Capital Structure with Taxes and Bankruptcy Costs

Relaxing the assumption of no financial distress costs introduces

another claimant in the form of bankruptcy claims by lawyers
and others.
Lecture 5: Capital Structure 3

FNCE201 Corporate Finance

Firm value is therefore maximized for the capital structure that

pays the least in taxes and bankruptcy claims.
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Financial Distress and Bankruptcy Under Perfect Capital Market Conditions...

If taxes were the only consideration, most firms would be 100% Question 1
debt financed. Debt, however, puts pressure on firms because Sun Enterprises is about to launch a new venture. If the new venture
interest and principal payments are contractual obligations firms succeeds, Sun will be worth $250m at the end of the year. If it fails,
must meet. Sun will be worth only $90m. Sun may employ one of two alternative
capital structures:
A firm that finds it increasingly difficult to service its debt faces All-equity financing.
financial distress. If the firm defaults on debt payments or
violates a debt covenant, debt holders are given certain rights to Debt that matures at the end of the year with a total of $150
its assets. In the extreme case, debt holders take legal ownership million due.
of the firm’s assets through a bankruptcy process.

Shareholders, in contrast, cannot force a firm into bankruptcy if

it does not pay them (or reduces dividend payments).

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Scenario 1: New Venture Succeeds Scenario 1: New Venture Succeeds

If the new venture succeeds, Sun is worth $250m: In perfect capital markets, as long as the value of the firm’s
assets exceeds its liabilities, it will be able to repay the loan.
– Without Leverage: Equity-holders own the full amount.

– With Leverage: Sun must make $150m debt payment and If the firm does not have the cash immediately available, it can
equity-holders will own the remaining $100m. raise cash by obtaining a loan or issuing new shares.

Without Leverage With Leverage

Debt
Equity
Total

What if Sun does not have $150m in cash available at the end of
the year?

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Scenario 2: New Venture Fails Comparing the Two Scenarios

If the new venture fails, Sun is worth $90 million: Without Leverage With Leverage
– Without Leverage: The value to equity holders will fall to Success Failure Success Failure
$90m. Debt
Equity
– With Leverage: Sun will experience financial distress and Total
default. In bankruptcy, debt holders will receive legal
ownership of the firm’s assets, leaving shareholders with
nothing. Both debt and equity holders are worse o↵ if the new venture
fails:
– Without Leverage: If the venture fails, equity-holders will
Without Leverage With Leverage
lose $160m.
Debt
Equity – With Leverage: Equity-holders lose $100m, debt-holders
Total lose $60m.

The total loss is the same.

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Comparing the Two Scenarios
The decline in value when the new venture fails is not caused by
bankruptcy. It occurs whether or not the firm has leverage.
If the new venture fails, Sun will experience economic distress
(significant decline in the value of the firm’s assets) whether or
not it experiences financial distress due to leverage.
Assuming perfect capital markets, the risk of bankruptcy is
therefore not a disadvantage of debt. Bankruptcy instead shifts
ownership from equity holders to debt holders, without changing
the total value to all investors.
Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 9 / 37
The Costs of Bankruptcy and Financial Distress
Bankruptcy is however rarely simple and straightforward. It is
often a long and complicated process that imposes both direct
costs and indirect costs on the firm and its investors.
When a firm defaults, debt holders can take legal action to
collect payment by seizing the firm’s assets. Because most firms
have multiple creditors, it is difficult to guarantee that each
creditor will be treated fairly without proper coordination.
To this end, the bankruptcy code was created, so that firms can
file for bankruptcy protection.
Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 11 / 37
Bankruptcy and Capital Structure
Question 1 (Continued)
Suppose the risk-free rate is 4% and Sun’s new venture is equally
likely to succeed or fail. Also, assume that Sun’s cash flows are
unrelated to the state of the economy, so that the venture has a beta
of 0 and the cost of capital is equal to the risk-free rate.
Compute the value of Sun’s securities at the beginning of the
year with and without leverage.
Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 10 / 37
Bankruptcy Code
Chapter 7 (Liquidation). A trustee is appointed to oversee
the sale of the firm’s assets through an auction. Proceeds from
the liquidation are used to pay the firm’s creditors and the firm
ceases to exist.
Chapter 11 (Reorganization)
– All pending collection attempts are suspended and the firm
is given the opportunity to propose a reorganization plan.
– The plan specifies the treatment of each creditor who may
receive cash payments and/or new debt or equity securities
of the firm.
– Creditors must vote to accept the plan and it must be
approved by the bankruptcy court. If an acceptable plan is
not put forth, the court may ultimately force a Chapter 7
liquidation.
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Direct Costs of Bankruptcy
Although the bankruptcy code provides an orderly process for
settling a firm’s debt, it is still complex, time-consuming and
costly. The direct costs include legal, accounting, and
administrative costs that amount to about 2–5% of total firm
value for large (Fortune 500) companies.
Given the substantial costs involved, firms may avoid filing for
bankruptcy by first negotiating directly with creditors via:
– Workout. Where the firm in financial distress negotiates
directly with its creditors to reorganize.
– Prepackaged Bankrupty (Prepack). Where the firm
first develops a reorganization plan with the agreement of
its main creditors and then files Chapter 11 to implement
the plan.
Lecture 5: Capital Structure 3 FNCE201 Corporate Finance
Sun Enterprises again...
Question 2
With debt of $150 million, Sun will be forced into bankruptcy if the
new venture fails. In this case, some of the value of Sun’s assets will
be lost to bankruptcy and financial distress costs, such that debt
holders will receive $15 million less.
Without Leverage With Leverage
Success Failure Success Failure
Debt
Equity
Total
The costs of financial distress will lower the total value of the
firm with leverage and the MM Proposition I will no longer hold.
Lecture 5: Capital Structure 3 FNCE201 Corporate Finance
Indirect Costs
Although difficult to measure accurately, the indirect costs are
often much larger than direct costs, and is estimated at about
10 – 20% of firm value. Indirect costs include:
– Loss of customers. Customers may be unwilling to
purchase products whose values depend on their future
support or service from the distressed firm.
– Loss of suppliers. Suppliers may be unwilling to provide
firms with inventory if they fear they will not be paid.
– Loss of key employees. Difficulty in hiring new
employees. Existing ones may quit or be hired away.
– Loss of receivables. Difficulty collecting money owed
from customers.
– Fire-sale of assets. Accepting lower prices for its assets to
quickly raise cash.
13 / 37 Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 14 / 37
Sun Enterprises again...
Compute the value of Sun’s securities at the beginning of the
year with and without leverage, given that financial distress is
costly.
15 / 37 Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 16 / 37
Who Pays for Financial Distress Costs?
If the new venture fails, equity holders in Sun lose their
investment in the firm and will not care about bankruptcy costs.
Part I
Debt holders, however, recognize that if the new venture fails
and the firm defaults, they will not receive the full value of the
assets. They will therefore pay less for the debt initially.
Trade-O↵ Theory
Less money is therefore available for the firm to pay dividends,
repurchase shares, and make investments.

Who pays for Financial Distress Costs?

When securities are fairly priced, the original shareholders of a firm
pay the present value of the costs associated with bankruptcy and
financial distress.

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Trade-O↵ Theory Optimal Leverage

Where the firm picks its capital structure by trading o↵ the
benefits of the tax shield from debt against the costs of financial
distress.

VL = VU + PV (ITS) PV (Financial Distress Costs)

It implies that firms should increase their leverage until the level
at which the firm value is maximized, since the tax savings from
increasing leverage are perfectly o↵set by the increased
probability of incurring the costs of financial distress.

Trade-o↵ Theory can help explain:

– Why firms choose debt levels that are too low to fully
exploit the interest tax shield.
– Di↵erences in the use of leverage across industries.
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Factors determining the Present Value of Financial
Distress Costs

Probability of Financial Distress. Increases with the amount

of a firm’s liabilities (relative to its assets). Also increases with
the volatility of the firm’s cash flows and asset values.

Magnitude of the costs after a firm is in distress. Likely to

vary by industry. Higher for technology firms due to the
potential loss of customers and key personnel, as well as a lack
of tangible assets that can be easily liquidated.

Appropriate discount rate for the distress costs. The

present value of financial distress costs will be higher for high
beta firms.

Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 21 / 37

Agency Costs of Leverage

Part II Agency costs. Costs that arise when there are conflicts of
interest between the firm’s stakeholders.

Agency Costs & Benefits of Leverage Managers will generally make decisions that increase the value of
the firm’s equity.

However, when a firm has leverage, managers may make

decisions that benefit shareholders, but harm the firm’s creditors
and lower the total value of the firm.

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Exploiting Debt Holders Asset Substitution (or Over-investment)
Question 3 When a firm faces financial distress, shareholders can gain from
Baxter Inc. is facing financial distress. The firm has a loan of $1m decisions that increase the risk of the firm sufficiently, even if
due at the end of the year. Without a change in strategy, the market they have negative NPV. Because leverage encourages
value of its assets will be only $900,000 at that time and the firm will shareholders to replace low-risk assets with riskier assets, this is
default on its debt. Baxter is considering a new strategy that needs often referred to as the asset substitution problem.
no upfront investment but only has a 50% chance of success. If the
new strategy succeeds, the value of the firm’s assets will increase to May also lead to over-investment, as shareholders may gain if
$1.3m. Otherwise, it will fall to $300,000. the firm undertakes negative-NPV but sufficiently risky, projects.
Old Strategy New Risky Strategy
Success Failure Expected In either case, the total value of the firm will fall if the firm
Assets increases risk through a negative NPV decision or investment.
Debt Debt holders anticipating this bad behavior will pay less for the
Equity firm initially.

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Debt Overhang and Under-investment Debt Overhang (Under-investment)

Question 4
Assume Baxter does not adopt the risky strategy but instead
considers an investment opportunity that requires an initial Debt Overhang (Under-investment). When a firm faces
investment of $100,000 and will generate a risk-free return of 50%. financial distress, it may choose not to finance new,
The current risk-free rate is 5%. Baxter does not have the cash on positive-NPV projects because existing debt holders capture
hand to make the investment. Will shareholders fund the $100,000 in most of the project’s benefits.
new equity to make the investment?
The failure to invest is costly for debt holders and for the overall
Without New Project With New Project
value of the firm, because the firm is giving up on the NPV of
Existing assets
missed opportunities.
New project
Total firm value
Debt
Equity

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Estimating the Debt Overhang Estimating the Debt Overhang
How much leverage must a firm have for there to be a
significant debt overhang problem? Question 6
A firm has a D/E ratio of 1.2, an equity beta of 2.0, and a debt beta
Suppose shareholders invest an amount I in a new investment of 0.30. It is currently evaluating the following projects (amounts in
with similar risk to the rest of the firm. Equity holders will $m):
benefit from the new investment only if:
Project A B C D E
NPV DD Investment 100 50 85 30 75
PI = > (1)
I EE NPV 20 6 10 15 18

If D = 0 or D = 0 then NPV > 0. If the firm’s debt is risky,

the cuto↵ > 0 and increases with the firm’s leverage. Equity
holders will reject positive NPV projects with PI below the
cuto↵ leading to under-investment and reduction in firm value.

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Estimating the Debt Overhang Agency Benefits of Leverage

Concentration of Ownership. Leverage can benefit the firm
Which project will shareholders agree to fund?
by preserving ownership concentration and avoiding the agency
costs of reduced e↵ort and excessive spending on perks.

Encourage Leverage and Commitment. Leverage may also

Project A B C D E tie managers’ hands and commit them to pursue strategies with
Investment greater vigor than they would without the threat of financial
NPV distress. A firm with greater leverage may also become a fiercer
NPV competitor and act more aggressively in protecting its markets
I because it cannot risk the possibility of bankruptcy.

Reduces Wasteful Investment. Managers may make large,

What is the cost to the firm of the debt overhang?
Lecture 5: Capital Structure 3
unprofitable investments due to empire building and
overconfidence. Leverage increases firm value because it
commits the firm to making future interest payments, thereby
reducing excess cash flows and wasteful investment by managers.
FNCE201 Corporate Finance 30 / 37 Lecture 5: Capital Structure 3 FNCE201 Corporate Finance 31 / 37
Agency Costs and the Trade-O↵ Theory Agency Costs & Benefits of Leverage

Question 7
VL =VU + PV (ITS) PV (FD Costs) PV (Agency Costs)
If managed e↵ectively, Rearden Metal will have assets with a market
+ PV (Agency Benefits)
value of $200m, $300m or $400m next year, with each outcome being
equally likely. Managers, however, may decide to engage in wasteful
empire building, which will reduce Rearden’s market value by $20m in
all cases. Managers may also increase the risk of the firm, changing
the probability of each outcome to 50%, 5%, and 45% respectively.

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Workings Workings
What is the expected value of Rearden’s assets if it were run Suppose that the managers at Rearden Metal will engage in
efficiently? empire building unless that behavior increases the likelihood of
bankruptcy. What is the expected value of Rearden’s assets if it
has $190m in debt due in one year?
Suppose that the managers at Rearden Metal will engage in
empire building unless that behavior increases the likelihood of
bankruptcy. What is the expected value of Rearden’s assets if it
has $180m in debt due in one year?

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Workings Suggested Readings
Suppose that the managers at Rearden Metal will increase risk
to maximize the expected payo↵ to equity holders. What is
the expected value of its assets if it has $180m in debt due in
one year? J. Berk. and P. DeMarzo.
Corporate Finance 5th Global Edition 2020, Pearson Education,
Chapter 16.

FNCE201 Corporate Finance

Practice Questions 4 (Capital Structure 3)

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