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Financial distress Financial distress Presentation Transcript

  • Chapter 16 Chapter Outline 16.1 Default and Bankruptcy in a Perfect Market Financial Distress, 16.2 The Costs of Bankruptcy and Managerial Financial Distress Incentives, and Information 16.3 Financial Distress Costs and Firm Value 16.4 Optimal Capital Structure: The Tradeoff Theory Copyright © 2011 Pearson Prentice Hall. All rights reserved. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-2 16.1 Default and BankruptcyChapter Outline (contd) in a Perfect Market16.5 Exploiting Debt Holders: The Agency Costs of • Financial Distress Leverage – When a firm has difficulty meeting its debt obligations16.6 Motivating Managers: The Agency Benefits of • Default Leverage – When a firm fails to make the required interest or principal payments on its debt, or violates a debt16.7 Agency Costs and the Tradeoff Theory covenant • After the firm defaults, debt holders are given certain16.8 Asymmetric Information and Capital Structure rights to the assets of the firm and may even take legal ownership of the firm’s assets through bankruptcy.16.9 Capital Structure: The Bottom LineCopyright © 2011 Pearson Prentice Hall. All rights reserved. 16-3 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-4
  • 16.1 Default and Bankruptcy Armin Industries:in a Perfect Market (contd) Leverage and the Risk of Default • Armin is considering a new project. • An important consequence of leverage is the risk of bankruptcy. – While the new product represents a significant advance over Armin’s competitors’ products, the products success – Equity financing does not carry this risk. While equity is uncertain. holders hope to receive dividends, the firm is not • If it is a hit, revenues and profits will grow, and Armin will legally obligated to pay them. be worth $150 million at the end of the year. • If it fails, Armin will be worth only $80 million. • Armin may employ one of two alternative capital structures. – It can use all-equity financing. – It can use debt that matures at the end of the year with a total of $100 million due.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-5 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-6Scenario 1: New Product Succeeds Scenario 2: New Product Fails • If the new product is successful, Armin is worth • If the new product fails, Armin is worth only $80 $150 million. million. – Without leverage, equity holders will lose $20 million. – Without leverage, equity holders own the full amount. – With leverage, Armin will experience financial distress – With leverage, Armin must make the $100 million debt and the firm will default. payment, and Armin’s equity holders will own the • In bankruptcy, debt holders will receive legal ownership of remaining $50 million. the firm’s assets, leaving Armin’s shareholders with – With perfect capital markets, as long as the value of nothing. the firm’s assets exceeds its liabilities, Armin will be – Because the assets the debt holders receive have a value of $80 million, they will suffer a loss of $20 million. able to repay the loan. – If it does not have the cash immediately available, it can raise the cash by obtaining a new loan or by issuing new shares.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-7 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-8
  • Table 16.1 Value of Debt and Equity with andComparing the Two Scenarios without Leverage ($ millions)• Both debt and equity holders are worse off if the product fails rather than succeeds. – Without leverage, if the product fails equity holders lose $70 million. – With leverage, equity holders lose $50 million, and debt holders lose $20 million, but the total loss is the same, $70 million.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-9 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-10Comparing the Two Scenarios (contd) Bankruptcy and Capital Structure• If the new product fails, Armin’s investors are • With perfect capital markets, Modigliani-Miller equally unhappy whether the firm is levered and (MM) Proposition I applies: The total value to all declares bankruptcy or whether it is unlevered investors does not depend on the firm’s capital and the share price declines. structure.• Note, the decline in value is not caused by • There is no disadvantage to debt financing, and a bankruptcy: the decline is the same whether or firm will have the same total value and will be not the firm has leverage. able to raise the same amount initially from investors with either choice of capital structure. – 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.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-11 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-12
  • Textbook Example 16.1 Textbook Example 16.1 Example 16.1 (contd)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-13 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-1416.2 The Costs of Bankruptcy The Bankruptcy Codeand Financial Distress • With perfect capital markets, the risk of • The U.S. bankruptcy code was created so that bankruptcy is not a disadvantage of debt, rather creditors are treated fairly and the value of the bankruptcy shifts the ownership of the firm from assets is not needlessly destroyed. equity holders to debt holders without changing the total value available to all investors. – U.S. firms can file for two forms of bankruptcy protection: Chapter 7 or Chapter 11. – In reality, bankruptcy is rarely simple and straightforward. It is often a long and complicated process that imposes both direct and indirect costs on the firm and its investors.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-15 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-16
  • The Bankruptcy Code (contd) The Bankruptcy Code (contd)• Chapter 7 Liquidation • Chapter 11 Reorganization – A trustee is appointed to oversee the liquidation of the – Chapter 11 is the more common form of bankruptcy for firm’s assets through an auction. The proceeds from the large corporations. liquidation are used to pay the firm’s creditors, and the – With Chapter 11, all pending collection attempts are firm ceases to exist. automatically suspended, and the firm’s existing management is given the opportunity to propose a reorganization plan. • While developing the plan, management continues to operate the business. – The reorganization plan specifies the treatment of each creditor of the firm.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-17 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-18The Bankruptcy Code (contd) Direct Costs of Bankruptcy• Chapter 11 Reorganization • The bankruptcy process is complex, time- – Creditors may receive cash payments and/or new debt or consuming, and costly. equity securities of the firm. – Costly outside experts are often hired by the firm to • The value of the cash and securities is typically less than assist with the bankruptcy process. the amount each creditor is owed, but more than the creditors would receive if the firm were shut down – Creditors also incur costs during the bankruptcy process. immediately and liquidated. • They may wait several years to receive payment. – The creditors must vote to accept the plan, and it must • They may hire their own experts for legal and professional advice. be approved by the bankruptcy court. – The average direct costs of bankruptcy are – If an acceptable plan is not put forth, the court may approximately 3% to 4% of the pre-bankruptcy ultimately force a Chapter 7 liquidation. market value of total assets.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-19 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-20
  • Indirect Costs of Financial Distress Overall Impact of Indirect Costs• While the indirect costs are difficult to measure • The indirect costs of financial distress may accurately, they are often much larger than the be substantial. direct costs of bankruptcy. – It is estimated that the potential loss due to financial – Loss of Customers distress is 10% to 20% of firm value – Loss of Suppliers – The incremental losses that are associated with financial distress, above and beyond any losses that would occur – Loss of Employees due to the firm’s economic distress, must be identified. – Loss of Receivables – Fire Sale of Assets – Delayed Liquidation – Costs to CreditorsCopyright © 2011 Pearson Prentice Hall. All rights reserved. 16-21 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-2216.3 Financial Distress Costs Table 16.2 Value of Debt and Equity with andand Firm Value without Leverage ($ millions)• Armin Industries: The Impact of Financial Distress Costs – With all-equity financing, Armin’s assets will be worth $150 million if its new product succeeds and $80 million if the new product fails. – With debt of $100 million, Armin will be forced into bankruptcy if the new product fails. • In this case, some of the value of Armin’s assets will be lost to bankruptcy and financial distress costs. • As a result, debt holders will receive less than $80 million. • Assume debt holders receive only $60 million after accounting for the costs of financial distress.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-23 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-24
  • 16.3 Financial Distress Costs Textbook Example 16.2and Firm Value (contd)• Armin Industries: The Impact of Financial Distress Costs – As shown on the previous slide, the total value to all investors is now less with leverage than it is without leverage when the new product fails. • The difference of $20 million is due to financial distress costs. • These costs will lower the total value of the firm with leverage, and MM’s Proposition I will no longer hold.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-25 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-26Textbook Example 16.2 (contd) Who Pays for Financial Distress Costs? • For Armin, if the new product fails, equity holders lose their investment in the firm and will not care about bankruptcy costs. • However, debt holders recognize that if the new product fails and 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 (the present value of the bankruptcy costs less).Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-27 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-28
  • Who Pays for Financial Textbook Example 16.3Distress Costs? (contd)• When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-29 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-30 16.4 Optimal Capital Structure:Textbook Example 16.3 (contd) The Tradeoff Theory • According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs. V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-31 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-32
  • Determinants of the Present Value Determinants of the Present Valueof Financial Distress Costs of Financial Distress Costs (contd) Three key factors determine the present value of Three key factors determine the present value of financial distress costs: financial distress costs: 1. The probability of financial distress. 2. The magnitude of the costs after a firm is in distress. • The probability of financial distress increases with the • Financial distress costs will vary by industry. amount of a firm’s liabilities (relative to its assets). – Technology firms will likely incur high financial distress costs • The probability of financial distress increases with the due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily volatility of a firm’s cash flows and asset values. liquidated. – Real estate firms are likely to have low costs of financial distress since the majority of their assets can be sold relatively easily.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-33 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-34Determinants of the Present Value Optimal Leverageof Financial Distress Costs (contd) Three key factors determine the present value of • For low levels of debt, the risk of default remains financial distress costs: low and the main effect of an increase in leverage 3. The appropriate discount rate for the distress costs. is an increase in the interest tax shield. • Depends on the firm’s market risk • As the level of debt increases, the probability of – Note that because distress costs are high when the firm does poorly, the beta of distress costs has the opposite sign to default increases. that of the firm. – The higher the firm’s beta, the more negative the beta of its distress costs will be • The present value of distress costs will be higher for high beta firms.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-35 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-36
  • Figure 16.1 Optimal Leverage with Taxes and Optimal Leverage (contd)Financial Distress Costs • The tradeoff theory can help explain – Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the presence of financial distress costs) – Differences in the use of leverage across industries (due to differences in the magnitude of financial distress costs and the volatility of cash flows)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-37 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-38Textbook Example 16.4 Textbook Example 16.4 (contd)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-39 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-40
  • 16.5 Exploiting Debt Holders: 16.5 Exploiting Debt Holders:The Agency Costs of Leverage The Agency Costs of Leverage (contd)• Agency Costs • Consider Baxter, Inc., which is facing – Costs that arise when there are conflicts of interest financial distress. between the firm’s stakeholders – Baxter has a loan of $1 million due at the end of the• Management will generally make decisions year. that increase the value of the firm’s equity. – Without a change in its strategy, the market value of its However, when a firm has leverage, managers assets will be only $900,000 at that time, and Baxter will default on its debt. may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-41 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-42 Excessive Risk-Taking and Over-investmentExcessive Risk-Taking and Over-investment (contd)• Baxter is considering a new strategy • The expected value of the firm’s assets under the new strategy is $800,000, a decline of $100,000 – The new strategy requires no upfront investment, but it has only a 50% chance of success. from the old strategy. • 50% × $1.3 million + 50% × $300,000 = $800,000• If the new strategy succeeds, it will increase the value of the firm’s asset to $1.3 million. • Despite the negative expected payoff, some within the firm have suggested that Baxter should• If the new strategy fails, the value of the firm’s go ahead with the new strategy. assets will fall to $300,000. – Can shareholders benefit from this decision?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-43 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-44
  • Table 16.3 Outcomes for Baxter’s Debt and Excessive Risk-Taking and Over-investmentEquity Under Each Strategy ($ thousands) (contd) • Equity holders gain from this strategy, even though it has a negative expected payoff, while debt holders lose. – If the project succeeds, debt holders are fully repaid and receive $1 million. – If the project fails, debt holders receive only $300,000. • The debt holders’ expected payoff is $650,000, a loss of $250,000 compared to the old strategy. – 50% × $1 million + 50% × $300,000 = $650,000Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-45 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-46Excessive Risk-Taking and Over-investment Excessive Risk-Taking and Over-investment(contd) (contd)• The debt holders $250,000 loss corresponds to • Over-investment Problem the $100,000 expected decline in firm value due – When a firm faces financial distress, shareholders can to the risky strategy and the equity holder’s gain at the expense of debt holders by taking a negative- $150,000 gain. NPV project, if it is sufficiently risky.• Effectively, the equity holders are gambling with • Shareholders have an incentive to invest in the debt holders’ money. negative-NPV projects that are risky, even though a negative-NPV project destroys value for the firm overall. – Anticipating this bad behavior, security holders will pay less for the firm initially.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-47 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-48
  • Table 16.4 Outcomes for Baxter’s Debt and EquityDebt Overhang and Under-investment with and without the New Project ($ thousands)• Now assume Baxter does not pursue the risky strategy but instead the firm is considering an investment opportunity that requires an initial investment of $100,000 and will generate a risk- free return of 50%.• If the current risk-free rate is 5%, this investment clearly has a positive NPV. – What if Baxter does not have the cash on hand to make the investment? – Could Baxter raise $100,000 in new equity to make the investment?Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-49 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-50Debt Overhang and Under-investment (contd) Debt Overhang and Under-investment (contd)• If equity holders contribute $100,000 to fund the • Under-investment Problem project, they get back only $50,000. – A situation in which equity holders choose not to invest – The other $100,000 from the project goes to the debt in a positive NPV project because the firm is in financial holders, whose payoff increases from $900,000 to $1 distress and the value of undertaking the investment million. opportunity will accrue to bondholders rather than – The debt holders receive most of the benefit, thus this themselves. project is a negative-NPV investment opportunity for equity holders, even though it offers a positive NPV for • When a firm faces financial distress, it may the firm. choose not to finance new, positive-NPV projects. • This is also called a debt overhang problem.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-51 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-52
  • Cashing Out Agency Costs and the Value of Leverage • When a firm faces financial distress, • Leverage can encourage managers and shareholders have an incentive to withdraw shareholders to act in ways that reduce firm money from the firm, if possible. value. – For example, if it is likely the company will default, the – It appears that the equity holders benefit at the expense firm may sell assets below market value and use the of the debt holders. funds to pay an immediate cash dividend to the – However, ultimately, it is the shareholders of the firm shareholders. who bear these agency costs. • This is another form of under-investment that occurs when a firm faces financial distress.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-53 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-54Agency Costs Textbook Example 16.6and the Value of Leverage (contd)• When a firm adds leverage to its capital structure, the decision has two effects on the share price. – The share price benefits from equity holders’ ability to exploit debt holders in times of distress. – The debt holders recognize this possibility and pay less for the debt when it is issued, reducing the amount the firm can distribute to shareholders. • Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-55 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-56
  • Textbook Example 16.6 (contd) Debt Maturity and Covenants • The magnitude of agency costs often depends on the maturity of debt. – Agency costs are highest for long-term debt and smallest for short-term debt. • Debt Covenants – Conditions of making a loan in which creditors place restrictions on actions that a firm can take • Covenants may help to reduce agency costs, however, because covenants hinder management flexibility, they have the potential to prevent investment in positive NPV opportunities and can have costs of their own.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-57 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-5816.6 Motivating Managers: Concentration of OwnershipThe Agency Benefits of Leverage• Management Entrenchment • One advantage of using leverage is that it allows – A situation arising as the result of the separation of the original owners of the firm to maintain their ownership and control in which managers may make equity stake. As major shareholders, they will decisions that benefit themselves at investors’ expenses have a strong interest in doing what is best for• Entrenchment may allow managers to run the the firm. firm in their own best interests, rather than in the best interests of the shareholders.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-59 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-60
  • Concentration of Ownership (contd) Concentration of Ownership (contd)• Assume Ross is the owner of a firm and he plans • With leverage, Ross retains 100% ownership and to expand. He can either borrow the funds needed will bear the full cost of any “perks,” like country for expansion or raise the money by selling club memberships or private jets. shares in the firm. If he issues equity, he will • By selling equity, Ross bears only 60% of the need to sell 40% of the firm to raise the cost; the other 40% will be paid for by the new necessary funds. equity holders. – Thus, with equity financing, it is more likely that Ross will overspend on these luxuries.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-61 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-62Reduction of Wasteful Investment Reduction of Wasteful Investment (contd)• A concern for large corporations is that managers • Managers may over-invest because they may make large, unprofitable investments. are overconfident.• Managers may engage in empire building. – Even when managers attempt to act in shareholders’ interests, they may make mistakes. – Managers of large firms tend to earn higher salaries, and • Managers tend to be bullish on the firm’s prospects and they may also have more prestige and garner greater may believe that new opportunities are better than they publicity than managers of small firms. actually are. • Thus, managers may expand unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-63 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-64
  • Reduction of Wasteful Investment (contd) Reduction of Wasteful Investment (contd) • Free Cash Flow Hypothesis • Leverage can reduce the degree of managerial – The view that wasteful spending is more likely to occur entrenchment because managers are more likely when firms have high levels of cash flow in excess of to be fired when a firm faces financial distress. what is needed after making all positive-NPV – Managers who are less entrenched may be more investments and payments to debt holders concerned about their performance and less likely to • When cash is tight, managers will be motivated engage in wasteful investment. to run the firm as efficiently as possible. • In addition, when the firm is highly levered, – According to the free cash flow hypothesis, creditors themselves will closely monitor the leverage increases firm value because it commits the actions of managers, providing an additional layer firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by of management oversight. managers.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-65 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-6616.7 Agency Costsand the Tradeoff Theory Figure 16.2 Optimal Leverage with Taxes, Financial Distress, and Agency Costs• The value of the levered firm can now be shown to be V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs) − PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-67 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-68
  • The Optimal Debt Level Debt Levels in Practice• R&D-Intensive Firms • Although the tradeoff theory explains how firms – Firms with high R&D costs and future growth should choose their capital structures to maximize opportunities typically maintain low debt levels. value to current shareholders, it may not coincide – These firms tend to have low current free cash flows and with what firms actually do in practice. risky business strategies. • The arguments of the tradeoff theory are static,• Low-Growth, Mature Firms but there seems to be a dynamic component in the choice of the optimal capital structure. – Mature, low-growth firms with stable cash flows and tangible assets often carry a high-debt load. • Real firms seem to change their capital structure – These firms tend to have high free cash flows with few frequently and to converge towards an optimal good investment opportunities. level only in the very long run.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-69 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-7016.8 Asymmetric Information Leverage as a Credible Signaland Capital Structure• Asymmetric Information • Credibility Principle – A situation in which parties have different information – The principle that claims in one’s self-interest are credible only if they are supported by actions that would – For example, when managers have superior information be too costly to take if the claims were untrue. to investors regarding the firm’s future cash flows • “Actions speak louder than words.” • Signaling Theory of Debt – The use of leverage as a way to signal information to investors • Thus a firm can use leverage as a way to convince investors that it does have information that the firm will grow, even if it cannot provide verifiable details about the sources of growth.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-71 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-72
  • Leverage as a Credible Signal (contd) Textbook Example 16.7• Assume a firm has a large new profitable project, but cannot discuss the project due to competitive reasons. – One way to credibly communicate this positive information is to commit the firm to large future debt payments. • If the information is true, the firm will have no trouble making the debt payments. • If the information is false, the firm will have trouble paying its creditors and will experience financial distress. This distress will be costly for the firm.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-73 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-74Textbook Example 16.7 (contd) Issuing Equity and Adverse Selection • Adverse Selection – The idea that when the buyers and sellers have different information, the average quality of assets in the market will differ from the average quality overall • 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.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-75 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-76
  • Issuing Equity Issuing Equityand Adverse Selection (contd) and Adverse Selection (contd)• A classic example of adverse selection and the • This same principle can be applied to the market lemons principle is the used car market. for equity. – If the seller has private information about the quality of – Suppose the owner of a start-up company offers to sell you 70% of his stake in the firm. He states that he is the car, then his desire to sell reveals the car is probably selling only because he wants to diversify. You suspect of low quality. the owner may be eager to sell such a large stake – Buyers are therefore reluctant to buy except at heavily because he may be trying to cash out before negative discounted prices. information about the firm becomes public. – 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.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-77 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-78Issuing Equity Issuing Equityand Adverse Selection (contd) and Adverse Selection (contd)• Firms that sell new equity have private • Therefore, managers who know their prospects information about the quality of the future are good (and whose securities will have a high projects. value) will not sell new equity. – However, due to the lemon principle, buyers are • Only those managers who know their firms have reluctant to believe management’s assessment of the poor prospects (and whose securities will have new projects and are only willing to buy the new equity at heavily discounted prices. low value) are willing to sell new equity.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-79 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-80
  • Textbook Example 16.8 Textbook Example 16.8 (contd)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-81 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-82 Figure 16.3 Stock Returns BeforeImplications for Equity Issuance and After an Equity Issue• The lemons principle directly implies that: – The stock price declines on the announcement of an equity issue. – The stock price tends to rise prior to the announcement of an equity issue. – Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-83 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-84
  • Implications for Capital Structure Implications for Capital Structure (contd)• Managers who perceive the firm’s equity is • Pecking Order Hypothesis underpriced will have a preference to fund – The idea that managers will prefer to fund investments investment using retained earnings, or debt, by first using retained earnings, then debt and equity rather than equity. only as a last resort – The converse is also true: Managers who perceive the – However, this hypothesis does not provide a clear firm’s equity to be overpriced will prefer to issue equity, prediction regarding capital structure. While firms should as opposed to issuing debt or using retained earnings, to prefer to use retained earnings, then debt, and then fund investment. equity as funding sources, retained earnings are merely another form of equity financing. • 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 sufficiently profitable to finance all investment using retained earnings.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-85 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-86Textbook Example 16.9 Textbook Example 16.9 (contd)Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-87 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-88
  • Implications for Capital Structure (contd) 16.9 Capital Structure: The Bottom Line• Market Timing View of Capital Structure • The optimal capital structure depends on market – The firm’s overall capital structure depends in part on imperfections, such as taxes, financial distress the market conditions that existed when it sought costs, agency costs, and asymmetric information. funding in the past. • The tradeoff theory assumes an optimal capital structures that arises as the tradeoff of the tax benefits of debt with the costs of distress and of agency problems. • In reality the chosen capital structure seems to depend more on current financing costs, that result out of problems of asymmetric information.Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-89 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 16-90