Capital structure limits to the use of debt
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BWFF3013: Corporate Finance February 2013 School of Economics, Finance and Banking College of Business Universiti Utara Malaysia
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Capital structure limits to the use of debt
- 1. CAPITAL STRUCTURE limits to the use of debt 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 1
- 2. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • Debt provides tax benefits • However, debt also create the pressure of financial distress • The ultimate distress is ‘bankruptcy’ – ownership of assets is legally transferred from stockholders to bondholders • Bankruptcy costs/ financial distress costs tend to offset the advantages of debt (see following example). 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 2
- 3. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • Knight corporation and Day corporation will remain in business for one more year • Both has identical possible cash flows – $100 with 50 percent probability (boom times) – $50 with 50 percent probability (recession) • These firms do not have any other asset • They have different interest and principal obligations – Knight: $49 – Day: $60 • Taxes are ignored 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 3
- 4. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • In case of recession, Day corporation cannot meet the financial obligations in full • If bankruptcy occurs, bondholders will receive all the cash and stockholders will receive nothing 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 4 Knight Corporation Day Corporation Boom times (prob. 50%) Recession (prob. 50%) Boom times (prob. 50%) Recession (prob. 50%) Cash flow $100 $ 50 $100 $ 50 Financial obligation on debt 49 49 60 50 Distribution to stock holders $ 51 $ 1 $ 40 $ 0
- 5. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • Assuming – Both bondholders and stockholders are risk neutral – The interest rate is 10% 𝑽 𝑲𝑵𝑰𝑮𝑯𝑻 = 𝑺 𝑲𝑵𝑰𝑮𝑯𝑻 + 𝑩 𝑲𝑵𝑰𝑮𝑯𝑻 = $𝟓𝟏×𝟎.𝟓𝟎+$𝟏×𝟎.𝟓𝟎 𝟏.𝟏𝟎 + $𝟒𝟗×𝟎.𝟓𝟎+$𝟒𝟗×𝟎.𝟓𝟎 𝟏.𝟏𝟎 = $𝟐𝟑. 𝟔𝟒 + 𝟒𝟒. 𝟓𝟒 = $𝟔𝟖. 𝟏𝟖 𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀 = $𝟒𝟎×𝟎.𝟓𝟎+$𝟎×𝟎.𝟓𝟎 𝟏.𝟏𝟎 + $𝟔𝟎×𝟎.𝟓𝟎+$𝟓𝟎×𝟎.𝟓𝟎 𝟏.𝟏𝟎 = $𝟏𝟖. 𝟏𝟖 + $𝟓𝟎 = $𝟔𝟖. 𝟏𝟖 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 5
- 6. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • In case of bankruptcy, some additional costs associated with the bankruptcy would reduce the value of the firm. • In this example, if the bankruptcy costs are $15, 𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀 = $𝟒𝟎 × 𝟎. 𝟓𝟎 + $𝟎 × 𝟎. 𝟓𝟎 𝟏. 𝟏𝟎 + $𝟔𝟎 × 𝟎. 𝟓𝟎 + $𝟑𝟓 × 𝟎. 𝟓𝟎 𝟏. 𝟏𝟎 = $𝟏𝟖. 𝟏𝟖 + $𝟒𝟑. 𝟏𝟖 = $𝟔𝟏. 𝟑𝟔 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 6 Knight Corporation Day Corporation Boom times (prob. 50%) Recession (prob. 50%) Boom times (prob. 50%) Recession (prob. 50%) Cash flow $100 $ 50 $100 $ 50 Financial obligation on debt 49 49 60 5035 Distribution to stock holders $ 51 $ 1 $ 40 $ 0
- 7. COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • The yield or promised return to the bondholders of Day Corporation (without considering bankruptcy costs) $𝟔𝟎 $𝟓𝟎 − 𝟏 = 𝟐𝟎% • The yield or promised return to the bondholders of Day Corporation (considering bankruptcy costs) $𝟔𝟎 $𝟒𝟑. 𝟏𝟖 − 𝟏 = 𝟑𝟗% • Summary – 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 the value. Rather, it is the costs associated with bankruptcy that lower value. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 7
- 8. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 8 COSTS OF FINANCIAL DISTRESS Bankruptcy risk or bankruptcy cost? • Summary – 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 the value. Rather, it is the costs associated with bankruptcy that lower value. B Fees and costs related to bankruptcy procedure
- 9. DESCRIPTION OF FINANCIAL DISTRESS COSTS Direct costs of financial distress • Legal and administrative costs of liquidation or reorganization – lawyers fee – administrative and accounting fee – expert witnesses fee • Although large in absolute amount, these direct costs are actually small as a percentage of firm value 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 9
- 10. DESCRIPTION OF FINANCIAL DISTRESS COSTS Indirect costs of financial distress • Impaired ability to conduct business – impaired service – loss of trust 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 10
- 11. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs • Conflict of interest arises between stockholders and bondholders of a levered firm • Stockholders are tempted to pursue selfish strategies • In a financial distress situation, these conflicts are magnified and impose agency costs • There are three kinds of selfish strategies – taking large risks – underinvestment – milking the property 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 11
- 12. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs: taking large risks • When a firm is near bankruptcy, management may try to get the incentive from taking large risks – high risk projects increases firm value in a boom and its benefit is captured only by stockholders • Consider a levered firm considering two mutually exclusive projects to choose from: a low-risk one and a high-risk one • There are two equally likely outcomes: recession, and boom • The firm promises to pay $100 to bondholders as principal and interest payment • In case of a recession, The firm will – come near to bankruptcy with the low-risk project – actually fall into bankruptcy with the high-risk project 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 12
- 13. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs: taking large risks • If the firm invests in the low risk project: 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 13 Outcome Prob. Value = Stock + Bonds Recession 0.50 $100 = $ 0 + $100 Boom 0.50 $200 = $100 + $100 Expected value of the firm: $𝟏𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟎𝟎 Expected value of the stock: $𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎 • If the firm invests in the high risk project: Outcome Prob. Value = Stock + Bonds Recession 0.50 $ 50 = $ 0 + $ 50 Boom 0.50 $240 = $140 + $100 Expected value of the firm: $𝟏𝟒𝟓 = 𝟎. 𝟓𝟎 × $𝟓𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟒𝟎 Expected value of the stock: $𝟕𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟒𝟎
- 14. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs: underinvestment • If there is a significant probability of bankruptcy, stockholders often find that new investment only help bondholders at their expense • Consider a firm considering the decision to accept or reject a new project requiring investment of $1000. • The project will generate a cash flow of $1700, if accepted • The financial obligation to the bondholders is $4000. • There are two equally likely outcomes: recession, and boom 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 14
- 15. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs: taking large risks • Cash flows with and without the project: 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 15 Without project With project Boom Recession Boom Recession Firm cash flows $5000 $2400 $6700 $4100 Bondholders’ claim 4000 2400 4000 4000 Stockholders’ claim $1000 $ 0 $2700 $ 100 Expected value of stockholder interest without the project (also without any cost): $𝟓𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟎 Expected value of stockholder interest with the project (also with a $1000 cost): $𝟏𝟒𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟐𝟕𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎 Thus, after spending $1000, stockholder interest rises by only: $𝟗𝟎𝟎 = $𝟏𝟒𝟎𝟎 − $𝟓𝟎𝟎 Therefore, underinvestment brings incentive to the stockholders
- 16. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs: milking the property • If there is a significant probability of bankruptcy, the firm may attempt higher cash distributions such as extra dividends to the stockholders • This strategy would result less assets to remain in the firm for the bondholders. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 16
- 17. DESCRIPTION OF FINANCIAL DISTRESS COSTS Agency costs • Who pays for the cost of selfish investment strategies? – it is ultimately stockholders • Rational bondholders know that stockholders would not help them at the time of financial distress, rather they will become selfish • Hence, bondholders protects themselves by requiring higher interest rate on the bonds, which is paid by the stockholders • Thus, firms with greater probability of financial distress would find debt costly 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 17
- 18. CAN COSTS OF DEBT BE REDUCED? Protective covenants • Stockholders will have to pay higher interest as insurance against their selfish strategy • They often hope to lower the rate by agreeing several conditions imposed by bondholders • These conditions are called ‘protective covenants’ • Broken covenants can lead to default • Two types of protective covenants – negative covenants – positive covenants 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 18
- 19. CAN COSTS OF DEBT BE REDUCED? Protective covenants • Negative covenants limit or prohibit company actions – limit of the amounts of dividend to pay – Restriction on pledging assets to other lender – Restriction on merger – Restriction on selling or leasing of major assets – Restriction on issuing additional debt • Positive covenants specify an action that the company agrees to take – Maintaining a minimum level of working capital – Furnishing periodic financial statements to the lender • Covenants reduce flexibility, but increase firm value and also can be the lowest cost solution to stockholder-bondholder conflict 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 19
- 20. CAN COSTS OF DEBT BE REDUCED? Consolidation of debt • If the financially distressed firm has many creditors, they may contend with each other • In this situation, negotiating costs increases • This problem can be alleviated by proper arrangement of bondholders and stockholders – one, or perhaps a few lenders can shoulder the entire debt – bondholders can purchase the stocks 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 20
- 21. INTEGRATION OF TAX EFFECTS AND FINANCIAL DISTRESS COSTS 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 21 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 VL = VU + TCB V = Actual value of firm VU = Value of firm with no debt B* Maximum firm value Optimal amount of debt
- 22. INTEGRATION OF TAX EFFECTS AND FINANCIAL DISTRESS COSTS 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 22 Debt (B) Cost of capital (%) 0 R0 RWACC B* R0 Optimal amount of debt
- 23. INTEGRATION OF TAX EFFECTS AND FINANCIAL DISTRESS COSTS • A firm’s capital structure decision involves a trade-off between the tax benefits of debt and the costs of financial distress. • Thus, there is an optimal amount of debt for any individual firm • This amount becomes the firm’s target level of debt • This approach is frequently called the static trade-off theory of capital structure. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 23
- 24. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 24 B INTEGRATION OF TAX EFFECTS AND FINANCIAL DISTRESS COSTS G L S
- 25. INTEGRATION OF TAX EFFECTS AND FINANCIAL DISTRESS COSTS • The essence of the MM intuition is, firm’s capital structure merely cuts 𝑽 𝑻 into slices, it does not affect the total value, 𝑽 𝑻 • The value of a firm equals the some of stockholders’ claim (S), bondholders’ claim (B), taxes (G), and bankruptcy claims (L) i.e., 𝑽 𝑻 = 𝑺 + 𝑩 + 𝑮 + 𝑳 = 𝑽 𝑴 + 𝑽 𝑵 Where, 𝑽 𝑴 represents marketable claims and 𝑽 𝑵 represents nonmarketable claims • 𝑽 𝑴 can change with changes in the capital structure • By the pie theory, any increase in 𝑽 𝑴 must imply identical decrease in 𝑽 𝑵 • Rational financial managers will choose a capital structure that maximizes 𝑽 𝑴 and minimizes 𝑽 𝑵 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 25
- 26. SIGNALING • The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. • Investors view debt as a signal of firm value. – Firms with low anticipated profits will take on a low level of debt. – Firms with high anticipated profits will take on a high level of debt. • A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 26
- 27. 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.” • While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. • The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the 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. 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 27
- 28. THE PECKING ORDER THEORY • Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. – Rule 1 • Use internal financing first – Rule 2 • Issue debt next, new equity last • The pecking-order theory is at odds with the tradeoff theory: – There is no target D/E ratio – Profitable firms use less debt – Companies like financial slack 4/30/2013 Dr. Md Mohan Uddin http://lnkd.in/vvppcr 28
- 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 real world. As a result, 100% debt financing is sub-optimal.
- 30. PERSONAL TAXES • Individuals, in addition to the corporation, must pay taxes. Thus, personal taxes must be considered in determining the optimal capital structure.
- 31. PERSONAL TAXES • Dividends face double taxation (firm and shareholder), which suggests a stockholder receives the net amount: • (1-TC) x (1-TS) • Interest payments are only taxed at the individual level since they are tax deductible by the corporation, so the bondholder receives: • (1-TB)
- 32. PERSONAL TAXES • If TS= TB then the firm should be financed primarily by debt (avoiding double tax). • The firm is indifferent between debt and equity when: (1-TC) x (1-TS) = (1-TB)
- 33. HOW FIRMS ESTABLISH CAPITAL STRUCTURE • Most corporations have low Debt-Asset ratios. • Changes in financial leverage affect firm value. – Stock price increases with 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-Equity ratio.
- 34. HOW FIRMS ESTABLISH CAPITAL STRUCTURE Factors in target D/E ratio • Taxes – Since interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit). • 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 a high probability of experiencing financial distress. • Pecking Order and Financial Slack – Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.