1. Capital Structure I. Financial Distress, Managerial Incentives and Information

Debt financing puts an obligation on a firm. A firm that fails to make the required inter- est or principal payments on the debt is in default.

After the firm defaults, debt holders are given certain rights to the assets of the firm. In the extreme case, the debt holders take legal ownership of the firm’s assets through a process called bankruptcy. Recall that equity financing does not carry this risk. While equity holders hope to receive dividends, the firm is not legally obligated to pay them.

When a firm has trouble meeting its debt obligations

This scenario shows that if a firm has access to capital markets and can issue new securities at a fair price, then it need not default as long as the market value of its assets exceeds its liabilities.

That is, whether default occurs depends on the relative values of the firm’s assets and liabilities,

not on its cash flows. Many firms experience years of negative cash flows yet remain solvent.

n bankruptcy, debt holders will receive legal ownership of the firm’s assets, leaving Armin’s shareholders with nothing. Because the assets the debt holders receive have a value of $80 million, they will suffer a loss of $20 million relative to the $100 million they were owed. Equity holders in a corporation have limited liability, so the debt holders cannot sue Armin’s shareholders for this $20 million—they must accept the loss.

if the new product fails, Armin’s investors are equally unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and the share price declines.

That is, if the new product fails, Armin will experience economic distress, which is a significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

Wert der entgangenen Zahlungen an die FK-Geber

Im Ausfall-Zustand entgehen X

Dies ist der Unterschiedsbetrag zwischen dem Wert des nicht ausfallbedrohten FK und dem tatsächlichen Wert

By purchasing fairly priced credit insurance (its costs would bbe the default put option value) creditors could create a risk free position Dnom1

The total value to all investors does not depend on the firm’s capital structure. Investors as a group are not worse off because a firm has leverage. While it is true that bankruptcy results from a firm having leverage, bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.

With or without leverage, the total value of the securities is the same, verifying MM Proposition I. The firm is able to raise the same amount from investors using either capital structure.

In Chapter 7 liquidation, a trustee is appointed to oversee the liquidation of the firm’s assets through an auction. The proceeds from the liquidation are used to pay the firm’s creditors, and the firm ceases to exist.

In the more common form of bankruptcy for large corporations, Chapter 11 reorganization, all pending collection attempts are automatically suspended, and the firm’s existing management is given the opportunity to propose a reorganization plan. While de- veloping the plan, management continues to operate the business. The reorganization plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated. The creditors must vote to accept the plan, and it must be approved by the bankruptcy court.

If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm.

Because most firms have multiple creditors, without coordination it is difficult to guarantee that each creditor will be treated fairly. Moreover, because the assets of the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm.

-Process is complex, time-consuming and costly

-Costly experts are often hired by the firm to assist with the bankruptcy process

-Creditors also incur costs during the bankruptcy process

-They may wait several years to receive payment

-The may hire their own experts for legal and professional advice (Paid by them or firm - Both reduces value)

-The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive (the average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets).

-Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy by first negotiating directly with creditors.

-Workout

-A method for avoiding bankruptcy in which a firm in financial distress negotiates directly with its creditors to reorganize.

-The costs of a workout should not exceed the direct costs of bankruptcy.

-Prepacked bankruptcy

-Firm will first develop a reorganization plan with the agreement of its main creditors, and then file Chapter 11 to implement the plan (And pressure any creditors who attemt to hold out for better terms)

-With a prepack, the firm emerges from bankruptcy quickly and with minimal direct costs

Although the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy:

• Loss of Customers

• Loss of Suppliers

• Loss of Employees

• Loss of Receivables

• Fire Sale of Assets

• Delayed Liquidation

• Costs to Creditors

The costs of financial distress described in the previous section represent an important departure from Modigliani and Miller’s assumption of perfect capital markets. MM assumed that the cash flows of a firm’s assets do not depend on its choice of capital structure. As we have discussed, however, levered firms risk incurring financial distress costs that reduce the cash flows available to investors.

It is true that after a firm is in bankruptcy, equity holders care little about bankruptcy costs. But debt holders are not foolish—they recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially. How much less? Precisely the amount they will ultimately give up—the present value of the bankruptcy costs.

But if the debt holders pay less for the debt, there is less money available for the firm to pay dividends, repurchase shares, and make investments. That is, this difference is money out of the equity holders’ pockets. This logic leads to the following general result:

When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress.

The tradeoff theory weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage.

According to this theory, the total value of a levered firm equals the value of the firm with- out leverage plus the present value of the tax savings from debt, less the present value of financial distress costs

Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs.

(1) the probability of financial distress

(2) the magnitude of the costs if the firm is in distress

(3) the appropriate discount rate for the distress costs

The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default. This probability increases with the amount of a firm’s liabilities (relative to its as- sets). It also increases with the volatility of a firm’s cash flows and asset values. Thus, firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much lower levels of debt to avoid a significant risk of default.

The magnitude of the financial distress costs will depend on the relative importance of the costs discussed in Section 16.2, and is also likely to vary by industry. For example, firms, such as technology firms, whose value comes largely from human capital, are likely to incur high costs when they risk financial distress, due to the potential for loss of customers and the need to hire and retain key personnel, as well as a lack of tangible assets that can be eas- ily liquidated. In contrast, firms whose main assets are physical capital, such as real estate firms, are likely to have lower costs of financial distress, because a greater portion of their value derives from assets that can be sold relatively easily.

Finally, the discount rate for the distress costs will depend on the firm’s market risk. Note that because distress costs are high when the firm does poorly, the beta of distress costs will have an opposite sign to that of the firm.18 Also, the higher the firm’s beta, the more likely it will be in distress in an economic downturn, and thus the more negative the beta of its distress costs will be. Because a more negative beta leads to a lower cost of capi- tal (below the risk-free rate), other things equal the present value of distress costs will be higher for high beta firms.

Optimal Leverage with Taxes and Financial Distress Costs As the level of debt, D, in- creases, the tax benefits of debt increase by t*D until the interest expense exceeds the firm’s EBIT (see Figure 15.8). The probability of default, and hence the present value of financial distress costs, also increase with D. The optimal level of debt, D*, occurs when these effects balance out and V L is maximized. D* will be lower for firms with higher costs of financial distress.

The costs of financial distress reduce the value of the levered firm, V L. The amount of the reduction increases with the probability of default, which in turn increases with the level of the debt D. The tradeoff theory states that firms should increase their leverage until it reaches the level D * for which V L is maximized. At this point, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

First, the presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield.

Second, differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.

That said, bankruptcy costs alone are not sufficient to explain all of the variation observed. As we will explore in subsequent sec- tions, an even more significant cost of leverage may arise well before financial distress, in the form of conflicts between the firm’s investors.

agency costs—costs that arise when there are conflicts of interest between stakeholders. Because top managers often hold shares in the firm and are hired and retained with the approval of the board of directors, which itself is elected by shareholders, managers will generally make decisions that increase the value of the firm’s equity. When a firm has leverage, a conflict of inter- est exists if investment decisions have different consequences for the value of equity and the value of debt.

Because leverage gives shareholders an incentive to replace low-risk assets with riskier ones, this result is often referred to as the asset substitution problem.20 It can also lead to over-investment, as shareholders may gain if the firm undertakes negative-NPV, but suf- ficiently risky, projects.

In either case, if the firm increases risk through a negative-NPV decision or investment, the total value of the firm will be reduced. Anticipating this bad behavior, security holders will pay less for the firm initially. This cost is likely to be highest for firms that can easily increase the risk of their investments.

Effectively, the equity holders are gambling with the debt holders’ money.

This example illustrates a general point: When a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently, even if they have a negative NPV.

When a firm faces financial distress, it may choose not to finance new, positive-NPV projects. In this case, when shareholders prefer not to invest in a positive-NPV project, we say there is a debt overhang or under-investment problem. This failure to invest is costly for debt holders and for the overall value of the firm, because it is giving up the NPV of the missed oppor- tunities. The cost is highest for firms that are likely to have profitable future growth opportunities requiring large investments.

When a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm if possible. This incentive to liquidate assets at prices below their actual value to the firm is an extreme form of under- investment resulting from the debt overhang.

But, as with financial distress costs, it is the shareholders of the firm who ultimately bear these agency costs. Although equity holders may benefit at debt holders’ expense from these negative-NPV decisions in times of distress, debt holders recognize this possibility and pay less for the debt when it is first issued, reducing the amount the firm can distribute to shareholders. The net effect is a reduction in the initial share price of the firm corresponding to the negative NPV of the decisions.

These agency costs of debt can arise only if there is some chance the firm will default and impose losses on its debt holders. The magnitude of the agency costs increases with the risk, and therefore the amount, of the firm’s debt. Agency costs, therefore, represent another cost of increasing the firm’s leverage that will affect the firm’s optimal capital structure choice.

The leverage ratchet effect captures these observations: Once existing debt is in place, (1) shareholders may have an incentive to increase leverage even if it decreases the value of the firm, and (2) shareholders will not have an incentive to decrease leverage by buy- ing back debt, even if it will increase the value of the firm.23 The leverage ratchet effect is an important additional agency cost of leverage which affects the firm’s future financing decisions (rather than its investment decisions). While it will induce firms to borrow less initially in order to avoid these costs, over time it may lead to excessive leverage as share- holders prefer to increase, but not decrease, the firm’s debt.

when an unlevered firm issues new debt, equity holders will bear any anticipated agency or bankruptcy costs via a discount in the price they receive for that new debt. This discount deters the firm from taking on high leverage initially if doing so would reduce the value of the firm.

But once a firm has debt already in place, some of the agency or bankruptcy costs that result from taking on additional leverage will fall on existing debt holders. Because that debt has already been sold, the negative consequences for these debt holders will not be borne by shareholders. As a result, shareholders may benefit from taking on higher leverage even though it might reduce the total value of the firm.

In addition, debt overhang will inhibit firms from reducing leverage once it is in place, even if leverage is excessive.

The reason equity holders do not gain by reducing debt in Example 16.7 is that in order to buy back the debt, the company must pay its post-transaction market value, which in- includes the value of the anticipated investment. A similar outcome would apply to the case of excessive risk-taking. By reducing debt, equity holders lose their incentive to take on a risky negative NPV investment. While this effect increases the value of the firm, equity holders would not gain, as they would be forced to pay a price for the debt that reflects the value of eliminating the incentives for excessive risk-taking.

First, note that the magnitude of agency costs likely depends on the maturity of debt. With long-term debt, equity holders have more opportunities to profit at the debt holders’ expense before the debt matures. Thus, agency costs are smallest for short-term debt.

Second, as a condition of making a loan, creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants. Covenants may limit the firm’s ability to pay large dividends or restrict the types of investments that the firm can make. They also typically limit the amount of new debt the firm can take on.

This separation of ownership and control creates the possibility of management entrenchment: facing little threat of being fired and replaced, managers are free to run the firm in their own best interests. As a result, managers may make decisions that benefit themselves at investors’ expense. In this section, we consider how leverage can provide incentives for managers to run the firm more efficiently and effectively. The benefits we describe in this section, in addition to the tax benefits of leverage, give the firm an incen- tive to use debt rather than equity financing.

One advantage of using leverage is that it allows the original owners of the firm to maintain their equity stake. As major shareholders, they will have a strong interest in doing what is best for the firm.

Any decision the owner makes that increases the value of the firm by $1 increases the value of his own stake by $1.

Problems when dispersing ownership:

-Less hard working

-Enjoying perks

The costs of reduced effort and excessive spending on perks are another form of agency cost. These agency costs arise in this case due to the dilution of ownership that occurs when equity financing is used. Who pays these agency costs? As always, if securities are fairly priced, the original owners of the firm pay the cost.

1. Original owners retire and new managers will likely not hold a large ownership stake

2. Firms often need to raise more capital for investment

3. Owners often sell off their stakes and invest in a well-diversified portfolio to reduce risk

-> Low ownership stakes increase the potential for conflict of interest between managers and equity holders

Some financial economists explain a manager’s willingness to engage in negative-NPV investments as empire building. According to this view, managers prefer to run large firms rather than small ones, so they will take on investments that increase the size—rather than the profitability—of the firm.

-One potential reason for this preference is that managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

-Another reason that managers may over-invest is that they are overconfident. Even when managers attempt to act in shareholders’ interests, they may make mistakes. Managers tend to be bullish on the firm’s prospects and so may believe that new opportunities are better than they actually are. They may also become committed to investments the firm has already made and continue to invest in projects that should be canceled.29

For managers to engage in wasteful investment, they must have the cash to invest. This observation is the basis of the free cash flow hypothesis, the view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed to make all positive-NPV investments and payments to debt holders.30 Only when cash is tight will managers be motivated to run the firm as efficiently as possible.

hypothesis, leverage increases firm value because it commits the firm to making future in- terest payments, thereby reducing excess cash flows and wasteful investment by managers. A related idea is that leverage can reduce the degree of managerial entrenchment be- cause managers are more likely to be fired when a firm faces financial distress.

In addition, when the firm is highly levered, creditors

themselves will closely monitor the actions of managers, providing an additional layer of management oversight.

Optimal Leverage with Taxes, Financial Distress, and Agency Costs As the level of debt, D, in- creases, the value of the firm increases from the interest tax shield as well as improvements in managerial incentives. If leverage is too high, however, the present value of financial distress costs, as well as the agency costs from debt holder–equity holder conflicts, dominates and reduces firm value. The optimal level of debt, D*, balances these benefits and costs of leverage.

With no debt, the value of the firm is V U. As the debt level increases, the firm benefits from the interest tax shield (which has present value t*D). The firm also benefits from improved incentives for management, which reduce wasteful investment and perks. If the debt level is too large, however, firm value is reduced due to the loss of tax benefits (when interest exceeds EBIT), financial distress costs, and the agency costs of leverage. The optimal level of debt, D*, balances the costs and benefits of leverage.

Too Litte Leverage:

-Lost Tax benefits

-Excessive Perks

-Wasteful investment

-Empire building

Too Much Leverage:

-Excess Interest

-Financial Distress Costs

-Excessive Risk Taking

-Under-investment

R&D-Intensive Firms. Firms with high R&D costs and future growth opportunities typically maintain low debt levels. These firms tend to have low current free cash flows, so they need little debt to provide a tax shield or to control managerial spending. In addition, they tend to have high human capital, so there will be large costs as a result of financial distress. Also, these firms may find it easy to increase the risk of their business strategy (by pursuing a riskier technology) and often need to raise additional capital to fund new invest- ment opportunities. Thus, their agency costs of debt are also high. Biotechnology and technology firms often maintain less than 10% leverage.

Low-Growth, Mature Firms. Mature, low-growth firms with stable cash flows and tan- gible assets often fall into the high-debt category. These firms tend to have high free cash flows with few good investment opportunities. Thus, the tax shield and incentive benefits of leverage are likely to be high. With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value. Examples of low-growth industries in which firms typically maintain greater than 20% leverage include real estate, utilities, and supermarket chains.

First, recall from the leverage ratchet effect discussed earlier that if the firm—perhaps due to negative shocks—has debt that exceeds D*, shareholders will find it costly to reduce leverage because the benefits will accrue to the firm’s creditors.

On the other hand, capital structure decisions, like investment decisions, are made by managers who have their own incentives. Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure primarily to avoid the discipline of debt and maintain their own entrenchment. Thus, managers seek to minimize leverage to prevent the job loss that would accompany financial distress. Of course, if managers sacrifice too much firm value, disgruntled shareholders may try to replace them or sell the firm to an acquirer. Under this hypothesis, firms will have lever- age that is less than the optimal level D*, and increase it toward D* only in response to a takeover threat or the threat of shareholder activism.

Managers’ information about the firm and its future cash flows is likely to be superior to that of outside investors—there is asymmetric information between managers and investors. In this section, we consider how asymmet- ric information may motivate managers to alter a firm’s capital structure.

One potential strategy is to launch an investor relations campaign. Smith can issue press releases, describing the merits of the new innovations and the manufacturing improve- ments. But Smith knows that investors may be skeptical of these press releases if their claims cannot be verified.

Because investors expect her to be biased, to convince the market Smith must take actions that give credible signals of her knowledge of the firm. That is, she must take actions that the market understands she would be unwilling to do unless her statements were true. This idea is more general than manager–investor communication; it is at the heart of much human interaction.

Claims in one’s self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.

This principle is the essence behind the adage, “Actions speak louder than words.” One way a firm can credibly convey its strength to investors is by making statements about its future prospects that investors and analysts can ultimately verify. Because the penalties for intentionally deceiving investors are large,37 investors will generally believe

such statements.

One strategy is to commit the firm to large future debt payments. If Smith is right, then Beltran will have no trouble making the debt payments. But if Smith is making false claims and the firm does not grow, Beltran will have trouble paying its creditors and will experience financial distress.

The use of leverage as a way to signal good information to investors is known as the signaling theory of debt.

The idea that buyers will be skeptical of a seller’s motivation for selling was formalized by George Akerlof.39 Akerlof showed that if the seller has private information about the quality of the car, then his desire to sell reveals the car is probably of low quality. Buyers are therefore reluctant to buy except at heavily discounted prices. Owners of high-quality cars are reluctant to sell because they know buyers will think they are selling a lemon and offer only a low price. Consequently, the quality and prices of cars sold in the used-car market are both low. This result is referred to as adverse selection: The selection of cars sold in the used-car market is worse than average.

Adverse selection extends beyond the used-car market. In fact, it applies in any setting in which the seller has more information than the buyer. Adverse selection leads to the lemons principle:

When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection.

Based on the lemons principle, you therefore reduce the price you are willing to pay. This discount of the price due to adverse selection is a potential cost of issuing equity, and it may make owners with good information refrain from issuing equity.

Thus, issuing new shares when management knows they are underpriced is costly for the original shareholders.

If managers care primarily about the firm’s current shareholders, they will be reluctant to sell securities at a price that is below their true value. If they believe the shares are underpriced, managers will prefer to wait until after the share price rises to issue equity.

This preference not to issue equity that is underpriced leads us to the same lemons problem we had before: Managers who know securities have a high value will not sell, and those who know they have a low value will sell. Due to this adverse selection, investors will be willing to pay only a low price for the securities. The lemons problem creates a cost for firms that need to raise capital from investors to fund new investments. If they try to issue equity, investors will discount the price they are willing to pay to reflect the possibility that managers are privy to bad news.

1. The stock price declines on the announcement of an equity issue. When a firm issues equity, it signals to investors that its equity may be overpriced. As a re- sult, investors are not willing to pay the pre-announcement price for the equity and so the stock price declines.

As was true for Gentec, managers issuing equity have an incentive to delay the issue until any news that might positively affect the stock price becomes public. In contrast, there is no incentive to delay the issue if managers expect negative news to come out. These incentives lead to the following pattern:

2. The stock price tends to rise prior to the announcement of an equity issue.

They found that stocks with equity issues outperformed the market by almost 50% in the year and a half prior to the announcement of the issue.

Managers may also try to avoid the price decline associated with adverse selection by is- suing equity at times when they have the smallest informational advantage over investors. For example, because a great deal of information is released to investors at the time of earnings announcements, equity issues are often timed to occur immediately after these an- nouncements. That is,

3. Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements.

Studies have confirmed this tim- ing and reported that the negative stock price reaction is smallest immediately after earnings announcements.44

Managers who perceive the firm’s equity to be overpriced will prefer to issue equity, as opposed to issuing debt or using retained earnings, to fund investment.

However, due to the negative stock price reaction when issuing equity, it is less likely that equity will be overpriced.

The idea that managers will prefer to use retained earnings first, and will issue new equity only as a last resort, is often referred to as the pecking order hypothesis

These observations can also be consistent with the tradeoff theory of capital structure, however, and there is substantial evidence that firms do not follow a strict pecking order, as firms often issue equity even when borrowing is possible.46

Aside from a general preference for using retained earnings or debt as a source of fund- ing rather than equity, adverse selection costs do not lead to a clear prediction regarding a firm’s overall capital structure. Instead, these costs imply that the managers’ choice of financing will depend, in addition to the other costs and benefits discussed in this chapter, on whether they believe the firm is currently underpriced or overpriced by investors. This dependence is sometimes referred to as the market timing view of capital structure: The firm’s overall capital structure depends in part on the market conditions that existed when it sought funding in the past. As a result, similar firms in the same industry might end up with very different, but nonetheless optimal, capital structures.

Indeed, even the pecking order hypothesis does not provide a clear prediction regarding capital structure on its own.

While it argues that firms should prefer to use retained earn- ings, then debt, and then equity as funding sources, retained earnings are merely another form of equity financing (they increase the value of equity while the value of debt remains unchanged). Therefore, firms might have low leverage either because they are unable to issue additional debt and are forced to rely on equity financing or because they are suffi- ciently profitable to finance all investment using retained earnings.

Actively changing a firm’s capital struc- ture (for example, by selling or repurchasing shares or bonds) entails transactions costs, firms may be unlikely to change their capital structures unless they depart significantly from the optimal level. As a result, most changes to a firm’s debt-equity ratio are likely to occur passively, as the market value of the firm’s equity fluctuates with changes in the firm’s stock price.50