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16-0

What if there are:



1. Financial distress
1. Cost of Financial Distress, taxes and
financial distress: the Trade-Off Theory

2. The Pecking-Order Theory
3. Personal taxes
.
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A Fundamental Question
Why do firms fail to take greater advantage of the
deductibility of corporate interest to increase the
value of their equity?
Possible Answers:
Offsetting costs of financial distress and bankruptcy: The
Traditional Tradeoff Theory
Offsetting personal taxes: The Miller Equilibrium
Offsetting Agency Costs of Debt
16-2
The Traditional Tradeoff Theory
Stages of financial distress:
First-stage: Negative net cash flow and earnings; falling
market equity value
Second-stage: Managements attempts to reduce costs
employee layoffs, temporary plant closings
Third-stage: Late payments to suppliers, employees, and
creditors; more drastic actions such as: (i) issuing new debt
or equity securities, if indeed this would be possible; (ii)
selling assets; (iii) merging with a more successful firm; or
(iv) negotiating with creditors to reschedule debt payments
End-stage: Bankruptcy
16-3
Costs of financial distress:
Direct costs:
Legal and administrative costs
Indirect Costs
Loss of competitiveness in a product/service market
Profitable cap. inv. opportunities passed up
Forced sale of valuable assets, subsidiaries, or divisions to shore up
liquidity
Competitors may push new products and/or lower prices to squeeze the
distressed firm out of business
Concessions to various stakeholders to compensate them for the risk of doing
business with a distressed firm
Suppliers may deny previously granted trade credit
Employees may leave or demand higher pay to stay
Product prices may have to be cut as customers are wary of the firms
warranties
Loss of the value of the interest tax shield (as well as the value of depreciation
as a tax shield)
The Traditional Tradeoff Theory
16-4
Estimating the present value of costs of future
financial distress (CFFD):




Finally, the tradeoff:
The Traditional Tradeoff Theory
CFFD )] FFD .( ob [Pr ) CFFD ( E =
T
cfd
) r 1 (
) CFFD (
)] CFFD ( [ PV
+
=
E
E
| | ) CFFD ( E PV D V V
debt c U L
t + =
16-5
Predictions of the Traditional Tradeoff Theory
Each firms leverage should be fairly stable over time if
the notion of optimal leverage is to have meaning.
A firms operations and financing activities over time
are likely to cause its leverage to change, and thus to
temporarily deviate from the optimal. But mean reversion
should be observed.
Firms with tax-loss carryforwards are less likely to
issue debt.
A firms debt capacity is limited to the value of its
collateralizable assets (basically, PP&E). Other assets,
notably intangible assets, are not collateralizable, and
therefore cannot be financed with debt.
16-6
The Trade-Off Theory of Capital Structure
Finding the optimal capital structure is a trade-off
between the tax shield of debt and costs of
financial distress.
This theory predicts that target ratios of leverage
should be different from firm to firm:
Firms with safe assets and stable earnings should have
high target ratios of leverage.
Firms with large intangible assets and volatile earnings
should have low target ratios.
16-7
Financial Distress and Optimal Capital Structure
Debt (B)
Value of firm (V)
0
Present value of tax
shield on debt
Present value of
financial distress costs
Value of firm under
MM with corporate
taxes 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
16-8
FIGURE 6.4 An Illustration of the Traditional Tradeoff Theory:
Optimal Leverage for Firms A and B Differ Because for the Latter the
PV of Expected Costs of Financial Distress Increases with Leverage at a
Faster Rate
$80
$85
$90
$95
$100
$105
$110
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60
Leverage (D/V, %)
F
i
r
m

V
a
l
u
e
Unlevered Firm Value Value of Firm A Value of Firm B
Optimal Leverage
for Firm A (38%)
Optimal Leverage
for Firm B (16%)
16-9
The Pecking Order Hypothesis and leverage: In the
pecking order theory, there is no well-defined optimal debt
ratio. The attraction of interest tax shields and the threat of
financial distress are assumed second-order. Debt ratios
change when there is an imbalance of internal cash flow, net of
dividends, and real investment opportunities. Highly profitable
firms with limited investment opportunities work down to low
debt ratios. Firms whose investment opportunities outrun
internally generated funds borrow more and more. Changes in
debt ratios are driven by the need for external funds, not by
any attempt to reach an optimal capital structure. [Shyam-
Sunder and Myers (1999),pp. 220-221]
Other Arguments Related to Leverage
16-10
Asymmetric Information
Managers will issue new equity only if they think that it is
overpriced.
Investors are rational.
Whenever there is a new issue of equity, investors will know that the
firms shares are overpriced and revise their opinion about the firms
value.
This leads to pecking order:
Managers will first resort to internal funds,
then debt,
and as a last resort equity.
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Asymmetric Information
This theory explains the observed, inverse relationship
between profitability and the debt-equity ratio:
Profitable firms have large retained earnings and therefore do not
have to issue debt to keep growing.
Less profitable firms have limited (or no) internal funds and have to
issue debt regularly.

Finally, 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

16-12
Growth and the Debt-Equity Ratio
Growth implies significant equity financing, even in
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.
16-13
Personal Taxes: The Miller Model
The Miller Model shows that the value of a levered 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
16-14
Personal Taxes: The Miller Model (cont.)
Thus the Miller Model shows that the value of a levered
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
- In the case where T
B
= T
S
, we return to M&M with
only corporate tax:
B T V V
C U L
+ =
16-15
Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
Debt (B)
V
U

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

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

but (1-T
B
) > (1-T
C
)(1-T
S
)
V
L
=V
U

when (1-T
B
) = (1-T
C
)(1-T
S
)
V
L
< V
U
when (1-T
B
) < (1-T
C
)(1-T
S
)
B
T
T T
V V
B
S C
U L

(


+ =
1
) 1 ( ) 1 (
1
16-16
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
when they lever up.
There are Differences in Capital Structure Across
Industries.
There is evidence that firms behave as if they had
a target Debt to Equity ratio.
16-17
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.
Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.