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AppliedCorporateFinance

Week4
Capital Structure
CapitalStructure
References:
BerkandDeMarzo Ch.16

Lecture Outline
LectureOutline
C it l St t
CapitalStructureChoices
Ch i
MeasuringtheEffectsofLeverageonaBusiness
g
g
CostsofFinancialDistress
TheTradeoffTheory
A
AgencyCostsofLeverage
C t fL
AgencyBenefitsofLeverage
g y
g
InformationBenefitsofLeverage

CapitalStructureChoices
Whenraisingfundsfromoutsideinvestors,afirm
must choose what type of security to issue and
mustchoosewhattypeofsecuritytoissueand
whatcapitalstructuretohave
Capitalstructure
Capital structure
thecollectionofsecuritiesafirmissuestoraisecapital
frominvestors

Firmsconsiderwhetherthesecuritiesissued:

Willreceiveafairpriceinthemarket
Havetaxconsequences
Entailtransactionscosts
Changefutureinvestmentopportunities

Afirmsdebttovalueratioisthefractionof
p
thefirmstotalvaluethatcorrespondstodebt
D/(E+D)

Figure15.6DebttoValueRatio
[D/(E+D)]ofU.S.Firms,19752011

Source:Compustat andFederalReserve,FlowofFundsAccountsoftheUnited
States,2012.

Figure15.7DebttoValueRatio[D/(E
+D)]forSelectIndustries

Source:CapitalIQ,2012.

MeasuringtheEffectsofLeverageona
Business
LeveragedRecapitalization:
d
i li i
Achangeincapitalstructureorownership
compositioninvolvingsubstantialdebtfinancing
iti i l i
b t ti l d bt fi
i

Examples:
Issuingdebtandusingtheproceedstofinancealarge
projectoracquisition
Issuingdebtandusingtheproceedstopayadividend
I i d b
d i
h
d
di id d
toequityholders
Issuingdebtandusingtheproceedstorepurchase
Issuing debt and using the proceeds to repurchase
shares

Capital Structure in Perfect Capital


Markets
A perfect capital market is a market in which:
SecuriNes are fairly priced
No tax consequences or transacNons costs
Investment cash ows are independent of
nancing choices

Leverage will increase the risk of the rms


equity and raise its equity cost of capital

M&M
Modigliani and Miller (MM) ProposiNon I:

In a perfect capital market, the total value of a rm is


equal to the market value of the free cash ows
generated by its assets and is not aected by its
choice of capital structure.
VL= E + D =VU

MM ProposiNon I (with taxes):

The total value of the levered rm exceeds the value


of the rm without leverage due to the present value
of the tax savings from debt:
VL= VU + PV(Interest Tax Shield)

Valuing a rm in the presence of tax


shields
We can explicitly model the tax shields:
With an assumpNon of permanent debt:
PV (Interest Tax Shield) =

c Interest
(rd D)
= c
rd
rd

= c D

Non-permanent/changing debt: model tax shields


as an addiNonal cash ow
Discount using unlevered cost of capital
This method is a bit more labor-intensive, but is much
more exible

Valuing a rm in the presence of tax


shields
We can also use the aler-tax WACC and
evaluate the cash ows without the interest
tax shields:
rwacc

E
D
=
rE +
rD (1 c )
E + D
E + D

rwacc =

rU

D
rD c
E
+
D


This assumes that capital structure is staying at a
given target (Say D/V=50%) and not changing (for
the life of the rm or project
Pretax WACC

Reduction Due
to Interest Tax Shield

Example
Midco Industriescurrentlyhas20million
g
p
sharesoutstandingwithamarketpriceof$15
pershareandnodebt.Midco hashad
consistently stable earnings and pays a 35%
consistentlystableearnings,andpaysa35%
taxrate.Managementplanstoborrow$100
million on a permanent basis and they will use
milliononapermanentbasisandtheywilluse
theborrowedfundstorepurchase
outstandingshares.

The Tax Benefit


TheTaxBenefit
Withoutleverage
VU =(20millionshares)
(20millionshares) ($15/share)
($15/share)=$300
$300
million

IfMidco borrows$100millionusing
p
permanentdebt,thepresentvalueofthe
,
p
firmsfuturetaxsavingsis
PV(interesttaxshield)=
PV(i t
tt
hi ld) cD =35%
35% $100million
$100 illi
=$35million

Thusthetotalvalueoftheleveredfirmwillbe
VL =V
VU + cD =$300million+$35million
$300 million + $35 million =$335
$335
million

Becausethevalueofthedebtis$100million,
q y
thevalueoftheequityis
E= VL D =$335million$100million=$235
million

Althoughthevalueofthesharesoutstanding
p
dropsto$235million,shareholderswillalso
receivethe$100millionthatMidco willpay
out through the share repurchase
outthroughthesharerepurchase.
Intotal,theywillreceivethefull$335million,
y
againof$35millionoverthevalueoftheir
shares without leverage
shareswithoutleverage.

The Share Repurchase


TheShareRepurchase
AssumeMidco repurchasesitssharesatthe
p
currentpriceof$15/share.Thefirmwill
repurchase6.67millionshares.
$100million
$100 million $15/share=6.67millionshares
$15/share = 6 67 million shares

It
Itwillthenhave13.33millionshares
will then have 13 33 million shares
outstanding.
20million6.67million=13.33million

Thetotalvalueofequityis$235million;
p
thereforethenewsharepriceis
$17.625/share.
$235million
$235 million 13.33millionshares=$17.625
13 33 million shares = $17 625

Shareholders
Shareholdersthatkeeptheirsharesearna
that keep their shares earn a
capitalgainof$2.625pershare.
$17.625
$
$
$15=$2.625
$

Thetotalgaintoshareholdersis$35million.
$2.625/share
$2.625/share 13.33millionshares
13.33millionshares=$35million
$35million

Ifthesharesareworth$17.625/shareafter
therepurchase,whywouldshareholders
tender their shares to Midco at$15/share?
tendertheirsharestoMidco
at $15/share?

No Arbitrage Pricing
NoArbitragePricing
Ifinvestorscouldbuysharesfor$15immediately
y
$
y
beforetherepurchase,andtheycouldsellthese
sharesimmediatelyafterwardatahigherprice,
y
g
p ,
thiswouldrepresentanarbitrageopportunity.
Realistically, the value of the Midcoss equitywill
equity will
Realistically,thevalueoftheMidco
riseimmediatelyfrom$300millionto$335
millionaftertherepurchaseannouncement.
p
With20millionsharesoutstanding,theshare
price will rise to $16.75 per share.
pricewillriseto$16.75pershare.
$335million 20millionshares=$16.75pershare

Witharepurchasepriceof$16.75,the
shareholderswhotendertheirsharesandthe
shareholders who hold their shares both gain
shareholderswhoholdtheirsharesbothgain
$1.75pershareasaresultofthetransaction.
$16.75$15=$1.75
$16 75 $15 $1 75

Thebenefitoftheinteresttaxshieldgoestoall
20 million of the original shares outstanding for a
20millionoftheoriginalsharesoutstandingfora
totalbenefitof$35million.
$1.75/share 20millionshares=$35million

Whensecuritiesarefairlypriced,theoriginal
shareholdersofafirmcapturethefullbenefitof
f f
p
f
f f
theinteresttaxshieldfromanincreasein
leverage.

RelaxingMoreAssumptions:Costsof
FinancialDistress
Ifincreasingdebtincreasesthevalueofthe
y
firm,whynotshiftto100%debt?
Withmoredebt,thereisagreaterchancethat
the firm will default on its debt obligations
thefirmwilldefaultonitsdebtobligations.
Afirmthathastroublemeetingitsdebt
obligationsisinfinancialdistress.

TheCostsofBankruptcy
andFinancialDistress
With
Withperfectcapitalmarkets,theriskof
f t
it l
k t th i k f
bankruptcyisnotadisadvantageofdebt:
Bankruptcyshiftstheownershipofthefirmfrom
equityholderstodebtholderswithoutchanging
th t t l l
thetotalvalueavailabletoallinvestors.
il bl t ll i
t

Bankruptcy
Bankruptcyisrarelysimpleand
is rarely simple and
straightforward.
Itisoftenalongandcomplicatedprocessthat
It is often a long and complicated process that
imposesbothdirectandindirectcostsonthefirm
anditsinvestors.

The Bankruptcy Code


TheBankruptcyCode
TheU.S.bankruptcycodewascreatedsothat
y
creditorsaretreatedfairlyandthevalueof
theassetsisnotneedlesslydestroyed.
U.S.firmscanfilefortwoformsofbankruptcy
S fi
fil f
f
fb k
protection:Chapter7orChapter11.
QuitesimilarforAustralianfirms,either
liquidation (Chapter 7 in US) or administration
liquidation(Chapter7inUS)oradministration
(Chapter11)

Chapter 7 Liquidation
Chapter7Liquidation
Atrusteeisappointedtooverseethe
q
g
liquidationofthefirmsassetsthroughan
auction.
Theproceedsfromtheliquidationareusedto
p y
paythefirmscreditors,andthefirmceasesto
exist

Chapter 11 Reorganization
Chapter11Reorganization
Ch
Chapter11isthemorecommonformof
t 11 i th
f
f
bankruptcyforlargecorporations.
WithChapter11,allpendingcollection
attemptsareautomaticallysuspended,and
thefirmsexistingmanagementisgiventhe
opportunitytoproposeareorganizationplan.
Whiledevelopingtheplan,management
continuestooperatethebusiness.

Thereorganizationplanspecifiesthe
treatmentofeachcreditorofthefirm.

C
Creditorsmayreceivecashpaymentsand/ornew
dit
i
h
t
d/
debtorequitysecuritiesofthefirm.
Th
Thevalueofthecashandsecuritiesistypicallyless
l
f th
h d
iti i t i ll l
thantheamounteachcreditorisowed,butmorethan
thecreditorswouldreceiveifthefirmwereshutdown
immediatelyandliquidated.

Thecreditorsmustvotetoaccepttheplan,andit
p
p ,
mustbeapprovedbythebankruptcycourt.
If
Ifanacceptableplanisnotputforth,thecourt
an acceptable plan is not put forth the court
mayultimatelyforceaChapter7liquidation

Direct Costs of Bankruptcy


DirectCostsofBankruptcy
Thebankruptcyprocessiscomplex,time
consuming, and costly.
consuming,andcostly.
Costlyoutsideexpertsareoftenhiredbythefirm
toassistwiththebankruptcyprocess.
Creditorsalsoincurcostsduringthebankruptcy
Creditors also incur costs during the bankruptcy
process.
Theymaywaitseveralyearstoreceivepayment.
They may wait several years to receive payment
Theymayhiretheirownexpertsforlegaland
professional advice
professionaladvice.

Thedirectcostsofbankruptcyreducethe
valueoftheassetsthatthefirmsinvestors
willultimatelyreceive.
Theaveragedirectcostsofbankruptcyare
h
di
fb k
approximately3%to4%oftheprebankruptcy
marketvalueoftotalassets.
k
l
f
l

Giventhedirectcostsofbankruptcy,firms
y
g
p y y
mayavoidfilingforbankruptcybyfirst
negotiatingdirectlywithcreditors.
Workout
Amethodforavoidingbankruptcyinwhichafirm
infinancialdistressnegotiatesdirectlywithits
creditorstoreorganize
Thedirectcostsofbankruptcyshouldnotsubstantially
exceedthecostofaworkout.

PrepackagedBankruptcy(Prepack)
Amethodforavoidingmanyofthelegalandother
A method for avoiding many of the legal and other
directcostsofbankruptcyinwhichafirmfirst
develops a reorganization plan with the
developsareorganizationplanwiththe
agreementofitsmaincreditorsandthenfiles
Chapter 11 to implement the plan
Chapter11toimplementtheplan
Withaprepackagedbankruptcy,thefirmemergesfrom
bankruptcy quickly and with minimal direct costs
bankruptcyquicklyandwithminimaldirectcosts.

Indirect Costs of Financial Distress


IndirectCostsofFinancialDistress
Whiletheindirectcostsaredifficulttomeasureaccurately,
theyareoftenmuchlargerthanthedirectcostsof
bankruptcy.
bankruptcy
LossofCustomers
LossofSuppliers
fS
li
LossofEmployees
LossofReceivables
FireSaleofAssets
DelayedLiquidation
CoststoCreditors

Th
Theindirectcostsoffinancialdistressmay
i di t
t f fi
i l di t
besubstantial.
It
Itisestimatedthatthepotentiallossduetofinancial
is estimated that the potential loss due to financial
distressis10%to20%offirmvalue

When
Whenestimatingindirectcosts,twoimportantpoints
estimating indirect costs two important points
mustbeconsidered.
Losses
Lossestototalfirmvalue(andnotsolelylossestoequity
to total firm value (and not solely losses to equity
holdersordebtholders,ortransfersbetweenthem)must
beidentified.
Theincrementallossesthatareassociatedwithfinancial
distress,aboveandbeyondanylossesthatwouldoccur
,
duetothefirmseconomicdistress,mustbeidentified.

Example:Moon Industries
Considerthefollowingoutcomesbothforthe
C
id th f ll i
t
b th f th
followingscenarioswithandwithoutleveragefor
Moon Industriesnewventure:
MoonIndustries
new venture:

ValueofDebtandEquitywithandwithoutLevearge
($million)
With t L
WithoutLeverage
With L
WithLeverage
Success Failure Success Failure
Debtvalue

$150
$90
Equityvalue
$250
$90
$100
$0
Totaltoallinvestors
$250
$90
$250
$90

Assume:
Moonsnewventureisequallylikelytosucceedorto
fail.
Theriskfreerateis4%.
Theventurehasabetaof0andthecostofcapitalis
equaltotheriskfreerate.
q

.5($250) .5($90)
Equity (unlevered) V
$163.46 million
1 04
1.04
U

.5($100)
5($100) .5($0)
5($0)
Equity (Levered) V
$48.08 million
1.04
L

.5($150) .5($90)
Debt
$115.38 million
1 04
1.04

VL =$48.08+$115.38
$48.08 + $115.38 =$163.46
$163.46
AsstatedbyMMPropositionI,thetotalvalueofthe
fi i
firmisunaffectedbyleverage.
ff t d b l

assumenowthatthecostsoffinancialdistressare
$15million:
ValueofDebtandEquitywithandwithoutLevearge
($ million)
($million)
WithoutLeverage
WithLeverage
Success Failure Success Failure
Debtvalue

$150
$75
Equityvalue
$250
$90
$100
$0
Total to all investors
Totaltoallinvestors
$250
$90
$250
$75

ComputethevalueofMoon
Compute
the value of Moonsssecuritiesatthe
securities at the
beginningoftheyearwithandwithoutleverage
giventhatfinancialdistressiscostly.

.5($250) .5($90)
Equity (unlevered) V
$163.46 million
1 04
1.04
U

.5($100) .5($0)
Equity (Levered) V
$48.08
$48 08 million
1.04
L

.5($150)
5($150) .5($75)
5($75)
Debt
$108.17 million
1.04

VL =$48.08+$108.17=$156.25

VL V
VU inthepresenceoffinancialdistresscosts.
in the presence of financial distress costs
Thedierence,($163.46$156.25=$7.21),isthe
presentvalueofthe$15millioninfinancialdistress
costs:

.5($0) .5($15)
PV(Financial Distress Costs)
$7
$7.21
21 million
1.04

Who Pays for Financial Distress Costs?


WhoPaysforFinancialDistressCosts?
if
ifthenewventurefails,equityholderslose
h
f il
i h ld l
theirinvestmentinthefirmandwillnotcare
aboutbankruptcycosts.
However
However,debtholdersrecognizethatifthe
debt holders recognize that if the
newventurefailsandthefirmdefaults,they
will not be able to get the full value of the
willnotbeabletogetthefullvalueofthe
assets.
Asaresult,theywillpaylessforthedebtinitially
l h
ll
l
f h d b
ll
(thepresentvalueofthebankruptcycostsless).

Ifthedebtholdersinitiallypaylessforthe
f h d b h ld i i i ll
l
f h
debt,thereislessmoneyavailableforthe
fi t
firmtopaydividends,repurchaseshares,
di id d
h
h
andmakeinvestments.
Thisdifferencecomesoutoftheequity
holderspockets.

Whensecuritiesarefairlypriced,theoriginal
shareholdersofafirmpaythepresentvalueof
thecostsassociatedwithbankruptcyand
financialdistress

OptimalCapitalStructure:
TheTradeoffTheory
The firm picks its capital structure by trading off the
benefits of the tax shield from debt against the costs of
fi
financial
i l distress
di
and
d agency costs.
The total value off a levered ffirm equals
q
the value off the
firm without leverage plus the present value of the tax
savings from debt, less the present value of financial
distress costs.

VL VU PV(Interest Tax Shield) PV(Financial Distress Costs)

Determinants of financial distress costs


Determinantsoffinancialdistresscosts
1 Theprobabilityoffinancialdistress.
1.
Th
b bilit f fi
i l di t

Theprobabilityoffinancialdistressincreaseswiththe
amountofafirmsliabilities(relativetoitsassets).
(
)
Theprobabilityoffinancialdistressincreaseswiththe
volatilityofafirmscashflowsandassetvalues.

2. Themagnitudeofthecostsafterafirmisindistress.

Financialdistresscostswillvarybyindustry.
Technology
Technologyfirmswilllikelyincurhighfinancialdistresscostsdue
firms will likely incur high financial distress costs due
tothepotentialforlossofcustomersandkeypersonnel,aswell
asalackoftangibleassetsthatcanbeeasilyliquidated.
Realestatefirmsarelikelytohavelowcostsoffinancialdistress
y
sincethemajorityoftheirassetscanbesoldrelativelyeasily.

3.Theappropriatediscountrateforthedistress
costs.
Dependsonthefirmsmarketrisk

Notethatbecausedistresscostsarehighwhenthefirm
doespoorly,thebetaofdistresscostshastheoppositesign
tothatofthefirm.

Thehigherthefirm
The
higher the firmssbeta,themorenegativethebetaofits
beta, the more negative the beta of its
distresscostswillbe

Thepresentvalueofdistresscostswillbehigherfor
highbetafirms.

Optimal Leverage
OptimalLeverage
Forlowlevelsofdebt,theriskofdefault
l l l fd b h i k fd f l
remainslowandthemaineffectofan
increaseinleverageisanincreaseinthe
interesttaxshield.
Asthelevelofdebtincreases,theprobability
of default increases
ofdefaultincreases.
Asthelevelofdebtincreases,thecostsof
financialdistressincrease,reducingthevalue
oftheleveredfirm.

Th
Thetradeofftheorystatesthatfirmsshouldincreasetheir
t d ff th
t t th t fi
h ld i
th i
leverageuntilitreachesthelevelforwhichthefirmvalueis
maximized.
Atthispoint,thetaxsavingsthatresultfromincreasingleverage
areperfectlyoffsetbytheincreasedprobabilityofincurringthe
costs of financial distress
costsoffinancialdistress.

Thetradeofftheorycanhelpexplain
Whyfirmschoosedebtlevelsthataretoolowtofullyexploit
y
y p
theinteresttaxshield(duetothepresenceoffinancialdistress
costs)
Differences
Differencesintheuseofleverageacrossindustries(dueto
in the use of leverage across industries (due to
differencesinthemagnitudeoffinancialdistresscostsandthe
volatilityofcashflows)

OptimalLeveragewithTaxesand
FinancialDistressCosts

ExploitingDebtHolders:
TheAgencyCostsofLeverage
AgencyCosts
C
Coststhatarisewhenthereareconflictsofinterest
betweenthefirmsstakeholders

Management
Managementwillgenerallymakedecisions
will generally make decisions
thatincreasethevalueofthefirmsequity.
H
However,whenafirmhasleverage,managers
h
fi h l
maymakedecisionsthatbenefitshareholdersbut
harm the firmsscreditorsandlowerthetotal
harmthefirm
creditors and lower the total
valueofthefirm.

ConsiderBaxter,Inc.,whichisfacing
financial distress
financialdistress.
Baxterhasaloanof$1milliondueattheendoftheyear.
Withoutachangeinitsstrategy,themarketvalueofits
assetswillbeonly$900,000atthattime,andBaxterwill
default on its debt
defaultonitsdebt.
Anewstrategyrequiresnoupfrontinvestment,butithasonly
a50%chanceofsuccess.
Ifthenewstrategysucceeds,itwillincreasethevalueof
thefirmsassetto$1.3million.
Ifthenewstrategyfails,thevalueofthefirmsassetswill
fallto$300,000

The
Theexpectedvalueofthefirmsassetsunderthe
expected value of the firms assets under the
newstrategyis$800,000,adeclineof$100,000
fromtheoldstrategy.
gy
50% $1.3million+50% $300,000=$800,000

IfBaxterdoesnothing,itwillultimatelydefault
and equity holders will get nothing with certainty
andequityholderswillgetnothingwithcertainty.
EquityholdershavenothingtoloseifBaxtertriesthe
riskystrategy.
y
gy

Ifthestrategysucceeds,equityholderswill
receive $300,000 after paying off the debt.
receive$300,000afterpayingoffthedebt.
Givena50%chanceofsuccess,theequityholders
expectedpayoffis$150,000.

EEquityholdersgainfromthisstrategy,even
it h ld
i f
thi t t
thoughithasanegativeexpectedpayoff,
while debt holders lose
whiledebtholderslose.
Iftheprojectsucceeds,debtholdersarefully
repaidandreceive$1million.
d d
$
ll
Iftheprojectfails,debtholdersreceiveonly
p j
,
y
$300,000.
Thedebtholdersexpectedpayoffis$650,000,alossof
$250,000comparedtotheoldstrategy.
50% $1million+50% $300,000=$650,000

ExcessiveRiskTakingandOver
investment
Th
Thedebtholders$250,000losscorrespondsto
d bt h ld $250 000 l
d t
the$100,000expecteddeclineinfirmvaluedue
to the risky strategy and the equity holderss
totheriskystrategyandtheequityholder
$150,000gain.
EEquityholdersgainallofthepotentialbenefits,
it h ld
i ll f th
t ti l b
fit
butdebtholdersfaceallofthepotentialcosts.
Overall this is negative NPV for the firm but for
OverallthisisnegativeNPVforthefirm,butfor
equityitispositiveNPV
Effectively
Effectively,theequityholdersaregamblingwith
the equity holders are gambling with
thedebtholdersmoney.

OverinvestmentProblem
Whenafirmfacesfinancialdistress,shareholders
When a firm faces financial distress shareholders
cangainattheexpenseofdebtholdersbytaking
a negative NPV project if it is sufficiently risky
anegativeNPVproject,ifitissufficientlyrisky.
Anticipatingthisbadbehavior,securityholders
willpaylessforthefirminitially.

Debt Overhang and Under investment


DebtOverhangandUnderinvestment
N
NowassumeBaxterdoesnotpursuetherisky
B t d
t
th i k
strategybutinsteadthefirmisconsideringan
investment opportunity that requires an initial
investmentopportunitythatrequiresaninitial
investmentof$100,000andwillgeneratearisk
freereturnof50%.
Ifthecurrentriskfreerateis5%,thisinvestment
clearlyhasapositiveNPV.
WhatifBaxterdoesnothavethecashonhandto
maketheinvestment?
CouldBaxterraise$100,000innewequitytomake
theinvestment?

OutcomesforBaxtersDebtandEquitywithand
withouttheNewProject($thousands)

Ifequityholderscontribute$100,000tofundtheproject,they
g
getbackonly$50,000.
y
Theother$100,000fromtheprojectgoestothedebtholders,
whose payoff increases from $900 000 to $1 million
whosepayoffincreasesfrom$900,000to$1million.
Thedebtholdersreceivemostofthebenefit,thusthisproject
is a negative NPV investment opportunity for equity holders
isanegativeNPVinvestmentopportunityforequityholders,
eventhoughitoffersapositiveNPVforthefirm

UnderinvestmentProblem
Asituationinwhichequityholderschoosenotto
A situation in which equity holders choose not to
investinapositiveNPVprojectbecausethefirmis
in financial distress and the value of undertaking
infinancialdistressandthevalueofundertaking
theinvestmentopportunitywillaccrueto
bondholders rather than themselves
bondholdersratherthanthemselves.

Alsocalledadebtoverhangproblem(cashing
outisanexample)

Estimating the Debt Overhang


EstimatingtheDebtOverhang
Howmuchleveragemustafirmhavefortheretobe
asignificantdebtoverhangproblem?
SupposeequityholdersinvestanamountIinanew
investmentwithsimilarrisktotherestofthefirm.
Equityholderswillbenefitfromthenewinvestment
o y
onlyif:

NPV D D
>
I
E E

Debt Maturity and Covenants


DebtMaturityandCovenants
Agencycostsarehigherforlongerterm
hi h f l
maturities
DebtCovenants
Conditionsofmakingaloaninwhichcreditorsplace
restrictionsonactionsthatafirmcantake
h
f
k

Mayhelptoreduceagencycosts
y p
g y
Mayhindermanagementflexibilityandprevent
investment in positive NPV opportunities and can
investmentinpositiveNPVopportunitiesandcan
havecostsoftheirown.

The Agency Benefits of Leverage


TheAgencyBenefitsofLeverage
Entrenchmentmayallowmanagerstorunthe
h
ll
h
firmintheirownbestinterests,ratherthanin
thebestinterestsoftheshareholders.
AllowsConcentrationofOwnership
Allows Concentration of Ownership
Manager/ownershaveskininthegame,less
potential agenc problems
potentialagencyproblems
Concentratedownersbettermonitors

Creditorswillcloselymonitorafirms
managers,providingmoremonitoring

Reducewastefulinvestmentbyreducingfree
cashflow
Empirebuilding(managerswanttorunlargefirms
more than small firms)
morethansmallfirms)
Managersmaybeoverconfident
Petprojects,donations,etc
P t
j t d
ti
t

Wh
Whencashistight,managerswillbemotivatedto
h i ti ht
ill b
ti t d t
runthefirmasefficientlyaspossible.
Commitsthefirmtomakingfutureinterestpaymentsthus
f
f
reducescashforbadinvestments
Reduces
Reducesmanagerialentrenchmentasmanagersaremore
managerial entrenchment as managers are more
likelytobefiredwhenafirmfacesfinancialdistress.
Managers
Managersmoreconcernedabouttheirperformanceand
more concerned about their performance and
lesslikelytoengageinwastefulinvestment.
Firmbecomeafiercercompetitorandactsmore
aggressivelyinprotectingitsmarketsbecauseitcannot
riskthepossibilityofbankruptcy.

The Information Benefits of Leverage


TheInformationBenefitsofLeverage
Crediblesignalofpositiveinformation
C dibl i l f
iti i f
ti
Signaling theoryofdebt

IssuingEquityandAdverseSelection
I i E it
d Ad
S l ti
AdverseSelection
Th
Theideathatwhenthebuyersandsellershave
id th t h th b
d ll h
differentinformation,theaveragequalityofassetsin
themarketwilldifferfromtheaveragequalityoverall

LemonsPrinciple
When
Whenasellerhasprivateinformationaboutthevalue
a seller has private information about the value
ofagood,buyerswilldiscountthepricetheyare
willingtopayduetoadverseselection

Eg UsedCars
d
Ifsellerknowsthecarisgood,theywillkeepit.If
itadud,theywillsellit
Buyersknowthisandonlywillpaypriceofbadcar

Equityasalemon:
Managerswhoknowtheirprospectsaregoodwill
Managers who know their prospects are good will
notissueequity(andsharethesegains)
Willfundinternallyorissuedebt
Will fund internally or issue debt
PeckingOrderHypothesis

AgencyCosts
andtheTradeoffTheory
Thevalueoftheleveredfirmcannowbe
showntobe:
V
VL =V
VU +PV(InterestTaxShield)+PV
PV (I
T Shi ld) PV
(FinancialDistressCosts)+PV(AgencyCostsof
Debt)+PV(AgencyBenefitsofDebt)+PV
(Information Benefits of Leverage)
(InformationBenefitsofLeverage)

The Optimal Debt Level


TheOptimalDebtLevel
R&DIntensiveFirms
R&D I t i Fi
FirmswithhighR&Dcostsandfuturegrowth
opportunitiestypicallymaintainlowdebtlevels.
t iti t i ll
i t i l d bt l l
Thesefirmstendtohavelowcurrentfreecashflows
andriskybusinessstrategies.
d ik b i
t t i

LowGrowth,MatureFirms
Mature,lowgrowthfirmswithstablecashflowsand
tangibleassetsoftencarryahighdebtload.
Thesefirmstendtohavehighfreecashflowswithfew
goodinvestmentopportunities.

Homework
Chapter15:Problems8,10,16
Chapter16:Problems1,6,8,12,13,20,21,
Chapter 16 : Problems 1, 6, 8, 12, 13, 20, 21,
24,26,28,33
ReadChapter12
R d Ch
12