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Capital structure limits to the use of debt
 

Capital structure limits to the use of debt

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BWFF3013: Corporate Finance

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 Capital structure limits to the use of debt Presentation Transcript

    • CAPITAL STRUCTURElimits to the use of debt4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr1
    • COSTS OF FINANCIAL DISTRESSBankruptcy 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 tobondholders• Bankruptcy costs/ financial distress costs tend to offset theadvantages of debt (see following example).4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr2
    • COSTS OF FINANCIAL DISTRESSBankruptcy risk or bankruptcy cost?• Knight corporation and Day corporation will remain in business for onemore 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 ignored4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr3
    • COSTS OF FINANCIAL DISTRESSBankruptcy 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 willreceive nothing4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr4Knight Corporation Day CorporationBoom times(prob. 50%)Recession(prob. 50%)Boom times(prob. 50%)Recession(prob. 50%)Cash flow $100 $ 50 $100 $ 50Financial obligation on debt 49 49 60 50Distribution to stock holders $ 51 $ 1 $ 40 $ 0
    • COSTS OF FINANCIAL DISTRESSBankruptcy 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+$𝟏×𝟎.𝟓𝟎𝟏.𝟏𝟎+$𝟒𝟗×𝟎.𝟓𝟎+$𝟒𝟗×𝟎.𝟓𝟎𝟏.𝟏𝟎= $𝟐𝟑. 𝟔𝟒 + 𝟒𝟒. 𝟓𝟒 = $𝟔𝟖. 𝟏𝟖𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀=$𝟒𝟎×𝟎.𝟓𝟎+$𝟎×𝟎.𝟓𝟎𝟏.𝟏𝟎+$𝟔𝟎×𝟎.𝟓𝟎+$𝟓𝟎×𝟎.𝟓𝟎𝟏.𝟏𝟎= $𝟏𝟖. 𝟏𝟖 + $𝟓𝟎 = $𝟔𝟖. 𝟏𝟖4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr5
    • COSTS OF FINANCIAL DISTRESSBankruptcy risk or bankruptcy cost?• In case of bankruptcy, some additional costs associated with the bankruptcy would reduce thevalue of the firm.• In this example, if the bankruptcy costs are $15,𝑽 𝑫𝑨𝒀 = 𝑺 𝑫𝑨𝒀 + 𝑩 𝑫𝑨𝒀=$𝟒𝟎 × 𝟎. 𝟓𝟎 + $𝟎 × 𝟎. 𝟓𝟎𝟏. 𝟏𝟎+$𝟔𝟎 × 𝟎. 𝟓𝟎 + $𝟑𝟓 × 𝟎. 𝟓𝟎𝟏. 𝟏𝟎= $𝟏𝟖. 𝟏𝟖 + $𝟒𝟑. 𝟏𝟖= $𝟔𝟏. 𝟑𝟔4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr6Knight Corporation Day CorporationBoom times(prob. 50%)Recession(prob. 50%)Boom times(prob. 50%)Recession(prob. 50%)Cash flow $100 $ 50 $100 $ 50Financial obligation on debt 49 49 60 5035Distribution to stock holders $ 51 $ 1 $ 40 $ 0
    • COSTS OF FINANCIAL DISTRESSBankruptcy risk or bankruptcy cost?• The yield or promised return to the bondholders of Day Corporation (withoutconsidering bankruptcy costs)$𝟔𝟎$𝟓𝟎− 𝟏 = 𝟐𝟎%• The yield or promised return to the bondholders of Day Corporation (consideringbankruptcy costs)$𝟔𝟎$𝟒𝟑. 𝟏𝟖− 𝟏 = 𝟑𝟗%• Summary– The possibility of bankruptcy has a negative effect on the value of the firm. However, it isnot the risk of bankruptcy itself that lowers the value. Rather, it is the costs associatedwith bankruptcy that lower value.4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr7
    • 4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr8COSTS OF FINANCIAL DISTRESSBankruptcy risk or bankruptcy cost?• Summary– The possibility of bankruptcy has a negative effect on the value of thefirm. However, it is not the risk of bankruptcy itself that lowers thevalue. Rather, it is the costs associated with bankruptcy that lowervalue.BFees and costs related tobankruptcy procedure
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSDirect 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 actuallysmall as a percentage of firm value4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr9
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSIndirect costs of financial distress• Impaired ability to conduct business– impaired service– loss of trust4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr10
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs• Conflict of interest arises between stockholders and bondholders of alevered firm• Stockholders are tempted to pursue selfish strategies• In a financial distress situation, these conflicts are magnified andimpose agency costs• There are three kinds of selfish strategies– taking large risks– underinvestment– milking the property4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr11
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs: taking large risks• When a firm is near bankruptcy, management may try to get the incentive fromtaking large risks– high risk projects increases firm value in a boom and its benefit is captured only bystockholders• 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 project4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr12
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs: taking large risks• If the firm invests in the low risk project:4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr13Outcome Prob. Value = Stock + BondsRecession 0.50 $100 = $ 0 + $100Boom 0.50 $200 = $100 + $100Expected value of the firm: $𝟏𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟎𝟎Expected value of the stock: $𝟓𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎• If the firm invests in the high risk project:Outcome Prob. Value = Stock + BondsRecession 0.50 $ 50 = $ 0 + $ 50Boom 0.50 $240 = $140 + $100Expected value of the firm: $𝟏𝟒𝟓 = 𝟎. 𝟓𝟎 × $𝟓𝟎 + 𝟎. 𝟓𝟎 × $𝟐𝟒𝟎Expected value of the stock: $𝟕𝟎 = 𝟎. 𝟓𝟎 × $𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟒𝟎
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs: underinvestment• If there is a significant probability of bankruptcy, stockholders oftenfind that new investment only help bondholders at their expense• Consider a firm considering the decision to accept or reject a newproject 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 boom4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr14
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs: taking large risks• Cash flows with and without the project:4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr15Without project With projectBoom Recession Boom RecessionFirm cash flows $5000 $2400 $6700 $4100Bondholders’ claim 4000 2400 4000 4000Stockholders’ claim $1000 $ 0 $2700 $ 100Expected value of stockholder interest without the project (also without any cost):$𝟓𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟎Expected value of stockholder interest with the project (also with a $1000 cost):$𝟏𝟒𝟎𝟎 = 𝟎. 𝟓𝟎 × $𝟐𝟕𝟎𝟎 + 𝟎. 𝟓𝟎 × $𝟏𝟎𝟎Thus, after spending $1000, stockholder interest rises by only:$𝟗𝟎𝟎 = $𝟏𝟒𝟎𝟎 − $𝟓𝟎𝟎Therefore, underinvestment brings incentive to the stockholders
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs: milking the property• If there is a significant probability of bankruptcy, the firm mayattempt higher cash distributions such as extra dividends to thestockholders• This strategy would result less assets to remain in the firm forthe bondholders.4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr16
    • DESCRIPTION OF FINANCIAL DISTRESS COSTSAgency costs• Who pays for the cost of selfish investment strategies?– it is ultimately stockholders• Rational bondholders know that stockholders would not help them atthe time of financial distress, rather they will become selfish• Hence, bondholders protects themselves by requiring higher interestrate on the bonds, which is paid by the stockholders• Thus, firms with greater probability of financial distress would finddebt costly4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr17
    • CAN COSTS OF DEBT BE REDUCED?Protective covenants• Stockholders will have to pay higher interest as insurance againsttheir selfish strategy• They often hope to lower the rate by agreeing several conditionsimposed by bondholders• These conditions are called ‘protective covenants’• Broken covenants can lead to default• Two types of protective covenants– negative covenants– positive covenants4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr18
    • 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 costsolution to stockholder-bondholder conflict4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr19
    • CAN COSTS OF DEBT BE REDUCED?Consolidation of debt• If the financially distressed firm has many creditors, they maycontend with each other• In this situation, negotiating costs increases• This problem can be alleviated by proper arrangement ofbondholders and stockholders– one, or perhaps a few lenders can shoulder the entire debt– bondholders can purchase the stocks4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr20
    • INTEGRATION OF TAX EFFECTS AND FINANCIALDISTRESS COSTS4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr21Debt (B)Value of firm (V)0Present value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + TCBV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debt
    • INTEGRATION OF TAX EFFECTS AND FINANCIALDISTRESS COSTS4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr22Debt (B)Cost of capital (%)0R0RWACCB*R0Optimal amount of debt
    • INTEGRATION OF TAX EFFECTS AND FINANCIALDISTRESS COSTS• A firm’s capital structure decision involves a trade-off betweenthe 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 ofcapital structure.4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr23
    • 4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr24BINTEGRATION OF TAX EFFECTS AND FINANCIALDISTRESS COSTSGLS
    • INTEGRATION OF TAX EFFECTS AND FINANCIALDISTRESS COSTS• The essence of the MM intuition is, firm’s capital structure merely cuts 𝑽 𝑻 intoslices, 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 𝑵Where, 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 andminimizes 𝑽 𝑵4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr25
    • SIGNALING• The firm’s capital structure is optimized where the marginal subsidyto 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 tofool investors will pay the cost in the long run.4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr26
    • AGENCY COST OF EQUITY• An individual will work harder for a firm if he is one of the owners than ifhe is one of the “hired help.”• While managers may have motive to partake in perquisites, they also needopportunity. Free cash flow provides this opportunity.• The free cash flow hypothesis says that an increase in dividends shouldbenefit the stockholders by reducing the ability of managers to pursuewasteful activities.• The free cash flow hypothesis also argues that an increase in debt will reducethe ability of managers to pursue wasteful activities more effectively thandividend increases.4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr27
    • THE PECKING ORDER THEORY• Theory stating that firms prefer to issue debt rather than equity if internalfinancing 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 slack4/30/2013Dr. Md Mohan Uddinhttp://lnkd.in/vvppcr28
    • GROWTH AND THE DEBT-EQUITY RATIO• Growth implies significant equity financing, even in a worldwith 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.
    • PERSONAL TAXES• Individuals, in addition to the corporation, must pay taxes. Thus,personal taxes must be considered in determining the optimalcapital structure.
    • PERSONAL TAXES• Dividends face double taxation (firm and shareholder), whichsuggests a stockholder receives the net amount:• (1-TC) x (1-TS)• Interest payments are only taxed at the individual level since they aretax deductible by the corporation, so the bondholder receives:• (1-TB)
    • 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)
    • 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 withtaxes.– 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.
    • HOW FIRMS ESTABLISH CAPITAL STRUCTUREFactors 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 probabilityof experiencing financial distress.• Pecking Order and Financial Slack– Theory stating that firms prefer to issue debt rather than equity if internalfinancing is insufficient.