporate and personal taxes needs to be evaluated.


Top Federal Tax Rates in the US1971-2005

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After-Tax Investor Cash Flows Resulting from $1 of EBIT


Including Personal Taxes in the Interest Tax Shield

Every $1 received after taxes by debt holders from interest payments costs equity holders $(1-τ*) on an after tax basis

Equity holders get 15% less than debt holders after taxes ((0.65-0.5525)/0.5525)Effective tax advantage of debt:

(1-0.35)(1-0.15)=0.5525(1-τC)(1-τE)To Equity Holders

(1-0.35)=0.65(1-τI)To Debt Holders

Using 2005 Tax RatesAfter-Tax Cash Flows

( ) ( )( )( )

( )( )( )

* 1 1 1 1 11

1 1i c e c e

i i

τ τ τ τ ττ

τ τ− − − − − −

= = −− −

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Value of Interest Tax Shieldwith Personal Taxes

Value of levered firm (with personal taxes & permanent debt):» VL = VU+τ*D» Because of the personal tax disadvantage of debt, τ* < τC

» This means that the benefit of leverage is reduced!

Personal taxes have a similar effect on the firm’s weighted average cost of capital. » While we still compute the WACC as

with personal taxes the firm’s equity and debt costs of capital will adjust to compensate investors for their respective tax burdens.

(1 ) wacc E D c

E Dr r rE D E D

τ= + −+ +


Value of Interest Tax ShieldPractical Considerations

Practical Considerations» We assumed capital gains taxes are paid every year

– E.g., hold asset for 10 years with cap gains @ 15% and rf = 6%Effective tax rate for this year is (15%)/1.0610=8.4%

– Accrued losses can also offset capital gains

» We used an (equal-weighted) average of capital gains and dividend tax rates

– Reasonable for firms that pay 50% of earnings out in dividends (rest is buried in capital gains)

– Not reasonable for other payout ratios (need to reweight)

» We assumed top marginal income tax rates for investors

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So, Do Firms Prefer Debt?

In aggregate, firms prefer debt to equity for external financing


Corporate Debt UsageAverage Leverage Ratios

2424


Average Debt toValue Ratios ByIndustry


Optimal Capital Structure with Taxes

To receive the full tax benefits of debt, a firm need not use 100% debt financing! » Firms must first have taxable earnings

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Optimal Capital Structure with Taxes (Cont.)

With:1. no leverage, the firm receives no tax benefit.

2. high leverage, the firm saves $350 in taxes.

3. excess leverage, the firm has a net operating loss and there is no increase in the tax savings.– Because firm is not paying taxes, no immediate tax shield from the excess

leverage (ignoring carry-back and carry-forward)

No corp tax benefit from incurring interest payments that regularly exceed EBIT» Because interest payments constitute a tax disadvantage at the investor

level, investors will pay higher personal taxes with excess leverage


Limits of Tax Benefit of Debt

We can quantify the tax disadvantage for excess interest payments (Assuming there’s no reduction in corporate tax for excess interest payments & investors will pay higher personal taxes with excess leverage):

This is < 0 because equity is taxed less heavily than interest for investors (τe < τi)Optimal level of leverage from a tax perspective is such that interest equals EBIT» The firm shields all taxable income and no tax-disadvantaged excess

interest

(1 ) 1 0(1 ) (1 )

e e iex

i i

τ τ τττ τ

∗ − −= − = <

− −

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Limits of Tax Benefit of DebtPractical Considerations

However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely. » If there is uncertainty regarding EBIT, then there is a risk

that interest will exceed EBIT. As a result, the tax savings for high levels of interest falls, possibly reducing the optimal level of the interest payment.

In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt declines, limiting the amount of debt the firm should use.


Debt and Growth

Growth will affect the optimal leverage ratio. » To avoid excess interest, a firm with positive earnings should have a

level of debt such that interest payments are below its expected taxable earnings.

From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings. However, the value of the firm’s equity will depend on the growth rate of earnings: » The higher the growth rate, the higher the value of equity

The optimal proportion of debt in the firm’s capital structure [D / (E + D)] will be lower, the higher the firm’s growth rate.

Interest Debt EBIT or Debt EBIT / D Dr r= × ≤ ≤

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Other Tax Shields

There are numerous provisions in the tax laws for deductions and tax credits:» R&D,» depreciation, » investment tax credits, » carry forwards of past operating losses, etc.

To the extent that a firm has other tax shields, its taxable earnings will be reduced and it will rely less heavily on the interest tax shield.


Are Firms Underlevered?Interest as a % of EBIT for S&P500 Firms

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Are Firms Underlevered?

Notice:» Ratio of interest to EBIT is increasing…consistent with the

increase in the tax advantage of debt» Ratio of interest is far below 1, near which would be

optimal according to our analysis

What’s missing? Why is leverage so low if there is such a big benefit to minimizing taxes?» One possibility = ?


Capital Structure with TaxesSumming it Up

Taxes generate a role for capital structure in shaping firm valueMust consider all taxes:» Corporate» Personal

Optimal debt shields all taxable incomeFirms appear very conservative if taxes are the only considerationThere must be something more than just taxes…

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Financial Distress, Default, and Bankruptcy

Financial Distress occurs when a firm has difficulty meeting its debt obligationsDefault» Technical Default is the violation of a covenant other than one

requiring the payment of interest or principal» Payment Default is the violation of a covenant requiring the payment

of interest or principal» Defaults entitle debt holders certain rights, typically the ability to

accelerate all payments and terminate any unutilized commitments.Bankruptcy» Ch 11 – Reorganization» Ch. 7 – Liquidation

Without debt, there is no risk of any of these events


Default in a Perfect Capital MarketArmin Industries

Armin is considering a new product:» if successful worth $150mil» if unsuccessful worth $80mil

Two capital structure choices:» All equity financing» 1-year debt with face value of $100mil

What are the consequences under these two scenarios?

3030


Comparing the Two Scenarios

Scenario 1: New Product Succeeds» Armin is worth $150mil

– No leverage E = $150– Leverage D = $100mil, E = $50mil

» Note that even if Armin doesn’t have the $100mil in cash at the end of the year, it can always roll over debt in perfect market


Comparing the Two Scenarios

Scenario 2: New Product Fails» Armin is worth $80mil

– No leverage E = $80 (loss of $70mil)– Leverage D = $80mil, E = 0 (loss of $20mil + $50mil = $70mil)

» Loss is the same regardless of leverage

Product failure leads to economic distress

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Bankruptcy and Capital Structure in Perfect Capital Markets

With perfect capital markets, M&M I applies:» The total value to all investors does not depend on the

firm’s capital structure.

No disadvantage to debt financing. All of the firms cash flows are split among the claimants and no one else…no value loss.


Bankruptcy Risk and Firm ValueExample

Without leverage:» E = » Project risk is diversifiable discount with risk-free rate

With leverage:» E = » D =

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The Costs of Bankruptcy and Financial Distress

Direct Costs» Legal, accounting, consultants, appraisers, auctioneers, investment

bankers, “workout experts,” etc. grab pieces of the pie» Enron reorganization costs ~10% of assets, typically 3-4% of pre-

bankruptcy assetsIndirect Costs» Loss of

– customers– suppliers– Employees– Receivables

» Asset fire sales» Distinct from Economic Distress costs


Financial Distress and Firm ValueArmin Industries Revisited

Same setup as before but now assume:» Debt holders receive only $60mil if product fails due to financial

distress costs

Financial distress costs lower the value of the firm and M&M I no longer holds» Recall VU = $109.52mil (from before)» VL =» Costs of financial distress =

??

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Who Pays for Financial Distress Costs?

If new product fails, shareholders lose their investment but don’t care about bankruptcy costs (limited liability)Debt holders know about loss of value in bankruptcy and therefore pay less for debt initially» The present value of the distress costs

This means the firm receives less money from debt offering» This difference comes out of shareholders pockets (so they

have incentive to minimize these costs!)


Financial Distress and the Stock PriceExample

Recall VU = $109.52mil Price/Shr =Recall VL = $100mil Price/Shr =» Share price declines in anticipation of this value loss after debt issuance

After Repurchase:» D =» # of shares repurchased = » # of shares remaining after repo = » E =» Price per Share =

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?

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Optimal Capital StructureThe Tradeoff Theory

Firms choose their capital structure by trading off the benefits of the tax shield against the costs of financial distress

Two key factors determine costs of financial distress» Probability of entering distress» Magnitude of the costs after entering distress

Helps explain why firms don’t fully exploit interest tax shield (because of financial distress costs)

(Interest Tax Shield) (Financial Distress Costs)L UV V PV PV= + −


Optimal Capital StructureThe Tradeoff Theory

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Agency Costs

Agency Costs are costs that arise when there are conflicts of interest between the firm’s stakeholdersDifferent claimants have different incentives, which can lead firms to undertake actions that hurt one groups to benefit another» Overinvestment and Asset Substitution» Underinvestment and Debt Overhang

Agency costs are another cost of increasing leverage, just like bankruptcy costs


Asset Substitution or OverinvestmentBaxter Inc.

Owes $1mil due at end of yearWithout a change in strategy, assets will be worth only $0.9mil

Baxter will default if they take no actionBaxter’s considering a new strategy:» No upfront investment» Success will increase firm’s assets to $1.3mil w.p. 50%» Failure will decrease firm’s assets to $0.3mil w.p. 50%

This is a negative NPV project since expected value of firm’s assets decline from $0.9mil to $0.8mil» Cash Flow from Strategy|Success = $0.4mil» Cash Flow from Strategy|Failure = -$0.6mil» E(Cash Flow from Strategy) = -$0.1mil

But, does this mean Baxter won’t undertake the investment?

3636


Asset Substitution or OverinvestmentBaxter Inc. (Cont.)

Note:» Equityholders gain $0.150mil from investment (0 to $0.150mil)» Debtholders lose $0.250mil from investment ($0.900mil to $0.650mil)» Net gain (loss) in firm value of -$0.100mil = NPV of strategy =

0.5(1.300-0.900) + 0.5(0.300-0.900) = -0.100mi

Equity holders have incentive to “gamble” with debt holder’s money but debt holders will anticipate this and pay less ex ante


Debt Overhang and UnderinvestmentBaxter Inc.

Owes $1mil at end of year but without a change in strategy, assets will be worth only $0.9mil defaultConsidering alternative strategy:» Requires initial investment of $0.1mil» Generates risk-free return of 50%» Clearly a positive NPV investment

Problem (?): Baxter doesn’t have the cash on hand» Can they raise the money in the equity market?

3737


Debt Overhang and UnderinvestmentBaxter Inc. (Cont.)

If equity holders contribute $0.1mil, they only get back $0.05mil» $0.1mil goes to debt holders, whose payoff goes from $0.9mil to $1mil

Even though project is positive NPV, equity holders won’t undertake it because most of the benefit goes to debt holdersUnderinvestment or Debt Overhang


Agency Costs and the Value of Leverage

Leverage can encourage managers and shareholders to act in ways that reduce firm value.» It appears that equity holders benefit at expense of debt holders. » But, ultimately the shareholders bear these agency costs.

When a firm adds leverage to its capital structure, the decisionhas two effects on the share price.» The share price benefits from equity holders’ ability to exploit debt

holders in times of distress. » But, debt holders recognize this possibility and pay less for the debt

when it’s issued reduces amount firm can distribute to shareholders. Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm.

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Agency Costs and the Amount of LeverageExample

Scenario 1: Do nothing» Firm will be worth

Scenario 2: Risky strategy

» Equity worth only $0.45mil under risky strategy, $0.5mil under existing so shareholders will reject it

4500900500Equity350300400400Debt

8003001300900AssetsExpectedFailureSuccess

New Risky StrategyOld Strategy

? E = ? D = ?


Agency Costs and the Amount of Leverage Example (Cont.)

Scenario 3: Conservative strategy

» Shareholders value increase by $0.15mil for a $0.1mil investment so they’re willing to invest in the project

650500Equity400400Debt

1050900Firm Value150New Project

900900Existing AssetsWith New ProjectWithout New Project

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Mitigating Agency Costs

Shorter maturity debt can offset agency costs by limiting scope of expropriationCovenants can mitigate agency costs by forcing managers to commit not to expropriate debtholders


Agency Benefits of Leverage

Managerial Entrenchment occurs from the separation of ownership and control in which managers make decisions to benefit themselves at the expense of investorsLeverage can preserve ownership concentration and mitigate agency costs» Issuing debt can maintain the original shareholders stake, while issuing

equity can dilute original shareholders incentives because any agency costs are shared with others

Leverage can mitigate empire building tendencies arising from incentives to run large firms (e.g., salary structure, perquisites)» Leverage imposes discipline by pre-committing the cash flows and by

creditor monitoring

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Agency Costs and the Tradeoff Theory

The value of the levered firm can now be shown to be(Interest Tax Shield) (Financial Distress Costs)

(Agency Costs of Debt)+ (Agency Benefits of Debt)

L UV V PV PVPV PV

= + −−


Capital Structure and Asymmetric Information

Asymmetric information refers to a situation where parties have different information» E.g., Managers often have better information relative to

investors regarding their firm

Leverage can act as a signal to investors to convey nonverifiable information» Issuing debt suggests that the firm really will grow since

I’ve pre-committed to pay back the debt» Or, I promise not to waste money on inefficient investment

since I’ve pre-committed to pay back the debt

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Adverse Selection

Adverse selection refers to the idea that with asymmetric information, the average quality of assets in the market will differ from the average overall qualityLemons principle: when seller has private information about the value of a good, buyers will discount the price they will pay because of adverse selectionThink used cars: » The desire to sell the car suggest it sucks so buyers won’t pay much» Owners of good cars don’t want to sell because buyers will think

they’re selling a lemon and offer a low price» The quality and prices of cars sold in the used-care market are both

low


Equity Issuance and Adverse Selection

Same idea can be applied to equity markets» Firms that issue equity have private information about the quality of the future

projects.» Lemon principle suggests that buyers are reluctant to believe management’s

assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.

» Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity.

» Only those managers who know their firms have poor prospects (and whose securities will have low value) are willing to sell new equity.

The lemons principle implies:» The stock price declines on the announcement of an equity issue.» The stock price rises prior to the announcement of an equity issue.» Equity issues occur when information asymmetries are minimized (e.g.,

immediately after earnings announcements).

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Stock Returns Around Equity Issuances


Aggregate Sources of Funding for Capital Expenditures, U.S. Corporations

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Summary

Optimal capital structure depends on a variety of imperfections» Taxes» Financial distress» Agency costs» Asymmetric information

We are currently figuring out why firms do what they doNext we can figure out what they should do

Documents

LSH Capital Structure - Wharton Finance