McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-0
Chapter Outline
Costs of Financial Distress
Description of Costs
Can Costs of Debt Be Reduced?
Integration of Tax Effects and Financial Distress Costs
Shirking, Perquisites, and Bad Investments: A Note on
Agency Cost of Equity
The Pecking-Order Theory
Growth and the Debt-Equity Ratio
Personal Taxes
How Firms Establish Capital Structure
Summary and Conclusions
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-1
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 with bankruptcy.
• It is the stockholders who bear these costs.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-2
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 (., lost sales)
– Agency Costs
• Selfish strategy 1: Incentive to take large risks
• Selfish strategy 2: Incentive toward underinvestment
• Selfish Strategy 3: Milking the property
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16-3
Balance Sheet for a Company in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300
Fixed Asset $400 $0 Equity $300
Total $600 $200 Total $600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
$200
$0
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16-4
Selfish Strategy 1: Take Large Risks
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × + $0 = $100
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16-5 Selfish Stockholders Accept Negative NPV
Project with Large Risks
• Expected CF from the Gamble
– To Bondholders = $300 × + $0 = $30
– To Stockholders = ($1000 - $300) × + $0 = $70
• PV of Bonds Without the Gamble = $200
• PV of Stocks Without the Gamble = $0
• PV of Bonds With the Gamble = $30 / = $20
• PV of Stocks With the Gamble = $70 / = $47
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-6
Selfish Strategy 2: Underinvestment
• Consider a government-sponsored project that guarantees
$350 in one period
• Cost of investment is $300 (the firm only has $200 now) so
the stockholders will have to supply an additional $100 to
finance the project
• Required return is 10%
·Should we accept or reject?
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-7 Selfish Stockholders Forego Positive NPV
Project
• Expected CF from the government sponsored project:
– To Bondholder = $300
– To Stockholder = ($350 - $300) = $50
• PV of Bonds Without the Project = $200
• PV of Stocks Without the Project = $0
• PV of Bonds With the Project = $300 / = $
• PV of Stocks with the project = $50 / - $100 = -$
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16-8
Selfish Strategy 3: Milking the Property
• Liquidating dividends
– Suppose our firm paid out a $200 dividend to the shareholders.
This leaves the firm insolvent, with nothing for the
bondholders, but plenty for the former shareholders.
– Such tactics often violate bond indentures.
• Increase perquisites to shareholders and/or management
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16-9
Can Costs of Debt Be Reduced?
• Protective Covenants
• Debt Consolidation:
– If we minimize the number of parties, contracting costs
fall.
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16-10
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 paying
lower interest rate.
– Buy another company’s 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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-11 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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-12 Integration of Tax Effects and Financial
Distress Costs
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
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-13
The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just another
claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
• VT = S + B + G + L
• The essence of the M&M intuition is that VT depends on the
cash flow of the firm; capital structure just slices the pie.
S
G
B
L
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-14 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 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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-15
The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather
than equity if internal finance is insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next, equity last.
• 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
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-16
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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-17
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:
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
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16-18
Personal Taxes: The Miller Model
The derivation is straightforward:
Continued…
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16-19
Personal Taxes: The Miller Model (cont.)
The first term is the cash
flow of an unlevered firm
after all taxes.
Its value = VU.
A bond is worth B. It promises to
pay rBB×(1- TB) after taxes. Thus
the value of the second term is:
The total cash flow to all stakeholders in the levered firm is:
The value of the sum of these
two terms must be VL
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16-20
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:
· In the case where TB = TS, we return to M&M with
only corporate tax:
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-21 Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
Debt (B)
V
al
ue
o
f f
ir
m
(V
)
VU
VL = VU+TCB when TS =TB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VL < VU when (1-TB) < (1-TC)×(1-TS)
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-22 Integration of Personal and Corporate Tax Effects
and Financial Distress Costs and Agency Costs
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
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Agency Cost of Equity Agency Cost of Debt
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-23
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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-24
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.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-25
Summary and Conclusions
• Costs of financial distress cause firms to restrain
their issuance 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
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-26
Summary and Conclusions
• Because costs of financial distress can be reduced
but not eliminated, firms will not finance entirely
with debt.
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
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-27
Summary and Conclusions
• If distributions to equity holders are taxed at a lower effective
personal tax rate than interest, the tax advantage to 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 tax
shield on debt
Present value of
financial distress costs Value of firm underMM 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
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Agency Cost of Equity Agency Cost of Debt
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
16-28
Summary and Conclusions
• Debt-to-equity ratios vary across industries.
• 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.
