Leverage, Financial Risk, and Firm Value

Learning Objectives

Upon completion of Chapter 8, you will be able to:

• Describe the various theories of capital structure.

• Understand the tax advantage of debt.

• Know how potential bankruptcy costs limit the amount of debt firms take on.

• Understand some agent–principal conflicts associated with capital structure.

• Understand why debt capacity is a valuable resource and identify the factors that determine it.

• Discuss some practical factors that affect a company’s capital structure decision.

Leverage, Financial Risk, and Firm Value

8

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CHAPTER 8Section 8.1 Perfect Capital Markets

Managers choose products and services that create value for shareholders. Chap-ters 5, 6, and 7 discussed how these investments affect shareholders’ wealth. Investing in positive NPV projects adds to the wealth of shareholders, whereas investing in negative NPV projects detracts from it. In this chapter we examine how man- agers choose the mix of financing required to support these investment decisions. We call this the capital structure decision. As we turn our attention to the right-hand side of the bal- ance sheet, we assume that capital budgeting decisions have been made. Our concerns are choosing the mix of debt and equity used to fund the firm’s assets and whether this capital structure choice can affect shareholders’ wealth.

You might think that there is a standard proportion of debt that most firms use—a finan- cial rule-of-thumb—but the debt–equity mix varies enormously across industries and companies. Some, such as young high-tech or biotech firms, use little or no debt, while public utilities use high levels. Private equity firms such as Bain, KKR, the Blackstone Group, and Warburg Pincus often finance their purchases of companies with 60% or even 80% debt.

Why do debt ratios vary so much? The general answer is that in each case managers believe they are choosing a capital structure that maximizes their firm’s worth while stay- ing within its risk tolerance. How each of these decisions can be optimal yet so different is explained in this chapter as we explore the link between capital structure and firm value.

The use of debt to fund the firm (called leveraging) carries with it benefits as well as risks. As the term leverage implies, the presence of debt in a company’s financial structure can magnify profits when times are good, just as a mechanical lever can magnify your strength when you’re trying to move a heavy object. Another benefit of debt is that inter- est payments to lenders are a tax-deductible expense, unlike dividend payments made to equity holders. Paying bills with pretax dollars is much cheaper than making an equiva- lent payment with dollars after taxes have been paid.

8.1 Perfect Capital Markets

Our discussion of the debt–equity mix begins with the assumption that capital mar-kets are perfect. Perfect capital markets are an ideal and do not reflect the real world, but they are very useful for developing an understanding of capital struc- ture’s impact on share value. Under the very strict (and unrealistic) assumptions of perfect markets, we will see that capital structure has no impact on value. That is, the decision of how much debt versus equity to use in financing the firm is irrelevant to shareholders under perfect market condition: Any mix of debt and equity results in the same overall value of the firm. It may seem like a poor use of time to study something that is irrelevant to firm value, but this model gives us insights about why capital structure may matter in the real world. As we relax the assumptions of perfect capital markets, we will begin to identify the factors that help determine a company’s optimal capital structure.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Perfect capital markets may be characterized as

1. being strong-form efficient, 2. having no leakages, such as taxes or transaction costs, and 3. having the same cost of borrowing for investors and companies.

Strong-form efficiency defines a market in which security prices reflect all pertinent infor- mation. Prices in such markets are unbiased estimates of value, fully reflecting the cash flows and risk expected to accrue to security holders. In strong-form efficient markets, securities offering the same cash flows with equal risk will be equally priced.

The second characteristic is that no leakages occur as cash flows move between the firm and capital suppliers. Examples of leakages include taxes (where a portion of the cash which otherwise would flow to security holders is paid to the government) and transac- tion costs (cash paid to investment bankers as part of the firm’s capital acquisition). Figure 8.1 illustrates some leakages.

Figure 8.1: The financial balance sheet, illustrating some leakages

Because in perfect capital markets such leakages do not exist, these markets are some- times characterized as being frictionless. In physics, friction refers to resistance as objects are moved. The more friction there is, the more energy it takes to move an object. Thus, it is easier to push a heavy box across a smooth tile floor than across a carpeted floor. The analogy to economic friction is straightforward: As cash or securities move from the investors to the firm, between investors, or from the firm to investors, there is no loss of value in a frictionless market. Anyone who has sold a house for $150,000 yet nets only $135,000 after commissions, fees, and taxes can attest to the frictions that exist in most markets.

$

Corporate income taxes

Product and service markets

Goods

Services

Investments made by the firm

Claims on cash flow

Capital markets

Fees to investment bank

$ $

$

$

$

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CHAPTER 8Section 8.1 Perfect Capital Markets

Capital Market Irrelevance When Markets Are Perfect

We illustrate the irrelevance of capital structure to shareholders by developing a simple example in which capital markets are assumed to be perfect, and the firm’s investments are identified. Suppose the firm in our example is a small, closely held corporation that does business as a doughnut shop. Further, suppose that you are the sole owner of the shop, providing 100% of the corporation’s capital. All of the shop’s capital is provided via stock, so its capital structure is all equity, and you own all the shares.

In the perfect markets we have described, the value of the doughnut shop is unaffected by the fact that you have chosen to finance it using only equity. Had you decided to loan the company half of its capital and provided the other half in the form of equity, then the total value of your investment would be unchanged. Why doesn’t capital structure matter? Capital structure is irrelevant because it does not affect the cash flows that the shop gener- ates or their riskiness, and it is these characteristics of the shop that determine its value. To see this, ask yourself whether you think customers care about a doughnut shop’s capital structure when they choose to make a purchase. No, they care about price, flavor, cleanli- ness, selection, service, and convenience when choosing the shop they wish to patronize. These shop characteristics are independent of the proportion of debt and equity the busi- ness chooses to use as sources of capital. It’s the shop’s menu customers are interested in, not its balance sheet.

In our example, all of the cash flows to you, the owner, whether it is an all-equity firm or a 50% debt–50% equity firm. You will be receiving the same cash flow stream whether all the cash comes in the form of dividends, or part of the return is dividend income and part is interest income. Since there are no taxes or transaction costs, you see no advantage in receiving interest income or dividend income. As the sole owner, you receive identical cash flow and bear identical risk with either capital structure; therefore, your business will have the same value with either structure. To put it another way, the components of value (the size and riskiness of expected cash flows) are determined by the left-hand (assets) side of the financial balance sheet and are reflected in the values of the right-hand (equity and liabilities) side claims. Thus, it is the left-hand side that is critical to a firm’s valuation.

It follows that in a perfect capital market, capital structure has no impact on value. This is the irrelevance proposition we referred to at the beginning of this section. It means that when capital markets are perfect, managers need not waste their time worrying about right-hand-side decisions. One capital structure is as good as another, and they all result in the same value for owners.

Irrelevance is probably easiest to understand by recognizing that both cash and risk flow from the left-hand side of the balance sheet (from assets and the products those assets produce) to the right-hand side of the balance sheet (to financial claims, such as debt and equity). Capital structure simply determines how these cash flows and risk are distributed to claimants. A good analogy is that of a pie: A firm’s capital budgeting determines the size of the pie, while capital structure determines who gets the pieces of the pie. Capital structure has no impact on the size of the pie (i.e., the value of the firm) in a perfect world.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Leverage and the Risk of Common Stock

The term financial leverage is used to describe the proportion of debt used in a firm’s capital structure. An all-equity firm is unleveraged. The term leverage is used in finance because the presence of debt in a firm’s capi- tal structure has a magnifying effect on financial performance. Just as a lever in physics magni- fies strength, financial leverage can make good cash flows to shareholders even better (and poor cash flows to shareholders even worse). To demonstrate this property of leverage, we extend the doughnut shop example.

Suppose your doughnut com- pany, The Whole Doughnut Inc., required $1 million in financing. The firm can be financed either using half debt and half equity or all equity. The company can borrow $500,000 at an inter- est rate of 6%. As you consider the two financing alternatives, your market research consultant has identified three possible cash flow scenarios for the coming year: a best case of $170,000; an expected level of cash flows of $100,000; and a worst-case scenario, when cash flows total only $30,000. Table 8.1 shows the return on the common-stock investment for both the unleveraged (all-equity) financial structure and the firm leveraged by borrowing $500,000.

Table 8.1: The effect of financial leverage

Worst case Expected Best case

A. Total investment $1,000,000 $1,000,000 $1,000,000

B. Operating cash flows

$30,000 $100,000 $170,000

C. Return on total investment (B 4 A)

3% 10% 17%

All Equity

D. Payments on fixed claims

$0 $0 $0

E. Total residual cash flow (B 2 D)

$30,000 $100,000 $170,000

(continued)

Leo Cullum/The New Yorker Collection/www.cartwoonbank.com

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CHAPTER 8Section 8.1 Perfect Capital Markets

Table 8.1: The effect of financial leverage (continued)

Worst case Expected Best case

F. Equity investment $1,000,000 $1,000,000 $1,000,000

G. Return on equity (E 4 F)

3% 10% 17%

Leveraged Firm

H. Payments to fixed claims (6% of 500,000)

$30,000 $30,000 $30,000

I. Residual cash flow (B 2 H)

$0 $70,000 $140,000

J. Equity investment $500,000 $500,000 $500,000

K. Return on equity (I 4 J)

0% 14% 28%

In Table 8.1 we’ve calculated returns to shareholders under three scenarios: the worst case, when the project only produces total cash flow of $30,000; the expected case, when the project produces total cash flow of $100,000; and the best case, when the project produces total cash flow of $170,000. Returns are found for both the all-equity (unleveraged) firm and the leveraged firm financed with $500,000 of debt and $500,000 of equity.

Look at rows D through G first. This shows that for the all-equity–financed firm the ROE (return on equity) ranges from 3% under the worst-case scenario to 17% for the best-case scenario. The all-equity firm has an expected ROE of 10%. Rows H through K show results for the same firm when financed with a mix of debt and equity. For the leveraged com- pany the ROE ranges from 0% under the worst-case scenario to 28% for the best-case sce- nario, with an expected ROE of 14%. The leveraged firm has a higher expected ROE, but twice the range of possible ROEs compared to the all-equity firm. The table demonstrates a tradeoff between risk and return using financial leverage. With debt financing, all else being equal, shareholders have a higher expected return, but they also have higher return variability.

This result makes economic sense. We know that risk-averse investors require a higher expected return if they anticipate being exposed to more risk or variability. In our example (Table 8.1), the 3% increase in the expected return to equity investors will just compensate investors for the greater risk created by leverage, leaving stock prices, and thereby firm value, unchanged.

This section has shown that capital structure is irrelevant in perfect capital markets. But markets in the real world are not perfect. Therefore, in the following section, we relax the perfect market assumptions to better reflect reality.

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CHAPTER 8Section 8.1 Perfect Capital Markets

A Closer Look: Leverage

Leverage increases the impact of positive (and nega- tive) results. Known in the United Kingdom as gear- ing, the analogy to mechanical advantage in physics holds true: With a little leverage the fruits of your effort can have a more dramatic impact on outcome. The strategy of leveraging a brand name in order to maximize the benefit from a hard-won positive image and reputation did not go unnoticed by Richard Bran- son, the entrepreneurial founder of Virgin Records. The Virgin brand is now associated with records, soft drinks, an airline, railroads, financial services, wines, mobile phones, energy, automobiles, and more. Disney, on the other hand, may have wanted to distance its famous brand name from its venture into more mature movies than the traditional fam- ily entertainment usually associated with the Disney name. To avoid any possible negative leverage, the firm chooses to produce movies for the new market under alternative brand names, such as Miramax and Touchstone, rather than Disney Pictures.

Spencer Platt/Staff/Getty Images

The Virgin brand has been leveraged and is now associated with a wide variety of products and services.

Although leverage has its benefits, it also has a downside. Keep in mind that debt must be repaid, whereas equity is conceptually a perpetual security that never matures. A firm that is unable to make the scheduled principal and interest payments to its lenders faces bankruptcy. Bankruptcy can be very costly, disruptive, and may cause ownership of the company to pass from stockholders to creditors. Another downside of debt is that its leveraging action also affects the firm when things are bad—in other words, it magnifies “bad outcomes” in the same fashion that it magnifies “good times.” The earnings of a lev- eraged firm, therefore, are much more variable than those of a company that does not use debt in its capital structure. These risks associated with leverage are known as financial risks. A company’s capital structure is chosen by assessing these benefits and risks associ- ated with borrowing money.

Capital Market Imperfections and Capital Structure

To better reflect capital structure’s effect on the firm in the real world, we will relax the perfect market assumptions that were made at the beginning of the chapter.

We now introduce imperfections into our model of capital markets. These imperfections in capital markets will make the environment in our example more realistic and more complicated. As with any real-world decision that involves uncertainty, capital structure choice will involve pros and cons, or tradeoffs between the potential benefits of leverage and its potential adverse effects. Let’s begin by relaxing the assumption of no leakages.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Taxes and Leverage In the real world, all cash flows that could flow to claimants do not. There are leakages. Just as physical friction reduces our ability to do physical labor, frictions in capital mar- kets lower the cash flows to investors. The most obvious leakage or friction is that of taxes.

Interest payments made by the corporation are paid before corporate income taxes, and dividend payments are paid after corporate income taxes. Thus, the firm may reduce taxes paid to the government by using more debt in its capital structure. A corporation could conceptually avoid taxes altogether by financing exclusively with debt. If all cash flows were distributed to claimants in the form of interest payments, the government would collect no corporate taxes, because all interest would be paid before taxes. On the other hand, a corporation financed solely with equity would pay taxes before any distri- butions could be made to its suppliers of capital because dividends would be paid after taxes. Few firms are all-equity financed, and none are all-debt financed. The Internal Rev- enue Service would probably claim that an all-debt financing scheme was a tax-avoidance strategy and would impose taxes on that portion of the debt they felt was de facto equity. Normally, corporations have a mix of debt and equity, so let’s look at this choice in light of corporate taxation.

Table 8.2 shows cash flows to claimholders of The Whole Doughnut Inc. when the firm is unleveraged and when it is leveraged with $500,000 of debt bearing a 6% interest rate. We have assumed a 30% corporate tax rate. As the table shows, the unleveraged firm pays $30,000 in taxes to the government, whereas the levered firm pays only $21,000. With debt financing, the leakage to the government is $9,000 less, and cash flows to investors are $9,000 greater compared to the unleveraged financing model. The $9,000 is the tax savings resulting from the interest being a tax-deductible expense. We could compute the interest tax savings directly as the interest expense times the tax rate ($9,000 5 $30,000 3 0.30).

Table 8.2: The effects of taxes on cash flows

Unlevered $500,000 of 6% debt

A. Expected operating cash flow

$100,000 $100,000

B. Interest payments to debtholders (6%)

$0 $30,000

C. Cash flow after interest payments (A 2 B)

$100,000 $70,000

D. Corporate taxes (30% of C)

2$30,000 2$21,000

E. Cash flow to residual claims (C 2 D)

$70,000 $49,000

F. Total cash flows to all claimants (B 1 E)

$70,000 $79,000

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CHAPTER 8Section 8.1 Perfect Capital Markets

Increasing leverage reduces taxes, which increases the cash flows available to investors and thereby the value of the firm. Figure 8.2 illustrates this result. This conclusion is not difficult to understand if we return to the pie analogy. When taxes (or other leakages) are introduced into otherwise perfect markets, then a piece of the cash flow pie is effectively given to a third party. By avoiding taxes through debt financing, less of the pie is distrib- uted to third parties, leaving more cash flows available for distribution to the capital sup- pliers. In either case, leveraged or unleveraged, the corporation’s risk is entirely borne by these capital suppliers, so firm value will be directly linked to the amount of cash security holders can claim. Minimizing taxes will increase cash flows and will therefore increase the value of the company.

Figure 8.2: The impact of leverage on firm value in a perfect capital market with corporate income taxes

The upper horizontal line in Figure 8.2 represents the irrelevance of leverage when capi- tal markets are perfect. Regardless of the debt–equity mix that the corporation chooses for its capital structure, firm value remains unchanged. The upward-sloping line shows the benefits of leverage. As more debt is incorporated into the firm’s capital structure, a greater proportion of operating cash flows is distributed before taxes are paid. The deductibility of interest payments allows the firm to distribute more of its cash flows, a characteristic known as the tax shield of debt. This benefit increases firm value as the firm uses more debt.

The conclusion reached by studying Figure 8.2 is that a firm should use almost no equity in its capital structure. Indeed, in the 1980s some firms did leverage themselves to such an extent that debt represented 70%, 80%, and even 90% or more of their capital. Yet the

Debt’s tax shield

Impact of taxes on value

Firm value with interest paid before taxes

Irrelevance of leverage in perfect markets with no taxes

Firm value if interest were paid after taxes

F ir

m v

a lu

e

Financial leverage (debt/equity)

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CHAPTER 8Section 8.1 Perfect Capital Markets

majority of corporations did not follow the lessons of Figure 8.2, choosing instead to keep a more moderate level of debt in their financing mix. The average debt ratio among U.S. firms is around 32%. (See the Web Resources at the end of the chapter for more informa- tion.) Why don’t firms take full advantage of the debt tax shield? We answer that question in the next section as we study a second leakage, bankruptcy costs.

Bankruptcy Costs and Leverage As more and more debt is added to a firm’s capital structure, that debt becomes riskier because interest payments are fixed. If a company performs poorly, it may decide not to pay dividends to stockholders, but it must pay interest to debt holders. Bonds and loans are contractual agreements, so if these claimants are not paid on time and in full, they can bring legal action against the company. As debt levels rise, smaller variations in per- formance can leave a company unable to service its debt. The possibility of default on mandatory debt service payments increases with debt levels. A default that cannot be corrected or negotiated can lead to bankruptcy. Therefore, the probability of bankruptcy increases as debt increases.

Figure 8.3 is a stylized graph of our firm’s cash flows under different economic condi- tions over time. Figure 8.3(a) shows our firm with $500,000 of debt, which carries a 6% interest rate and, therefore, requires $30,000 of annual interest payments. These required payments are represented by the dotted horizontal line. Because the cash flows never dip below that line, we know the firm can make its interest payments regardless of the future economic scenario. Thus, at this level of leverage, our firm’s debt is riskless.

Figure 8.3: How the likelihood of bankruptcy changes as more debt is introduced into a firm’s capital structure

Economic conditions

Economic conditions

Economic conditions

Debt is riskless because cash flows never fall below $30,000.

(a) $500,000 debt at 6% yields $30,000 interest payment.

(b) $700,000 debt at 6% yields $42,000 interest payment.

(c) $700,000 debt at 8% yields $56,000 interest payment.

$30,000 interest

$42,000 interest

$56,000 interest

Potential financial distress; thus, debt is not risk free and lenders won’t lend at 6%.

Risky debt results in higher rate of interest.

Cash flow

Cash flow

Cash flow

Required interest payment

Required interest payment

Required interest payment

$170,000

$100,000

$30,000

$170,000

$100,000

$30,000

$170,000

$100,000

$30,000

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CHAPTER 8Section 8.1 Perfect Capital Markets

Figure 8.3: How the likelihood of bankruptcy changes as more debt is introduced into a firm’s capital structure (continued)

Now, suppose that the firm chooses to take greater advantage of debt’s tax shielding ben- efits by borrowing a greater proportion of its capital. Suppose the firm borrows $700,000. At that level of debt, the loan would no longer be riskless. Even at a 6% interest rate, lend- ers stand the chance of not being paid under certain economic conditions because the cash flow curve falls below the $42,000 threshold in Figure 8.3(b). Knowing this, lenders will require a higher interest rate to compensate them for this risk, say 8%. Figure 8.3(c) shows the interest payment threshold of $56,000 when $700,000 is borrowed at 8%. The shaded areas illustrate potential cash shortfalls when the conditions turn out to be poor for the firm’s business.

If the economy turns sour and cash flows are insufficient to cover interest payments, the firm stands a chance of being unable to pay its contractual interest (or other fixed obliga- tions). Firms unable to meet their fixed claims are in default, and this may lead to bank- ruptcy. Some firms may avoid default during these shortfalls by keeping a cash reserve on hand or having other sources of capital that can be tapped to meet these obligations. They may borrow funds to make the payments, sell off assets, or sell more stock. However, if the shortfall is extreme, the firm may be unable to raise more cash and could be forced into bankruptcy.

Bankruptcy has many forms, but for our purposes it may be characterized as the transfer of control of assets from the residual claimants (i.e., shareholders) to fixed claimants (i.e., lenders). A simple example will help illustrate bankruptcy and its impact. Suppose a bank lends someone the cash to purchase an automobile. The bank is a fixed claimant and the borrower is the owner of the car. Let’s say the owner is unable to make the payments the loan requires and is in default. This is like bankruptcy in that the borrower must transfer ownership of the vehicle to the fixed claimant (the bank). If this is done without friction, as in a perfect market setting, then there is no loss in the value of the automobile or the bank’s claim.

However, we know that the bank incurs some costs when repossessing a car. It pays law- yers to do the legal paperwork, the state charges fees to transfer the car’s title, and so on. These are the direct costs of this transfer. Additionally, the car’s owner may have neglected

Economic conditions

Economic conditions

Economic conditions

Debt is riskless because cash flows never fall below $30,000.

(a) $500,000 debt at 6% yields $30,000 interest payment.

(b) $700,000 debt at 6% yields $42,000 interest payment.

(c) $700,000 debt at 8% yields $56,000 interest payment.

$30,000 interest

$42,000 interest

$56,000 interest

Potential financial distress; thus, debt is not risk free and lenders won’t lend at 6%.

Risky debt results in higher rate of interest.

Cash flow

Cash flow

Cash flow

Required interest payment

Required interest payment

Required interest payment

$170,000

$100,000

$30,000

$170,000

$100,000

$30,000

$170,000

$100,000

$30,000

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CHAPTER 8Section 8.1 Perfect Capital Markets

to maintain the vehicle in an effort to conserve cash. He may not have had the oil changed, or had new tires put on, although they were needed, all in an effort to save money and avoid default. Once the bank has possession of the car, this deferred maintenance must be done at a cost to the bank. Bank officers will also spend considerable time doing in- house paperwork, making phone calls, and so on in order to take possession of the car and to pay the advertising costs associated with selling the automobile. These activities are costly and represent the indirect costs of the transaction. Both the direct and indirect costs of transferring ownership of the car represent frictions in this transaction, and they effectively lower the value of the car to the bank.

Similarly, corporate bankruptcies are never frictionless. It is never the case that residual claimants recognize that the firm cannot meet its fixed claims and transfer their ownership rights to fixed claimants with no cost. There are always costs to the bankruptcy procedure.

The direct costs of bankruptcy include attorney’s fees and court fees. Indirect bankruptcy costs include management’s time spent on paperwork, phone calls, meetings, and so on, time that could otherwise be spent on more productive activities. Furthermore, some key employees may conclude that, given the firm’s financial distress, now is a good time to take another job, which is also costly to the corporation. Customers may stay away from the firm’s products because they fear that the firm’s guarantees will not be honored as a result of the bankruptcy. Suppliers may also be less willing to sell inventory to a com- pany facing bankruptcy. Distressed airlines, for example, often find demand for their ser- vices declines as customers worry about deferred aircraft maintenance or canceled flights. These represent bankruptcy’s indirect costs.

All of these costs lower the firm’s cash flows in the event of bankruptcy. Imagine that The Whole Doughnut began experiencing financial distress because of difficulty in making interest payments. It is possible that the shop would try to conserve cash by reducing labor costs. The money saved could be used to meet interest payments on the firm’s debt. However, the shop’s regular customers may begin to notice that they must wait longer to be served, that the shop isn’t as clean as it used to be, and that employees aren’t as friendly because they’re stressed from too much work. In short, The Whole Doughnut could lose business—lowering cash flows—as a result of the cost-cutting strategy brought on by financial distress. Had The Whole Doughnut not used leverage in its capital struc- ture, these financial difficulties and their accompanying negative impact on firm value could have been avoided.

Figure 8.4 is similar to Figure 8.3, but it shows the reduction of cash flows in the event of bankruptcy. It is important to note that the expected cash flow for the firm is no lon- ger $100,000. The friction caused by financial distress lowers the cash available to claim- ants in several potential economic conditions. Recognizing this, investors incorporate these costly outcomes into their cash flow estimates, lowering their estimate of the firm’s expected cash flow. They may also require a higher return because of the greater vari- ability of cash flows given potential bankruptcy costs. The value of the firm must decline because expected cash flows are lower and/or risk is higher.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Figure 8.4: Forecasted cash flows across economic conditions, showing the impact of potential bankruptcy costs

The reduction in expected cash flows are one of the expected costs of bankruptcy. Like all expected values, expected bankruptcy costs are the likelihood of bankruptcy times the potential costs. If there is very little or no debt in the firm’s capital structure, the corpora- tion will not be in danger of default, and no potential bankruptcy costs will be included when investors value the firm. This occurs because the probability of bankruptcy is zero or close to zero. Yet, as more debt is added, the likelihood that these costs will be incurred becomes greater, and the expected value of bankruptcy costs rise, lowering firm value. Figure 8.5 shows the impact of bankruptcy costs on firm value as leverage increases.

Best case = $170,000

“Old” expected cash flow of $100,000 “New” expected

cash payment

$56,000 required interest payment

Worst case = $30,000

Expected cash flow is reduced by the introduction of bankruptcy costs.

Costs of bankruptcy

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CHAPTER 8Section 8.1 Perfect Capital Markets

Figure 8.5: Leverage’s effect on firm value with taxes and bankruptcy costs entering the analysis

The lesson that should be learned from this discussion is that as leverage increases, so does the likelihood of incurring bankruptcy costs or costs associated with financial dis- tress. These potential costs reduce firm value, partially offsetting the tax benefit of debt. This is the first tradeoff mentioned earlier: Managers must balance the tax advantage of debt against the potential for costly bankruptcy. Leveraging the firm reduces the leakages to the government (lowers taxes), while increasing potential leakages to third parties in the case of bankruptcy proceedings or financial distress (lawyers fees, court costs, custom- ers lost to competitors, etc.).

Debt’s tax shield

Impact of taxes on value

Leverage’s impact with taxes

Leverage’s impact with taxes and bankruptcy costs

F ir

m v

a lu

e

Leverage

Expected bankruptcy costs

Demonstration Problem 8.1: Leverage’s Effect on Return and Risk

You have $10,000 to invest. You may choose to invest the $10,000 in a project that will pay one of two equally likely amounts in 1 year, either $15,000 or $8,000. As an alternative, you could borrow an additional $10,000 at 10% interest and invest a total of $20,000 in the project, which would then have equally likely payoffs of either $30,000 or $16,000. Find the expected return for both alternative investment strategies and then comment on the relative returns and risk of the leveraged versus the unlevered approach. (continued)

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CHAPTER 8Section 8.1 Perfect Capital Markets

Demonstration Problem 8.1: Leverage’s Effect on Return and Risk (continued)

Solution

Unleveraged investment  10,000 Leveraged investment  20,000

A. Amount borrowed

$0 $10,000

B. Equity $10,000 $10,000

C. Gross cash flow

$15,000 $8,000 $30,000 $16,000

D. Loan payoff 0 0 11,000 11,000

E. Cash to equity $15,000 $8,000 $19,000 $5,000

F. Return on equity

50% 220% 90% –50%

G. Expected return

(0.5)(50%) 1 (0.5)(220%) (0.5)(90%) 1 (0.5)(250%)

5 15% 5 20%

Leverage increases the average return by 5%, but the risk also increases.

Now repeat Demonstration Problem 8.1, this time assuming the interest rate is 18%.

Unleveraged investment  10,000 Leveraged investment  20,000

A. Amount borrowed

$0 $10,000

B. Equity $10,000 $10,000

C. Gross cash flow

$15,000 $8,000 $30,000 $16,000

D. Loan payoff 0 0 11,800 11,800

E. Cash to equity $15,000 $8,000 $18,200 $4,200

F. Return on equity

50% 220% 82% 258%

G. Expected return

(0.5)(50%) 1 (0.5)(220%) (0.5)(82%) 1 (0.5)(258%)

5 15% 5 12%

The higher interest rate increases the interest owed from $11,000 to $11,800. The average return drops to 12%. In this case the use of leverage is clearly detrimental because the 18% interest rate on the debt is below the investment’s expected return of 15%.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Information Asymmetry and Agency Costs When capital markets are perfect, no information gap exists between corporate insiders and outsiders. All market participants have the same, or symmetric, information. In such conditions no agency problem would exist because investors would observe the problem (excessive perquisite consumption, growth for growth’s sake, shirking behavior, etc.) and take remedial action. When we drop the assumption of symmetric information, we get a much more realistic view of how corporations conduct their affairs.

Asymmetric information means that corporate managers know more about many of the firm’s activities than do most corporate owners—the outside shareholders. Under these conditions agency problems can arise and be quite costly. How does leverage affect agency problems? The answer lies in the discipline of debt.

To understand the discipline of debt, first consider the nature of the manager–stockholder agency problem. Managers control corporate expenditures and oversee their own efforts. They may choose to invest cash in wasteful purchases—unneeded corporate jets, luxury offices, and so on—and they may choose to play a lot of golf and take 2-hour lunches, or they may pursue low-risk projects designed more to ensure their employment than to create shareholder value. These resources, corporate cash, and managerial effort, could be put to better, wealth-producing use. In sum, agency problems can be costly for the corporation. Now consider bankruptcy, the likelihood of which increases with leverage. In the event of bankruptcy, or financial distress that could lead to bankruptcy, managers are often fired, demoted, or forced to retire early. These consequences of bankruptcy are especially costly to managers who have most of their “wealth” linked to their jobs (e.g., their human capital and financial capital).

Shareholders, who also suffer from bankruptcy’s costs, are not impacted to the same degree as managers because investors’ portfolios are diversified. Managers, with so much depending on their careers, are highly motivated to avoid bankruptcy.

What do you suppose managers might do when a firm’s leverage increases? Their fear of bankruptcy causes managers to become more frugal, conserving cash to minimize the chances of a default. They may tend to play less golf and work harder to avoid financial distress. They waste less money, including excessive perquisites, and they waste less time. This is the discipline of debt.

The use of leverage increases the likelihood of financial distress, threatening manage- ment’s job security. In order to minimize the chance of default, managers of highly lev- eraged firms work hard to cut wasteful pursuits, reducing agency costs and increasing firm value. The discipline of debt argument states that firms become more efficient and therefore more valuable as leverage increases. Figure 8.6 illustrates the effect of debt’s discipline on firm value.

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CHAPTER 8Section 8.1 Perfect Capital Markets

Figure 8.6: Leverage and firm value when (1) markets are perfect, (2) taxes are introduced, (3) with bankruptcy costs included, and (4) considering the discipline of debt

Harvard Professor Emeritus Michael C. Jensen, who developed this theory of the dis- cipline of debt, argued that the agency cost problem would be particularly severe in companies with lots of cash flow and limited growth or investment opportunities. Such companies have lots of cash for managers to spend, but few value-creating investments to make. Industries that fit this description include the tobacco or cigarette industry and, when oil prices are high, the oil and gas industry. Debt reduces the cash available for managers to spend by requiring that it be paid to lenders. Dividends, being somewhat discretionary, usually don’t have the same agency cost reducing effect that debt has.

Information Asymmetry and Signaling with Debt Knowing that leverage may lead to financial distress and possibly the loss of their jobs, you might ask why a manager would ever take on more debt financing. With information asymmetry, outside stockholders must estimate firm value without all the information that inside managers have. Rational investors will typically assign at best an average value (but more likely a lower value) to aspects of a business about which they are uncer- tain. Managers don’t want their companies undervalued (they own stock in the company and their performance is often related to share price). Issuing debt helps address this undervaluation problem.

Debt may be viewed as management’s signal of the firm’s future cash flow prospects. When firms take on greater leverage, the managers, whose decision it was to increase leverage, must believe that the firm’s future cash flows are sufficiently large and steady enough to make higher interest payments. Thus, such leveraging decisions signal man- agement’s faith in the corporation’s cash flow–producing capabilities. Because leverage is increasing, the signal to outsiders is that the firm has a greater capacity for servicing its

1. Irrelevance in a perfect market

F ir

m v

a lu

e

Leverage

Taxes lower cash flows and thus lower firm value.

Expected bankruptcy costs increase with leverage,

lowering value.

Interest payments, being tax deductible, lower taxes and therefore increase firm value.

3. With tax and costs of bankruptcy

4. With taxes, bankruptcy costs, and the discipline of debt

The discipline of debt increases cash flows as waste is cut, increasing firm value.2. W

ith deb

t’s tax

sh ield

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CHAPTER 8Section 8.1 Perfect Capital Markets

debt, meaning management expects cash flows to increase. Therefore, the corporation’s value will increase in the opinion of outsiders, based on the signal from management.

Why don’t managers simply announce that cash flow prospects have improved? An announcement would convey the same information as the leveraging signal. The differ- ence between the announcement and taking on more debt is the faith outsiders put in the information. In other words, announcements have less credibility than increasing lever- age. Why? There is little penalty for announcements that turn out to be false. Managers are generally not fired, demoted, or subjected to having their pay slashed because they weren’t entirely forthcoming about a firm’s future prospects. In fact, managers’ announce- ments are often seen in the same light as politicians’. No one takes them too seriously. (This is true of managers’ (and politicians’) positive announcements. Negative announce- ments are usually taken seriously because they are made only when things are so bad that there is no possibility of “glossing over them”). On the other hand, a leveraging signal is credible because of its penalty for managers—the possible loss of a job if the firm can’t meet its debt payments.

Consider the opposite signal, increasing the equity base. Suppose a firm issued and sold additional stock using the funds to pay off debt. Such action reduces fixed claims on cash flows, thereby reducing the likelihood of financial distress. Perhaps management feels the firm’s future cash flows may be more variable or are at a lower level than they have been in the past. In order to reduce the chance of default, the management of the firm has reduced leverage, signaling to stockholders that the firm has less value. A second similar argument is that the firm’s management has sold stock to raise funds because with their inside information they feel that the stock’s value is currently too high. If the value is too high, it is a good time to sell some stock to raise funds before the market discovers its error and lowers equity’s price. In both cases, the signal is clear: Firm value is too high in light of management’s information. Leverage, therefore, may be a credible signal of man- agement’s superior information about firm value: Increasing leverage signals increasing value and vice versa.

Clearly, there are tradeoffs to consider when deciding which capital structure should be used to finance the firm’s investments. Tax benefits are partially offset by bankruptcy costs, which tend to be offset by the discipline of debt. Debt may also be viewed as a sig- nal of the firm’s future prospects, given the inside information of management. Note that there are no formulas in this chapter that let us solve for the optimal degree of leverage. Instead, managers must evaluate the characteristics of the firm and its environment in order to arrive at the best estimate of the firm’s optimal capital structure. The next section outlines the factors that should be considered in making that decision.

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

8.2 Determinants of the Target Capital Structure or Debt Capacity

So far we have discussed what is often called the tradeoff theory of capital structure. The tradeoff theory argues that companies have an optimal level of debt (a mix of debt and equity that maximizes value). This optimum point is a tradeoff between the tax and agency cost reduction benefits of debt and its bankruptcy costs. This optimum point becomes the target capital structure that companies strive to maintain. Another way to look at the target capital structure is as the company’s debt capacity, or the maximum amount of debt that can safely be serviced. Debt capacity implies that debt is a valuable resource and that a company that does not utilize its capacity to borrow may not be maxi- mizing value for shareholders. In this section we discuss the characteristics that determine a company’s debt capacity, beginning with those suggested by the tradeoff theory—taxes, potential bankruptcy costs, agency costs, and signaling—and then adding some other fac- tors that also appear important to companies.

Taxes

Tax rates vary among states, countries, and industries. In addition, some firms may be more adept than others at sheltering income from taxes. The higher the tax bracket in which a firm finds itself, the greater the tax-shielding benefit of debt will be for that corpo- ration, and the more leverage the firm should employ in its capital structure. On the other hand, firms with large tax-loss carryforwards or high depreciation expense will garner less benefit from leverage’s tax shield and will choose lower levels of debt. This is also true for startup firms that have not yet reached profitability and therefore pay no taxes.

Bankruptcy Costs

Two considerations must be given to bankruptcy: the likelihood of default and the costs of bankruptcy.

Cash Flow Levels and Variability To estimate the likelihood of default, a firm must estimate the level of expected cash flows and their variability. Figure 8.7 depicts a sine-wave model of three firms’ future cash flows. Firm A has a greater debt capacity than either Firm B or C. Firm A’s expected level of cash flows is $200,000, and its minimum level is $75,000. Thus, Firm A could take on fixed obligations of $75,000 per year that would be virtually riskless. Firms B and C, on the other hand, both have expected cash flows of $125,000 that could fall to $30,000 and 2$50,000, respectively. Firm B could carry more debt than Firm C because its cash flows are less variable. Any amount of debt taken on by Firm C would carry a risk premium, because, in some economic conditions, the firm would produce a cash flow deficit.

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

Figure 8.7: Three firms’ forecasted cash flows across economic conditions and their respective debt capacity

Probably the most important factor in determining cash flow characteristics such as those stylized in Figure 8.7 is the type of product market in which the firm competes. Utilities, for example, operate in markets where product demand is relatively price-inelastic. Con- sumers and businesses use a certain level of energy, regardless of the economic climate. Utilities often have regional monopolies, meaning that they are the only suppliers of natu- ral gas, electricity, or water in a given area. Utilities, therefore, traditionally have high degrees of leverage in their capital structure. Extremely cyclical businesses would be more uncertain of their level of future cash flows. Producers of nonessential luxury goods may find that product demand varies radically with economic conditions. Such firms would carry lower proportions of debt than utilities with their more stable cash flows.

A second factor that impacts a firm’s ability to avoid bankruptcy is its mix of operational fixed costs and variable costs, a mix known as its operating leverage. Fixed costs do not vary with production. These are costs such as rent or salaried workers. Variable costs are dependent on the firm’s activity. Variable costs include raw materials, labor, and sales commissions. The higher the percentage of a firm’s costs that are fixed, the more likely

Cash flow

Economic conditions

Expected cash flow of

$125,000

Expected cash flow of

$125,000

Expected cash flow of

$200,000

$0

Minimum $75,000

Minimum $30,000

Minimum $50,000

Firm C: Lowest debt capacity

Firm B: Debt capacity higher than firm C but lower than Firm A

Firm A: Highest debt capacity

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

there will be financial distress in an economic downturn. When economic times are good, fixed costs have the opposite effect: They benefit the firm when activity increases. Firms may substitute fixed costs for variable costs many times in their operating structure in the same way they substitute debt for equity in their capital structure. For example, a firm may choose to lease a delivery truck (a fixed cost), or it may hire a carrier to deliver goods as needed (a variable cost). Just as added debt increases financial leverage, more fixed operating costs increase operating leverage. Both types of leverage tend to magnify the firm’s performance and risk: Leverage makes good times better, and it makes bad times worse.

To illustrate operating leverage, consider two retail clothing stores. One store pays its salesperson a salary of $2,000 a month, a fixed cost. The other store pays its salesperson a 50% commission on sales, a variable cost. Now, consider two possible economic envi- ronments: bad times and good times. In bad times both firms sell $1,000 worth of goods in a month; in good times both stores sell $5,000 worth of goods in a month. Which store has more operating leverage? Which store is more likely to default on its payments to its sales staff? Which store could maintain a higher degree of financial leverage? As shown in Table 8.3, clearly, the store with lower operating leverage (lower fixed costs) has greater debt capacity.

Table 8.3: The effect of operating leverage (high fixed costs) on profitability

Good times Bad times

Sales $5,000 $1,000

Low operating leverage store:

Salary $0 $0

Commissions $2,500 $500

Operating profit (or loss) $2,500 $500

High operating leverage store:

Salary $2,000 $2,000

Commissions $0 $0

Operating profit (or loss) $3,000 ($1,000)

Cost of Distress The costs of bankruptcy are also a determinant of corporate borrowing capacity. Recall that bankruptcy is essentially the transfer of asset ownership from residual claimants to fixed claimants. The frictions associated with such a transfer are somewhat predictable. We know, for example, that ease of transfer or sale of an asset is dependent on several characteristics of that asset. The liquidity, or nearness to cash, of the firm’s assets also affects the level of expected bankruptcy costs. As a general rule, tangible assets are more easily sold (more liquid) than intangible assets (such as patents, goodwill, or copyrights). Businesses whose assets are primarily land, buildings, and equipment will have lower

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

bankruptcy costs than those whose value depends on intangibles such as the firm’s repu- tation or the brand value of its products. Cash and marketable securities are easily and almost costlessly transferred from owner to owner, while work-in-progress inventory is often sold in financial distress yielding $0.50 or less per dollar invested. Asset specificity adds to its cost of transfer, lowering its liquidity. An abandoned nuclear power plant, in spite of its tangible nature, has almost no use other than as a nuclear power plant—thus its use is highly specific. Although such a plant may have cost billions of dollars, almost no one would be willing to receive it as a gift—free of charge. In fact, most of us would require compensation just for accepting such a gift. In a bankruptcy, such an asset would have a very high transfer cost. A delivery truck used in business can be more easily sold because it can be used in a variety of ways. Such a vehicle’s use is not highly specific—a characteristic that enhances its marketability.

To summarize, bankruptcy’s impact on leverage depends on the likelihood of its occur- rence and the costs associated with the procedure should it occur. Evaluation of these considerations involves analysis of the firm’s future cash flow–generating capacity and of the nature of the assets underlying the business. It is no wonder that lenders look at two factors when considering the debt capacity of a borrower: the primary source of repay- ment (cash flow) and the collateral (the assets backing the loan) that could be sold as a secondary source of repayment. Firms (or individuals) with high and steady cash flows who hold assets easily marketed for their full value can borrow more than those without these characteristics. By borrowing more, they are able to take greater advantage of debt’s tax-shielding benefit.

Agency Problems

Companies whose cash flows are high but that are in a mature stage, with few positive NPV projects in which to invest, find themselves with excess cash on hand. They are flush with free cash flow (cash not needed to fund promising projects). In such firms the poten- tial for wasted money and time is greater than in firms in their formative stage. Manag- ers of large companies with widely dispersed ownership are less likely to be held closely accountable for their actions because no single stockholder owns enough stock to present a threat to incumbent management. In the 1980s, for example, even future presidential candidate Ross Perot was unable to redirect General Motors’s strategy despite being the firm’s largest shareholder. When combined, excessive free cash flow and widely dispersed ownership are ingredients that foster wasted resources. These firms may benefit from the discipline of debt. Leveraging upward puts more pressure on management to perform effectively and efficiently. More free cash flow is guaranteed to be paid out as fixed claims increase, reducing the potential for discretionary expenditures like excessive perquisites. In such cases, adding leverage can add to firm value.

Signaling

Another consideration is the use of leverage as a credible signal to outside sharehold- ers and analysts. If, for example, managers are confident that the firm’s performance is improving, then a strong signal would be to borrow funds and use the proceeds to repur- chase some shares. More debt signals the ability to produce the cash necessary to meet a higher level of fixed claims in order to avoid default. Additionally, insiders would direct

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

the firm to repurchase shares when the share price is below its value—in other words, when buying one’s own shares is a positive NPV investment.

Transaction Costs

The empirical evidence doesn’t support the notion that companies constantly fine-tune their capital structure to be at or near their optimal mix of debt and equity. Observers see companies going years between security issues that would bring them back toward their historical debt ratios. Transaction or issuance costs may explain this slow response.

There are two types of costs associated with issuing securities in the public capital mar- kets: direct and indirect costs. Direct costs are the fees paid to lawyers, accountants, and investment bankers; listing fees paid to exchanges; printing, advertising, and marketing costs; and management time spent on the issuance process rather than on other activities. Indirect fees are underpricing of security issues by underwriters and any reactions in the price of existing securities to the announcement of a new issue. We will discuss both types of costs in more detail in a moment. First, let’s introduce some definitions:

• New equity IPO is the very first issuance of stock for a company; it is the company’s initial public offering (IPO). Determining the market value of an IPO is difficult, so underwriters tend to underprice these issues severely. This leads to large indirect issuance costs in addition to the high direct costs. More on this below.

• Seasoned equity is an issue of more common stock being offered to the public by a company that already has publicly traded common stock outstanding. These new shares will dilute existing ownership, so some shares of stock have preemp- tive rights, which give existing shareholders the right to buy shares in any new stock issues to maintain their original proportional ownership. Most states do not require companies to include preemptive rights in their articles of incorporation, so this right is not guaranteed. Seasoned equity offerings are valued based on the market value of the existing shares, so underwriter underpricing occurs much less frequently than in IPOs.

• Convertible bonds have both a debt and equity component. While the debt portion is relatively easy to value, the equity portion can be complex, increasing the cost of issuance.

• Straight debt (i.e., nonconvertible debt) is relatively easy to value, as we saw in the first weeks of the class. Once the bond issue is rated and a coupon rate set, it is a standard PV exercise.

Table 8.4 shows the direct costs for various sizes and types of securities. These data are from the period 1990–1994, so note that they are dated.

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CHAPTER 8Section 8.2 Determinants of the Target Capital Structure or Debt Capacity

Table 8.4: Issuance costs for various types of corporate securities

Amount issued (in millions) New equity IPO

Seasoned equity

Convertible bonds

Straight bonds

, $40 12.2% 8.8% 7.4% 2.9%

, $40 to $100 8.5% 5.5% 3.5% 2.1%

. $100 6.8% 4.0% 2.6% 2.2%

Weighted average 11.0% 7.1% 3.8% 2.2%

Table 8.4 shows some clear patterns. First, notice that smaller issues cost more than larger issues of the same type of security. This suggests that there are fixed costs associated with the underwriting and issuance process. Second, the more difficult a security is to value, the higher the costs. Equity for a new firm is the most difficult to value because the com- pany has a limited track record, may be offering a new product in a relatively new market, and may have some untested managers (which implies that venture capital or private equity costs will be higher still, since those valuations would be more complex than those for companies ready to go public). Seasoned equity is simpler because there is an existing stock price, but the value of the stock (new and existing) will depend on what the com- pany will do with the proceeds. If investors are not confident that managers will make good use of this pot of money, then they will push share prices down (increase indirect issuance costs). Bonds are the simplest security to value and have the lowest costs. Valu- ation therefore entails not simply setting the price at or just below current market value, but it must also include some analysis of the prospects of the firm making good use of the proceeds of the issuance.

A Closer Look: Level of Debt for the Average Firm by Industry

This table shows the level of debt for the average firm in a variety of industries. Can you spot any pattern regarding what the relatively low debt industries have in common versus the higher debt industries?

Industry Capital structure

Water utility 45% debt

Semiconductor 7.7% debt

Restaurant 11.3% debt

Oil/gas distribution 37% debt

Packaging and containers 34% debt

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CHAPTER 8Section 8.3 The Pecking-Order Theory

As we discussed earlier in this chapter, pricing equity (both IPOs and seasoned equity) is complicated by the presence of asymmetric information—managers know more about the value of the firm’s assets and growth prospects than outside investors do. Consider a company that has a positive NPV project that it wants to finance. It could offer debt or equity. When will it offer equity? If you are the CEO and you work for the benefit of exist- ing shareholders, you will only offer equity if it is fairly or overpriced. That means that sometimes investors are paying too much for new stock offerings. To combat this, they will only buy new shares at a discount, so we see new shares selling at a discount to the price of the shares immediately before the new stock offering is announced. This notion is supported by the facts that seasoned equity offerings tend to happen after share price has been rising during the year previous (consistent with the stock being overvalued) and after the issuance of a seasoned equity offering, the stock performance for the next 5 years is subpar. That investors tend to underprice new equity issues is an indirect cost of issuing equity. The high costs of equity issuance give companies a good reason to avoid issuing equity and have led to the development of an alternative theory of how companies make their debt–equity decisions.

8.3 The Pecking-Order Theory

So far this chapter has argued that firm value can be maximized at some target amount of debt; that is, that companies have an optimal capital structure they should pursue. The pecking-order theory of capital structure takes an entirely different view of how companies choose their financing mix. This theory, developed by Stuart Myers of MIT, argues that the costs of issuing securities in the capital market, especially equity, is so high that companies try to avoid those costs. Companies try to fund as much of their invest- ment as possible from internal sources (e.g., retained earnings). When external funds have to be used, companies issue safe debt; if more funds are needed for investment in produc- tive assets, risky debt is issued; and finally, if the company doesn’t want to bear too much bankruptcy risk, equity is issued. There is no target debt level as in the previous models. Instead, companies consider internally generated cash flow, their investment opportu- nities, and the costs associated with security issuance. Figure 8.8 summarizes the main points of the theory.

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CHAPTER 8Section 8.4 Financial Flexibility

Figure 8.8: Pecking-order theory

Companies want to avoid issuing equity unless it is absolutely necessary—the direct and indirect costs are very high. Debt issues, particularly high-rated or relatively safe debt, will have the absolute lowest costs of all sources of external finance. Retained earnings have no issuance costs whatsoever, so they are at the top of the pecking order.

8.4 Financial Flexibility

Companies appear to have debt targets somewhat lower than expected. Some econo-mists argue that this allows a company to maintain financial flexibility. Flexibility is most easily thought of as the ability to raise funds for investment (and for paying dividends) during periods when cash generation is low. The notion of financial flexibility also explains why companies sometimes issue debt and exceed their estimated target debt levels and then slowly adjust back toward the target. In a survey of about 250 global com- panies, researchers found that financial flexibility is considered extremely important; in fact, flexibility manifested as the ability to continue making investments and paying divi- dends represents the second- and fourth-ranked determinants, respectively, of debt levels.

Another aspect of financial flexibility is maintaining a high credit rating. Having a high credit rating means that a firm can issue debt at a reasonable cost at any time, which supports flexibility. As an example, A Closer Look: Moody’s Long-Term Corporate Obligation Ratings elaborates on this topic.

Internal Resources (retained earnings)

External Resources (issue safe debt)

External Resources (issue risky debt)

Equity

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CHAPTER 8Summary

A Closer Look: Moody’s Long-Term Corporate Obligation Ratings

Moody’s long-term obligation ratings are opinions of the relative credit risk of fixed-income obliga- tions with an original maturity of 1 year or more. They address the possibility that a financial obliga- tion will not be honored as promised. Such ratings use Moody’s Global Scale and reflect both the likelihood of default and any financial loss suffered in the event of default:

Aaa: Obligations rated Aaa are judged to be of the highest quality with minimal credit risk.

Aa: Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.

A: Obligations rated A are considered upper-medium grade and are subject to low credit risk.

Baa: Obligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics.

Ba: Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk. Bonds classified as Ba or below are often called “junk” bonds.

B: Obligations rated B are considered speculative and are subject to high credit risk.

Caa: Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.

Ca: Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.

C: Obligations rated C are the lowest-rated class of bonds and are typically in default, with little prospect for recovery of principal or interest.

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a midrange ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.

Summary

Debt acts like a lever. When the firm is doing well, financial leverage increases the return to stockholders. When times are tough, it magnifies the negative effect on shareholders’ returns. The more leverage, the greater the magnifying effect. Thus, while leverage can increase expected returns, it also increases variability or risk. In perfect capital markets, these two effects just offset one another, leaving value unchanged.

In reality, market imperfections exist that make the capital structure choice similar to a bal- ancing act between the benefits of debt and its effects that harm value. Debt may increase cash flows to claimants by avoiding corporate taxes, by limiting agency problems, and by sending a positive signal to outsiders. On the other hand, added leverage increases the likelihood of a costly bankruptcy.

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CHAPTER 8Key Terms

Although there is no precise method for finding the optimal capital structure of a firm, certain characteristics of corporations help to guide managers toward an appropriate tar- get structure. First, firms with high taxable income operating in areas with high corpo- rate tax rates should consider higher leverage than unprofitable firms. Next, corporations with widely dispersed ownership and excess free cash flow may find that leverage low- ers potentially wasteful cash expenditures. Leverage may also be used as a signal of the increased debt capacity of the borrower. Finally, firms may deviate from optimal target debt levels to maintain financial flexibility.

These benefits of leverage must be balanced against the corporation’s potential bank- ruptcy costs. Firms with more volatile cash flows are in greater jeopardy of experiencing financial distress than firms with stable cash flows. Therefore, businesses should consider the stability of their income when targeting their debt level. Should a firm have financial difficulty, those with highly liquid or marketable assets should experience lower bank- ruptcy costs than those whose assets are unique or specific to their current use. Firms with illiquid, highly specific assets have higher potential bankruptcy costs and must carefully consider their levels of debt.

Key Terms

asset specificity The use of a capital good for a very specific purpose.

asymmetric information The situation in which corporate managers know more about many of the firm’s activities than do most outside shareholders.

bankruptcy costs The expenses and opportunity costs associated with bank- ruptcy and financial distress, including direct costs (such as lawyer fees and court costs), as well as indirect costs (such as loss of sales, the time of executives who must deal with the process, and the poten- tial loss of key employees who may seek employment elsewhere).

debt capacity The optimal amount of debt that a firm is able to take on.

financial flexibility The firm’s ability to raise new funds for investment even when cash flows are slow; can mean a firm does not borrow all the way to its limit, or may mean that the firm keeps some extra cash on hand to meet unforeseen needs.

financial risk The possibility that share- holders will lose money when they invest in a company that has debt, if the compa- ny’s cash flow proves inadequate to meet its financial obligations.

leveraging The act of using various finan- cial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

pecking-order theory The theory that firms choose their capital structure by following a prioritized list of methods for raising capital; according to this theory, there is no targeted level of debt.

perfect capital markets Markets where there is no information asymmetry, no transaction costs, and no taxes, and in which the choice of capital structure has no effect on the overall value of the firm; capi- tal structure is said to be irrelevant when markets are perfect.

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CHAPTER 8Web Resources

signal An action taken by management that is interpreted by outsiders as revealing something about the firm that is otherwise unobservable because of information asym- metry, such as the issue of more debt, which signals that the firm has better future pros- pects that increase its debt capacity.

target capital structure The optimum financing mix chosen by the firm to fund its assets and operations; usually includes a mix of debt and equity.

tax shield of debt The saving in taxes realized because interest on debt is tax deductible.

tradeoff theory of capital structure A theory stating that firms have a capi- tal structure that considers the tradeoff between advantages of debt (the tax shield of debt and the discipline of debt) and debt’s disadvantages (the costs associated with bankruptcy and financial distress).

Web Resources

Capital structure irrelevance was demonstrated for perfect markets by Franco Modigli- ani and Merton Miller in one of the most important articles ever written in economics. They both received Nobel prizes, in part for their capital structure studies. See “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, 48 (June 1958), available at http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20phd%20program/fin%20 635/3/modiglianimiller1.pdf.

Find business tax information at http://raw.rutgers.edu/.

See “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have” by Stewart C. Myers and Nicholas S. Majluf (1984), from the Journal of Financial Economics, 13(2), pages 187–221. The article is available online at http://www.nber.org/papers/w1396.pdf?new_window51.

In a well-known 1980 study (“The Effects of Capital Structure Policy Change on Security Prices: A Study of Exchange Offers,” Journal of Financial Economics, 8, 158–159; http://www.sciencedirect.com/science/article/pii/0304405X8090015X), Masulis found that 69% of the firms had positive market responses to their announced decision to increase leverage, while only 11% of firms announcing leverage decreases saw the value of their equity increase.

The discipline of debt argument was developed by Michael Jensen in his May 1986 article “Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers,” published in the American Economic Review, 76(2). You can find it online at http://ssrn.com/abstract599580 or http://dx.doi.org/10.2139/ssrn.99580.

Students interested in agency problems or corporate takeover battles are advised to read Bryan Burough and John Helyar’s book Barbarians at the Gate, the story of the battle for control of RJR Nabisco, which led to one of the largest corporate takeovers in history (visit http://en.wikipedia.org/wiki/Barbarians_at_the_Gate:_The_Fall_of_RJR_Nabisco).

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http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20phd%20program/fin%20635/3/modiglianimiller1.pdf
http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20phd%20program/fin%20635/3/modiglianimiller1.pdf
http://www.nber.org/papers/w1396.pdf?new_window51
http://www.sciencedirect.com/science/article/pii/0304405X8090015X
http://ssrn.com/abstract599580 or http://dx.doi.org/10.2139/ssrn.99580

 

CHAPTER 8Critical Thinking and Discussion Questions

Henri Servaes and Peter Tufano’s book, The Theory and Practice of Corporate Capital Struc- ture, Deutsche Bank, was published in January 2006. It is available for download at http://faculty.london.edu/hservaes/Corporate%20Capital%20Structure%20-%20Full%20 Paper.pdf.

For more information on capital structure, read the February 2011 article by DeAngelo, DeAngelo, and Whited, published in the Journal of Financial Economics, 99(2), and avail- able at https://msbfile03.usc.edu/digitalmeasures/deangelo/intellcont/DDW%20JFE%202011%20 final%20version-1.pdf.

To access extensive financial information about virtually any company, explore http://finance.yahoo.com.

New York University Professor Aswath Damodar maintains data concerning average debt ratios at http://pages.stern.nyu.edu/~adamodar/.

Critical Thinking and Discussion Questions

1. Name four examples of frictions, or cash flow leakages, that exist in imperfect capital markets.

2. Consider the following: a. If fixed claimants (bondholders) supply half of a corporation’s capital and

residual claimants (stockholders) supply the other half of the capital, will these two classes of claimants each be exposed to half the firm’s total risk? Why or why not?

b. Will each class of claimants receive half of the firm’s cash flows? Explain, using your answer to part a, and what you know about the risk and return relationship.

3. Suppose a savings and loan must foreclose on an individual’s house because the homeowner is unable to meet the mortgage payments. What costs will poten- tially lower the value of the house to the savings and loan? Can you think of both direct and indirect costs in this example of financial distress?

4. Which of the following hotels could potentially carry a greater proportion of debt in its capital structure and why? Both Hotel A and Hotel B have the same cost, have the same expected cash flows, their cash flows are equally risky, and they are located across the street from one another; but Hotel A is built so that it could be easily converted to a nursing home and Hotel B is built so that its conversion to another use is impractical.

5. The Gonzales twins are each shopping for a loan. They both have good payment records on their other debts and have impeccable character. They both earn, on average, $40,000 each year. Hector Gonzales is a carpenter and Juan Gonzales is a nurse. Which twin do you think has the greater debt capacity, and why?

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CHAPTER 8Practice Problems

Practice Problems

1. Firm A has a high degree of operating leverage. All of its operating expenses are fixed at $12,500 a month. Firm B utilizes no operating leverage. Its operat- ing expenses are all tied to sales, equaling 60% of total revenues. Suppose both Firm A and Firm B have sales of $20,833 in June, $30,000 in July, and $15,000 in August. Find the operating cash flows for each firm for each of the 3 months. Which has more variable operating cash flows? Which firm could take on more financial leverage?

2. Consider the following: a. Suppose there is a one-third probability that a firm will have an operating

cash flow of $100,000 next year. There is a one-third chance that the firm will have an operating cash flow of $150,000, and a one-third chance of it having an operating cash flow of $200,000. You may purchase all of the stock in the firm (50,000 shares) if you wish. The corporate income tax rate is 40%. What will be next year’s cash flows per share on the potential stock purchase under each of the three outcomes?

b. Now, suppose the firm leverages itself. You can still purchase all of the firm’s securities ($1,600,000 of bonds paying 10% interest and 10,000 shares of stock). Corporate income tax rates are still 40%. What will be your total cash flow for these investments next year under each outcome for the leveraged firm?

c. Should operating cash flows fall below the level required to make interest payments, the firm will be forced to file bankruptcy papers, which will cost the firm $10,000, to be paid before distributions to claimants. How does this potential bankruptcy cost affect the total expected cash flows on your claim? (Hint: Recall that E(CF) 5 P

1 (CF

1 ) 1 P

2 (CF

2 ) 1 P

3 (CF

3 ) where P

1 , P

2 , and P

3

denote probabilities that the cash flows CF 1 , CF

2 , and CF

3 will occur, respec-

tively.) How does the expected cash flow for part c compare with the expected cash flow calculated using the answers to part b of this problem?

3. Suppose you buy some vacant land as an investment. You can invest $50,000 of your own money. The land is selling for $5,000 an acre. You can buy either a 10-acre parcel or a 20-acre parcel. If you buy the smaller parcel, you will invest only your own funds. If you decide on the larger parcel, you will borrow $50,000 at an 8% interest rate and fund the balance of the purchase price with your money. Ignore taxes in this problem. If you hold the land for 1 year, what is the percentage return on your $50,000 out-of-pocket investment for both strategies when a. you sell the land for $4,500/acre. b. you sell the land for $5,100/acre. c. you sell the land for $5,500/acre. d. Why didn’t using leverage raise your return in part b? After all, the value of

the land increased.

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CHAPTER 8Practice Problems

4. The Whole Doughnut is expected to produce operating cash flows of $200,000 a year in perpetuity. If the firm was financed using 100% equity, calcu-

late the total annual dividends paid by the firm, assuming The Whole Doughnut pays all of its after-tax cash flows out as individuals.

Operating Cash Flows

2 Taxes (25%)

5 After-Tax Cash Flows

5 Total Dividends Paid

Now, suppose the firm is financed with $500,000 of 6% debt, and the balance is financed by equity. Again, no operating cash is retained. What will be The Whole Doughnut’s total cash flows to claimants?

Operating Cash Flow

2 Interest Payments

Cash Flow Before Taxes

2 Taxes (25%)

5 After-Tax Cash Flows

5 Total Dividends

1 Interest Payments

5 Total Cash Flows to Claimants

5. Frank Baez hates to pay taxes and decides to change the capital structure of the firm he manages in order to avoid taxation. The firm currently has earnings before taxes of $3,000,000 and is in the 34% tax bracket. Presently, all of the firm’s financing is in the form of equity. Frank intends to issue $10,000,000 worth of 9% bonds and trade each bond for a portion of each shareholder’s stock. The interest payment s on the bonds are tax deductible. If the firm pays out all of its after-tax earnings as dividends, how much more cash will stockholders receive as a group under Frank’s plan?

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