Professional Documents
Culture Documents
Capital structure
A. Modigliani-Miller
Perfect capital markets
Capital structure irrelevant
Taxes
Financial distress costs
Manager-shareholder conflicts
Asymmetry of information
Capital Structure
With market imperfections, there is such a concept as
optimal capital structure
1. Tax benefits
2. Financial distress costs
VLev =
VLev
=
VUnlev + D
Consequences?
To maximize shareholder value:
A firm should lever up to the max!
2. Bonds
In default:
A.
B.
All your legal and professional fees to deal with the bankruptcy
and reorganization
Loss of Customers
Loss of Suppliers
Loss of Employees
Loss of Receivables
Fire Sale of Assets
0% -30% of pre-bankruptcy market value of total assets
There is a trade-off
Trade-off between
1. Too little debt: Giving up the tax advantage of debt
2. Too much debt: Incurring significant financial distress costs
VL = VU + D
Present value of
financial distress costs
Maximum
firm value
D*
Debt (D)
Why?
When probability is low, chances are, the firm will not suffer from
financial distress any time soon!
Hence PV(costs) are low by the principle of time value of money!
Industry matters
Probability of distress occurring
B.
C.
In any given year, a firm with more volatile earnings has a higher risk of generating less than what
it owes
Examples:
Some industries (oil & gas, airlines) rely a lot on external capital
The higher the debt burden, the more likely you will not cope!
Quality of collateral
If a firm can pledge more of its assets, it gets more leeway from its bankers/lenders, it has more
debt capacity
Industry matters II
The cost of distress when distress occurs
Depends on industry in which the firm operates
In particular:
Loss of customers
After-sale service: Auto-industry vs. Grocery retailing
Reputation of service: Airline vs. Grocery retailing
Loss of employees
Human capital: IT firm vs. Grocery retailing
Other indirect effects
Suppliers might treat you worse, etc.
Examples:
1. Private-equity firms
LBOs
2.
Management
Leveraged recapitalization
Reasons:
1.
2.
An Example
An Example