Some Evidence of BC and OCS

Some Evidence on Financial Distress Costs and Their Effect on Cash Flows
Ignacio Vélez-Pareja
Politécnico Grancolombiano, Colombia
ivelez@poligran.edu.co
nachovelez@gmail.com
Patricia Rojas-Linero
Universidad de Los Andes, Colombia
patr-roj@uniandes.edu.co
First Version: October 24, 2006

This Version: October 29, 2006
Ignacio Vélez-Pareja and Patricia Rojas-Linero
Abstract
In this work we explore the effect of book value leverage upon some financial indexes, such as real
growth, payment terms from suppliers and gross and operating margins. We explore if there is
statistical evidence on the influence of the book value leverage level in the financial distress or
bankruptcy costs that appear as measured by the worsening of those indexes. Four dependent variables
were explored: gross margin, operating margin, real growth in sales and payment terms from suppliers.
In order to estimate the financial distress and bankruptcy costs associated with each dependent variable,
logarithmic and semi-logarithmic models were constructed using data panel. We used a balanced
sample composed by 644 firms from the commercial Colombian industry, provided by the
Superintendence of Societies of Colombia. We also examined an unbalanced sample of 683 firms with
Ordinary Least Squares (OLS) analysis. We found that there exists a relationship between book value
leverage perceived by the market and gross margin. This allows us to explore the possibility to
introduce the financial distress costs in the cash flows. The aim of the study is to explore a model that
allows the analyst to include this effect in the forecasted financial statements. When this effect is
included in the financial statements the free cash flows will be affected and hence the interaction of
cash flows, cost of capital (weighted average cost of capital) and firm value calculated with the cash
flows will eventually allow determining an optimal capital structure.
JEL codes: D61, G31, H43

Keywords: Cash flows, forecasted financial statements, cost of capital, bankruptcy costs, financial
distress costs.
ii
1 Introduction
In this work we explore the effect of book value leverage upon some financial indexes, such as
real growth, payment terms from suppliers and gross and operating margins. We explore if there
is statistical evidence on the influence of the book value leverage level in the financial distress or
bankruptcy costs that appear as measured by the worsening of those indexes. Four dependent
variables were explored: gross margin, operating margin, real growth in sales and payment terms
from suppliers. In order to estimate the financial distress and bankruptcy costs associated with
each dependent variable, logarithmic and semi-logarithmic models were constructed using data
panel. We used a balanced sample composed by 644 firms from the commercial Colombian
industry, provided by the Superintendence of Societies of Colombia. We also examined an
unbalanced sample of 683 firms with Ordinary Least Squares (OLS) analysis. We found that
there exists a relationship between book value leverage perceived by the market and gross
margin. This allows us to explore the possibility to introduce the financial distress costs in the
cash flows. The aim of the study is to explore a model that allows the analyst to include this
effect in the forecasted financial statements. When this effect is included in the financial
statements the free cash flows will be affected and hence the interaction of cash flows, cost of
capital (weighted average cost of capital) and firm value calculated with the cash flows will
eventually allow determining an optimal capital structure.
2 Theoretical Context
It might seem a paradox, but the greater the debt, the greater the firm value (see Modigliani
and Miller, 1958, 1959 and 1963). If that is true, then the idea would be to leverage the firm to
the maximum, 100%, however, this does not happen in reality because some financial distress of
bankruptcy costs arise. Some prefer to call them indirect bankruptcy costs. When a firm is
leveraged and pay taxes the firm value increases. This happens because when the firm has
enough earnings before interest and taxes (EBIT) and it pays interest, (that is deductible) the
government subsidizes the firm. This is an externality. When EBIT is greater than or equal to the
financial expenses this subsidy is
TSt = T×Kdt×Dt−1 (1)
where TS is the tax savings, T is the corporate tax rate, Kd is the cost of debt, and D is the
book value of the debt. Hence, the unlevered value of the firm is increased by the present value of
the tax savings.
VL = VUn+VTS = VEquity L+VDebt (2)
Where VL is the levered value of the firm, VUn is the unlevered value of the firm, VTS is the
value (present value) of the tax savings, VEquity L is the levered market value of equity, and VDebt
is the value of debt.
The literature on the subject, which is abundant, fundamentally looks for finding the optimal
capital structure. Nevertheless, we will mention the works of some relevant authors. Baumol and
Malkiel, 1967, demonstrate analytically that an optimal capital structure must exist. Warner,
1977, shows the evidence of the existence of the financial distress costs or bankruptcy costs in
some companies from the railway transport industry and assumes that an optimal capital structure
can be found. DeAngelo and Masulis (1980) predict that the leverage is inversely proportional to
the level of tax savings different from the generated by the interests payments and that the
leverage depends on the corporate tax rate, the firm size, the future growth, the conditions of the
1
capital market, the inflation rate and the volatility of the net income (cited by Homaifar et al.
1994). Bradley et al., 1984 analyzed 850 firms during 20 years and concluded: “[…] that optimal
firm leverage is related inversely to costs of financial distress”. Myers 1984, compares the trade-
off theory with the modified pecking order theory and raises too many questions regarding the
structure of capital; Cutler and Summers 1989 discuss the financial distress costs or bankruptcy
costs in the Texaco-Pennzoil case. John, 1993, defines financial distress costs or bankruptcy costs
as those costs that appear when there is a mismatch between the current assets available of a firm
and their “difficult” financial liabilities. With “difficult” the author means those debts that cannot
be postponed. Homaifar et al. 1994 make a criticism to the DeAngelo and Masulis model.
According to Van Horne, 1998, the financial distress costs or bankruptcy costs include
inefficiencies in the operation of a company when is near their bankruptcy and usually liquidates
its assets at prices below the market price. Ju et al. 2005, examine “optimal capital structure
choice using a dynamic capital structure model […]”. Chui et al, 2002 try to predict the optimal
structure of capital from country to country. Martínez, (2002) using probit regression techniques
develops a model in which the relevant variables are identified to predict the stress or financial
fragility of Colombian firms in 2001. Lopez Dumrauf, 2003, proposes a model, based on
perpetuities, in which the cost of the debt increases with the leverage (qualification of risk), the
cost of equity is the cost of the debt plus a constant and the cost of the equity without debt varies
since it is the weighed average between these two costs: equity and debt; using this he finds a
weighed average cost of capital that maximizes the value of the firm (in the example there are
several optimal points). In that case, he calculates the value of financial distress costs as the
difference between the value of the firm without financial distress costs and the value obtained
with this weighed average cost of capital. Using a similar approach, he calculates the value of the
share in the market. Mao, 2003, says that the optimal leverage is positively correlated with the
marginal volatility of the investment and that there is empirical evidence of it. De Luna, 2004,
illustrates the calculation of an optimal leverage with a hypothetical example where the cost of
the debt raises with the leverage and the weighed average cost of capital reaches a minimum
value, maximizing therefore the value of the firm. On the other hand, he proposes the calculation
of the optimal capital structure using theory of option valuation (OPT) to the valuation of sources
of financing in the real estate investment. He does not consider indirect financial distress costs,
but only the bankruptcy costs (legal processes of recovering the asset). Welch et al. 2004, discuss
the liquidation costs. Ross, 2005, using an option pricing approach solved the optimal policy for
capital structure, “where the structure is fixed until bankruptcy occurs”. Titman et al. 2005,
present “a continuous time model of a firm that can dynamically adjust both its capital structure
and its investment choices”.
We use extensively the theory of trade off that says that when the leverage of a firm increases,
simultaneously it incurs in greater financial distress or bankruptcy costs. This is to say that the
optimal level of leverage is reached when the marginal tax savings for interest expenses is
identical to the marginal cost of financial distress. What happens is that the financial distress
costs or bankruptcy costs would increase until a point where they become equal to and then
greater than the tax savings for interest expenses. This means that a firm cannot finance its
investment by means of debt in a one hundred percent.
Rodríguez-Puente, 2003, citing the works of Gilson et al., 1990, Wruck, 1990, Opler y Titman,
1994, and Andrade and Kaplan, 1998, mentions the most likely effects that reduce the value of a
firm as follows:
1. “Reduction in investments or loss of opportunities on profitable investments.
2. Loss of competitiviness.
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3. Decrease in sales revenues o loss of market share.

4. Decrease in dividends.
5. Time of management lost devoted to the reorganization of the firm.
6. The need to make decisions reaching consensus with creditors.”
It is possible to distinguish among financial, commercial, human resources and legal financial
distress or bankruptcy costs.
Financial costs.
When a firm becomes more and more leveraged, it increases the risk perceived by third parties,
for instance, the debt holders. A bank might charge the firm with a higher interest rate. This
increased cost affects both, the cash flows and the Weighted Average Cost of Capital, WACC.
All this constitutes a vicious circle and the firm will possibly have to resort to the non
institutional capital market that usually charges very high rates (rates of usury). The financial
costs over usury might not be accepted by the law as a deducible expense. That is to say, the TS
is lost.
Commercial Financial Distress or Bankruptcy Costs
Regarding the commercial costs of financial distress or bankruptcy costs, when the firm is
highly leveraged, suppliers can lose confidence and would not grant favorable short term
payment conditions (at zero cost), and eventually could require payment on delivery or even in
advance. This is reflected in a reduction of the cash flows.
On the other hand, customers could panic and then switch to a safer supplier, either buying
lower quantities or even canceling any further purchase. The final result is that real growth rates
deteriorate and cash flows are reduced.
Additional to these commercial costs of the financial distress we can think of human resources
(human capital) losses when some of the best employees look over other jobs with the
competition. Finally, when bankruptcy appears, the firm has to assume legal costs such as the
lawyers and liquidation fees.
As we can imagine, financial distress and bankruptcy costs are very difficult to measure.
However, anyone that has worked with a firm in financial distress or in bankruptcy will have
evidence of the appearance of these costs.
According the trade off theory, as seen in the literature, several authors have proposed to
include a cost of capital premium based in the probability of bankruptcy that has as a direct effect
the increase of the weighted average cost of capital. This means that cash flows are discounted in
the valuation model with a higher discount rate and the value decreases. Other authors have
proposed a direct increase in the cost of capital not related to the probability of bankruptcy but as
and additional value for the discount rate. In summary, they approach to the problem of financial
distress costs looking at the discount rate and not at the cash flows. That is to say, the approach is
to affect the denominator of the following formula: (Philosophov and Philosophov, 1999, Ross,
2005).
3
Proposed method
n
CFt
Valor = ∑
t =1 (1 + r )t
n = # of periods Other methods
CF = cashflow
r = discount rate
Exhibit 1. Proposed and traditional methods
Our approach, on the contrary, seeks to model the behavior of financial distress costs and
include them in the cash flows as a monetary value. This is equivalent to follow the theory of the
trade off, because what we do is to affect the cash flows and to reflect it in a lower value of the
firm. (This is to say, the tax savings are compensated with the higher costs that arise for the
financial distress of the firm).
In this paper we correlate accounting indexes with the book value leverage (Total
liabilities/Total assets) and not with the market leverage that arises when calculate the cost of
capital. The reason is that the market (customers, suppliers, etc.) does not perceive the market
value of the leverage but the book value leverage that can be derived easily from the financial
statements. We have not found previous work on financial distress costs to be included directly in
the cash flows. However, there is evidence of the existence of such costs especially in firms with
high leverage. For instance, Opler and Titman, 1994, found that companies with high leverage
lose a large market share (their sales revenues are reduced up to 26% than the most conservative
companies) in favor of others more conservative in relation with the leverage issue. On the other
hand, Andrade and Kaplan, 1998, studied a sample of thirty highly leveraged firms that suffered
financial distress costs in the mid 80’s and found that the financial distress costs range between
10% and 23% of the firm value.
In emerging markets there is a meager advance in the research of financial distress or
bankruptcy costs because most of the firms do not trade in the stock market and the lack of
confidence to provide information to the researcher. On the other hand, the availability of reliable
information is limited. Prasad et al. 2001, referring to the financing policy, capital structure and
firm ownership, say that “There is a large volume of research on these issues in industrial
countries, but virtually no work has been done on developing countries” and mention the work
done by Hamid and Singh, 1992, Singh, 1995, Hussain, 1995, Brada and Singh, 1999 and
Prasad, 2000. Sanz and Ayca 2006 in an article on the financial costs of liquidity problems in
Latin America found that these costs are larger that those found in previous studies in developed
markets. In particular, they studied the Venezuelan firm CPVEN, and found that it showed
several indicators of worsening of financial indexes or ratios such as:
• Growth of liabilities of 100% between 1996 and 1999.

• Net equity diminished between 1997 and 2000 even to become negative.
• The Income Statement showed an increase in direct costs (“cost of goods sold”) going up
to more than 100% in 1999.
• Sales revenues decreased 70% between 1999 and 2000.
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This financial chaos caused by the costs of financial stress costs had an impact on the value of
that firm: the firm value decreased in more than 30% during the crisis and assets decreased, these
effect are much higher than the 20% average of decrease in assets reported by Andrade and
Kaplan, 1998.
To understand why we should incorporate the financial distress costs in the cash flows we have
to remind that more than 99% of the firms in the world are not traded. Even in the U.S. that
percent is well above 99%. (See Vélez-Pareja, 2005). The most popular method to value non
traded firms is the discounted cash flow (DCF) method. Our work is focused into the finding of a
methodology to estimate the financial distress costs to be included directly in the cash flows and
eventually to estimate the optimal capital structure.
3 Our Hypothesis
Based in experience, we think that the market (customers, suppliers, etc.) perceives the
financial distress situation looking at the firm’s financial statements and some financial ratios
derived from them. In particular, they look at the total leverage. They react negatively against the
firms with high leverage. For instance, many firms, either private or official ones, restrict the
access to open bids of suppliers when they have high leverage indexes.
Our central hypothesis is based on the idea that the total book value leverage is a good
indicator that might induce the market to make decisions that affect firm value. For instance,
customers might decide to buy fewer quantities or none at all and suppliers could restrict the
amount dispatched or even to reduce the payment terms. We focus our work in the measurement
of these commercial financial distress costs. We measure the effect of this behavior based on the
real (deflated) growth in sales revenues, gross and operating margins and the payment terms from
suppliers.
Our general hypothesis can be stated in relation to some financial indicators:
Is there a relationship between book value leverage and Gross margin, Operative margin,
payment terms from the suppliers and real Growth in sales?
i) Real growth in sales

Real growth would be affected by the partial or total retirement of customers of the firm. These
customers might fear to depend totally on a firm with potential financial problems. This reduces
the real growth of the firm. A simple example of it is when a firm cannot offer its products and/or
services because it does not fulfill the conditions of maximum leverage established by some
customers (governmental and even private ones) in the conditions for bidding. Customers do not
want to assume risks with a supplier in financial stress and they might retire total or partially.
Consequently, the firm sells less, losing participation in the market and reducing its levels of
sales in real dollars. Hence, the higher the leverage, the lower the real growth.
ii) Margin
Margins would be affected when a supplier restricts the provision of inputs to the firm and it is
forced to change of supplier and/or to buy reduced amounts of its inputs to different suppliers,
reducing scale discounts and hence increasing the cost of goods sold. Hence, the higher the
leverage, the lower the gross and operative margins.
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iii) Payment terms from suppliers

When imposing stringent conditions to the firm, the suppliers would tend to reduce the granted
payment terms to the firm. This will be reflected in the cash flows that determine the value of the
firm. For instance, they might require payment in 30 days instead of payments in 60 days.
According to this, the expected relationship is, the larger the leverage, the lower the terms of
payment.
4 Data Analyzed
For this study we utilized a sample of the 60 industries classified by the Superintendence of
Societies. These data were reclassified in 12 macro sectors.
After cleaning up the database we obtained a sample of 644 firms from the Colombian
commercial industry that every year reported their financial statements from 1997 to 2004. This
industry represents 26.7% of the firms included in the balanced sample. The financial statements
of the companies to study are available in http://www.supersociedades.gov.co/.
The criteria used to clean up the data were:
1. We deleted outliers with the following criteria:
1.1. A real growth rate greater than 200%.
1.2. Gross and operating margins lower than -200%.
This cleaning up of the sample reduced it to 683 firms (4,723 observations).
2. As we use data panel to analyze the data, we needed a balanced sample and this means that
every firm should have the complete financial statements for the 7 years of the time window
examined. Then, we deleted from the sample those firms that did not have complete
information for all years from 1998 to 2004. After this process, we ended up with a sample of
644 firms with complete data for 7 years each (4,508 observations).
5 Testing the hypothesis

We tested the hypothesis analyzing different models.
5.1 Models analyzed
We explored logarithmic (log-log) and semi logarithmic (lin-log) models with and without
intercept, when needed, to measure the effect of leverage upon the dependent variables.
The lin-log model was:
Dependent variableit = β1 + β1 × ln D%BVt−1
This model is equivalent to the following econometric model:
Dependent variableit = β1 + β1 × ln D%BVt−1 + µ
Where:
i: 1…N is the number of firms in the data panel
t: 1..M is the years in the data panel (1998-2004)
µ is the error.
In the log-log model we used:
ln(Dependent variable)it = β1 + β1 × ln D%BVt−1
This model is equivalent to the following econometric model:
ln(Dependent variable)it = β1 + β1 × ln D%BVt−1 + µ
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Where:
i: 1…N is the number of firms in the data panel
t: 1..M is the years in the data panel (1998-2004)
µ is the error.
In a logarithmic model the coefficient β1, indicates the percent change in the dependent
variable caused by an increment of 1% in the leverage of previous year.
5.2 “Proxies” for the dependent variables

i) Proxy for the real growth in sales:
St
S
grt = t -1 − 1
1+ it
Where gr is real growth, S is sales revenue and i is inflation rate for the current year
ii) Margin:
EBITt
OM t =
St
Where OM is the operating margin, EBIT is Earnings Before Interest and Taxes and S is sales
revenue.
GI
GM t = t
St
Where GM is the gross margin, GI is Gross Income and S is sales revenues
Proxy for payment terms from suppliers

APt
PTt =
St
Where ST is payment terms from suppliers, AP is accounts payable and S is sales revenues
APt
PTt =
COGS t
Where PT is the payment terms from suppliers, AP is accounts payable and COGS is the cost
of goods sold.
5.3 Independent Variables
• Leverage.
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TL t −1
D% BVt −1 =
TA t −1
Where D%BVt-1 is the book value leverage in year t-1, TL is total liabilities for year t−1 and
TA is total assets for year t−1.
Other elements in the equations are
• Ln (D%BVt-1): Natural or neperian Logarithm of D%BVt-1

• β is the regression coefficients for the independent variables.
6 Findings
We analyzed three aspects using data panel:
1. The Haussman Test that indicates if the approach to analyze the data is the appropriate.
Data panel technique has two approaches for analyzing data: Random effects and fixed
effects. This is indicated by the p-value for the Haussman index. If it is greater than
0.05, then the random effect approach is the appropriate one; if lower, the appropriate
model is the fixed effects.
2. The sign of the regression coefficients associated to the independent variable (natural
logarithm of leverage, lnD%BVt−1) according to the hypothesis. As the hypothesis says
that the greater the leverage the lower the independent variable, a positive coefficient
would be contrary to it and hence the model would be inadequate.
3. The statistical significance of the coefficients. This is to say that we tested if the
regression coefficients had a p-value lower than 0.05.
Our initial approach was to assume that the market was aware of the average leverage for the
industry. Then we analyzed a data panel model that split the sample in two groups: the firms with
leverage above the average and those with leverage below the average. Although the results were
significant statistically, the behavior of the coefficients was inconsistent: for the firms with
leverage greater than the average the coefficient was less negative than the firms with lower
leverage and on the other hand, the firms with leverage lower than the average had a coefficient
more negative than the former.
In addition, we introduced some other variables in the model, such as real growth of Gross
Domestic Product (GDP) and growth of population to explain the real growth and interest rates
charged by the banks to explain the terms of payment granted by the suppliers. However, we
discarded these variables because they were not statistically significant.
We tested lineal, semi logarithmic (lin-log) and logarithmic (log-log) model using data panel.
In all models, the Gross Margin, GM, was statistically significant and with the correct sign for the
regression coefficients. Finally, we studied two models: one based upon data panel analysis and
another one based upon Ordinary Least Squares, OLS.
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Model 1 (log-log). Model with fixed effects for 644 firms 7 years each, data panel
R2 0.8726
Coefficient -1.80972
Intercept
(p-value) <0.0001
Coefficient -0.06511
β for ln(D%BV)
(p-value) (<0.0001 )
Model 2 (log-log) Model with 683 firms 7 years, OLS

R2 adjusted 0.01978551
Coeficiente -1.62171828
Intercept
(p-value) (0)
Coeficiente -0.14282552
β for lnD%BV
(p-value) (1.6086E-22)
As can be seen, there is a statistically significant relationship between book value leverage and
GM. In order to take advantage of the total simple we analyzed a log-log model with 683 firms
(4,723 observations).
The interpretation (see Gujarati, 2003) of the regression coefficient β1 for lnD%BV is that if
D%BVt−1 changes 1%, Gross Margint changes on the average, β1. For each 1% of change in
D%BVt−1, the change in Gross Margin (GM) will be β1×1%.
Change in GM = β1×(D%BVt−2 − D%BVt−1)/D%BVt−2
With Data Panel
Change in GM = −0.06511×(D%BVt−2 − D%BVt−1)/D%BVt−2
Then the model to be used in the forecasting of financial statements would be
GMt forecasted = GMt expected + β1×(D%BVt−2 − D%BVt−1)/D%BVt−2
GMt forecasted = GMt expected −0.06511×(D%BVt−2 − D%BVt−1)/D%BVt−2
With OLS
Change in GM = −0.14282552×(D%BVt−2 − D%BVt−1)/D%BVt−2
Then the model to be used in the forecasting of financial statements would be
GMt forecasted = GMt expected + β1×(D%BVt−2 − D%BVt−1)/D%BVt−2
GMt forecasted = GMt expected −0.14282552×(D%BVt−2 − D%BVt−1)/D%BVt−2
These models have some restrictions in their use from the statistical point of view. Strictly,
when we eliminated some observations from the sample in order to have a balanced sample, the
results obtained with models such as the above mentioned could not be used to extrapolate to
firms not included in the sample. On the other hand, this type of study assumes the ceteris
paribus conditions, which means that we only could include in the model one effect each time.
This is to say that when forecasting financial statements we only could include, for instance, the
effect from one of the independent variables, say real growth, or gross margin or payment terms
from suppliers. This problem can be solved using simultaneous equations (see Gujarati, 2003).
However, using this type of models allow us appreciate and quantify the effect of book value
leverage in Gross Margin. This model could be used for forecasting with above mentioned
restrictions and caveats or if using simultaneous equations, we could include the effect of
leverage on more that one dependent variable.
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Using these models we are assuming that any level of book value leverage will affect Gross
Margin and hence, generates financial distress costs.
7 Example
Next we present a simple example where we apply the model presented above. In this example
we assumed that the change in working capital is zero, no accounts receivable, no accounts
payable, no inventory, no cash in hand, that we keep the level of fixed assets by investing the
amount of the depreciation charge, that we forecasted a level of Gross Margin, that there was not
other income, that debt is fully repaid in the 4 years, that all the cash excess is distributed either
as dividends or as stock repurchase and that at the end of the 4 years the firm is liquidated. We
assumed that the discount rate for the tax savings is Ku, the unlevered cost of equity and hence
that the capital cash flow, (CCF) discounted at the unlevered cost of equity gives the correct
value of the firm. CCF can be calculated as
CCF = CFD + CFE = FCF + TS
Where CCF is capital cash flow, CFD is cash flow to debt, FCF is free cash flow and TS is tax
savings. The CFD and the CFE can be calculated directly from the cash budget and the FCF can
be calculated either using the indirect or direct method. The input data is given in the next table.
We fixed market value leverage and that defines the value of debt as D%×VL. This creates
a circularity which can be solved very easily. The calculation of a PV in this way involves
iterative solution (circularity in MS Excel™). To solve circularity in MS Excel™, go to Tools
Options Calculations tick Iteration and construct the required formulas with the circularity
and MS Excel™ will solve it. (See Tham and Vélez-Pareja, 2005, Vélez-Pareja and Tham, 2006).
The reader could study the financial statements with and without the effect of leverage, in
the appendix.
7.1 Model with GM (based in Data Panel analysis)

Input data
Tax rate 35% D% at market value 30%
Cost of debt, Kd 11.2% P% at market value 70%
Unlevered cost of equity, Ku 15.10% Ke=Ku+(Ku-Kd)×D/E 17.70%
Year 0 Year 1 Year 2 Year 3 Year 4
Inflation rate 6.00% 6.00% 6.00% 6.00%
Real growth 4.00% 3.00% 2.00% 1.00%
β1 -0.06511
Fixed assets 650.00
Expected Gross margin 60.00% 60.00% 60.00% 60.00%
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Cash flows with and without the effect of accounting leverage, D%BV, in gross margin, GM
Without the effect of D%BV Year 0 Year 1 Year 2 Year 3 Year 4
D% of firm market value 30.00% 30.00% 30.00% 30.00%
Debt 484.50 525.15 566.10 607.56
D% book value 74.54% 80.79% 87.09% 93.47% 0.00%
Capital Cash Flow, CCF 108.37 127.86 146.75 164.63
Firm value PV(FCC at Ku) 1,615.00 1,750.51 1,886.99 2,025.19 2,166.38
With the effect of D%BV
D% of firm market value 30.00% 30.00% 30.00% 30.00%
Debt 484.43 525.08 566.02 607.47
D%BV book value 74.53% 80.78% 87.08% 93.46% 0.00%
(D%BVt-1 - D%BVt-2)/(D%BVt-2) 0.00000% 8.39007% 7.79685% 7.32382%
Forecasted Gross margin 60.0000% 59.9945% 59.9949% 59.9952%
CCF 108.36 127.84 146.73 164.61
Firm value PV(FCC at Ku) 1,614.78 1,750.26 1,886.73 2,024.91 2,166.08
The behavior of value as a function of market leverage can be seen in the next table:
5.0% 1,564
10.0% 1,574
15.0% 1,584
20.0% 1,594
25.0% 1,605
30.0% 1,615
35.0% 1,625
40.0% 1,636
45.0% 1,646
50.0% 1,657
55.0% 1,667
60.0% 1,678
65.0% 1,689
70.0% 1,700
75.0% 1,709
90.0% 1,726
1,726,5853707
92.0%
1,727,2658997
94.0%
1,727,2658985
95.0%
1,727,2658985
96.0%
1,727,2658985
97.0%
1,727,2658985
98.0%
1,727,2658985
99.0%
Assuming that the optimal capital structure could be determined considering only the effect of
book value leverage on the gross margin is bizarre; however, we could look at the trend that
would show that in this hypothetical example the “optimal” capital structure is located at 94%.
This can be seen in the next exhibit.
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Firm Value vs D% at market value
1,728
Value of the firm

1,727
1,727
1,726
1,726
88.0% 90.0% 92.0% 94.0% 96.0% 98.0% 100.0%
D%
Exhibit 2. Value of firm versus market leverage, D%

This exhibit shows that there is a leverage level at which firm value reaches it maximum
value.
8 Concluding Remarks
As concluding remarks we can say the following:
1. We found that the greater the book value leverage, the lower the Gross Margin, GM.
When we analyze the data for the 644 firms with a balanced sample and using the lin-log
model with data panel with fixed effects, the greater the book value leverage, the lower
the Gross Margin. When we use the log-log model we found the same behavior, but the
Haussman Test indicates that it is better to use the fixed effects model. In this case, the
finding is that the relationship between book value leverage and gross margin is
significant. When we analyze the sample of 683 firms, non balanced sample, and using
OLS with a log-log model, the relationship between book value leverage and Gross
Margin is significant as well.
2. Real growth is not statistically significant and this variable presents some measurement
problems. To deflate the sales revenues is not the most appropriate measure of real growth
because what we do is just to eliminate the inflationary effect. What we obtain as real
growth is not such, because it includes the real growth in units and the real increase in
prices. It is possible that a negative real growth be compensated with a real increase in
prices, ending up with a “positive” real growth. This of course, is hiding a negative real
growth. The hypothesis of the greater the book value leverage the lower the real growth is
rejected with all models.
3. We found that the greater the book value leverage the greater the payment terms from
suppliers in all models. In the case of CPVEN studied by Sanz and Ayca, 2006, the firm
presents a behavior contrary to our hypothesis. One explanation for this behavior is that if
it is true that the supplier requires lower payment terms, due to the same financial stress
the firm is suffering, the firm does not comply with those terms and it pays when it is
possible. Then the hypothesis is rejected.
12
4. The hypothesis that relates Operating margin and book value leverage is rejected with all
models.
5. There is no evidence that the market (suppliers, customers) watches the book value
leverage for each industry. We found evidence that the market looks at the D%BV for the
firm.
6. In future work we could explore other variables and approaches such as other regression
models, book value leverage from two o more years behind, and explore the relationship
between cost of debt and leverage. One possibility is to use simultaneous equations that
include the dependent variables and a unique independent variable (the book value
leverage). And last but not least, we should improve the quality of the information is
crucial to the quality of the results.
7. The major conclusion from this exploratory work is that aside the restrictions imposed to
the models by the reduction of the sample to obtain a balanced sample, and the ceteris
paribus conditions, we could include the effect of the leverage in the financial statements
of a firm and hence in the cash flows. Eventually, we could explore a different approach
to the determination of an optimal capital structure.
8. From this exploratory study we share the old position posited by Myers (1984) about the
ignorance regarding the optimal capital structure. We even question if in reality it is just a
theoretical idea without empirical evidence. All this means that we have to much ahead to
do regarding the issue of optimal capital structure.
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16
Appendix
In this appendix we present a simple example where we apply the model presented above.
In this example we assumed that the change in working capital is zero, no accounts
receivable, no accounts payable, no inventory, no cash in hand, that we keep the level of
fixed assets by investing the amount of the depreciation charge, that we forecasted a level
of Gross Margin, that there was not other income, that debt is fully repaid in the 4 years,
that all the cash excess is distributed either as dividends or as stock repurchase and that at
the end of the 4 years the firm is liquidated. We assumed that the discount rate for the tax
savings is Ku, the unlevered cost of equity and hence that the capital cash flow, (CCF)
discounted at the unlevered cost of equity gives the correct value of the firm. CCF can be
calculated as
CCF = CFD + CFE = FCF + TS
Where CCF is capital cash flow, CFD is cash flow to debt, FCF is free cash flow and TS
is tax savings. The CFD and the CFE can be calculated directly from the cash budget and
the FCF can be calculated either using the indirect or direct method. The input data is given
in the next table.
We fixed market value leverage and that defines the value of debt as D%×VL. This
creates a circularity which can be solved very easily. The calculation of a PV in this way
involves iterative solution (circularity in MS Excel™). To solve circularity in MS Excel™,
go to Tools Options Calculations tick Iteration and construct the required
formulas with the circularity and MS Excel™ will solve it.
Hypothetical Financial statements without effect of D%BV
Income Statement
Year 1 2 3 4
Sales revenues 500.00 545.90 590.23 631.90
Cost of goods sold -200.00 -218.36 -236.09 -252.76
Gross Income 300.00 327.54 354.14 379.14
Depreciation charge -162.50 -162.50 -162.50 -162.50
EBIT 137.50 165.04 191.64 216.64
Interest payments -54.26 -58.82 -63.40 -68.05
EBT 83.24 106.22 128.23 148.59
Income Taxes -29.13 -37.18 -44.88 -52.01
Net Income 54.10 69.04 83.35 96.58
Balance Sheet
Year 0 1 2 3 4
Accounts receivable. AR 0.00 0.00 0.00 0.00
Fixed Assets 650.00 812.50 975.00 1.137.50 1.300.00
Cumulated Depreciation -162.50 -325.00 -487.50 -650.00
Net fixed assets 650.00 650.00 650.00 650.00 650.00
Total assets 650.00 650.00 650.00 650.00 650.00
Accounts payable. AP - - - -
Debt 484.50 525.15 566.10 607.56
Equity 165.50 165.50 165.50 165.50 165.50
Retained earnings 0.00 0.00 0.00 0.00
Repurchase of equity -40.65 -81.60 -123.06 484.50
Net equity 165.50 124.85 83.90 42.44 650.00
Total liabilities and equity 650.00 650.00 650.00 650.00 650.00
17
Cash budget
Year 0 1 2 3 4
Inflow from AR 0.00 0.00 0.00 0.00
Sales in cash 500.00 545.90 590.23 631.90
Payments to suppliers -200.00 -218.36 -236.09 -252.76
Outflow from AP 0.00 0.00 0.00 0.00
Capital investment -650.00 -162.50 -162.50 -162.50 -162.50
Taxes -29.13 -37.18 -44.88 -52.01
Net Cash Balance -650.00 108.37 127.86 146.75 164.63
Loan inflows 484.50
Principal payment 40.65 40.94 41.46 -607.56
Net Cash Balance 484.50 -13.61 -17.87 -21.94 -675.60
Equity investment 165.50
Dividends -54.10 -69.04 -83.35 -96.58
Net Cash Balance 165.50 -94.76 -109.99 -124.81 510.97
Cumulated Net Cash Balance 0.00 0.00 0.00 0.00 0.00
Financial Statements with the effect of D%BV in Gross Margin

Income Statement
Year 1 2 3 4
Sales revenues 500.00 545.90 590.23 631.90
Cost of goods sold -200.00 -218.39 -236.12 -252.79
Gross Income 300.00 327.51 354.11 379.11
Depreciation charge -162.50 -162.50 -162.50 -162.50
EBIT 137.50 165.01 191.61 216.61
EBT 83.24 106.20 128.21 148.57
Income Taxes -29.14 -37.17 -44.87 -52.00
Net Income 54.11 69.03 83.34 96.57
Balance Sheet
Year 0 1 2 3 4
Accounts receivable, AR 0.00 0.00 0.00 0.00 0.00
Fixed Assets 650.00 812.50 975.00 1.137.50 1.300.00
Cumulated Depreciation -162.50 -325.00 -487.50 -650.00
Net fixed assets 650.00 650.00 650.00 650.00 650.00
Total assets 650.00 650.00 650.00 650.00 650.00
Accounts payable, AP 0.00 0.00 0.00 0.00

Debt 484.43 525.08 566.02 607.47
Equity 165.57 165.57 165.57 165.57 165.57
Retained earnings -0.00 -0.00 0.00 -0.00
Net equity 165.57 124.92 83.98 42.53 650.00
Total liabilities and equity 650.00 650.00 650.00 650.00 650.00
18
Cash Budget
Year 0 1 2 3 4
Inflow from AR 0.00 0.00 0.00 0.00
Sales in cash 500.00 545.90 590.23 631.90
Payments to suppliers -200.00 -218.39 -236.12 -252.79
Outflow from AP 0.00 0.00 0.00 0.00
Capital investment -650.00 -162.50 -162.50 -162.50 -162.50
Taxes -29.14 -37.17 -44.87 -52.00
Net Cash Balance -650.00 108.36 127.84 146.73 164.61
Loan inflows 484.43
Principal payment 40.64 40.94 41.45 -607.47
Net Cash Balance 484.43 -13.61 -17.87 -21.94 -675.51
Equity investment 165.57
Dividends -54.11 -69.03 -83.34 -96.57
Net Cash Balance 165.57 -94.75 -109.97 -124.79 510.90
Cumulated Net Cash Balance 0.00 0.00 0.00 0.00 0.00
19

Some Evidence of BC and OCS

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Some Evidence of BC and OCS

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Some Evidence on Financial Distress Costs and Their Effect on Cash Flows

First Version: October 24, 2006

JEL codes: D61, G31, H43

VL = VUn+VTS = VEquity L+VDebt (2)

3. Decrease in sales revenues o loss of market share.

Exhibit 1. Proposed and traditional methods

• Growth of liabilities of 100% between 1996 and 1999.

i) Real growth in sales

iii) Payment terms from suppliers

5 Testing the hypothesis

5.2 “Proxies” for the dependent variables

Where GM is the gross margin, GI is Gross Income and S is sales revenues

Proxy for payment terms from suppliers

5.3 Independent Variables

Other elements in the equations are

• Ln (D%BVt-1): Natural or neperian Logarithm of D%BVt-1

Model 2 (log-log) Model with 683 firms 7 years, OLS

7.1 Model with GM (based in Data Panel analysis)

Firm Value vs D% at market value

Value of the firm

Exhibit 2. Value of firm versus market leverage, D%

44. Vélez-Pareja, Ignacio. 2006a, Decisiones de Inversión. Para la Valoración Proyectos y

Financial Statements with the effect of D%BV in Gross Margin

Accounts payable, AP 0.00 0.00 0.00 0.00

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