Finance 2 (6012B0457Y)

Arnoud Boot
University of Amsterdam – Finance Group
Tuesday FEBRUARY 20, 2024

Week 3: Lecture 1 = Concepts and Theory

Last time….

 Chapter 14: Capital structure indifference and fallacies

 Chapter 15: Capital structure and taxes
 Chapter 16: Capital structure and financial distress
 Followed by information and agency problems

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M&M with tax: disturbing (?) message

Question: What is the optimal capital structure when no tax

assumption is relaxed?
Answer: Firms should have as much leverage as possible….
Does capital structure matter now? Yes!
 But does this maximum leverage make any sense??

Many companies have low leverage. WHY? Today, we will try

to answer this question…

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Chapter 16: Theories of Optimal Financial Leverage

Agenda for today (and next lecture…)

 Trade-off theory (considering tax benefits vs costs of
financial distress)
 Agency theory (based on agency costs arising from
conflicts between managers, shareholders and creditors)
 Pecking order theory (leads to ranking of types of
financing: from retained earnings, debt to equity)
 Theory is based on asymmetric information
 Issuing equity may signal poor information about the firm

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Introducing another market imperfection –
financial distress…

• What happens if a firm increases its debt level?

• Probability that the firm defaults on its debt
because of financial distress increases
• What is the impact?

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Consider financial distress

• What is financial distress?

 When a firm has difficulty meeting its debt obligations
 Insolvency means: unable to pay obligations

• Default
 When a firm fails to make the required interest or principal
payments on its debt, or violates a debt covenant
• After the firm defaults, debt holders can go to court – and might be
given certain rights to the assets of the firm and may even take legal
ownership of the firm’s assets through bankruptcy (= legal
procedure)
• Note:
 Equity-holders are residual claimants (i.e. last in line)
 100% equity financing carries no risk of default (from financing)
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Capital structure and insolvency: costly?

• In perfect markets, capital structure does not affect

the cost of financial distress/insolvency
 Ownership moves smoothly to debt holders…
 What does this mean?
• Yet, in reality, disagreements and conflicts of
interest…
 Main problem: information problems
• These conflicts lead to costly legal procedures and
distort real decisions

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Capital structure and insolvency: the
‘does not matter result’
Example:
Consider two identical yet differently financed firms. Assume
everybody is risk neutral, and no discounting.
Firm A Firm B
State 1 State 2 State 1 State 2
(50% prob) (50% prob) (50% prob) (50% prob)
Cash flow 100 50 100 50

Claim of debt holders 40 40 60 60 (!)

Available for shareholders 60 10 40 0

Is there a possibility of financial distress/insolvency/default?

 Calculate the equity, debt and firm values for each firm
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 Example insolvency cont’d
Firm A Firm B
State 1 State 2 State 1 State 2
(50% prob) (50% prob) (50% prob) (50% prob)
Cash flow 100 50 100 50

Claim of debt holders 40 40 60 60 (50!)

Available for shareholders 60 10 40 0

What is the market value of both firms?

DA = 0.5*40 + 0.5*40 = 40 DB = 55
EA = 0.5*60 + 0.5*10 = 35 EB = 20
VA = 0.5*100 + 0.5*50 = 75 VB = 75

Conclusion? Does insolvency matter??

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Capital structure and insolvency: costly?
• In perfect markets, capital structure does not affect costs of
financial distress/insolvency
 ownership moves smoothly to debt holders

NOW:
• Yet, in reality, disagreements and conflicts of
interest…  main problem information problems
• These conflicts lead to costly legal procedures and
distort real decisions

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Determinants of the Present Value
of Financial Distress Costs
• Two key qualitative factors determine the present value
of financial distress costs:
1. probability of financial distress
• The probability of financial distress increases with the amount of
a firm’s debt (relative to its assets)
• The probability of financial distress increases with the volatility
of a firm’s cash flows and asset values

2. magnitude of costs when a firm is in distress

• Financial distress costs will vary by industry
Ex: Technology firms will likely incur high financial distress costs
due to the potential for loss of customers and key personnel, as
well as a lack of tangible assets that can be easily liquidated

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 Real world even more complicated: costs
of financial distress
• Typically involves bankruptcy procedure: a legal
proceeding for liquidating (in US: Chapter 7) or
reorganizing a business (Chapter 11)
• Direct bankruptcy costs: the costs that are directly
associated with bankruptcy, such as legal and
administrative expenses
• Indirect costs of financial distress: the difficulties of
running a business that is experiencing financial
distress
• Financial distress costs: the direct and indirect costs
associated with experiencing financial distress

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Costs of distress and insolvency
DIRECT COSTS
i.Management wastes time on crisis negotiations with
creditors, costs of legal procedures, etc.
INDIRECT COSTS
i.New projects are on hold. No financing available because of
conflict situation
ii.Suppliers and customers run away. Existing activities suffer,
or come to full stop
iii.Actions to fool others, e.g. hide problems…
iv.Strategic actions to anticipate future frictions. Including
myopic decisions to have cash at hand
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Direct and Indirect Costs of Bankruptcy

• The average direct costs of bankruptcy are 3% to 4% of

the pre-bankruptcy market value of total assets

• While the indirect costs are difficult to measure

accurately, they are often much larger than the direct
costs of bankruptcy
• It is estimated that the potential loss due to indirect costs of
financial distress is 10% to 20% of firm value

• Given the costs of bankruptcy, it may be in the mutual

interest of the firm and its creditors to avoid filing for
bankruptcy and renegotiate instead (informal resolution)

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Optimal capital structure with taxes and
distress costs
• Tradeoff Theory of capital structure
The firm picks its capital structure by trading off the
benefits of the tax shield from debt against the costs of
financial distress and agency costs caused by debt.

Tax COFD
shield

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Trade-off Theory
Firm value under
Value of firm (V) M&M with taxes:
VL = VU + PV(ITS)
PV of interest
tax shield

PV of financial
Maximum distress costs
firm value
VL = Actual firm value

Firm value under M&M

without taxes: VU

0 Debt
Optimal debt D*

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Optimal Leverage

• The trade-off theory states that firms should increase their

leverage until it reaches the level at which the firm value
is maximized
• At the point where value is maximized (optimal debt level
D*), the tax savings that result from further increasing
leverage are equal to the increased costs of financial
distress

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Trade-off theory: Optimal Leverage

• Note that the optimal debt level differs for each firm
• Question: what types of firms have low D* levels?
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Optimal Leverage

• The tradeoff theory can help explain

 Why firms choose debt levels that are too low to fully
exploit the interest tax shield (due to the presence of
financial distress costs)
 Differences in the use of leverage across industries
(due to differences in the magnitude of financial
distress costs and the probability of default)

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Optimal Leverage

• Can the tradeoff

theory help explain
this ranking?

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Theories of Optimal Financial Leverage

 Trade-off theory (considering tax benefits vs costs of

financial distress)
 Agency theory (based on agency costs arising from
conflicts between managers, shareholders and creditors)
 Pecking order theory (leads to ranking of types of
financing: from retained earnings, debt to equity)
 Theory is based on asymmetric information
 Issuing equity signals poor information about the firm

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The Agency Costs of Leverage
• Types of agency conflicts
1. Between debt holders and shareholders
2. Between managers and shareholders

• Agency costs
 Costs arising from agency conflicts (typically due to
information problem), and
 Costs incurred in order to sustain an effective agency
relationship, i.e. costs incurred to mitigate agency
conflicts

• Agency benefits????
 Benefits arising from the use of debt (yes – sometimes
debt may help…)
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 Agency problems
Between shareholders and debt-holders:
Debt overhang (underinvestment)
 Outstanding debt makes raising equity costly
 May result in firm not taking a positive NPV project
Excessive risk taking (asset substitution)
 Funding with debt may induce risk-taking
 May result in overinvestment

Between managers and shareholders (here debt may help…):

Empire building
 Managers may prefer to run larger firms, so seek to increase the size of firm
 More likely if firm has excess cash (free cash flow hypothesis)
Outside equity financing may dilute managerial ownership
 Smaller ownership of manager, may lower his effort incentives
 Leverage introduces threat of default – disciplines manager?
•Having fewer outside shareholders makes them more willing to monitor
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Agency costs of Leverage:
Shareholders - Debtholders Conflicts
We will now focus on the two types of agency conflicts between
shareholders and debtholders:
Debt overhang and under-investment: When a firm faces financial
distress, shareholders may decide not to finance new positive
NPV investments because the firm’s existing debtholders would
capture most of the benefits

Excessive risk taking and asset substitution: When a firm faces

financial distress, shareholders may benefit from taking extra
risky investments even if they are negative NPV
 This risk taking is often referred to as ‘moral hazard’

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The Agency Costs of Leverage: Example
Assume a firm has current activities that will give tomorrow 100
(good state) or 50 (bad state). Each state has equal probability. The
firm also has 20 cash. Debt repayment tomorrow is 80. For simplicity,
there is no discounting
•The firm considers to invest the 20 cash, three possibilities
 Project A: payoff in good state 25, in bad 25
 Project B: payoff in good state 30, in bad 0
 Project C: payoff in good state 10, in bad 35
Questions:
 What is each projects’ NPV? Project A has highest NPV, correct?
 Which project(s) would managers, who act in the interests of
shareholders, implement?
 What do managers’ choices imply for the value of debt?
 What are the agency costs of debt?

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No Project
Good State (50%) Bad State (50%)

Cash 20 20

Going concern 100 50

Debtholders (80) 80 70 (!)

Equity holders 40 0

Note: in the bad state the company defaults on its debt.

To debt holders: 0.5*80 + 0.5*70 = 75
To equity holders: 0.5*40 + 0.5*0 = 20
Firm value = 75 + 20 = 95
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Project A)
I = 20, Income Good = 25, Income Bad = 25

Good State (50%) Bad State (50%)

Cash 0 0
Project 25 25
Going concern 100 50
Debtholders (80) 80 75 (!)
Equity holders 45 0

• NPV project A: -20 + 0.5*25 + 0.5*25 = 5

• To debt holders: 0.5*80 + 0.5*75 = 77.5 > 75 so accept
• To equity holders: 0.5*45 + 0.5*0 = 22.5 > 20 so accept
• The project is accepted and has positive NPV
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Project B) Risk-Shifting :
I = 20, Income Good = 30, Income Bad = 0
Good State (50%) Bad State (50%)
Cash 0 0
Project ? ?
Going concern 100 50
Debtholders (80) ? ?
Equity holders ? ?

• NPV project B = -5
• To debt holders: XXXX compared to 75 they XXXXX
• To equity holders: YYYY compared to 20 they YYYYY
• Does acting in equity holders interest create a problem?
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Project B) Risk-Shifting :
I = 20, Income Good = 30, Income Bad = 0
Good State (50%) Bad State (50%)
Cash 0 0
Project 30 0
Going concern 100 50
Debtholders (80) 80 50 (!)
Equity holders 50 0

• NPV: -20 + 0.5*30 + 0.5*0 = -5 < 0

• To debt holders: 0.5*80 + 0.5*50 = 65 < 75 so reject
• To equity holders: 0.5*50 + 0.5*0 = 25 > 20 so accept
• But this project should never be accepted (‘overinvestment’)
• Equity holders may even prefer it over A (excessive risk taking!) 29
Project C) Underinvestment:
I = 20, Income Good = 10, Income Bad = 35

Good State (50%) Bad State (50%)

Cash 0 0
Project 10 35
Going concern 100 50
Debtholders (80) 80 80
Equity holders 30 5

• NPV: -20 + 0.5*10 + 0.5*35 = 2.5 > 0

• To debt holders: 0.5*80 + 0.5*80 = 80 > 75 so accept
• To equity holders: 0.5*30 + 0.5*5 = 17.5 < 20 so reject
• Equity holders reject this! Under-investment / debt overhang!
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 Agency Costs
• Equity holders choose Project B
 NPV of this project is negative!
 But expected payoff of equity holders is highest
 Excessive risk is preferred
NPV Debt Equity Value of
holders holders firm
Project A 5 77.5 22.5 100
Project B -5 65 25 90
Project C 2.5 80 17.5 97.5
No project 0 75 20 95
• What are the agency costs?
• Who pays these agency costs?
[By the way, note that equity holders had done even better if they had paid out the cash
immediately as extra dividend…] 31
Agency Costs: who pays?
• It appears that the equity holders by choosing
project B benefit at the expense of the debt
holders (risk-shifting)
• However, ultimately, it is the shareholders of the
firm who bear these agency costs. Why?
 Agency costs of debt are anticipated: debt holders
know that they might suffer later, and hence ask for
compensation beforehand!!
• This makes that equity holders pay for their own
(bad) behavior later on…

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… Debt may help! Why?
•There is also an agency conflict between managers and
shareholders
•What if managers act in their own interest?
• Separation of ownership and control creates possibility of
managerial entrenchment: may incentivize managers to
decisions that benefit themselves at investors’ expenses
• Entrenchment may allow managers to run the firm in their
own best interests, rather than in the best interests of the
shareholders

•Leverage may help reduce this agency conflict: why?

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Why Leverage may Help…
• Facilitates monitoring via concentration of ownership
 More debt means less equity, and hence makes it easier to have
concentrated ownership. E.g. having a few major outside
shareholders makes them more committed to the firm
• Reduction of wasteful investment
 If management is the equity holder, debt (rather than outside
equity financing) allows him to keep a bigger stake, and that
reduces tendency for perk consumption (eg, personal use
corporate jet). And/or makes management work harder. WHY?
 Leverage reduces the free cash flow problem. That is, the interest
payments reduce the amount of cash available. This reduces
empire building possibilities…

• Commitment
 Managers face threat of dismissal in case of default

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Agency Costs and the Tradeoff Theory

• The value of the levered firm can now be written

as

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The Optimal Debt Level

• Low optimal debt: R&D-Intensive Firms

 Firms with high R&D costs and future growth
opportunities typically maintain low debt levels
 These firms tend to have low current free cash flows
and risky business strategies
• High optimal debt: Low-Growth, Mature Firms
 Mature, low-growth firms with stable cash flows and
tangible assets often carry a high-debt load
 These firms tend to have high free cash flows with few
good investment opportunities

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Theories of Optimal Financial Leverage

 Trade-off theory (considering tax benefits vs costs of

financial distress)
 Agency theory (based on agency costs arising from
conflicts between managers, shareholders and creditors)
 Pecking order theory (leads to ranking of types of
financing: from retained earnings, debt to equity)
 Theory is based on asymmetric information
 Issuing equity may signal poor information about the firm
[Will be covered in next lecture]

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 Basics of Pecking Order: Asymmetric
Information and Adverse Selection
M&M assume that managers and investors have the same
information. This is not so in reality
•Asymmetric Information
 A situation in which one party has more information than the other (and
are aware of that)
 For example, when managers have superior information compared to investors
regarding the firm’s future cash flows

•Key terminology: ‘Adverse Selection’

 If the market cannot see who is good or who is bad: sellers with better
products may not be willing to sell their goods because the ‘pooling
price’ in the market is too low for them
 Known as Akerlof’s ‘lemon’ problem: the result is that quality and price in the
market are low
 This has implications for how firms finance themselves: Pecking order theory

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Conclusion: Financial decisions matter
because of imperfections…
 Trade-off theory (considering tax benefits vs costs of
financial distress)
 Agency theory (based on agency costs arising from
conflicts between managers, shareholders and creditors)
 NEXT TIME – Pecking order theory (with its ranking of
types of financing: from retained earnings, debt to equity)
 Theory is based on asymmetric information
 Issuing equity signals poor information about the firm

But next time we will

also expand a little more
on the Agency theory
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