Chapter 13 Capital Structure: Nontax Determinants of Corporate Leverage Professor XXXXX Course Name / # © 2007 Thomson South-Western.

Chapter 13Capital Structure:

Nontax Determinants of Corporate Leverage

Professor XXXXXCourse Name / #

© 2007 Thomson South-Western

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Bankruptcy costs are distinct from the decline in firm value that leads to financial distress.

Poor management, unfavorable movements in input and output prices, and recessions can push a firm into bankruptcy, but they are not examples of bankruptcy costs.

Bankruptcy costs refer to direct and indirect costs of the bankruptcy process itself.

Costs Of Bankruptcy and Financial Distress

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Bankruptcy Filings

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Costs of Bankruptcy

Unless the process of bankruptcy imposes costs on a company that a similarly distressed, but nonbankrupt firm would not have to bear, the mere possibility of falling into bankruptcy cannot influence capital structure decision making.

Bankruptcy is the result of economic failure, not the cause.

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Bankruptcy Cost

It is not the event of going bankrupt that matters, it is the costs of going bankrupt that matter.

If ownership of the firm’s assets was transferred costlessly to its creditors in the event of bankruptcy,

The optimal capital structure would still be 100% debt.

When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to

using leverage.

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Example

Firm 1 Firm 2

Market value of assets $100,000,000 $100,000,000

Debt $0 $50,000,000

Equity $100,000,000 $50,000,000

An example…– Suppose Firm 1 and Firm 2 have the following capital

structure (assume no bankruptcy costs):

$50,000,000$0

$40,000,000$40,000,000

If there is a tax advantage to debt, that tax advantage is still decisive because the firm that uses more debt can shelter more income and incurs no additional costs than does the

firm that has no debt.

Recession hits and the value of both firms’ assets drops to $40 million.

Firm 2 goes bankrupt because there are not enough assets to cover the debt. Bondholders become stockholders and own the company.

$40,000,000$40,000,000

$0

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Example

Firm 1 Firm 2

Market value of assets $100,000,000 $100,000,000

Debt $0 $50,000,000

Equity $100,000,000 $50,000,000

– Assume if firm goes bankrupt, $10 million in assets are lost in the process of transferring ownership from stockholders to bondholders:

$30,000,000$40,000,000

$0$0

$30,000,000$40,000,000

Firm 2 will calculate the tax advantage of debt and weigh that against the cost of bankruptcy times the probability of

bankruptcy at each debt level.

When the recession hits, Firm 1 has $40 million in assets, but Firm 2 has $30 million in assets.

We are now looking not at bankruptcy costs per se, but at expected bankruptcy costs.

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Costs of Bankruptcy

Three ways that bankruptcy costs can influence a firm’s mix of debt and equity:

1. If the process of bankruptcy entails deadweight costs—such as cash payments to lawyers, accountants, or advisers—then firms have an incentive to minimize leverage to reduce the likelihood of bankruptcy.

2. Bankruptcy costs are important if encountering financial distress reduces demand for a firm’s products or increases its costs of production.

3. Bankruptcy costs matter if financial distress gives the firm’s managers, operating as the shareholders’ agents, perverse incentives to take operating or financial actions that reduce overall firm value.

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Asset Characteristics and Bankruptcy Costs

Producers of complex products or services tend to use less debt than do firms producing nondurable goods or basic services.

Companies whose assets are mostly tangible and have well-established secondary markets should be less fearful of financial distress than companies whose assets are mostly intangible.

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Asset Characteristics and Bankruptcy Costs

Financial distress can be particularly damaging to firms that produce research and development—intensive goods and services, for two reasons. First, most of the production expenses

are sunk costs, which can be recovered only with a long period of profitable sales.

Second, “cutting-edge” goods require ongoing R&D spending to ensure market acceptance.

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Financial Distress: The Asset Substitution Problem

Asset substitution is the promise to invest in a safe asset to obtain an interest rate reflecting the risk, and then substituting a riskier asset promising a higher expected return.

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Financial Distress: The Underinvestment Problem

Underinvestment, like asset substitution, arises when a firm’s managers realize default is likely.

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Direct and Indirect Costs of Bankruptcy

Direct costs of bankruptcy are out-of-pocket cash expenses directly related to bankruptcy filing and administration (Document printing and filing expenses, as well as professional fees paid to lawyers, accountants, investment bankers, and court personnel). Indirect costs of bankruptcy are expenses that result from bankruptcy but are not cash expenses spent on the process itself (the diversion of management’s time, lost sales during and after bankruptcy, constrained capital investment and R&D spending, and the loss of key employees).

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Bankruptcy Costs

Direct Costs

Costs of bankruptcy-related litigation

Indirect Costs

Cost of management time diverted to bankruptcy process

Loss of customers who don’t want to deal with a distressed firm

Loss of employees who switch to healthier firms

Strained relationships with suppliers

Lost investment opportunities

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Indirect costs are likely to be much larger, and are likely to vary a great deal depending on the type of

firm in distress.

Indirect costs may be high:

When the firm’s product requires that the firm stay in business (e.g., when warranties or service are

important)

When the firm must make additional investments in product quality to maintain customers

For example, think of customers worrying that a bankrupt airline might try to save $ by cutting

spending on safety.

Bankruptcy Costs

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Direct costs of

bankruptcy

Legal, auditing and administrative costs (include court costs)

Large in absolute amount, but only 1-2% of large firm value

Financial distress also gives managers adverse incentives.

Asset substitution problem: Incentive to take large risks Under-investment problem: shareholders refuse to contribute funds

Costs Bankruptcy PV - ShieldsTax PV + V = V UL

Trade-off model of corporate capital structure:

Bankruptcy Costs

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Indirect Costs of Bankruptcy

Firms entering bankruptcy have lower sales in the years after filing than an extrapolation of prebankruptcy sales growth rates predicts.

Managers lose their jobs much more frequently than do managers of nonbankrupt firms, and the pay of managers who retain their jobs falls dramatically.

U.S. courts deviate from the absolute priority rules that are supposed to govern wealth distributions among security-holders.

Bankruptcy reduces a firm’s debt less than is usually needed, leaving many firms vulnerable to reentering bankruptcy later.

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Indirect Costs of Bankruptcy

Firms facing higher expected bankruptcy risk use less debt.

Companies with highly variable earnings use less debt than do those with more stable profits.

The observed leverage ratios across industries are systematically related to that industry’s investment opportunities. Capital-intensive industries with few growth options tend to

be highly levered, whereas high-tech industries with many growth options use little debt.

If a firm’s assets can pass through bankruptcy without losing value, it will use more debt.

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The Agency Cost / Tax Shield Trade-off Model of Corporate Leverage

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International Differences In Bankruptcy Costs

The U.S.: Chapter 7 filing, the court liquidates the firm’s assets

and pays investors according to the priority of their claims (i.e., debt before equity, secured before unsecured debt, and so on).

Chapter 11 filing is a petition to reorganize the firm’s liabilities to allow the company to emerge again as an independent business.

Most OECD countries make a similar distinction between liquidation and reorganization: They differ regarding creditors’ rights during bankruptcy

and which party holds the initiative as the process unfolds.

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Agency Costs and Capital Structure

Agency cost theory of financial structure

Using debt to overcome the agency costs of outside equityUsing debt means a firm can sell less

external equity and still finance its operations

Using debt is that it reduces managerial perquisite consumption

External debt serves as a bonding mechanism

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Agency Costs Of Outside Debt

Bondholders begin taking on an increasing fraction of the firm’s business and operating risk as firms use more debt.

Shareholders and managers still control the firm’s investment and operating decisions so managers have incentives to transfer wealth from bondholders to themselves and other shareholders. For example, managers might sell bonds and

then pay a huge dividend to shareholders, leaving bondholders with an empty corporate shell.

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Agency Costs Of Outside Debt

Debt helps mitigate these costs, but debt has its own agency costs:

Agency costs of outside

debt

Expropriate bondholders wealth by paying excessive dividends

Bait And Switch: Promise to use borrowed money for safe investment, then use to buy high/risk, high/return

asset

Bondholders protect themselves with positive and negative covenants in lending contracts.

Agency costs of debt are burdensome, but so are solutions.

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Agency Cost/Tax Shield Trade-off Model Of Corporate Leverage

The trade-off model expresses a levered firm’s value in terms an unlevered firm’s value, adjusted for the present values of tax shields, bankruptcy costs, and the agency costs of debt and equity

Weaknesses lead to development of Pecking Order Theory.

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Assumptions Underlying The Pecking-order Theory

Some studies find that the most profitable firms in an industry have the lowest debt ratios

Leverage-increasing events, such as stock repurchases and debt-for-equity exchange offers, almost always increase stock prices, while leverage-decreasing events reduce stock prices.

Firms issue debt securities frequently, but seasoned equity issues (equity issues from firms that already have stock) are rare.

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Assumptions Underlying The Pecking-order Theory

Dividend policy is “sticky Firms prefer internal financing (retained earnings

and depreciation) to external financing of any sort, debt or equity.

If a firm must obtain external financing, it will issue the safest security first.

As a firm requires more external financing, it will work down the “pecking order” of securities, beginning with safe debt, then progressing through risky debt, convertible securities, preferred stock, and finally, common stock as a last resort

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Assumptions Underlying The Pecking-order Theory

Assumptions

Manager acts in best interests of existing shareholders.

Information asymmetry between managers and investors.

Two key predictions about managerial behavior

Firms hold financial slack so they don’t have to issue securities.

Firms follow pecking order when issuing securities: sell low-risk debt first, equity only as last resort.

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Limitations of Pecking-Order Theory It fails to explain how taxes, bankruptcy

costs, security-issuance costs, and investment opportunities influence debt ratios.

It ignores significant agency problems that arise when too much financial slack makes managers immune to market discipline.

The most recent empirical studies do not find a negative relationship between leverage and profitability—which is one of the key underpinnings of the pecking-order theory.

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Signaling With Capital StructureCan Convey InformationA firm’s managers can adopt a

heavily leveraged capital structure, committing the firm to pay out large sums to bondholders.

In equilibrium, firms signal good news by issuing debt.

Investors know that with good prospects can afford to take on debt, they recognize a debt issuance as good news, and they bid up the firm’s shares.

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Empirical Evidence On Signaling Models

Leverage ratios are, if anything, negatively related to profitability in almost every industry.

Signaling models predict a positive relationship.

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A Checklist for Capital Structure Decision-Making

PositiveAsset tangibility

PositiveFirm size

PositiveRegulation (regulated industry?)

PositiveEffective (marginal) corp tax rate

NegativeNon-debt tax shields

NegativeEarnings volatility

NegativeMarket-to-book ratio

UnclearProfitability

Documented relationship between variable and leverageVariable

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A Checklist for Capital Structure Decision-Making

PositiveState ownership

NegativePersonal tax rate, debt income

PositivePersonal tax rate, equity income

PositiveCorporate income tax rate

NegativeCreditor power in bankruptcy

NegativeManagerial entrenchment

AmbiguousInsider share ownership

AmbiguousGrowth rate of firm’s assets

Documented relationship between variable and leverageVariable