1、Capital Structure: Limits to the Use of DebtChapter 17Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinKey Concepts and SkillsoDefine the costs associated with bankruptcyoUnderstand the theories that address the level of debt a firm carriesnTradeoff nSignalingnA
2、gency CostnPecking OrderoKnow real world factors that affect the debt to equity ratioChapter Outline17.1 Costs of Financial Distress17.2 Description of Financial Distress Costs17.3Can Costs of Debt Be Reduced?17.4 Integration of Tax Effects and Financial Distress Costs17.5 Signaling17.6 Shirking, Pe
3、rquisites, and Bad Investments: A Note on Agency Cost of Equity17.7 The Pecking-Order Theory17.8 Growth and the Debt-Equity Ratio17.9Personal Taxes17.10 How Firms Establish Capital Structure17.1 Costs of Financial DistressoBankruptcy risk versus bankruptcy costoThe possibility of bankruptcy has a ne
4、gative effect on the value of the firm.oHowever, it is not the risk of bankruptcy itself that lowers value.oRather, it is the costs associated with bankruptcy.oIt is the stockholders who bear these costs.17.2 Description of Financial Distress CostsoDirect CostsnLegal and administrative costs oIndire
5、ct CostsnImpaired ability to conduct business (e.g., lost sales)oAgency CostsnSelfish Strategy 1: Incentive to take large risksnSelfish Strategy 2: Incentive toward underinvestmentnSelfish Strategy 3: Milking the propertyExample: Company in DistressAssetsBVMVLiabilitiesBVMVCash$200 $200LT bonds $300
6、Fixed Asset $400$0Equity$300Total$600 $200Total$600 $200What happens if the firm is liquidated today?The bondholders get $200; the shareholders get nothing.$200$0Selfish Strategy 1: Take RisksThe GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is $200 (all the firms cash)Requi
7、red return is 50%Expected CF from the Gamble = $1000 0.10 + $0 = $100NPV = $200 + $100 (1.50)NPV = $133Selfish Strategy 1: Take RisksoExpected CF from the GamblenTo Bondholders = $300 0.10 + $0 = $30nTo Stockholders = ($1000 $300) 0.10 + $0 = $70oPV of Bonds Without the Gamble = $200oPV of Stocks Wi
8、thout the Gamble = $0$20 =$30 (1.50) PV of Bonds With the Gamble:$47 =$70 (1.50) PV of Stocks With the Gamble:Selfish Strategy 2: UnderinvestmentoConsider a government-sponsored project that guarantees $350 in one period.oCost of investment is $300 (the firm only has $200 now), so the stockholders w
9、ill have to supply an additional $100 to finance the project.oRequired return is 10%.Should we accept or reject?NPV = $300 + $350 (1.10)NPV = $18.18Selfish Strategy 2: UnderinvestmentExpected CF from the government sponsored project:To Bondholder = $300To Stockholder = ($350 $300) = $50PV of Bonds W
10、ithout the Project = $200PV of Stocks Without the Project = $0$272.73 =$300 (1.10) PV of Bonds With the Project: $54.55 =$50 (1.10) PV of Stocks With the Project: $100Selfish Strategy 3: Milking the PropertyoLiquidating dividendsnSuppose our firm paid out a $200 dividend to the shareholders. This le
11、aves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.nSuch tactics often violate bond indentures.oIncrease perquisites to shareholders and/or management17.3 Can Costs of Debt Be Reduced?oProtective CovenantsoDebt Consolidation:nIf we minimize the number o
12、f parties, contracting costs fall.17.4 Tax Effects and Financial DistressoThere is a trade-off between the tax advantage of debt and the costs of financial distress.oIt is difficult to express this with a precise and rigorous formula.Tax Effects and Financial DistressDebt (B)Value of firm (V)0Presen
13、t value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + TCBV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debtThe Pie Model RevisitedoTaxes and bankruptcy costs can be viewed as just
14、another claim on the cash flows of the firm.oLet G and L stand for payments to the government and bankruptcy lawyers, respectively.oVT = S + B + G + LoThe essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.SGBL17.5 SignalingoThe firms
15、capital structure is optimized where the marginal subsidy to debt equals the marginal cost.oInvestors view debt as a signal of firm value.nFirms with low anticipated profits will take on a low level of debt.nFirms with high anticipated profits will take on a high level of debt.oA manager that takes
16、on more debt than is optimal in order to fool investors will pay the cost in the long run.17.6 Agency Cost of EquityoAn individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.”oWhile managers may have motive to partake in perquisites, they also need op
17、portunity. Free cash flow provides this opportunity.oThe free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.oThe free cash flow hypothesis also argues that an increase in debt will reduce the
18、ability of managers to pursue wasteful activities more effectively than dividend increases.17.7 The Pecking-Order TheoryoTheory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. nRule 1oUse internal financing firstnRule 2oIssue debt next, new equity la
19、stoThe pecking-order theory is at odds with the tradeoff theory:nThere is no target D/E rationProfitable firms use less debtnCompanies like financial slack17.8 Growth and the Debt-Equity RatiooGrowth implies significant equity financing, even in a world with low bankruptcy costs.oThus, high-growth f
20、irms will have lower debt ratios than low-growth firms.oGrowth is an essential feature of the real world. As a result, 100% debt financing is sub-optimal.17.9 Personal TaxesoIndividuals, in addition to the corporation, must pay taxes. Thus, personal taxes must be considered in determining the optima
21、l capital structure.Personal TaxesoDividends face double taxation (firm and shareholder), which suggests a stockholder receives the net amount:o(1-TC) x (1-TS)oInterest payments are only taxed at the individual level since they are tax deductible by the corporation, so the bondholder receives:o(1-TB
22、)Personal TaxesoIf TS= TB then the firm should be financed primarily by debt (avoiding double tax).oThe firm is indifferent between debt and equity when:(1-TC) x (1-TS) = (1-TB)17.10 How Firms Establish Capital StructureoMost corporations have low Debt-Asset ratios.oChanges in financial leverage aff
23、ect firm value.nStock price increases with leverage and vice-versa; this is consistent with M&M with taxes.nAnother interpretation is that firms signal good news when they lever up.oThere are differences in capital structure across industries.oThere is evidence that firms behave as if they had a tar
24、get Debt-Equity ratio.Factors in Target D/E RatiooTaxesnSince interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit).oTypes of AssetsnThe costs of financial distress depend on the types of assets the firm has.oUncertainty of Operating IncomenEven without
25、 debt, firms with uncertain operating income have a high probability of experiencing financial distress.oPecking Order and Financial SlacknTheory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.Quick QuizoWhat are the direct and indirect costs of bankruptcy?oDefine the “selfish” strategies stockholders may employ in bankruptcy.oExplain the tradeoff, signaling, agency cost, and pecking order theories.oWhat factors affect real-world debt levels?
