Ross 7e Ch16

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Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16-1

Chapter Outline

16.1 Costs of Financial Distress16.2 Description of Costs

16.3 Can Costs of Debt Be Reduced?

16.4 Integration of Tax Effects and Financial Distress Costs

16.5 Signaling

16.6 Shirking, Perquisites, and Bad Investments:

A Note on Agency Cost of Equity

16.7 The Pecking-Order Theory

16.8 Growth and the Debt-Equity Ratio

16.9 Personal Taxes

16.10 How Firms Establish Capital Structure

16.11 Summary and Conclusions

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16.1 Costs of Financial Distress

Bankruptcy risk versus bankruptcy cost.

The possibility of bankruptcy has a negative

effect on the value of the firm.

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.

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16.2 Description of Costs

Direct Costs

Legal and administrative costs (tend to be a small

percentage of firm value).Indirect Costs

Impaired ability to conduct business (e.g., lost sales)

Agency CostsSelfish strategy 1: Incentive to take large risks

Selfish strategy 2: Incentive toward underinvestment

Selfish Strategy 3: Milking the property

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Balance Sheet for a Company in Distress

Assets BV MV Liabilities BV MV

Cash $200 $200 LT bonds $300

Fixed Asset $400 $0 Equity $300Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

$200

$0

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Selfish Strategy 1: Take Large Risks

The Gamble Probability Payoff

Win Big 10% $1,000

Lose Big 90% $0Cost of investment is $200 (all the firm’s cash)

Required return is 50%

Expected CF from the Gamble = $1000 × 0.10 + $0 = $100

NPV = – $200 + $100

(1.10)

NPV = – $133

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Selfish Stockholders Accept Negative NPV Project

with Large Risks

Expected CF from the Gamble

To Bondholders = $300 × 0.10 + $0 = $30

To Stockholders = ($1000 – $300) × 0.10 + $0 = $70

PV of Bonds Without the Gamble = $200

PV of Stocks Without the Gamble = $0

PV of Bonds With the Gamble:

PV of Stocks With the Gamble:

$20 = $30 (1.50)

$47 = $70

(1.50)

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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%

Should we accept or reject?

NPV = – $300 + $350 (1.10)

NPV = $18.18

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Selfish Stockholders Forego

Positive NPV Project

Expected CF from the government sponsored project:

To Bondholder = $300

To Stockholder = ($350 – $300) = $50

PV of Bonds Without the Project = $200

PV of Stocks Without the Project = $0

$272.73 =

$300

(1.10) PV of Bonds With the Project:

– $100$54.55 = $50

(1.10) PV of Stocks With the Project:

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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 formershareholders.

Such tactics often violate bond indentures.

Increase perquisites to shareholders and/ormanagement

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16.3 Can Costs of Debt Be Reduced?

Protective Covenants

Debt Consolidation:

If we minimize the number of parties, contracting

costs fall.

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Protective CovenantsAgreements to protect bondholders

Negative covenant: Thou shalt not:

Pay dividends beyond specified amount.

Sell more senior debt & amount of new debt is limited.

Refund existing bond issue with new bonds paying lowerinterest rate.

Buy another company’s bonds.

Positive covenant: Thou shall:

Use proceeds from sale of assets for other assets.Allow redemption in event of merger or spinoff.

Maintain good condition of assets.

Provide audited financial information.

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16.4 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 andrigorous formula.

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Integration of Tax Effects

and Financial Distress Costs

Debt (B )

Value of firm (V )

0

Present value of taxshield on debt

Present value of

financial distress costs

Value of firm underMM with corporatetaxes and debt

V L = V U + T C B

V = Actual value of firm

V U = Value of firm with no debt

B*

Maximum

firm value

Optimal amount of debt

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The Pie Model Revisited

Taxes and bankruptcy costs can be viewed as just another claimon the cash flows of the firm.

Let G and L stand for payments to the government and bankruptcylawyers, respectively.

V T = S + B + G + L

The essence of the M&M intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie.

S

G

B

L

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16.5 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.

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16.6 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, theyalso 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.

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16.7 The Pecking-Order Theory

Theory stating that firms prefer to issue debt rather thanequity if internal finance is insufficient.

Rule 1

Use internal financing first.Rule 2

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

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16.8 Growth and the Debt-Equity Ratio

Growth implies significant equity financing, evenin a world with low bankruptcy costs.

Thus, high-growth firms will have lower debt

ratios than low-growth firms.

Growth is an essential feature of the real world;

as a result, 100% debt financing is sub-optimal.

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16.9 Personal Taxes: The Miller Model

The Miller Model shows that the value of alevered firm can be expressed in terms of an

unlevered firm as:

B T

T T V V

B

S C U L

- - -

- + = 1

) 1 ( ) 1 ( 1

Where:

T S = personal tax rate on equity income

T B = personal tax rate on bond income

T C = corporate tax rate

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Personal Taxes: The Miller Model

The derivation is straightforward:

) 1 ( ) 1 ( ) (

receive firm levered a inrs Shareholde

S C B T T B r EBIT - - -

) 1 (

receive s Bondholder

B B T B r -

) 1 ( ) 1 ( ) 1 ( ) (

is rs stakeholde all to flow cashtotal the Thus,

B B S C B T B r T T B r EBIT - + - - -

-

- - - - + - -

B

S C B B S C

T

T T T B r T T EBIT

1

) 1 ( ) 1 ( 1 ) 1 ( ) 1 ( ) 1 (

as rewritten be canThis

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Personal Taxes: The Miller Model (cont.)

-

- - - - + - -

B

S C B B S C

T

T T T B r T T EBIT

1

) 1 ( ) 1 ( 1 ) 1 ( ) 1 ( ) 1 (

The first term is the cashflow of an unlevered firm

after all taxes.

Its value = V U .

A bond is worth B. It promises to pay r B B×(1- T B) after taxes. Thus

the value of the second term is:

-

---

B

S C

T

T T B

1

)1()1(

1

The total cash flow to all stakeholders in the leveredfirm is:

The value of the sum of thesetwo terms must be V L

B T

T T V V

B

S C U L

-

- - - + = \

1

) 1 ( ) 1 ( 1

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Personal Taxes: The Miller Model (cont.)

Thus the Miller Model shows that the value of alevered firm can be expressed in terms of an

unlevered firm as:

In the case where TB = TS, we return to M&Mwith only corporate tax:

B T

T T V V B

S C U L

-

-

- - + =

1 ) 1 ( ) 1 ( 1

B T V V C U L + =

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Integration of Personal and Corporate Tax Effects and

Financial Distress Costs and Agency Costs

Debt (B )

Value of firm (V )

0


Present value of

financial distress costs Value of firm underMM with corporatetaxes and debt

V L = V U + T C B



B*

Maximum

firm value


V L < V U + T C B

when T S < T B but (1-T B) > (1-T C )×(1-T S )

Agency Cost of Equity Agency Cost of Debt

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16 25

16.10 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 whenthey lever up.

There are Differences in Capital Structure AcrossIndustries.

There is evidence that firms behave as if they had atarget Debt to Equity ratio.

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Factors in Target D/E Ratio

Taxes

If corporate tax rates are higher than bondholder tax rates, thereis an advantage to debt.

Types of AssetsThe costs of financial distress depend on the types of assets thefirm has.

Uncertainty of Operating Income

Even without debt, firms with uncertain operating income havehigh probability of experiencing financial distress.

Pecking Order and Financial SlackTheory stating that firms prefer to issue debt rather than equityif internal finance is insufficient.

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Costs of financial distress cause firms to restrain theirissuance of debt.

Direct costsLawyers’ and accountants’ fees

Indirect CostsImpaired ability to conduct business

Incentives to take on risky projects

Incentives to underinvest

Incentive to milk the property

Three techniques to reduce these costs are:Protective covenants

Repurchase of debt prior to bankruptcy

Consolidation of debt

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Because costs of financial distress can be reduced but noteliminated, firms will not finance entirely with debt.

Debt (B )

Value of firm (V )

0


Present value offinancial distress costs

Value of firm underMM with corporatetaxes and debt

V L = V U + T C B



B*

Maximumfirm value


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If distributions to equity holders are taxed at a lower effective personal tax rate

than interest, the tax advantage to debt at the corporate level is partially offset.In fact, the corporate advantage to debt is eliminated if (1-T C ) × (1-T S ) = (1-T B)

Debt (B )

Value of firm (V )

0

Present value of tax

shield on debt

Present value offinancial distress costs Value of firm under

MM with corporatetaxes and debt

V L

= V U

+ T C B



B*

Maximumfirm value


V L < V U + T C B when T S < T B

but (1-T B) > (1-T C )×(1-T S )

Agency Cost of Equity Agency Cost of Debt

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Debt-to-equity ratios vary across industries.

Factors in Target D/E Ratio

Taxes

If corporate tax rates are higher than bondholder tax rates, there is an

advantage to debt.

Types of Assets

The costs of financial distress depend on the types of assets the firm

has.Uncertainty of Operating Income

Even without debt, firms with uncertain operating income have high

probability of experiencing financial distress.

Documents

Ross 7e Ch16