Capital Structure – Limits to the

Use of Debt

RWJ Chp 16
 Costs of Financial Distress
• Bankruptcy risk versus bankruptcy cost.
• The possibility of bankruptcy has a negative
effect on the value of the firm.
• However, it is not the risk of bankruptcy itself that
lowers value.
• Rather it is the costs associated with bankruptcy.
• It is the shareholders who bear these costs.
 Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a small
percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost
sales)
– Agency Costs
• Selfish strategy 1: Incentive to take large risks
• Selfish strategy 2: Incentive toward underinvestment
• Selfish Strategy 3: Milking the property
 Balance Sheet for a Company
in Distress
Assets BVMVLiabilities BV MV
Cash RM200 RM200 LT bonds RM300 RM200
F.Asset RM400RM0Equity RM300 RM0
Total RM600 RM200 Total RM600 RM200

What happens if the firm is liquidated today?

The bondholders get RM200; the shareholders get nothing.

 Selfish Strategy 1: Take Large
Risks
The Gamble Probability Payoff
Win Big 10% RM1,000
Lose Big 90% RM0

Cost of investment is RM200 (all the firm’s cash)

Required return is 50%
Expected CF from the Gamble = RM1000 × 0.10 + RM0 = RM100

$100
NPV  $200 
1.50
NPV  $133
Selfish shareholders Accept Negative
NPV Project with Large Risks
• Expected CF from the Gamble
– To Bondholders = RM300 × 0.10 + RM0 = RM30
– To shareholders = (RM1000 - RM300) × 0.10 +
RM0 = RM70

• PV of Bonds Without the Gamble = RM200

• PV of Stocks Without the Gamble = RM0

• PV of Bonds With the Gamble = RM30 / 1.5 = RM20

• PV of Stocks With the Gamble = RM70 / 1.5 = RM47
 Selfish Strategy 2:
Underinvestment
• Consider a government-sponsored project that guarantees
RM350 in one period
• Cost of investment is RM300 (the firm only has RM200 now)
so the shareholders will have to supply an additional RM100
to finance the project
• Required return is 10%
$350
NPV  $300 
1.10
NPV  $18.18
Should we accept or reject?
 Selfish shareholders Forego Positive
NPV Project
• Expected CF from the government sponsored project:
– To Bondholder = RM300
– To Stockholder = (RM350 - RM300) = RM50

• PV of Bonds Without the Project = RM200

• PV of Stocks Without the Project = RM0

• PV of Bonds With the Project = RM300 / 1.1 = RM272.73

• PV of Stocks with the project = RM50 / 1.1 - RM100 =

-RM54.55
 Selfish Strategy 3: Milking the
Property
• Liquidating dividends
– Suppose our firm paid out a RM200 dividend
to the shareholders. This leaves the firm
insolvent, with nothing for the bondholders, but
plenty for the former shareholders.
– Such tactics often violate bond indentures.
• Increase perquisites to shareholders
and/or management
 Can Costs of Debt Be Reduced?

• Protective Covenants
• Debt Consolidation:
– If we minimize the number of parties,
contracting costs fall.
 Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– Pay dividends beyond specified amount.
– Sell more senior debt & amount of new debt is
limited.
– Refund existing bond issue with new bonds paying
lower interest rate.
– Buy another company’s bonds.
• Positive covenant: Thou shall:
– Use proceeds from sale of assets for other assets.
– Allow redemption in event of merger or spinoff.
– Maintain good condition of assets.
– Provide audited financial information.
Integration of Tax Effects and Financial
Distress Costs
• There is a trade-off between the tax
advantage of debt and the costs of
financial distress.
• It is difficult to express this with a precise
and rigorous formula.
Integration of Tax Effects and Financial
Distress Costs
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCB

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B*
Optimal amount of debt
 The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
• Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
• VT = S + B + G + L
S
B

L G

• The essence of the M&M intuition is that VT depends on

the cash flow of the firm; capital structure just slices the
pie.
Shirking, Perquisites, and Bad Investments:
The Agency Cost of Equity
• An individual will work harder for a firm if he is one of
the owners than if he is one of the “hired help”.
• Who bears the burden of these agency costs?
• While managers may have motive to partake in
perquisites, they also need opportunity. Free cash flow
provides this opportunity.
• The free cash flow hypothesis says that an increase in
dividends should benefit the shareholders by reducing
the ability of managers to pursue wasteful activities.
• The free cash flow hypothesis also argues that an
increase in debt will reduce the ability of managers to
pursue wasteful activities more effectively than dividend
increases.
 The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next, equity last.
• The pecking-order Theory is at odds with the trade-off
theory:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack
Growth and the Debt-Equity Ratio

• Growth implies significant equity

financing, even in a world with 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: The Miller Model
• The Miller Model shows that the value of a levered firm
can be expressed in terms of an unlevered firm as:

 (1  TC )  (1  TS ) 
VL  VU  1  B
 1  TB 
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
 Personal Taxes: The Miller Model
The derivation is straightforward:
Shareholders in a levered firm receive
( EBIT  rB B)  (1  TC )  (1  TS )
Bondholders receive
rB B  (1  TB )
Thus, the total cash flow to all stakeholders is
( EBIT  rB B)  (1  TC )  (1  TS )  rB B  (1  TB )

This can be rewritten as

 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB B  (1  TB )  1  
 1  T B 
Continued…
 Personal Taxes: The Miller Model (cont.)
The total cash flow to all stakeholders in the levered firm is:

 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB B  (1  TB )  1  
 1  T B 

The first term is the cash A bond is worth B. It promises to

flow of an unlevered firm pay rBB×(1- TB) after taxes. Thus
after all taxes. the value of the second term is:
Its value = VU.  (1  TC )  (1  TS ) 
B  1  
 1  TB 
The value of the sum of these
two terms must be VL
 (1  TC )  (1  TS ) 
VL  VU  1  B
 1  TB 
Personal Taxes: The Miller Model (cont.)
• Thus the Miller Model shows that the value of a levered
firm can be expressed in terms of an unlevered firm as:

 (1  TC )  (1  TS ) 
VL  VU  1  B
 1  TB 
 In the case where TB = TS, we return to M&M with
only corporate tax:

VL  VU  TC B
Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
 (1  TC )  (1  TS ) 
VL  VU  1  B
 1  TB 
Value of firm (V)

VL = VU+TCB when TS =TB

V L < VU + T C B
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VU VL =VU
when (1-TB) = (1-TC)×(1-TS)

VL < VU when (1-TB) < (1-TC)×(1-TS)

Debt (B)
Integration of Personal and Corporate Tax Effects
and Financial Distress Costs and Agency Costs
Present value of
Value of firm (V) financial distress costs Value of firm under
MM with corporate
taxes and debt
Present value of tax
shield on debt VL = VU + TCB

Maximum VL < VU + TCB

firm value when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VU = Value of firm with no debt
V = Actual value of firm

Agency Cost of Equity Agency Cost of Debt

0 Debt (B)
B*
Optimal amount of debt
How Firms Establish Capital Structure

• Most Corporations Have Low Debt-Asset Ratios.

• Changes in Financial Leverage Affect Firm Value.
– Stock price increases with increases in leverage and
vice-versa; this is consistent with M&M with taxes.
– 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 to Equity ratio.
 Factors in Target D/E Ratio
• Taxes
– If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt.
• 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 high probability of experiencing financial distress.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
 Summary and Conclusions
• Costs of financial distress cause firms to restrain their
issuance of debt.
– Direct costs
• Lawyers’ and accountants’ fees
– Indirect Costs
• Impaired ability to conduct business
• Incentives to take on risky projects
• Incentives to underinvest
• Incentive to milk the property
• Three techniques to reduce these costs are:
– Protective covenants
– Repurchase of debt prior to bankruptcy
– Consolidation of debt
 Summary and Conclusions
• Because costs of financial distress can be
reduced but not eliminated, firms will not
finance entirely with debt.
Value of firm (V) Value of firm under
Present value of tax MM with corporate
shield on debt taxes and debt
VL = VU + TCB

Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt

0 Debt (B)
B*
Optimal amount of debt
 Summary and Conclusions
• If distributions to equity holders are taxed at a lower
effective personal tax rate than interest, the tax advantage
to debt at the corporate level is partially offset. In fact, the
corporate advantage to debt is eliminated if (1-TC) × (1-TS) =
(1-TB)
Present value of
Value of firm (V) financial distress costs Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt VL = VU + TCB

Maximum VL < VU + TCB when TS < TB

firm value
but (1-TB) > (1-TC)×(1-TS)
VU = Value of firm with no debt
V = Actual value of firm

Agency Cost of Equity Agency Cost of Debt

0 Debt (B)
B*
Optimal amount of debt
 Summary and Conclusions

• Debt-to-equity ratios vary across industries.

• Factors in Target D/E Ratio
– Taxes
• If corporate tax rates are higher than bondholder tax
rates, there is an advantage to debt.
– 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 high probability of experiencing financial
distress.