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Capital Structure

Finance 100
Prof. Michael R. Roberts

Copyright 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
Copyright Michael R. Roberts

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The Intuition Behind M&M


Buy a house today for $100,000 and sell one year later Assume mortgage rate is 10%
House Price Prob 1/3 1/3 1/3 Avg. SD Change -10% 10% 45% 15% 23%
(New Price)

Size of Mortgage 0% -10% 10% 45% 15% 23%


(What we owe)

50% -30% 10% 80% 20% 45%


(What we paid)

90% -190% 10% 360% 60% 227%

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


Copyright Michael R. Roberts

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

What does change with the size of the mortgage?

Copyright Michael R. Roberts

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Financing Investment Example


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 0 Date 1 Strong Weak Economy Economy 0 0 0 ? 1400 900 1000 1400 900

Debt (D) Equity (E) Firm

Copyright Michael R. Roberts

All Equity Financing Example (Cont.)


What is the project NPV ? How much equity can we raise? What are the entrepreneurs profits ? What are returns to shareholders (in both states and expectation)?

Copyright Michael R. Roberts

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Debt and Equity Financing Example (Cont.)


Now suppose borrow $500, in addition to selling equity ? Note: Project Cash Flows > Debt Owed in each state Payoffs to Debt and Equity
Date 0 Date 1 Strong Weak Economy Economy 500 525 525 ? 875 375 1000 1400 900

Debt (D) Equity (E) Firm

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!

Copyright Michael R. Roberts

Effect of Leverage on Risk and Return Example (Cont.)


Why isnt the value of equity Look at the returns to shareholders now
Date 0

1 ( 0.5 875 + 0.5 375 ) = 543 1.15


Date 1 Returns Strong Weak Strong Weak Expected Economy Economy Economy Economy Return 500 525 525 5% 5% 5% 500 875 375 75% -25% 25% 1000 1400 900 40% -10% 15%

Debt (D) Equity (E) Firm

Levered equity carries a higher risk premium than unlevered equity rE15% anymore Levered equity = higher risk = higher return (25%)
This is not due to default risk! (Debt is risk-free) Project risk is the same 15%

Copyright Michael R. Roberts

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Homemade Leverage Replicating 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
Date 0 Date 1 Strong Weak Economy Economy 1000 1400 900 -500 525 525 500 875 375

Unlevered E Margin Loan Levered Equity

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

Copyright Michael R. Roberts

Homemade Leverage Replicating Unlevered Equity


Imagine entrepreneur creates levered firm, but investor wants unlevered equity
Investor just has to buy both debt and equity in the firm
Date 0 Date 1 Strong Weak Economy Economy 500 525 525 500 875 375 1000 1400 900

Debt Levered Equity Levered Equity

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 dont benefit investors dont affect firm value
Copyright Michael R. Roberts 10

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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 doesnt matter.) Only thing that matters for value (size of the pie) is the PV of the cash flowsdoesnt matter how you divide them up (slice the pie)
Debt Equity

Equity

Debt

Equity

Copyright Michael R. Roberts 11

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:
E D RE + RD = RU = RA E+D E+D

But this implies:


RE = RU
Risk without leverage

D ( RU RD ) E
Additional risk due to leverage
Copyright Michael R. Roberts 12

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M&M II Leverage, 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

rE = rA +

D ( rA rD ) E

The WACC,
rWACC = rA = E D rE + rD = rU E+D E+D

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)

Copyright Michael R. Roberts 13

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
Copyright Michael R. Roberts 14

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Reducing Leverage and the Cost of Capital Example

El Pasos 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 = ?

Copyright Michael R. Roberts 15

Levered and Unlevered Betas


Everything we did with returns (rD, rE, rA), we can do with betas (D, E, A):
WACC = A =
E D E + D = U E+D E+D

E = A +

D ( A D ) E

Unlevering beta refers to the process of removing the effects of financial leverage from E to obtain a beta that captures only asset risk, A
Copyright Michael R. Roberts 16

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Levered and Unlevered Betas Examples from the Airline Industry

Copyright Michael R. Roberts 17

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?

Copyright Michael R. Roberts 18

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Implications of Leverage for EPS Example (Cont.)


Initial EPS:
LVIs 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 = ?

Copyright Michael R. Roberts 19

Leverage and EPS: A Closer Look Example (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 = ?

Copyright Michael R. Roberts 20

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Leverage and EPS: A Picture

Average EPS is higher for levered firm Risk is higher (steeper line) for levered firm
Copyright Michael R. Roberts 21

Leverage and Stock Price Example (Cont.)


Assume:
LVIs 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 = ?
Copyright Michael R. Roberts 22

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


Levered:
Recall: Issue $15mil debt to repo $15mil of equity @ $7.50/shr
buyback $15mil/$7.50/shr = 2mil shr remaining after buyback 10mil 2mil = 8mil shares

M&M I

New Market Cap = ?

New D/E ratio = ?

M&M II: New rE = ? Earnings Interest = ?


New EPS = ?

New Share Price = ?

Intuition:

Copyright Michael R. Roberts 23

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 firms 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?

Copyright Michael R. Roberts 24

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Effect of Equity Issuances on Stock Prices

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

Copyright Michael R. Roberts 25

Capital Structure in Perfect Capital Markets Summing 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)

Copyright Michael R. Roberts 26

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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. 2. 3. 4. 5. no taxes, no bankruptcy costs, no agency costs/benefits, no information asymmetry, and no transaction costs 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

What the !@#$% ? Whats the point of this?

Copyright Michael R. Roberts 27

Debt and Taxes


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

Safeways 2005 net income is lower with leverage than without and
Copyright Michael R. Roberts 28

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Debt and Taxes (Cont.)


equity is lower with leverage than without But, Safeway has greater value with leverage!

Whats 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% $400mil = $140mil
Copyright Michael R. Roberts 29

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 firms debt forecast of interest payments With forecasted interested payments interest tax shield Discount the interest tax shield at the appropriate risk-adjusted rate
Copyright Michael R. Roberts 30

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Present Value of Interest Tax Shield Example

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

Copyright Michael R. Roberts 31

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
PV (Interest Tax Shield) =

C Interest
rD

C ( rD D )
rD

= C D

Implication: For every $1 of debt issues, firm value C


Copyright Michael R. Roberts 32

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Leverage Recapitalization Revisited Example


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?

Copyright Michael R. Roberts 33

Leverage Recapitalization Revisited Example (Cont.)


Before Recap:
VA = VU = E = ?

After Recap:
PV(interest tax shield) = CD = ? VL = VU + CD = ? E = VL D = ?

Copyright Michael R. Roberts 34

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Leverage Recapitalization Revisited Example (Cont.)


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 =?

Copyright Michael R. Roberts 35

Leverage Recapitalization Revisited A 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 Midcos 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

Copyright Michael R. Roberts 36

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The WACC with Taxes


Tax deductibility of interest effectively lowers the cost of debt, rD, to rD(1-C) Example:

rA =

Firm with 35% MTR borrower $100,000 @ 10% pa Interest expense = rD x $100,000 = $10,000 Tax savings = - C x rD x $100,000 = -$3,500 After-tax cost of debt = rD(1-C) x $100,000 = $6,500

WACC with taxes:


E D E D D rE + rD (1 C ) = rE + rD rD C E+D E+D E+D E+D E+D
Pre-tax WACC Reduction due to Interest Tax Shield
Copyright Michael R. Roberts 37

The WACC with and Without Corporate Taxes

Copyright Michael R. Roberts 38

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Personal Taxes
Double taxation of equity income:
Cash flows to firm taxed at C and then again at the personal rate P 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.

Copyright Michael R. Roberts 39

Top Federal Tax Rates in the US 1971-2005

Copyright Michael R. Roberts 40

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

Copyright Michael R. Roberts 41

Including Personal Taxes in the Interest Tax Shield


Every $1 received after taxes by debt holders from interest payments costs equity holders $(1-*) on an after tax basis
After-Tax Cash Flows To Debt Holders To Equity Holders (1-I) (1-C)(1-E) Using 2005 Tax Rates (1-0.35)=0.65 (1-0.35)(1-0.15)=0.5525

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

(1 i ) (1 c )(1 e ) = 1 (1 c )(1 e ) (1 i ) (1 i )
Copyright Michael R. Roberts 42

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Value of Interest Tax Shield


with Personal Taxes
Value of levered firm (with personal taxes & permanent debt):
VL = VU+*D Because of the personal tax disadvantage of debt, * < C This means that the benefit of leverage is reduced!

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

rwacc =

E D rE + rD (1 c ) E + D E + D

with personal taxes the firms equity and debt costs of capital will adjust to compensate investors for their respective tax burdens.
Copyright Michael R. Roberts 43

Value of Interest Tax Shield Practical 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


Copyright Michael R. Roberts 44

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So, Do Firms Prefer Debt?


In aggregate, firms prefer debt to equity for external financing

Copyright Michael R. Roberts 45

Corporate Debt Usage Average Leverage Ratios

Copyright Michael R. Roberts 46

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Average Debt to Value Ratios By Industry

Copyright Michael R. Roberts 47

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

Copyright Michael R. Roberts 48

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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

Copyright Michael R. Roberts 49

Limits of Tax Benefit of Debt


We can quantify the tax disadvantage for excess interest payments (Assuming theres no reduction in corporate tax for excess interest payments & investors will pay higher personal taxes with excess leverage):
ex = 1

This is < 0 because equity is taxed less heavily than interest for investors (e < i) 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 e ) i = e < 0 (1 i ) (1 i )

Copyright Michael R. Roberts 50

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Limits of Tax Benefit of Debt Practical 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 firms interest expense approaches its expected taxable earnings, the marginal tax advantage of debt declines, limiting the amount of debt the firm should use.
Copyright Michael R. Roberts 51

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.

Interest = rD Debt EBIT or Debt EBIT / rD

From a tax perspective, the firms optimal level of debt is proportional to its current earnings. However, the value of the firms 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 firms capital structure [D / (E + D)] will be lower, the higher the firms growth rate.
Copyright Michael R. Roberts 52

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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.
Copyright Michael R. Roberts 53

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

Copyright Michael R. Roberts 54

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Are Firms Underlevered?


Notice:
Ratio of interest to EBIT is increasingconsistent 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

Whats missing? Why is leverage so low if there is such a big benefit to minimizing taxes? One possibility = ?

Copyright Michael R. Roberts 55

Capital Structure with Taxes Summing it Up


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

Optimal debt shields all taxable income Firms appear very conservative if taxes are the only consideration There must be something more than just taxes
Copyright Michael R. Roberts 56

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Financial Distress, Default, and Bankruptcy


Financial Distress occurs when a firm has difficulty meeting its debt obligations Default
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

Copyright Michael R. Roberts 57

Default in a Perfect Capital Market Armin 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?

Copyright Michael R. Roberts 58

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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 doesnt have the $100mil in cash at the end of the year, it can always roll over debt in perfect market
Copyright Michael R. Roberts 59

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


Copyright Michael R. Roberts 60

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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 firms capital structure.

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

Copyright Michael R. Roberts 61

Bankruptcy Risk and Firm Value Example

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

With leverage: E= ? D=?


Copyright Michael R. Roberts 62

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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 prebankruptcy assets

Indirect Costs
Loss of
customers suppliers Employees Receivables

Asset fire sales Distinct from Economic Distress costs

Copyright Michael R. Roberts 63

Financial Distress and Firm Value Armin 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 = ?
Copyright Michael R. Roberts 64

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Who Pays for Financial Distress Costs?


If new product fails, shareholders lose their investment but dont 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!)

Copyright Michael R. Roberts 65

Financial Distress and the Stock Price Example

Recall VU = $109.52mil Price/Shr = ? Recall VL = $100mil Price/Shr = ? After Repurchase: D=?


Share price declines in anticipation of this value loss after debt issuance

# of shares repurchased = ? # of shares remaining after repo = ? E =? Price per Share = ?


Copyright Michael R. Roberts 66

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Optimal Capital Structure The Tradeoff Theory


Firms choose their capital structure by trading off the benefits of the tax shield against the costs of financial distress
V L = V U + PV (Interest Tax Shield) PV (Financial Distress Costs)

Two key factors determine costs of financial distress


Probability of entering distress Magnitude of the costs after entering distress

Helps explain why firms dont fully exploit interest tax shield (because of financial distress costs)
Copyright Michael R. Roberts 67

Optimal Capital Structure The Tradeoff Theory

Copyright Michael R. Roberts 68

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Agency Costs
Agency Costs are costs that arise when there are conflicts of interest between the firms stakeholders Different 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
Copyright Michael R. Roberts 69

Asset Substitution or Overinvestment Baxter Inc.


Owes $1mil due at end of year Without a change in strategy, assets will be worth only $0.9mil Baxter will default if they take no action Baxters considering a new strategy:
No upfront investment Success will increase firms assets to $1.3mil w.p. 50% Failure will decrease firms assets to $0.3mil w.p. 50%

This is a negative NPV project since expected value of firms 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 wont undertake the investment?


Copyright Michael R. Roberts 70

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Asset Substitution or Overinvestment Baxter 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 holders money but debt holders will anticipate this and pay less ex ante
Copyright Michael R. Roberts 71

Debt Overhang and Underinvestment Baxter Inc.


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

Problem (?): Baxter doesnt have the cash on hand


Can they raise the money in the equity market?

Copyright Michael R. Roberts 72

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Debt Overhang and Underinvestment Baxter 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 wont undertake it because most of the benefit goes to debt holders Underinvestment or Debt Overhang
Copyright Michael R. Roberts 73

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 decision has 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 its 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.

Copyright Michael R. Roberts 74

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Agency Costs and the Amount of Leverage Example


Scenario 1: Do nothing Firm will be worth ? E= ? Scenario 2: Risky strategy
Old Strategy Success Assets Debt Equity 900 400 500 1300 400 900

D=?
New Risky Strategy Failure 300 300 0 Expected 800 350 450

Equity worth only $0.45mil under risky strategy, $0.5mil under existing so shareholders will reject it
Copyright Michael R. Roberts 75

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


Scenario 3: Conservative strategy
Without New Project Existing Assets New Project Firm Value Debt Equity 900 400 500 900 With New Project 900 150 1050 400 650

Shareholders value increase by $0.15mil for a $0.1mil investment so theyre willing to invest in the project

Copyright Michael R. Roberts 76

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Mitigating Agency Costs


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

Copyright Michael R. Roberts 77

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 investors Leverage 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
Copyright Michael R. Roberts 78

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Agency Costs and the Tradeoff Theory


The value of the levered firm can now be shown to be
V = V U + PV (Interest Tax Shield) PV (Financial Distress Costs)
L

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

Copyright Michael R. Roberts 79

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 Ive pre-committed to pay back the debt Or, I promise not to waste money on inefficient investment since Ive 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 quality Lemons principle: when seller has private information about the value of a good, buyers will discount the price they will pay because of adverse selection Think used cars:
The desire to sell the car suggest it sucks so buyers wont pay much Owners of good cars dont want to sell because buyers will think theyre selling a lemon and offer a low price The quality and prices of cars sold in the used-care market are both low

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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 managements 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

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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 do Next we can figure out what they should do
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