Post on 08-Apr-2018
transcript
8/7/2019 L11-Capital Structure1
1/29
Capital Structure Limits to the
Use of Debt
RWJ Chp 16
8/7/2019 L11-Capital Structure1
2/29
Costs of Financial Distress
Bankruptcy risk versus bankruptcy cost.
The possibility of bankruptcy has a
negative effect on the value of the firm. However, it is not the risk of bankruptcy
itself that lowers value.
Rather it is the costs associated withbankruptcy.
It is the shareholders who bear these
costs.
8/7/2019 L11-Capital Structure1
3/29
Description of Costs
Direct Costs
Legal and administrative costs (tend to be a
small percentage of firm value).
Indirect Costs Impaired ability to conduct business (e.g., lost
sales)
Agency Costs Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward
underinvestment
Selfish Strategy 3: Milking the property
8/7/2019 L11-Capital Structure1
4/29
Balance Sheet for a Company
in DistressAssets BV MV Liabilities BV MV
Cash RM200 RM200 LT bonds RM300
F.Asset RM400 RM0 Equity RM300
Total RM600 RM200 Total RM600 RM200
What happens if the firm is liquidated today?
The bondholders get RM200; the shareholders get nothing.
RM200
RM0
8/7/2019 L11-Capital Structure1
5/29
Selfish Strategy 1: Take Large
RisksThe Gamble Probability Payoff
Win Big 10% RM1,000
Lose Big 90% RM0
Cost of investment is RM200 (all the firms cash)
Required return is 50%
Expected CF from the Gamble = RM1000 0.10 + RM0 = RM100
133$
50.1
100$200$
!
!
NPV
NPV
8/7/2019 L11-Capital Structure1
6/29
Selfish shareholders Accept Negative
NPV Project with Large Risks
Expected CF from the Gamble
To Bondholders = RM300 0.10 + RM0 = RM30
To shareholders = (RM1000 - RM300) 0.10 +
RM0 = RM70
PV of Bonds Without the Gamble = RM200
PV of Stocks Without the Gamble = RM0
PV of Bonds With the Gamble = RM30 / 1.5 = RM20
PV of Stocks With the Gamble = RM70 / 1.5 = RM47
8/7/2019 L11-Capital Structure1
7/29
Selfish Strategy 2:
Underinvestment Consider a government-sponsored project that
guarantees RM350 in one period
Cost of investment is RM300 (the firm only has RM200
now) so the shareholders will have to supply anadditional RM100 to finance the project
Required return is 10%
18.18$10.1
350$300$
!
!
NPV
NPV
yShould we accept or reject?
8/7/2019 L11-Capital Structure1
8/29
Selfish shareholders Forego Positive
NPV Project
Expected CF from the government sponsored project:
To Bondholder = RM300
To Stockholder = (RM350 - RM300) = RM50
PVof Bonds Without the Project = RM200
PVof Stocks Without the Project = RM0
PVof Bonds With the Project = RM300 / 1.1 = RM272.73
PVof Stocks with the project = RM50 / 1.1 - RM100 = -
RM54.55
8/7/2019 L11-Capital Structure1
9/29
Selfish Strategy 3: Milking the
Property Liquidating dividends
Suppose our firm paid out a RM200 dividend
to the shareholders. This leaves the firminsolvent, with nothing for the bondholders, but
plenty for the former shareholders.
Such tactics often violate bond indentures.
Increase perquisites to shareholders
and/or management
8/7/2019 L11-Capital Structure1
10/29
Can Costs of Debt Be Reduced?
Protective Covenants
Debt Consolidation:
If we minimize the number of parties,contracting costs fall.
8/7/2019 L11-Capital Structure1
11/29
Protective Covenants
Agreements to protect bondholders Negative covenant: Thou shalt not:
Pay dividends beyond specified amount.
Sell more senior debt & amount of new debt is
limited. Refund existing bond issue with new bonds payinglower interest rate.
Buy another companys bonds.
Positive covenant: Thou shall:
Use proceeds from sale of assets for other assets.
Allow redemption in event of merger or spinoff.
Maintain good condition of assets.
Provide audited financial information.
8/7/2019 L11-Capital Structure1
12/29
Integration of Tax Effects and Financial
Distress Costs
There is a trade-off between the tax
advantage of debt and the costs of
financial distress.
It is difficult to express this with a precise
and rigorous formula.
8/7/2019 L11-Capital Structure1
13/29
Integration of Tax Effects and Financial
Distress Costs
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL
= VU
+ TCB
V= Actual value of firm
VU
= Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
8/7/2019 L11-Capital Structure1
14/29
The Pie Model Revisited
Taxes and bankruptcy costs can be viewed as justanother claim on the cash flows of the firm.
Let G and L stand for payments to the government andbankruptcy lawyers, respectively.
VT= S + B + G + L
The essence of the M&M intuition is that VTdepends onthe cash flow of the firm; capital structure just slices the
pie.
S
G
B
L
8/7/2019 L11-Capital Structure1
15/29
Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
An individual will work harder for a firm if he is one of
the owners than if he is one of the hired help.
Who bears the burden of these agency costs?
While managers may have motive to partake inperquisites, they also need opportunity. Free cash flow
provides this opportunity.
The free cash flow hypothesis says that an increase in
dividends should benefit the shareholders by reducingthe ability of managers to pursue wasteful activities.
The free cash flow hypothesis also argues that an
increase in debt will reduce the ability of managers to
pursue wasteful activities more effectively than
dividend increases.
8/7/2019 L11-Capital Structure1
16/29
8/7/2019 L11-Capital Structure1
17/29
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 realworld; as a result, 100% debt financing is
sub-optimal.
8/7/2019 L11-Capital Structure1
18/29
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:
BT
TTVV
B
SC
UL v
v!
1)1()1(1
Where:
TS= personal tax rate on equity income
TB = personal tax rate on bond income
TC= corporate tax rate
8/7/2019 L11-Capital Structure1
19/29
Personal Taxes: The Miller Model
The derivation is straightforward:
)1()1()(
receivefirmleveredainrsShareholde
SCBTTBrEBIT vv
)1(
receivesBondholder
BBTBr v
)1()1()1()(
isrsstakeholdealltoflowcashtotaltheThus,
BBSCB
TBrTTBrEBIT vvv
vvvvv
B
SC
BBSC
T
TTTBrTTEBIT
1
)1()1(1)1()1()1(
asrewrittenbecanThis
Continued
8/7/2019 L11-Capital Structure1
20/29
Personal Taxes: The Miller Model (cont.)
vvvvv
B
SC
BBSC
T
TTTBrTTEBIT
1
)1()1(1)1()1()1(
The first term is the cashflow of an unlevered firm
after all taxes.
Its value = VU.
A bond is worth B.It promises topay r
BB(1- T
B) after taxes. Thus
the value of the second term is:
v
v B
SC
T
TTB
1
)1()1(
1
The total cash flow to all stakeholders in the leveredfirm is:
The value of the sum of these
two terms must be VL
T
TTVV
Lv
v!@
1
)1()1(1
8/7/2019 L11-Capital Structure1
21/29
Personal Taxes: The Miller Model (cont.)
Thus the Miller Model shows that the value of alevered firm can be expressed in terms of an
unlevered firm as:
BT
TT
B
SCUL v
v! 1
)1()1(1
y In the case where TB = TS, we return to M&M withonly corporate tax:
BT!
8/7/2019 L11-Capital Structure1
22/29
Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
Debt (B)
VU
VL
= VU+T
CB when T
S=T
B
VL
< VU
+ TCB
when TS< T
B
but (1-TB
> (1-TC(1-T
S
VL
=VU
when (1-TB
= (1-TC(1-T
S
VL
< VU
when (1-TB
< (1-TC(1-T
S
BT
TTVV
B
SC
ULv
v!
1
)1()1(1
8/7/2019 L11-Capital Structure1
23/29
Integration of Personal and Corporate Tax Effects
and Financial Distress Costs and Agency Costs
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs Value of firm under
MM with corporatetaxes and debt
VL
= VU
+ TCB
V= Actual value of firm
VU
= Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
VL
< VU
+ TCB
when TS< T
B
but (1-TB
> (1-TC(1-T
S
Agency Cost of Equity Agency Cost of Debt
8/7/2019 L11-Capital Structure1
24/29
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 withtaxes.
Another interpretation is that firms signal good newswhen they lever up.
There are Differences in Capital Structure AcrossIndustries.
There is evidence that firms behave as if they had atarget Debt to Equity ratio.
8/7/2019 L11-Capital Structure1
25/29
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 ofassets 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.
8/7/2019 L11-Capital Structure1
26/29
Summary and Conclusions
Costs of financial distress cause firms to restrain theirissuance of debt.
Direct costs
Lawyers and accountants fees
Indirect Costs
Impaired ability to conduct business
Incentives to take on risky projects
Incentives to underinvest
Incentive to milk the property
Three techniques to reduce these costs are: Protective covenants
Repurchase of debt prior to bankruptcy
Consolidation of debt
8/7/2019 L11-Capital Structure1
27/29
Summary and Conclusions
Because costs of financial distress can bereduced but not eliminated, firms will not
finance entirely with debt.
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL= VU + TCB
V= Actual value of firm
VU
= Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
8/7/2019 L11-Capital Structure1
28/29
Summary and Conclusions If distributions to equity holders are taxed at a lower
effective personal tax rate than interest, the tax advantageto debt at the corporate level is partially offset. In fact, the
corporate advantage to debt is eliminated if (1-TC) (1-TS) =
(1-TB)
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value of
financial distress costs Value of firm underMM with corporatetaxes and debt
VL
= VU
+ TCB
V= Actual value of firm
VU= Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
VL
< VU
+ TCB when T
S< T
B
but (1-TB
> (1-TC(1-T
S
Agency Cost of Equity Agency Cost of Debt
8/7/2019 L11-Capital Structure1
29/29
Summary and Conclusions
Debt-to-equity ratios vary across industries.
Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholdertax 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 operatingincome have high probability of experiencingfinancial distress.