Financial - Management - Sessions 3 and 4

Introduction CS- Perfect capital markets CS- Taxes WACC considerations CS- Financial distress CS- Agency and
S- Agency and asymmetric info References
Master 1 International Economics

University of Orléans
Financial Management
Capital Structure Theory
Sessions 3 and 4
Léonore Raguideau1
1
Université Paris Nanterre - EconomiX
Léonore Raguideau (UPN- EconomiX) Financial Management - Capital Structure November 12th and 13th, 2021 1 / 62
Introduction CS- Perfect capital markets CS- Taxes WACC considerations CS- Financial distress CS- Agency and asymmetric info References
Introduction 1 Introduction 2
Financial Management - Capital Structure
1 Introduction
Introduction 1
Introduction 2
2 Capital Structure in perfect capital markets
3 Capital Structure with taxes
4 WACC considerations
5 Capital Structure with financial distress
6 Capital Structure with agency costs and asymmetric information
7 References
Introduction 1
Discussed in Sessions 1 and 2

▶ Financial Management cycle
▶ Corporate financing stylized facts (linked to financial instruments, financial
markets, liquidity management)
▶ Investment decisions: Valuation of corporate projects and stocks
⋆ Cash-flow based investment rules
⋆ Stock valuation methods
⋆ Financing assumption: taken independently from the investment decision; as if
the investment were all-equity financed
▶ Discount rates that account for the specific risk of the expected cash flow
⋆ Cost of equity capital (used in the Dividend Discount Model and in investment
project valuation)
⋆ Weighted Average Cost of Capital (WACC) used in the DCF model, based on
both equity and debt costs of capital
Today’s course objective: To understand financing decisions, that is:
”How should a firm finance its investments?”
Introduction 2
Assumption: We only use the two main financing instruments discussed so

far, which are equity and debt
Capital structure, which is the relative proportion of debt and equity, is
therefore summarized by the debt-to-equity ratio (leverage ratio)
We know from Session 2 that contrary to real investment projects, buying or
issuing debt and shares are zero NPV investments, so that they don’t add
value to the firm
In this case, why would we be interested in capital structure of the firm, and
in possibly finding an optimal level of equity and debt?
Development of several Capital Structure Theories since the 1950s
▶ Importance of the Modigliani Miller frameworks
▶ Some alternative theories emphasizing the role of financial constraints
(excessive debt, financial distress) and information asymmetries
▶ Always in reference with the Market Value of the firm
Perfect markets CC problem MM1 Notations Unlevered Case 1 MV Case 1 CC Levered Case 2 MV Case 2 CC WACC Leverage impact 1 RP MM2

1 Introduction

Perfect capital markets assumption
Modigliani and Miller: the cost of capital problem
Modigliani and Miller Proposition I
Notations
Case 1: All equity financing
Case 1: Market Value of the firm
Case 1: Unlevered cost of capital
Case 2: Mixed equity and debt financing
Expected returns comparison between levered and unlevered firm
The Weighted Average Cost of Capital
Impact of leverage on various stakeholders
Investors’ replicating portfolios
Impact of leverage on shareholders and MM II
Conclusions

Perfect capital markets assumption
Atomistic competition
No frictions (no transaction costs)
No taxes
No information asymmetries (EMH)
Unlimited borrowing capacity for investor
Any two commodities which are perfect substitutes for each other must sell,
in equilibrium, at the same price.
Difference with complete markets?
Modigliani and Miller: the cost of capital problem
Franco Modigliani and Merton H. Miller (1958): “The Cost of Capital,

Corporation Finance and the Theory of Investment”, American Economic
Review, volume 48, n°3, pp 261-297
In certainty, rational decision-making criteria (profit maximization and market
value maximization) imply the same result:
The cost of capital of physical assets is equal to the rate of interest of bonds
(known series of cash flows)
Attempts to account for risk based on risk-adjustment of the cost of capital
Nevertheless, empirical evidence suggest no such influence of rate of interest
over the rate of investment
MM therefore develop a theory of investment of the firm under conditions of
uncertainty
▶ Based on market value optimization criterion (independent from owners’ utility
functions)
▶ Dealing with the effects of financial structure on market valuations
Modigliani and Miller Proposition I
”The market value of the firm is independent of its capital structure

and is given by capitalizing its expected profit at the rate ρk ”
”The firm’s average cost of capital is independent of its capital

structure and is equal to the capitalization rate of a pure equity
stream”
X̄
ρk = Vjj is the ratio of the expected profit on the assets of the firm j
(uncertain stream) to the market value of all securities of j
Proof by arbitrage: investors can put in place arbitrage portfolios if market

value of levered firm is different from that of unlevered firm (they basically
sell overvalued stocks and buy undervalued ones until arbitrage disappears)
Notations
Si : State i of the world at time 1 (usually two or three), with its associated probability p
CFi : Project’s cash flow in State i
E: Expectations operator
E (C1 ): Project’s expected cash flow at time 1
U: Market value of unlevered equity

rU : Expected rate of return of unleveraged equity / unlevered cost of capital
E : Market value of equity if firm is leveraged

rE : Expected rate of return of leveraged equity
D: Market value of debt if firm is leveraged
rD : Expected rate of return of debt
A: Market value of firm’s assets

rA : Expected rate of return of firm’s assets
rWACC : Weighted Average Cost of Capital
Case 1: All equity financing

Investments are financed by equity issuance: leverage ratio is zero and equity
is therefore ”unleveraged” or ”unlevered”
We consider a single investment that generates two cash flows depending on
states of the world: its expected cash flow is
E (C1 )=CF1 x p(S1 ) + CF2 x p(S2 )

Market value of the firm: since there is no debt, stockholders get all
investment’s cash flows, so that firm’s market value is equal to the market
value of the unleveraged equity
E0 (C1 )
A=U= 1+rU
Cost of capital of the firm: Equal to expected return of unlevered equity

E0 (C1 )−U
rU = U
We can calculate the expected return: rU =RU (S1 ) x p(S1 ) + RU (S2 ) x p(S2 )

Table: Project NPV, Market Value of unlevered equity and firm
Date 0 Date 1
S1 S2
Investment Expansion Recession
CFi -800 1400 900
Expected cash flow i (pS1 = pS2 = 1/2) 1400 X 1/2 900 X 1/2
Expected cash flow i 700 450
Sum of expected cash flows E(C1) 1150
Cost of capital of the project (r U) 15%

PV Expected cash flows (U=E(C1)/1+r U) 1000
NPV of project 200
Market Value of firm (A=U) 1000
Number of shares issued 50

Share price 20
Case 1: Unlevered cost of capital
Table: Expected return of unlevered equity
Date 0 Date 1
S1 S2
Initial Equity value Expansion Recession
CFi U=1000 1400 900
Return i (R U(Si)) 1400 /1000 -1 900/1000-1
Return i (R U(Si)) 40% -10%
Expected return r U 15%
E (rU )=rU (S1 ) x p(S1 )+rU (S2 ) x p(S2 )

rU =rA , that is project=equity= firm cost of capital
Case 2: Mixed equity and debt financing

Investments are financed both by debt and equity: leverage ratio is positive
and equity is ”leveraged” or ”levered”
We consider a single investment that generates two cash flows depending on
states of the world: its expected cash flow is
E (C1 )=CF1 x p(S1 )+CF2 x p(S2 )
Market value of the firm: Unaffected by leverage, because firm’s total cash
flows are still equal to the cash flows of the investment project
E0 (C1 )
A=E +D = 1+rA
Cost of capital of the firm: weighted average of the expected returns of

levered equity and debt, based on their relative weights in the financing mix
of the firm
E D
rA = E +D rE + E +D rD
Table: Market value of the leveraged firm
Date 0 Date 1
S1 S2
Investment Expansion Recession
CFi 1400 900
Market Value of the leveraged firm A=1000 700 450
Debt holders D=500 D(1+r D)=525 D(1+r D)=525
Shareholders E= ? 1400-525=875 900-525=375
Market Value of the firm is unchanged since project’s expected cash flow at Date 1 is
unchanged; so is the firm’s cost of capital.
Expected cash flow at Date 1 is now split between debt holders and shareholders
▶ Debt holders get their investment back plus a rD =5% fixed coupon
▶ Shareholders get the difference between project’s cash flows and debt
We can infer Market Value of Equity E=500 from the equality A=D+E
What has changed then compared to the unlevered case??
Expected returns comparison between levered and

unlevered firm
Date 0 Date 1 Date 1 return E(R)

S1 S2 S1 S2
Investment Expansion Recession Expansion Recession
Debt (r D) 500 525 525 5% 5% 5%
Unlevered equity (r U) 1000 1400 900 40% -10% 15%
Levered equity (r E) 500 875 375 75% -25% 25%
Equity cost of capital has changed compared to unlevered case

Expected return of levered equity is 25% versus 15% for unlevered equity
The risk premium asked by investors to take on equity is higher for the leveraged firm than
for the unleveraged firm
Firm’s cost of capital is now a WACC: Weighted Average Cost of Capital, but is equal to
the unlevered firm’s cost of capital rU
rA = rWACC = 50% x rE + 50% x rD = 12.5% + 2.5% = 15% = rU
The Weighted Average Cost of Capital

The WACC is constant and the same for the unleveraged and the leveraged firms
Source: BDM Chapter 14
Impact of leverage on various stakeholders
Entrepreneur financing an investment opportunity: indifferent regarding

equity and debt financing
▶ They receive the same amount of cash corresponding to the PV of the
expected cash flow of the project
▶ In example: either 1000 from shareholders, either 500 from debt holders and
500 from shareholders
Investors: Indifferent to invest in an unlevered or levered firm

▶ They can create their own leverage level by putting in place a replicating
portfolio (conditional to the unlimited borrowing capacity)
▶ The investor can modify it virtually by borrowing himself to buy stocks
(positive leverage) or by buying risk free assets (negative leverage)
▶ Hence the firm’s financial structure does not change investors’ income
Investors’ replicating porfolios
Releveraging Date 0 Date 1

S1 S2
Expansion Recession
Invest in unleveraged equity 1000 1400 900
Borrow to buy equity -500 -525 -525
Investor’s portfolio 500 875 375
Unleveraging Date 0 Date 1

S1 S2
Equity value Expansion Recession
Invest in leveraged equity 500 875 375
Invest in risk-free bond 500 525 525
Investor’s portfolio 1000 1400 900
Impact of leverage on shareholders and MM II
Shareholders: Higher equity return since the leveraged firm is riskier, with
additional risk depending on leverage ratio
▶ Before Modigliani Miller, people considered that the return on equity of the
leveraged firm was the same than the one of the unleveraged firm: this is false
MM Proposition II derived from Proposition I:

The expected return of levered equity is a linear function of leverage
rE = rU + DE (rU -rD )
E D E +D D
Proof: Since rU = E +D rE + E +D rD , E rU =rE + E rD
D D
Rearranging terms: rU + E rU =rE + E rD
Conclusions
MM Proposition I: The market value of the firm does not depend on the
leverage ratio
Whether the firms finance itself by debt or equity:

▶ It will have the same market value
▶ It will finance itself at the same cost
MM Proposition II: The WACC does not depend on the leverage ratio
On the contrary, there is a linear and positive relationship between leverage

and equity cost of capital
Introduction Graph Interest deduction Example Tax shield MM I with taxes Tax shield valuation WACC with taxes Graph Target lev Constant debt ra

1 Introduction

Introduction
Use of debt, equity and internal funds by US firms
The interest tax deduction principle
Computing the interest tax shield
Formal derivation of the interest tax shield
Impact of Interest tax shield on Market Value
Valuation of interest tax shield
WACC with taxes
WACC with taxes - Graph
Relaxation of the permanent debt assumption
Constant debt ratio exercise - corrections
Conclusions
5 Capital Structure with financial

Léonore Raguideau (UPN- EconomiX) distress
Financial Management - Capital Structure November 12th and 13th, 2021 21 / 62
Introduction
The Modigliani-Miller Propositions depend on key assumptions: perfect

markets, no transaction costs, investors able to borrow at the risk free rate,
. . . , no taxes
In real world, firms share some patterns relative to their financial structure
that contrast with the capital structure irrelevance of MM Propositions
▶ Seen in Session 1 course material - Sections 4, 5 and 6: Debt financing is
much more important than by equity financing in most countries
▶ In aggregate, firms tend to repurchase equity and to issue debt
This preference for debt is due to a fiscal advantage: a indebted firm pays
less taxes than an unlevered firm
Objective of the Session: to understand the impact of corporate taxes on
Market Value of the firm and on its cost of capital
Use of debt, equity and internal funds by US firms
The interest tax deduction principle
In all countries, corporations must pay taxes on their generated income

(profits) to government
▶ Corporate tax rate in France: 33%
▶ More attractive corporate tax rate in Central and Eastern EU countries and
Ireland: average 20% / 12,5%
Taxes are paid on the earnings after interest payments relative to debt
obligations have been deducted
Therefore, interest payments are tax-exempt and contribute to market value
of the firm
The gain from tax deductibility of interest payments is ”interest tax shield”
Interest tax shield = Corporate tax rate x Interest payments
NB: Dividends and retained earnings are not tax deductible
Computing the interest tax shield
Unlevered firm Leveraged firm

EBIT 1000 1000
Interest payments -600 0
Income before tax 400 1000
Taxes (33%) -132 -330
Net Income 268 670
Interest paid to debt holders 600 0
Income available to equity holders 268 670
Total available to all investors 868 670
Interest tax shield for this specific year = 600 X 33% = 198
Formal derivation of the interest tax shield

Two firms with identical, pre-tax, perpetual, expected annual cash flows CF
Firm A is unlevered (100% equity financed) and has a cost of capital of rU
Firm B is leveraged with debt, with a market value of D and a perpetual
expected interest rate rD
Corporate income tax : τc
Firm A expected after-tax cash flow: CFA = (1−τc ) x CF

Firm B expected after-tax cash flow:
CFB = (1−τc ) x (CF - rD D) + rD D
CFB = (1−τc ) x CF + τc rD D
CFB = CFA + τc rD D
The cash flows differ by the tax shield created by the tax deductability of
interest payment
Impact of Interest tax shield on Market Value
There are now three stakeholders amongst with cash flows of the firm are
split: shareholders, debt holders and government
Interest tax shield corresponds to a redistribution of corporate tax (equivalent
to a cash flow to government) to both shareholders and debt holders, hence
an additional cash flow for them. On the contrary, the government’s share is
reduced by issuing debt.
This reallocation has an impact on firm’s value
Modigliani-Miller Proposition I with Taxes:

The contribution of debt to the firm’s value is the Present Value of its
tax shield
VDebtFinanced = VAllEquityFinanced + PV [Taxshield]
Valuation of interest tax shield
As in MM Propositions I and II, we made the assumption of perpetual debt

(i.e. a permanent fixed cash amount of debt) and cash flows for the firm
We need a tax shield cost of capital: we use the same as the required rate of
return on debt rD
τc rD D
PV[Tax shield]= rD
= τc D
Quite restrictive assumptions:

▶ Level of future interest payments varies due to changes in debt outstanding
(maturing debt and new issues)
▶ Changes in credit risk of the firm (may default and fail to make an interest
payment)
▶ Firm’s marginal tax rate may fluctuate due to changes in the taxcode and
changes in the firm’s income bracket
WACC with taxes
Tax deductibility of interest lowers the effective cost of debt financing to the
firm
Effective after-tax borrowing rate = rD (1 − τc )
We can therefore write the Weighted Average Cost of Capital after Taxes,
that includes the benefits of the interest tax shield on debt’s cost of capital
E D
rWACC = r
E +D E
+ r (1
E +D D
− τc )
E D D
rWACC = r
E +D E
+ r
E +D D
− r τ
E +D D c
Second formula indicates that WACC with Taxes is equal to

Pre-tax WACC + reduction due to Interest Tax shield
WACC with taxes - Graph

Relaxation of the permanent debt assumption

Firms usually don’t keep a constant cash level of debt
They follow a target debt/equity ratio D
E that they try to keep constant
D
NB: In WACC formula, we use the debt-to-value E +D or the equity-to-value
E
ratio E +D
Exercise: Implementing a constant debt to equity ratio
▶ 1/ Calculate the WACC of the company
▶ 2/ Would you invest in RFX project (E(CF): -28/18/18/18/18
▶ 3/ Calculate DE and E +D
D
▶ 4/ Which financing mix between debt, equity and cash should the CFO choose
to maintain this leverage ratio if he invests in RFX?
Constant debt ratio exercise - corrections
D
Conversion example: if leverage ratio is 50%, E
=50%, hence D=50%E;
D D
then E +D = 1.5E = 0.5
1.5
=0.33
To maintain its debt-to-value ratio, Avco must add 50% * 61.25 = USD 30.625 million in
new net debt. Avco can add this net debt either by reducing cash or by borrowing and
increasing debt.
Suppose Avco decides to spend its USD 20 million in cash and borrow an additional
USD10.625 million
Because only USD 28 million is required to fund the project, Avco will pay the remaining
30.625 - 28 = USD 2.625 million to shareholders through a dividend (or share repurchase)
This financing plan maintains Avco’s 50% debt-to-value ratio. The market value of Avco’s
equity increases by 330.625 - 300 = 30.625 million. Adding the dividend of 2.625 million,
the shareholders’ total gain is 30.625 + 2.625 = 33.25 million, which is exactly the NPV
we calculated for the RFX project.
Conclusions
Is there an optimal capital structure with regards to firm’s market value?

▶ In perfect capital markets: No, all capital structures are relevant or
equivalently, irrelevant
▶ With corporate taxes: interest payments should equal EBIT (the firm shields
all its taxable income, without excess leverage)
Stylized facts in favor of:
▶ A non-exhaustion of debt tax benefit: leverage ratio is more in the 30% area
and not 100%
▶ Leverage ratios depending on firm’s development stages (no debt for high
growth firms without taxable earnings)
▶ Leverage ratios depending on industries
One can therefore ask: what is the limit to debt?
WACC in perfect capital markets WACC with personal taxes Cost of capital practices Firm’s beta and leverage

1 Introduction
WACC in perfect capital markets
WACC with personal taxes
Cost of capital practices
Firm’s beta and leverage
7 References
WACC in perfect capital markets
In Modigliani Miller (1958), WACC is derived from two polar cases:

▶ either a one-year project
▶ or an investment yielding a perpetual cash flow (perpetuity)
Other assumptions: No taxes, constant unlevered equity cost of capital,
constant debt cost of capital
Miles and Ezzell (1980) prove WACC is relevant as a constant discount rate
for non-perpetual / uneven cash flow sequences
WACC with personal taxes
We have discussed so far the impact of corporate tax on market value and
WACC for the firm
In a similar fashion, personal taxes (i.e. at individual investor level) have also
a negative impact on cash flows available to debt holders and shareholders
▶ Tax on interest income: τi
▶ Tax on dividends (usually lower): τdiv
▶ Tax on capital gains (paid once): τcg
We therefore have an after-tax cash flow for debt holders equal to (1 − τi )
and for shareholders equal to (1 − τc )(1 − τdiv ) or (1 − τc )(1 − τcg )
there is still a tax advantage to debt, but a lower one
Impact on WACC: personal tax disadvantage for debt causes the WACC to
decline more slowly with leverage
NB: Many investors do not pay personal taxes (pension funds, investments
held in retirement accounts)
Cost of capital practices

Survey of industry practice (in Documents Booklet): W. Todd Brotherson, Kenneth M.
Eades, Robert S. Harris, and Robert C. Higgins (2013), “Best Practices in Estimating the
Cost of Capital: An Update”, Journal of Applied Finance
Weights: should be based on market-value mixes of debt and equity

After-tax cost of debt: should be estimated from marginal pretax costs, combined with
marginal tax rates
CAPM: currently the preferred model for estimating the cost of equity
Betas:drawn substantially from published sources and use of comparables
Risk-free rate: should match the tenor of the cash flows being valued. For most capital
projects and corporate acquisitions, the yield on the US government Treasury bond of ten
or more years in maturity would be appropriate.
Choice of an equity market risk premium: subject of considerable controversy both as to its
value and method of estimation
Monitoring for changes in WACC: at least annually
WACC should be risk-adjusted to reflect substantive differences among different businesses
in a corporation. For instance, financial advisors generally find the corporate WACC to be
inappropriate for valuing different parts of a corporation.
Firm’s beta and leverage
E D
βU = β
E +D E
+ β
E +D D
D
βE = βU + E
(βU -βD )
The firm’s unlevered beta (or asset beta) can be used to assess the cost of
capital for comparable investments
The firm’s equity beta increases with leverage
Financial distress Legal redress Bankruptcy 1 Bankruptcy 2 Bankruptcy and MM Distress costs MV Static Trade Off Theory Expected costs Distress a

1 Introduction

Financial distress
Legal redress
Bankruptcy (Legal liquidation)
Bankruptcy risk
Bankruptcy risk and Modigliani Miller Propositions
Costs of financial distress and bankruptcy
Market Value of the firm with financial distress
Static Trade Off Theory
Expected costs of financial distress
Distress costs and capital structure
6 Capital Structure with agencyFinancial

costsManagement
Léonore Raguideau (UPN- EconomiX) and asymmetric information
- Capital Structure November 12th and 13th, 2021 39 / 62
Financial distress definition

When taking on debt, the firm is committed to pay interest on a regular basis
and pay off the principal at maturity
There is a legal obligation for the firm to pay the interests
On the contrary, paying dividends to shareholders is optional, not mandatory.
When a firm has trouble meeting its debt obligations, the situation is called
“financial distress” and is due to leverage
Four stages
▶ Default of payment: the deadline for interest payments or pay off of the
principal is not fulfilled
▶ Suspension of payments: the firm is not able to pay back its debt considering
its assets.
▶ Bankruptcy: Management decides to start a legal proceeding. The court emits
a judgement, considering the firm’s situation
⋆ Legal redress of the company/ judicial management (most frequent)
⋆ Liquidation of the property
▶ Theoretically, a firm is in default when the market value of its assets fall below
the market value of its liabilities
Legal redress
Observation period: Appointment of a person (≪ receiver ≫ ) for evaluating

the assets and liabilities and assisting the manager
The court may take the following decisions
▶ Continuation schedule
▶ Rescheduling of debt and/ or haircut of the principal
▶ Cession plan : sale of a part of the assets
▶ Sale to a new owner, of all or parts of the firm
▶ Liquidation of the firm
Bankruptcy (Legal liquidation)
Legal situation: Chapter 7 of the Bankruptcy Code in the USA

The firm is shut down
The assets are sold at auction
Proceeds of the sale are divided amongst claim holders according to their
claims’ priority
▶ First employees
▶ Debtholders that have lent after the judicial process was triggered (privilege of
”fresh money”)
▶ Privileged lenders (Treasury,..)
▶ Debt holders with collateral (secured debt)
▶ Other debt holders according to their payment rank : senior, mezzanine, junior
▶ Stockholders (but there is little left, generally zero)
In the liquidation process, the ownership of the firm moves from the
shareholders to the bondholders
Bankruptcy risk
Bankruptcy risk does not always materialize and induce costs

Bankruptcy is not default
Taking on more debt raises the bankruptcy risk, because it is the non
payment of interests that leads to bankruptcy and not the non-payment of
dividends to shareholders
A firm unable to pay its interest with its current EBIT is no in default
necessarily, even if it has no cash
▶ EBIT may be negative for now, but not its expectations in the long run
▶ What matters is the NPV (with perfect information): If NPV > 0, the firm
can borrow more on financial markets and convince investors to bring more
cash to pay its interests
Bankruptcy risk and Modigliani Miller Propositions

Under perfect market assumptions, without taxes and without bankruptcy
costs, Modigliani Miller Proposition I holds
The market value of the levered firm is equal to the market value of the
unlevered firm
Even in the case of bankruptcy , the firm’s value recovered by the sum of
investors is equal to its assets, and then is independent of the financial
structure
Unlevered firm
Before bankruptcy After Bankruptcy
Debt value 0 0
Equity value 150 50
Levered firm
Before bankruptcy After Bankruptcy
Debt value 75 50
Equity value 75 0
The Modigliani Miller 2 Proposition holds as well: the WACC is still

independent of firm’s capital structure
Costs of financial distress and bankruptcy
In MM theory, financial distress and bankruptcy do not incur costs so they

have no impact on market value of the firm (total loss for the overall group
of investors does not change with leverage)
In real world, there are costs associated with financial distress and bankruptcy
▶ Direct costs: lawyers, auctioneers, auditors, bankers. . . (3 or 4% of assets)

▶ Indirect costs: loss of customers, contract breaks with suppliers, loss of
receivables, dismissals of employees, losses due to fire sales
▶ Some bankrutpcy costs examples: WorldCom USD 620m, Lehman Brothers
USD 2bn
In this context, MM Proposition 1 does not hold because these bankruptcy
and financial distress costs imply a loss of value to assets’ market value
Market Value of the firm with distress costs

1/ Bankruptcy without costs
Market Value of the firm without bankrutpcy costs

Cost of capital 5%
Unlevered Expected Equity value (U) - PV 95.24
Levered Expected Debt value - PV 59.52
Levered Expected Equity value - PV 35.71
E+D=U = MM 1 holds 95.24
2/ Bankruptcy with costs
Market Value of the levered firm with financial distress costs

Cost of capital 5%
Financial distress cost 25
Expected Value of Debt (D) - PV 49.40
Expected Value of Equity (E) - PV 35.71
E+D not equal to U = MM 1 does not hold 85.12
PV(financial stress costs) 10.12
Financial distress costs have a negative impact on the Market Value of the firm,
that can offset the interest tax shield benefit seen in previous Section
Trade Off Theory

VLeveredFirm =
VAllEquityFinanced + PV [Tax shield] − PV [Financial Distress Costs]
This trade off between financial leverage’s costs and benefits leads to another
optimal debt level compared to MM (Source: BDM Figure 16.1)
Expected costs of financial distress
Bankruptcy risk has a negative effect on the indebted firm, due to the
expected costs of financial distress
Probability of financial distress increases with debt level and with volatility in
firm’s benefits
Costs of financial distress depend on the recovery rate and liquidity of assets
▶ If costs of financial distress are zero, the expected cost is zero even if risk of
bankruptcy is high
Debt has a non linear effect on firm’s value
▶ When the debt ratio is low, an increase in the debt ratio mainly increases the
interest tax shield while financial distress is kept low
▶ When the debt ratio is high, a rise in the debt ratio mainly increases the risk
of bankruptcy and the expected costs of financial distress, more than trigger a
decrease in the interest tax shield
Distress costs and capital structure
Firms with low distress should use debt to get the interest tax shied (firms
with mostly tangible assets such as airlines, real estate companies)
Firms with high distress should follow conservative debt financing (firms with
mostly intangible assets)
Minimizing the costs of financial distress
▶ Avoid too much debt
▶ Use debt structure that is easy to understand (bank loans > bonds, few >
many banks,
few > many classes of debt)
NB: Firms with stable earnings can take on more debt (they can deduct paid
interest regularly from stable earnings) while firms with volatile benefits have
little incentive to borrow (earnings risk < paid interest, limit the deductibility
of earnings, while bankruptcy risk is higher)
Agency costs Asset substitution Under investment Free Cash Flow Theory Debt covenants Agency benefits Asymm info POT POT predictions STOT

1 Introduction

Agency costs of debt
Asset substitution or risk-shifting
Under investment
Free Cash Flow Theory
Debt covenants
Agency benefits of debt
Asymmetric information
Pecking Order Theory
Pecking Order Theory predictions
Static
Léonore Trade
Raguideau Off Theory predictions
(UPN- EconomiX) Financial Management - Capital Structure November 12th and 13th, 2021 50 / 62
Agency costs of debt
Agency costs: costs linked to conflicts inside the firm between the various
stakeholders (managers, shareholders and lenders)
Each of these categories has different interests (Session 1)
Incentives particularly diverge when a firm is on the edge of bankruptcy
▶ Shareholders fear to lose everything and want to extract a maximum of cash
from the firm, against lenders
▶ They may enter into non cooperative strategies when firms are in financial
distress
We focus here on:
▶ Stockholder-bondholder agency problems: asset substitution and under
investment
▶ Free-cash-flow agency problems
▶ How debt covenants may mitigate such problems
Asset substitution or risk-shifting

Agency problem: When a firm faces financial distress, shareholders can gain
from decisions that increase the risk of the firm sufficiently, even if these
decisions have a negative NPV (and as such decrease firm’s value)
There is an incentive for stockholders to shit from low risk assets to riskier
ones
Exercise
Immediate liquidation value of firm (for debtors) 200
NPV of risky project

Cost of capital 10%
PV [Sum of expected cash flows] E(C1) 90.91
NPV - 109.09
Market Value of the firm if risky project udertaken

Expected Value of Debt (D) - PV- Lenders are losers 27.27
Expected Value of Equity (E ) - PV- Stockholders are winners 63.64
Market Value 90.91
Under investment and debt overhang

Agency problem: When a firm faces financial distress, it may choose not to
finance new, positive NPV projects
Equity holders may be in a situation where they finance a positive NPV
project by lending cash to the firm (because firm cannot issue new equity for
instance): in this case, they are reluctant to invest because most of the
benefits go to debt holders
The project is therefore a negative NPV opportunity for shareholders, even
though it has a positive NPV for the firm
Exercise
Market Value of the firm
Without the project 200
With the project (increase) 218.18
Market Value for shareholders

With the project (we deduct the 100 cash loan) - decrease - 54.55
Market Value for debtholders

With the project - Increase 272.73
Free Cash Flow Theory
Agency problem: Managers may be tempted to undertake poor investments

once they have exhausted the good ones
Theory first advanced by M. Jensen in his 1986 AER article
”Empire Building” case: Managers are more interested in firm’s size than in
firm’s performance and value
More likely to happen when firms have high levels of cash flows in excess of
what is needed for operations
Leverage therefore increases firm value since it reduces unappropriate
investments from managers
Example: Oil industry in the 1970s and 1980s
▶ Excessive cash was not paid out to shareholders despite low oil demand and
high oil reserves
▶ Management continued exploration even though investment projects had a
negative NPV
Debt covenants
Covenants are clauses included in bond contracts that alleviate debt agency
costs
They protect the bond holders against the non cooperative strategies of
shareholders
They typically put limitations on:
▶ Dividend payments: don’t pay out dividends above a given amount (no
cashing out from the firm)
▶ Type of projects to be undertaken
▶ New debt issues: no more senior refinancing for the same assets, or new debt
with an order of priority above the current seniority
▶ Asset sales: use sales of assets to buy other assets (or maintain the assets in
good condition)
▶ Financial statements: Do release financial accounts at a regular frequency,
checked by an auditing firm
Agency benefits of debt
Shareholders and managers may collude against lenders, resulting in agency

costs
But diverging interests between shareholders and managers may also bring
about agency benefits of debt relatively to equity
Why may debt be preferable from equity in a agency cost context?
▶ Concentration of ownership: firm capital is less diluted. Less shareholders are
able to better control the manager; too many shareholders weaken their
control capacity
▶ Better control of management entrenchment effect: managers more likely to
be fired in case of financial distress, because because interest payments are
mandatory
▶ Monitoring of the firm through rating agencies
Asymmetric information
Managers have more information to assess the expected return on their
project than investors
Consequently, investors try to extract information from the manager’s
financial decisions
▶ Issuing debt is a positive signal
⋆ In theory investors know that managers in firms with low expected profits
should refrain from borrowing because of bankruptcy risk
⋆ On the contrary, firms with large expected profits should take on more debt to
benefit from fiscal deductions
⋆ Low risk of managers cheating investors
▶ Issuing equity is a negative signal (Issuing equity makes the equity price
decrease; Buying back equity increases the equity price)
⋆ Investor think managers have an incentive to issue equity when stock price is
high
⋆ If the manager decides to issue equity today, it is because he considers the
stock price is high, so maybe it is overvalued and will drop soon (?)
⋆ If the manager considered the equity price as low, he would expect it to
increase, and would have waited to issue new equity at a better price
⋆ This reasoning often triggers a decline in stock prices at the time of
announcement of a new issue (3 to 5%)
Pecking Order Theory
Pecking Order Theory developed by Myers (1984)

Because of asymmetric information, firms have a pecking order in their
financing sources
First: internal finance (it does not send any signal to investors)
Second: if they need external finance, they should issue debt (it only sends a
slightly positive signal)
Third: a firm can issue stocks
Theory seems consistent with stylized facts developed in Session 1 and 3
Empirical research from Fama and French (2002) that test the trade off and
pecking order model predictions
Pecking Order Theory predictions
Static Trade Off Theory predictions
1 Introduction
7 References
References
Leland, H.E., 1994, “Corporate Debt Value, Bond Covenants, and Optimal Capital Structure”,
Journal of Finance 49, 1213–1252.
Miles James A. and John R. Ezzell (1980), “The Weighted Average Cost of Capital, Perfect
Capital Markets, and Project Life: A Clarification”, The Journal of Financial and Quantitative
Analysis, Vol. 15, No. 3., pp. 719-730.
Modigliani, Franco and Merton H. Miller1 (1958), The Cost of Capital, Corporation Finance and
the Theory of Investment, The American Economic Review, Vol. 48, No. 3, pp. 261-297
Myers, S. C. (1974) ”Interactions of Corporate Financing and Investment Decision Implications

for Capital Budgeting.” Journal of Finance, Vol. 2, pp. 1-25
Bancel, Lathuille and Lhuissier (2013), “Why is your WACC necessarily wrong?“
W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins (2013), “Best
Practices in Estimating the Cost of Capital: An Update”, Journal of Applied Finance (Survey of
industry practice)
1 *The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1985,
awarded for “pioneering studies of saving and of financial markets”


Financial - Management - Sessions 3 and 4

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Financial - Management - Sessions 3 and 4

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Introduction CS- Perfect capital markets CS- Taxes WACC considerations CS- Financial distress CS- Agency and

S- Agency and asymmetric info References

Master 1 International Economics

Financial Management - Capital Structure

2 Capital Structure in perfect capital markets

3 Capital Structure with taxes

5 Capital Structure with financial distress

6 Capital Structure with agency costs and asymmetric information

Discussed in Sessions 1 and 2

Assumption: We only use the two main financing instruments discussed so

Financial Management - Capital Structure

2 Capital Structure in perfect capital markets

3 Capital Structure with taxes

Perfect capital markets assumption

Modigliani and Miller: the cost of capital problem

Franco Modigliani and Merton H. Miller (1958): “The Cost of Capital,

Modigliani and Miller Proposition I

”The market value of the firm is independent of its capital structure

”The firm’s average cost of capital is independent of its capital

Proof by arbitrage: investors can put in place arbitrage portfolios if market

U: Market value of unlevered equity

E : Market value of equity if firm is leveraged

A: Market value of firm’s assets

rWACC : Weighted Average Cost of Capital

Case 1: All equity financing

E (C1 )=CF1 x p(S1 ) + CF2 x p(S2 )

Cost of capital of the firm: Equal to expected return of unlevered equity

Case 1: Market Value of the firm

Cost of capital of the project (r U) 15%

Number of shares issued 50

Case 1: Unlevered cost of capital

Table: Expected return of unlevered equity

E (rU )=rU (S1 ) x p(S1 )+rU (S2 ) x p(S2 )

Case 2: Mixed equity and debt financing

E (C1 )=CF1 x p(S1 )+CF2 x p(S2 )

Cost of capital of the firm: weighted average of the expected returns of

Case 2: Market Value of the firm

Table: Market value of the leveraged firm

Expected returns comparison between levered and

Date 0 Date 1 Date 1 return E(R)

Equity cost of capital has changed compared to unlevered case

The Weighted Average Cost of Capital

Source: BDM Chapter 14

Impact of leverage on various stakeholders

Entrepreneur financing an investment opportunity: indifferent regarding

Investors: Indifferent to invest in an unlevered or levered firm

Investors’ replicating porfolios

Releveraging Date 0 Date 1

Unleveraging Date 0 Date 1

Impact of leverage on shareholders and MM II

MM Proposition II derived from Proposition I:

Whether the firms finance itself by debt or equity:

On the contrary, there is a linear and positive relationship between leverage

Financial Management - Capital Structure

2 Capital Structure in perfect capital markets

3 Capital Structure with taxes

5 Capital Structure with financial

The Modigliani-Miller Propositions depend on key assumptions: perfect

Use of debt, equity and internal funds by US firms

Source: BDM Chapter 16

The interest tax deduction principle

In all countries, corporations must pay taxes on their generated income