The Miller & Modigliani theorem

Turning to capital structure

The two key questions in corporate finance: Valuation: How do we distinguish between good investment projects and bad ones? Financing: How should we finance the investment projects we choose to undertake? We now turn to the second question.

Some facts about capital structure

1.
2.
-

Firms finance themselves through retained earnings (internal financing) and selling securities in the market (external financing) Internal financing (retained earnings) biggest source of financing for firms
Firms in countries with less developed financial markets use particularly little external financing

3. The external financing is done by issues of debt, equity and hybrid securities (such as convertible debt and preferred equity)

4. External financing is raised both in private and public markets

5. Sources of financing vary over time and over business cycle

Private sources: Private equity, bank debt, private placements of bonds and equity Public sources: IPOs, Seasoned equity issues; public bond issues

Equity issues increase when stock market returns have been high for some period of time Debt/borrowing issues less cyclical

4. Capital structures vary across different industries and countries

High leverage industries: Utilities, airlines, cars Low leverage industries: biotech, software/internet, hardware High leverage countries: Korea, Thailand, Indonesia, India Low leverage countries: UK, Australia, US

Industries Vary in Their Capital Structures

Industry
Electric and Gas Food Production Paper and Plastic

Debt Ratio* (%)

43.2 22.9 30.4

Equipment
Retailers Chemicals Computer Software Average over all industries

19.1
21.7 17.3 3.5 21.5%

*D/(D+E), Debt in book value, Equity in market value

U.S. data

Debt vs. equity

Equity and debt (and other corporate securities) differ along two dimensions: (1) Division of value - Debt is senior to equity get the value of the firm
(2) Division of control
-

until debt paid off Equity gets whatever is left after debt has been paid Equity holders control firm as long as not bankrupt Debt holders control firm when firm is bankrupt

Equity is a call option

Equity gets max (0, V - D), i.e. a call option with strike D Debt gets V max (0. V D) = min (V,D)
E(V)
Face of debt
Payment to debt holders, D(V).
Payment to Equity holders, E(V). V=D(V)+E(V)

D(V)

V Face of debt

Questions we will try to answer:

Is there an optimal capital structure, i.e., an optimal mix between debt and equity? More generally, can you ad value to existing owners (equity and debt holders) through decisions on the RHS of the balance sheet? If yes, does the optimal financial policy depend on the firms operations (Real investment policy), and how?

The Miller and Modigliani (MM) capital structure irrelevance theorem

MM (1958) maybe the most important paper in finance
Not only for corporate finance, but also for investments Black Scholes option pricing, for example, relies on arbitrage arguments introduced in this paper

One way to thing about it: what role does capital structure have in a neoclassical fully competitive model with frictionless markets Answer: None!
Like the CAPM

Why is MM so important?
We dont believe it, literally
Since markets are not perfect, frictionless, and fully competitive

Strength of theorem is that by showing when capital structure is irrelevant, it also implies when it is relevant.

To get some perspective: preMM views

Typical pre-MM view: debt is typically cheaper than equity
Interest rate on debt is lower than the investors required return on equity Equity issues are dilutive: decrease earnings per share, which hurts shareholders

But we cant have too much debt, because then we go bankrupt Optimal capital structure

The MM theorem shows that such arguments are flawed

The value of the firm is given by expected cash flows and the investors discount rate (or required rate of return) for these cash flows - V = E(FCF) / (1+R) In efficient markets (i.e. the MM assumptions) capital structure affects neither of these.

 V = E(FCF)/(1+R) Capital structure is just one way of splitting cash flows between different investors, but the total value of the firm remains the same Although the required returns of debtholders and equityholders may differ, the weighted average cost of capital to the firm will always equal R

The Miller Modigliani Irrelevance Proposition

Suppose the NPV of a new issue is zero. Suppose the free cash flow to a levered firm is the same as to an all equity financed firm. Then, financing does not matter! Value is maximized by taking all +NPV as before.

 Intuition: (Yogi Berra).

- The firm finances its projects by promising free cash flow from operations to different types of investors (debt and equity holders). - The size of the pie is the sum of the free cash flows it depends on the investment policy, not the way the pizza is divided between investors.

When is it true that financing is irrelevant?

Original MM (1958) homemade leverage proof:

Twin firms A and B with identical cash flows of CF
- A is all-equity financed, value of equity = EA = VA - B has debt of D, value of equity = EB; VB = EB + D,

Miller and Modigliani claim that VA = VB, otherwise there would be an arbitrage opportunity

Suppose debt D is risk less. If buy all of Bs equity, you get:

- CR D(1 + RD) = companysnet profits after interest - This costs you EB.

Instead suppose you buy all of As equity, but borrow on own account D of the purchase pries.
- So cost to you is EA D. - You get CF D(1+RD) = companys whole cash flow less personal interest you owe.

Since strategies yield same net cash flow to you, must cost the same to assemble: EB = EA D, of VB = VA.
- Otherwise there would be an arbitrage opportunity.

 NOTE: We have not assumed anything about how NPV is calculated.

MM does not rely, for example, on CAPM being true. What is essential is that there are no arbitrage opportunities (financial markets are competitive and complete).

Does all this seem a bit esoteric?

Capital structure arbitrage is currently a popular hedge fund strategy.

MM and the cost of capital

We have seen that when a firm levers up (finances with debt), it increases the risk ness of its equity. The weighted average cost of capital remains the same: In our example: - D/(D+E)*rD + E/(D+E)*rE = rA - (10/11)*(10%)+(1/11)*(100%)= 18.18% It is true that debt requires a lower return. However, when you lever up, the equity becomes riskier and requires an even higher return. These two effects exactly cancel.

Effect of leverage on returns in the MM world

return on assets

D E ra rD rE DE DE

Return on equity (MM proposition II): rE = rA + (D/E)(rA-rD) Risk of equity: E = A + (D/E)(A D)

Returns and leverage

Expected Returns

rE

rA rD

Debt becomes risky

Debt/Equity

Do we believe the MM assumptions?

MM irrelevance theorem holds if
A. NPV of a new issue of debt or equity is zero. B. The free cash flow to a levered firm is the same as to an all equity financed firm.

Do we believe that these assumptions are true in the real world?

(A) Is new issuance zero NPV?

I.

There are 3 conditions for this to be true. The first two are: Financial markets are competitive.
Financial markets are complete:

II.

New investors just demand fair return on their investment.

Investors can choose any consumption pattern by borrowing, lending, and hedging.

If not, the firm may be able to make money by offering a cash flow stream with attractive risk characteristics to certain clientele.

 For a typical corporation, these two conditions probably hold

It is hard to think that a corporation could make money by issuing some new, eotic security that did not exist before
There are close substitutes available for any security that a company can issue

Making profits from pure financial engineering is better left to the investment banks than regular corporations!

 But there is a third condition as well: 3. Prices reflect all existing information (strong form efficiency)
- BUT: if the manager has private information about prospects of the firm, MM does not hold! Could potentially issue misvalued securities and make money!

(2) Are FCF Levered = FCF All Equity?

1. 2. 3.

The assumptions for this to be true are:

4.

As we will see, all of these assumptions may not always hold in real world.

No taxes (or no asymmetric tax treatments) There are no extra costs of financial distress. There are no transaction costs from issuing securities (or the same costs for debt and equity) Managers and employees always work to maximize the value of the firm

Using M-M Sensibly

M-M is not a literal statement about the real world. It obviously leaves important things out. But it gets you to ask the right question: How is this financing move going to change the size of the pie? Helps you avoid making the wrong arguments, such as the cost of capital argument above. Lets go back to some logical fallacies that MM can address.

 Debt is cheaper than equity because it has a low interest rate

What matters for the value of the firm is RA, the opportunity cost of capital for the firms assets In an MM world, when you take on more leverage, your RE will increase to keep RA constant

MM applies to all corporate finance decisions

M-M Theorem was initially meant for capital structure, but applies to all aspects of financial policy:
capital structure is irrelevant. long-term vs. short-term debt is irrelevant. dividend policy is irrelevant. buying back shares is irrelevant. risk management is irrelevant. purely diversifying acquisitions are irrelevant. etc.

Indeed, the proof applies to all financial transactions because they are all zero NPV transactions.

(dividends) (net proceeds from new financing) = (cash flow from operations) (new investment) In other words: think about the choice of whether to pay a dividend or not.
If we increase our dividend we can always issue new equity (or debt) to offset this shortfall If we decrease our dividend we can always repurchase some shares (or pay down some debt) to offset.

We know that value is given by discounting the right hand side Free Cash Flows
LHS does not matter for value, if RHS given

 As long as excess cash retained earns a market return, net payments to financial markets do not matter.
$ 100 of excess cash today is worth $ 100 regardless of whether pay out now or later. Although the return on the firms assets may go down if you keep cash on your balance sheet, required return also goes down since firm cash flows become less risky

under MM, as long as retained cash flow earns a fair market return and is paid out at some future point.

Total payout policy does not matter either

 Essentially the payout policy argument is the same as the debt irrelevance argument. Important principle: Deciding how much debt to take on and deciding how much cash to pay out is essentially the same decision Cash = Negative debt!

This is why we should consider Net Debt = Debt Excess Cash when we evaluate capital structure and unlever betas.

Bottom line
Using the MM theorem, we can understand what does (and
doesnt) matter for financial policy. To understand capital structure and payout policy in the real world we will now see what happens when we relax some of the MM assumptions: What if there are corporate and personal taxes? Costs of financial distress? Conflicts of interest among managers, equity holders, and debt holders? Managers are better informed than investors?

Financial policy: Plan of Attack

1. Modigliani-Miller Irrelevance Proposition (1958):
In a world with out frictions, financial policy is completely irrelevant does not change value of firm. Taxes Costs of financial distress Other Frictions

2. Now: How does the M world differ from the real world?

Relaxing the Assumptions of MM

1. 2. 3. Almost true

Financial markets are competitive. Markets are strong form efficient. Markets are complete.

New investors get zero NPV.

Not true 4. 5. 6. 7.

No differential tax treatment. No costs of financial distress. No issuance costs. Managers and employees do not have an incentive to deviate from +NPV rule.

The financial policy does not change the free cash flow from real investment policy.

The effect of corporate taxes

The importance of taxes was first noted by MM Problem is not taxes per se, but that interest and dividends have a different tax treatment In the U.S. (and for most other countries), the interest payments of corporations are taxdeductible, while dividends are not Hence, there is a strict tax advantage to financing with debt rather than equity
As a matter of fact, implies firms should have 100% debt!
Which we clearly dont observe

Example: Debt tax shield

A firm generates $ 100M in profits for sure every period in perpetuity. This is the only cash flow the firm has. Risk-free rate is 10% Corporate tax rate (TC) is 40%. If the firm is 100% equity financed, what is the value of the firm?

 Every period, FCF = (1 0.40)*100= 60

V = E = 60/0.10 = 600 Now the firm takes of $ 500M of debt. What is the coupon of the debt?

 The debt is risk-free debt holders require 10% $ 50M coupon What is the value of the equity? Each period equity holders get the Net Income of the firm: (1-0.40)*(10050) = 30 Value of equity = 30 / 0.10 = 300

 Since the value of debt is $ 500, firm value is V = E + D = $ 500 + $ 300 = $ 800 The firm value has increased by $ 200!
Another way to think about this:
VL = VU + PVTS
VL = value of the levered firm VU = value of the unlevered firm PVTS = PV of the Interest Tax Shield

In this case PVTS = $ 200M. Why?

 Each period the firm saves TC*I in taxes where TC is the corporate tax rate and I is the interest payment
I.e. yearly tax savings are 40%*$50 = $20M

Hence, the Present Value of the Tax Shield is PVTS - $ 20 / 0.10 = $ 200M.

 This is also equal to TC*D = 40%*$500 = $200

the PVTS = TC*I/RD But the interest payment I D*RD The PVTS becomes TC*D*RD/RD=TC*D

PVTS = TC*D is a back of the envelope formula. It assumes that

D is constant (ta shield is a perpetuity) Taz shield and debt payments have same systematic risk can discount the tax shield at RD What is the optimal level of debt for this company?

Who gains from taking on the debt?

Say that the firm has 1000 shares outstanding Before taking on any debt, each share is worth $600/100=$0.60/share Now the firm takes on $500 of debt, and buys back $500 worth of shares Think about this as happening in two

(1) The firm raises $500 in debt. Firm now consist of the PV of future firm cash flows plus $500 in cash The value of firm is Cash + VU + PVTS= $500 + 600 + 200 = $1300
The value of equity is E = $1300 - $500 = $800 Share price increased from $0.60 to $0.80

equity gets the whole $200 gain of the new debt tax shield!

(2) Firm does a share repo of $500 buys

back $500/0.8 = 625 shares. Value of the firm is now $1300 - $500 = $800 E = V D = $800 - $500 = $300 The equity market cap is lower, but equity holders wealth consist of $300 in stock + $500 in cash = $800

Same argument applies to payout policy

Keeping excess cash of C in the company gives
you a negative tax shield of t*C Assume you keep $100 of excess cash in the firm and invests it in T-bonds @ 10%, say Pre-tax profits increase by $10M/yr (perpetuity) if TC=40%, after tax profits are $6M/yr What is the PV of this $100 T-bond investment?

 PV = CF/r = $6/0.1 = $60 Keeping $100 of excess cash in the firm, rather than paying it out, reduces value of cash to $60! if we keep excess cash of C in the firm rather than paying it out, this cash is only worth (1- TC)*C I.e. cash has a negative tax shield of TC*C!
Here (and in general) keeping excess cash in firm is like having negative debt!

Where do we stand now?

Adding corporate taxes to MMs world suggest firms should be 100% debt financed and keep 0% excess cash!
Firms value

Seems extreme:

Either CFOs are missing something, or something must be missing from our analysis.

- Average debt ratio has been around 35% in lastD/E decades. - Many firms (Microsoft, Intel) hoard large amount of cash.

In addition, most firms effectively pay less than the statutory rate in corporate taxes
Will not make profits every year Net operating losses (NOLs) can be carried back and forward to offset profits in other years. Some firms have large non-debt tax shields, such as depreciation, investment tax credits, etc.

 Firms have a lower tax benefit of debt if

Profits more volatile firm already has a lot of debt Have NOLs and substantial non-debt tax shields less likely to have profits left to shield with additional debt

John Graham (Journal. of Fin. -00) estimated the U.S. effective corporate tax rate at about 30%

 Bottom line: the effect of personal taxes and NOLs on the value of the interest tax shield is complex. Depends on
% of firms securities held by institutions and individuals whether investors adjust portfolios in a tax-efficient way the volatility of the firms profits, NOLs, and tax shelters

Still, clear that even after accounting for personal taxes and effective corporate tax rate, a substantial debt tax shield remains in the U.S.
Back-of-the envelope calculations of T in the U.S. typically come in around 10-20% Will vary from company to company, however
As low as 2% vs. as high as 35%

Debt Tax Shield Calculation Note!constant, perpetual Formula T*D assumes

debt. More generally, can value PV (debt tax shields) as
the discounted cash flow stream from the tax shield: E (taxshieldyear1) E (taxshieldyear 2) PV ( DebtTaxShield ) ... 2 1 rdts (1 rdts )

What should the discount rate rdts be?

We have used rd which is true if the risk of the tax shield is the same as the risk of the debt. In many instances, e.g. highly levered firms, the tax shield is likely to be riskier than the debt makes sense to use a higher discount rate, closer to rA

To summarize
If the only MM assumption we relax is taxes, we get the following
Firm should finance themselves with 100% debt All excess cash should be paid out to shareholders

Does not seem to match very well what we observe in reality

The Dark Side of Debt: Cost of Financial Distress

If taxes were the only issue, (most) companies would be 100% debt financed. Common sense suggests otherwise: If the debt burden is too high, the company will have trouble paying. The result: financial distress.
Can lead to value destruction that would not have happened in the absence of debt

MM and bankruptcy
Note: the possibility that a firm defaults on its debt obligations does not in itself violate MM as long as this does not impose any additional costs on the business! In the MM world, when the value of equity falls to zero, debt holders take over the firm. There should be no costs to bankruptcy no reduction in cash flows generated by the company.

What are the costs of financial distress and how big are they?
Most obvious: Direct costs of bankruptcy
Legal expenses, court costs, advisory fees Example: K-Mart spent more than $ 100 million on lawyers, accountants, investment bankers, and other advisors wile in bankruptcy.

Direct costs of financial distress

Direct costs represent (on average) some 2-5% of total firm value for large companies and up to 20-25% for small ones. But this needs to be weighted by the probability of bankruptcy: (/07% per year for NYSE-AMEX firms). Overall, expected direct costs tend to be very small: about .02% of firm value!

Direct costs are too small

The tax shield represents gain of 10-35 cents for a dollar of debt Direct costs of bankruptcy are too small to account for the low debt ratios we see in reality. But there are other, indirect costs of financial distress that could potentially be much more important

And that would be incurred even if the distressed firm is able to avoid outright bankruptcy or default!

What could these indirect costs be?

Inability to invest in the right projects Inefficient liquidation of assets Inability to respond to competition Losing valuable customers, employees, and suppliers Time and focus wasted negotiating with creditors rather than running the business

The importance of liquidity constraints

I.e. when firms not being able to access enough funds to be able to make the optimal operating decisions and still service the debt. But why do firms become liquidity constrained when they have too much debt?
E.g. why cant the firm just issue more equity, to both service the debt and cover investments?

Well, would you invest money in a firm on

A simple example
Firm has assets in place which will pay off next period:
Boom: Worth 100 with Probability = 0.5 Bust: Worth 20 with Probability = 0.5

Assume everyone risk neutral, discount rates are zero, and there are no taxes
This is not important, but makes things simple The value of the firm is then simply expected cash flows next period

So: firm value V = 60

 Assume this firm has debt outstanding with a face value F = 50 What is the value of equity and debt? The payoffs for debt and equity: So in the boom, the debt will be paid off in full, in the bust the firm will default
Boom: D = F = 50, E = 50 Bust: D = V = 20, E = 0 So today: D = 35, E = 25 Debt = min(V,F), Equity = max(V-F,0)

Debt is under water: trading below par

The debt overhang problem

Assume that this firm has a new investment:
Invest 10 today Worth 15 tomorrow for sure (both in boom and bust) Positive NPV = 5 optimal to invest Boom: cash flows increase to 115 Bust: cash flows increase to 35 Firm value increases from 60 to 75

The firms cash flows would not be

Assume firm has no liquid assets and needs to raise cash to invest Will equity-holders put in the money to invest?

 If invests: V = 75
The firm increases in value by 15, which is more than the 10 the equity holders put in good thing!

But how is value split between equity and debt?

Boom: D = 50, E = 65 Bust: D 35, E = 0

Today:
D = 42.5, increased by 7,5 E = 32,5, increased by 7,5

Equity will NOT invest, since would lose 7.5 10 = -2.5

Intuition:
Wealth transfer to debt holders!
Problem arises because debt is risky
Debt is senior and will get part of surplus junior claimants will not contribute capital Risk-less debt no wealth transfer, since debt is already as safe as it can be E.g. if F=20 D=20, regardless of investment

I.e. the debt overhang the problem arises when there is a significant probability that the debt will not be paid off = firm is in financial distress!

What about raising capital in other ways than equity?

As long as the new securities issued are junior to the existing debt, this problem will arise. A solution would be to finance the new investment with debt that is senior to the existing debt.

Equity worth 27.5, Old debt worth 37.5 everyone gains!

Then we could issue risk-free debt with a face value of 10 to finance the investment. Boom: Cash flows of 115. New D = 10, Old D = 50, E = 55 Bust: Cash flows of 35. New D= 10, Old D = 25, E = 0

 In the real world, debt typically has covenants preventing issues of new debt of the same (pari passu) or higher seniority Although one would think that the existing creditors would be willing to renegotiate these terms since the investment makes everyone better off, this may be hard and take time
Why do you think this is? We will get back to this question.

the Debtor in possession (DIP) financing rule in U.S. chapter 11 bankruptcy is meant to alleviate the debt overhang problem
Allows a bankrupt firm to issue new senior debt.

 So we understand why firms have a hard time getting new funds in financial distress. What are the costs when this happens? Having to cut profitable new investment
Lots of evidence that financially distressed firms cut capital expenditures and R&D while in distress
Harder to say how much value was permanently lost as a result. Or maybe this could even be a good thing in some cases?
E.g. GM and Ford?

Indirect Costs of Financial Distress

As in the example above This is probably the most common and obvious problem firms experience in distress.

Financial distress & product market competition

Firms that are financially constrained may have a harder time responding to competition There is evidence that highly levered firms can lose market share to competitors with lower leverage, cannot respond to competitors price changes, etc.
E.g. studies of the supermarket industry, trucking industry

Financial distress & customer, supplier, employee relationships

Firms in financial distress have a harder time keeping customers, employees, suppliers
Especially costly when long-term relationships are valuable
Would you want to work for a firm that is about to go bust?

Firms with high-skilled labor that is hard to retrain Firms with long-term supplier relationships Firms with durable goods

Customers rely on firm being there for warranties, service, etc.

Assets sold at fire-sale prices

Firms in financial distress are often forced to sell off assets Problem: price obtained is often less than what the assets are worth to firm
Firms assets are often highly specific, with a limited number of other buyers that could use them
E.g. semiconductor wafers, oil rigs, telecom assets

To avoid default and bankruptcy As part of a bankruptcy proceeding/liquidation

Some assets, like R&D and intangibles, that may be so specific that not possible to sell them Can explain why tech firms (semiconductor, software, biotech) have extremely low leverage

 Especially problematic when have to sell assets fast, and other industry firms are also facing problems
Other industry firms are also constrained and cannot pay as much Have to sell to a nonindustry, financial buyer As a result, cyclical industries face higher firesale costs for this reason (airlines, cars)
E.g. airlines sell aircraft at a 15% discount when the average airline is in financial distress

Often used as an argument to have a bankruptcy code that allows firms to reorganize rather than liquidate assets (such as the U.S. Chapter 11 code)
Bankruptcy liquidations experience fire-sale discounts of 30-50%

Managerial loss of focus/attention

Resolving bankruptcy takes considerable effort, time, and attention of managers and employees
Negotiate with creditors, informing shareholders dealing with media, etc. Less time and ability to run regular operations! Often, firms in financial distress often hire a new management team
Original managers responsible for current problems Some types of managers better at handling financial distress and turnarounds

Games played by shareholders at the expense of creditors

Question:
Suppose a levered firm is choosing between two projects with equal NPV, one of which is riskier than the other. Are equity- and debt holders indifferent between the two?

An option analogy
Equitys claim: a call option with a strike price equal to the face value of debt, F.
Equity gets man(V-F,0) Equity gets the upside, but does not bear the full downside Debt gets F-max(F-V,0)=min(V,F)

Debts claim: risk free bond minus put option

Options 1.01: option value increases in risk
E value increases in risk, D value decreases in risk

 Suppose firm consists of one risky cash flow in a year:

Value in a year

Firm

Equity Debt

Cash flow in a year

Equity is like a call option on the value of the firm

Face Value

Consequences
1. Equity holders prefer riskier projects, even when they may have negative NPV:

2. Equity holders are reluctant to contribute capital to safe projects, even when they have positive NPV: Underinvestment / 3. Anything that increases risk of debt without destroying value decreases value of debt and increases value of equity

Overinvestment / Asset substitution / Risk shifting

Debt overhang

Lets return to our previous example

Firm has payoffs next period:
Boom: Worth 100 with Probability = 0.5 Bust: Worth 20 with Probability = 0.5 Firm value V = 60

Firm has debt with a face value F = 50

Boom: D = F = 50, E = 50 Bust: D = V = 20, E = 0 So today: D = 35, E = 25

Debt is under water: trading below

 Assume there is a second investment project

In addition, assume that firm has 10 in cash sitting around

Would go to debt holders in bad state

Costs 10 as before, but pays off 18 in good state, 0 in bad state Negative NPV = 9-10 = -1 should not invest!

What if usus up 10 in cash and invests in this project?

Boom: V = 100 10 + 18 = 108, D = 50, E = 58 Bust: V = 20 10 + 0, D = 10, E = 0 Today:
Wealth transfer from debt to equity!
D = 30, decrease by 5; E = 29, increase by 4 V 59, decrease by 1

Risk-shifting problem: shareholders like risky projects where they get upside, and debt holders pay on the downside.

What if firm did not have any cash lying around, but that there was no covenant preventing the firm from issuing senior debt. Equity holders decide to issue 10 in senior debt to invest in project. New debt has face value of 10.
Boom: V = 100 + 118 = 108, new D = 10, old D = 50, E = 58 Bust: V = 20, new D = 10, old D = 10, E = 0 Same thing happens:
New D = 10. They get their money back. Old D = 30, decrease by 5; E = 29, increase by 4

Again, wealth transfer from debt to equity!

This explains why creditors demand seniority covenants

This is also a reason why the U.S. Chapter 11 code has been criticized:

Although such covenants make the debt overhang problem worse, it curbs the riskshifting problem

Allows equity to continue the firm for too long in bankruptcy, in the hope that firm is luck and equity gets in the money Famous example of this: Eastern Airlines bankruptcy.

The risk-shifting problem in practice

Maybe hard to find evidence of firms literally taking on risky projects in distress But we do observe instances where firms take more subtle actions that dilute their debt

Spin-offs of safer part of business (Marriott) Play for time: Postpone efficient liquidation in hope of a miracle (Eastern Airlines). Making excessive dividends or share repurchases Using cash or senior debt to take over a (risky) firm.
In 1988, RJR Nabisco announced intention to acquire company in a leveraged buyout with new debt. KB Toys and Bain Capital article

Who pays for this riskshifting behavior?

If equity holders gain from diluting debt holders, isnt this a benefit of debt (to equity)? Problem is that creditors arent stupid Will demand higher interest rates when firm borrows in the firms place Will impose covenants restricting firm behavior
Impose restrictions on investment, payout policy, spinoffs and asset sales. Etc. Browse Smith & Warner (packet) for examples.

Why cant we avoid costs of financial distress by renegotiating with creditors?

If a firm faces liquidity problems, this does not necessarily mean that the firm would have to incur deadweight costs of distress Although such debt restructuring occur, they costly and sometimes not feasible
Could negotiate with creditors to write down debt, postpone interest, or ease covenants in exchange for additional interest or some equity in the company

How can creditors know whether funds will be used for a good project? What if the firm is really risk-shifting? In addition, creditors are often dispersed and face conflicts of interest among themselves

The problem of measuring costs of financial distress

Although we believe that financial distress costs can be substantial, it is very hard to measure exactly how big they are. The problem is how to distinguish value loss due to financial distress from economic distress
E.g. U.S. Airlines files for bankruptcy in August 2002 (and then again in September 2004)

Andrade & Kaplan (Journal of Fin. 1997) look at a sample of financially distressed firms

They estimate indirect costs of financial distress of up to 20% of firm value.

That had previously undergone leveraged buyouts (LBOs) and recapitalizations, But operations were still generating positive cash flows
Probably best estimates we have. So if these firms expected a 10% chance of going into distress, say: E(COFD) = 10%*20%=2% Seems low, still, relative to tax benefits. Which kind of firms are likely to undergo highly leveraged transactions, such as LBOs?

Problems with these estimates?

We now have a trade-off theory of capital structure

The value of a leveraged firm is: V(with debt) = V(all equity) + PV(tax shield) PV(costs of distress)
Pr( distress ) t * Costst (1 r ) t PV (costs of distress) t=0

Probability of distress increases with leverage and decreases with excess cash. PV (costs of distress) increases with leverage and decreases with excess cash.

Practical Implications
Companies with low expected distress costs and high tax benefits should load up on debt to get tax benefits.

Companies with high expected distress costs should be more conservative.

ATTENTION COMMERCE STUDENTS

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