Session 7 (Part

2)
Capital Structure: Limits to the Use of Debt
Ng Eng Wan
FCPA CIA ACMA CGMA
 Define the costs associated with bankruptcy
 Understand the theories that address the level of debt a

firm carries
◦ Tradeoff
◦ Signaling
◦ Agency Cost
◦ Pecking Order
 Know real world factors that affect the debt to equity
ratio

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17.1 Costs of Financial Distress
17.2 Description of Financial Distress Costs
17.3 Can Costs of Debt Be Reduced?
17.4 Integration of Tax Effects and Financial Distress Costs
17.5 Signaling
17.6 Shirking, Perquisites, and Bad Investments: A Note on
Agency Cost of Equity
17.7 The Pecking-Order Theory
17.8 Personal Taxes
17.9 How Firms Establish Capital Structure

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 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 stockholders who bear these costs.

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 Direct Costs
◦ Legal and administrative costs
 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

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Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0
Total $600 $200 Total $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

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The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 +
$0 = $100
$100
NPV = –$200 +
(1.50)
NPV = –$133

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 Expected CF from the Gamble
◦ To Bondholders = $300 × 0.10 + $0 = $30
◦ To Stockholders = ($1000 – $300) × 0.10 + $0
= $70
 PV of Bonds Without the Gamble = $200
 PV of Stocks Without the Gamble = $0

$30
• PV of Bonds With the Gamble: $20 =
(1.50)
$70
• PV of Stocks With the Gamble: $47 =
(1.50)
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 Consider a government-sponsored project that
guarantees $350 in one period.
 Cost of investment is $300 (the firm only has $200
now), so the stockholders will have to supply an
additional $100 to finance the project.
 Required return is 10%.

$350
NPV = –$300 +
(1.10)
NPV = $18.18
Should we accept or reject?

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Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 – $300) = $50

PV of Bonds Without the Project = $200

PV of Stocks Without the Project = $0
$300
PV of Bonds With the Project: $272.73 =
(1.10)

$50
PV of Stocks With the Project: – $54.55 = – $100
(1.10)

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 Liquidating dividends
◦ Suppose our firm paid out a $200 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

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 Protective Covenants
 Debt Consolidation:
◦ If we minimize the number of parties, contracting costs fall through coordination
between bondholders and stockholders, a few lenders can bear the debt, bondholders
can convert into stockholders

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A loan covenant is a condition in a commercial loan or bond issue that
requires the borrower to fulfill certain conditions or which forbids the
borrower from undertaking certain actions, or which possibly restricts
certain activities to circumstances when other conditions are met.

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 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.

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 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

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 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.
 V =S+B+G+L
T
 = Vm + Vn S
 Vm = marketable claims
B
(can be bought & sold)
 Vn = non-marketable claims
L G
(IRS & lawyers pay nothing to the firm)
 The increase in Vm implies an increase in Vn. Firms will choose
a capital structure to maximise the value of Vm & at the same
time minimize the value of Vn. .

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 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.
 Share buybacks
o A share buyback signals that the management believes the shares are under-priced and that the
future prospects are bright.
 Dividend Signaling
o It signals that the management expects to produce sufficient cash flow in the future and so
believes that it will be able to return some of that cash flow to its shareholders. Cutting
dividends has the opposite effect. In fact, the adverse public and price reaction to cutting
dividends is so strong that most managements try and avoid it at all costs.
 Signals from Management Buying or Selling Shares
o Management selling shares  can be taken as a sign of overvaluation or low future prospects.

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17-19
Tesla just announced a $500 Million Common Stock Offering. In other words, Tesla is issuing new shares in return for $500
million of cash. This money is to be used for expanding its business including Tesla Energy, the development of its next car –
Model 3 and building a giga-factory. The announcement also said “Elon Musk, Tesla’s CEO, intends to purchase $20 million of
common stock in this offering at the public offering price.”

What do you make of Tesla’s announcement to issue $500 million to fund capital projects?

As an investor, would this lead you buy Tesla’s stock or would you pause if you were planning to invest in Tesla stock?
If corporate actions were signals, what could you infer from this move?

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 Signal 1:  The Pecking Order Theory would suggest that Tesla offering
Equity is a negative signal. Why did Tesla avoid using internal funds or
more debt to finance these capital projects? Clearly Tesla has little
internal funds. Could it be because it already has too much debt (long
term debt is more than twice total equity). Could it be that the
management believes that the market price is far higher than what it can
be and so it is a good time to issue new equity?
 Signal 2: Management buying equity: A key part of the announcement
(in fact the third sentence) said “Elon Musk, Tesla’s CEO, intends to
purchase $20 million of common stock in this offering at the public
offering price.” Could this signify that Elon Musk believes that the share
price is undervalued? This is not that clear as $20 million is only 4% of
the total stock offering of $500 million. When compared with his overall
holding in Tesla or his personal wealth, this may be a minor move
intended for the signaling effect.

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 An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
 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 stockholders 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 (coz interest
& principal payment has legal obligation)..

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 Theory stating that firms prefer to issue debt rather than
equity if internal financing 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 (each firm chooses its leverage ratio) vs
optimum leverage in trade-off
◦ Profitable firms use less debt vs more in trade-off
◦ Companies like financial slack (cumulate more cash)

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Suppose ABC Company is looking to raise $10 million for an
investment project. The company’s stock price is currently trading
at $53.77. Three options are available for ABC Company:
1.Finance the project directly through retained earnings;

2.One-year debt financing with an interest rate of 8%, although

management believes that 7% is the fair rate
3.Issuance of equity that will underprice the current stock price by
7%.
What would be the cost to shareholders for each of the three

options?

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 Option 1: If management finances the project directly through retained
earnings, the cost is $10 million.
 Option 2: If management finances the project through debt issuance,
the one-year debt would cost $10.8 million ($10 x 1.08 = $10.8).
Discounting it back one year with the management’s fair rate would
yield a cost of $10.09 million ($10.8 / 1.07 = $10.09 million).
 Option 3: If management finances the project through equity issuance,
to raise $10 million, the company would need to sell 200,000 shares
($53.77 x 0.93 = $50, $10,000,000 / $50 = 200,000 shares). The true
value of the shares would be $10.75 million ($53.77 x 200,000 shares =
$10.75 million). Therefore, the cost would be $10.75 million.
 As illustrated, management should first finance the project through
retained earnings, second through debt, and lastly through equity.

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 Individuals, in addition to the corporation, must pay
taxes. Thus, personal taxes must be considered in
determining the optimal capital structure.

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 Dividends face double taxation (firm and shareholder),
which suggests a stockholder receives the net amount:
 (1-TC) x (1-TS)
 Interest payments are only taxed at the individual level
since they are tax deductible by the corporation, so the
bondholder receives:
 (1-TB)

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 If TS= TB then the firm should be financed primarily by debt (avoiding double tax) because
bondholders will receive more than stockholders (1- T B ) > (1- TC ) x (1- Ts )
 The firm is indifferent between debt and equity when:
(1-TC) x (1-TS) = (1-TB)

Tc = corporate income tax

Ts = personal income tax rate on stock dividends
Tb = personal income tax rate on bond interest

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 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 with taxes.
◦ Another interpretation is that firms signal good news when they
lever up.
 There are differences in capital structure across industries
and even through time.
 There is evidence that firms behave as if they had a target
Debt-Equity ratio.

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 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. Firms with large tangible assets likely to have
higher D/E ratio
 Uncertainty of Operating Income
◦ Even without debt, firms with uncertain operating income
have a high probability of experiencing financial distress.
Finance mostly with equity.
Capital structures of firms can vary significantly over time

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 What are the direct and indirect costs of bankruptcy?
 Define the “selfish” strategies stockholders may

employ in bankruptcy.
 Explain the tradeoff, signaling, agency cost, and

pecking order theories.

 What factors affect debt-equity levels?

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