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The Miller & Modigliani theorem

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
. !irms finance themselves through retained
earnings "internal financing# and selling
securities in the market "e$ternal financing#
%. &nternal financing "retained earnings# biggest
source of financing for firms
' !irms in countries with less developed financial
markets use particularly little e$ternal financing
(. The e$ternal financing is done by issues of debt)
equity and hybrid securities "such as convertible
debt and preferred equity#

*. +$ternal financing is raised both in
private and public markets

,rivate sources: ,rivate equity) bank debt)


private placements of bonds and equity

,ublic sources: &,-s) .easoned equity


issues/ public bond issues
0. .ources of financing vary over time and
over business cycle

+quity issues increase when stock market


returns have been high for some period of
time

1ebt2borrowing issues less cyclical



*. 3apital structures vary across
different industries and countries

High leverage industries: 4tilities)


airlines) cars

5ow leverage industries: biotech)


software2internet) hardware

High leverage countries: 6orea) Thailand)


&ndonesia) &ndia

5ow leverage countries: 46) 7ustralia) 4.



Industries Vary in Their
Capital Structures
Industry Debt Ratio* (%)
+lectric and 8as
*(.%
!ood ,roduction
%%.9
,aper and ,lastic
(:.*
+quipment
9.
;etailers
%.<
3hemicals
<.(
3omputer .oftware
(.0
7verage over all industries
%.0=
*D/(D+E), Debt in book value, Equity in market value
U.S. data

Debt vs. equity

+quity and debt "and other corporate


securities# differ along two dimensions:
"# 1ivision of value
' 1ebt is senior to equity get the value of the firm
until debt paid off
' +quity gets whatever is left after debt has been paid
"%# 1ivision of control
' +quity holders control firm as long as not bankrupt
' 1ebt holders control firm when firm is bankrupt

quity is a call option

+quity gets ma$ ":) > ' 1#) i.e. a call


option with strike 1

1ebt gets > ? ma$ ":. > ? 1# @ min


">)1#
Face of
debt
Face of debt
E()
D()

!ayment to debt "older#, D().


!ayment to Equity "older#, E().
$D()+E()

!uestions "e "ill try to
ans"er#

&s there an AoptimalB capital


structure) i.e.) an optimal mi$
between debt and equity?

Core generally) can you ad value to


e$isting owners "equity and debt
holders# through decisions on the
;H. of the balance sheet?

&f yes) does the optimal financial


policy depend on the firmDs
operations ";eal investment policy#)
and how?

The Miller and Modigliani
$MM% capital structure
irrelevance theorem

CC "90E# maybe the most important paper in


finance

Fot only for corporate finance) but also for investments


Glack .choles option pricing) for e$ample) relies on
arbitrage arguments introduced in this paper

-ne way to thing about it: what role does capital


structure have in a neoclassical fully competitive
model with frictionless markets

5ike the 37,C

7nswer: FoneH

&hy is MM so important'

We donDt believe it) literally

.ince markets are not perfect)


frictionless) and fully competitive

.trength of theorem is that by


showing when capital structure is
irrelevant) it also implies when it is
relevant.

To get some perspective# pre(
MM vie"s

Typical pre'CC view: debt is typically


cheaper than equity

&nterest rate on debt is lower than the


investorsD required return on equity

+quity issues are dilutive: decrease earnings


per share) which hurts shareholders

Gut we canDt have too much debt) because


then we go bankrupt
-ptimal capital structure

The MM theorem sho"s that
such arguments are fla"ed

The value of the firm is given by


e$pected cash flows and the
investors discount rate "or required
rate of return# for these cash flows
' > @ +"!3!# 2 "I;#

&n Aefficient marketsB "i.e. the CC


assumptions# capital structure
affects neither of these.

J > @ +"!3!#2"I;#
J 3apital structure is just one way of
splitting cash flows between different
investors) but the total value of the
firm remains the same
J 7lthough the required returns of
debtholders and equityholders may
differ) the weighted average cost of
capital to the firm will always equal ;

The Miller Modigliani Irrelevance
)roposition
J .uppose the F,> of a new issue is Kero.
J .uppose the free cash flow to a levered
firm is the same as to an all equity
financed firm.
J Then) financing does not matterH >alue
is ma$imiKed by taking all IF,> as
before.

J &ntuition: "Logi Gerra#.
' The firm finances its projects by promising free
cash flow from operations to different types of
investors "debt and equity holders#.
' The siKe of the pie is the sum of the free cash
flows ? it depends on the investment policy) not
the way the piKKa is divided between investors.
When is it true that financing is irrelevant?

*riginal MM $+,-.% home(
made leverage proof#

ATwinB firms 7 and G with identical


cash flows of 3!
' 7 is all'equity financed) value of equity @
+7 @ >7
' G has debt of 1) value of equity @ +G/ >G
@ +G I 1)

Ciller and Codigliani claim that >7 @


>G) otherwise there would be an
arbitrage opportunity

.uppose debt 1 is risk less. &f buy all of GDs


equity) you get:
' 3; ? 1" I ;1# @ companyDsnet profits after
interest
' This costs you +G.

&nstead suppose you buy all of 7Ds equity) but


borrow on own account 1 of the purchase
pries.
' .o cost to you is +7 ? 1.
' Lou get 3! ? 1"I;1# @ companyDs whole cash flow
less personal interest you owe.

.ince strategies yield same net cash flow to


you) must cost the same to assemble: +G @ +7
? 1) of >G @ >7.
' -therwise there would be an arbitrage
opportunity.

F-T+: We have not assumed anything


about how F,> is calculated.

CC does not rely) for e$ample) on 37,C


being true.

What is essential is that there are no


arbitrage opportunities "financial markets
are competitive and complete#.

1oes all this seem a bit esotericM?

3apital 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:

&n our e$ample:


' 12"1I+#Nr1 I +2"1I+#Nr+ @ r7
' ":2#N":=#I"2#N"::=#@ E.E=

&t 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 e$actly
cancel.

ffect of leverage on returns
in the MM "orld

;eturn on equity "ACC proposition


&&B#:
r
+
@ r
7
I "12+#"r
7
'r
1
#

;isk of equity:
O
+
@ O
7
I "12+#"O
7
? O
1
#
E D a
r
E D
E
r
E D
D
r
+
+
+
=
return on a##et#

;eturns and leverage
Debt become# ri#ky Debt/Equity
E%&ected
'eturn#
r
(
r
D
r
E

Do "e believe the MM
assumptions'

CC irrelevance theorem holds if


7. F,> of a new issue of debt or equity is
Kero.
G. The free cash flow to a levered firm is
the same as to an all equity financed
firm.

1o we believe that these


assumptions are true in the real
world?

&f not) this gives us a role for capital


structureH

$/% Is ne" issuance 0ero
1)V'

There are ( conditions for this to be true.

The first two are:


&. !inancial markets are competitive.

Few investors just demand fair return on their


investment.
&. !inancial markets are complete:

&nvestors can choose any consumption pattern by


borrowing) lending) and hedging.

&f not) the firm may be able to make money by offering


a cash flow stream with attractive risk characteristics
to certain clientele.

!or a typical corporation) these two


conditions probably hold

&t is hard to think that a corporation could


make money by issuing some new) eotic
security that did not e$ist before

There are close substitutes available for any


security that a company can issue

Caking profits from pure financial


engineering is better left to the investment
banks than regular corporationsH

Gut there is a third condition as well:


(. ,rices reflect all e$isting information
"strong form efficiency#
' G4T: if the manager has private
information about prospects of the firm)
CC does not holdH
3ould potentially issue misvalued
securities and make moneyH

"%# 7re !3! 5evered @
!3! 7ll +quity?

The assumptions for this to be true are:


. Fo ta$es "or no asymmetric ta$ treatments#
%. There are no e$tra costs of financial distress.
(. There are no transaction costs from issuing securities
"or the same costs for debt and equity#
*. Canagers and employees always work to ma$imiKe the
value of the firm

7s we will see) all of these assumptions may not


always hold in real world.

2sing M(M Sensibly

C'C is not a literal statement about the real


world. &t obviously leaves important things out.

Gut it gets you to ask the right question: How is


this financing move going to change the siKe of
the pie?

Helps you avoid making the wrong arguments)


such as the cost of capital argument above.

5ets go back to some logical fallacies that CC


can address.

A1ebt is cheaper than equity because it


has a low interest rateB

What matters for the value of the firm is


;
7
) the opportunity cost of capital for the
firms assets

&n an CC world) when you take on more


leverage) your ;
+
will increase to keep ;
7

constant

MM applies to all corporate
finance decisions

C'C 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.

&ndeed) the proof applies to all financial transactions


because they are all Kero F,> transactions.

"dividends# ? "net proceeds from new financing#
@ "cash flow from operations# ? "new
investment#

&n other words: think about the choice of


whether to pay a dividend or not.

&f we increase our dividend we can always issue


new equity "or debt# to offset this shortfall

&f 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 !ree 3ash !lows

5H. does not matter for value) if ;H. given


7s long as e$cess cash retained earns a


market return) net payments to financial
markets do not matter.

P :: of e$cess cash today is worth P ::


regardless of whether pay out now or later.

7lthough the return on the firmDs assets may go


down if you keep cash on your balance sheet)
required return also goes down since firm cash
flows become less risky

Total payout policy does not matter either


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

+ssentially the payout policy argument is the


same as the debt irrelevance argument.

&mportant principle: 1eciding how much debt


to take on and deciding how much cash to pay
out is essentially the same decision
3ash @ Fegative debtH

This is why we should consider Fet 1ebt @


1ebt ? +$cess 3ash when we evaluate capital
structure and unlever betas.

3ottom line

4sing the CC theorem) we can understand what does "and


doesnDt# matter for financial policy.

To understand capital structure and payout policy in the


real world we will now see what happens when we rela$ some
of the CC assumptions:

What if there are corporate and personal ta$es?

3osts of financial distress?

3onflicts of interest among managers) equity holders)


and debt holders?

Canagers are better informed than investors?



!inancial policy: ,lan of
7ttack
1. Modigliani-Miller Irrelevance
Proosition (1!"#)$

&n a world with out frictions) financial policy


is completely irrelevant ? does not change
value of firm.
%. &o'$ (o' does t)e M 'orld di**er
*ro+ t)e real 'orld,

Ta$es

3osts of financial distress

-ther !rictions

4ela5ing the /ssumptions of
MM

Few investors get Kero F,>.


. !inancial markets are competitive.
%. Carkets are strong form efficient.
(. Carkets are complete.

The financial policy does not change


the free cash flow from real
investment policy.
*. Fo differential ta$ treatment.
0. Fo costs of financial distress.
Q. Fo issuance costs.
<. Canagers and employees do not have an
incentive to deviate from IF,> rule.
(lmo#t
true
)ot true

The effect of corporate ta5es

The importance of ta$es was first noted by CC

,roblem is not ta$es per se) but that interest and


dividends have a different ta$ treatment

&n the 4... "and for most other countries#) the


interest payments of corporations are ta$'
deductible) while dividends are not

Hence) there is a strict ta$ advantage to


financing with debt rather than equity

7s a matter of fact) implies firms should have ::=


debtH

Which we clearly donDt observeM



5ample# Debt ta5 shield

7 firm generates P ::C in profits for


sure every period in perpetuity. This is
the only cash flow the firm has.

;isk'free rate is :=
3orporate ta$ rate "T
3
# is *:=.

&f the firm is ::= equity financed)


what is the value of the firm?

+very period) !3! @ " ? :.*:#N::@ Q:

> @ + @ Q:2:.: @ Q::

Fow the firm takes of P 0::C of debt.


What is the coupon of the debt?

The debt is risk'free debt holders


require := P 0:C coupon

What is the value of the equity?

+ach period equity holders get the Fet


&ncome of the firm: "':.*:#N"::?0:# @
(:

>alue of equity @ (: 2 :.: @ (::


.ince the value of debt is P 0::) firm


value is > @ + I 1 @ P 0:: I P (:: @ P
E::

The firm value has increased by P %::H

7nother way to think about this:


>
5
@ >
4
I ,>T.

>
5
@ value of the levered firm

>
4
@ value of the unlevered firm

,>T. @ ,> of the &nterest Ta$ .hield

&n this case ,>T. @ P %::C. Why?



+ach period the firm saves T
3
N& in
ta$es where T
3
is the corporate ta$
rate and & is the interest payment

&.e. yearly ta$ savings are *:=NP0: @


P%:C

Hence) the ,resent >alue of the Ta$


.hield is ,>T. ' P %: 2 :.: @ P %::C.

This is also equal to T
3
N1 @ *:=NP0:: @
P%::
the ,>T. @ T
3
N&2;
1
Gut the interest payment & 1N;
1
The ,>T. becomes T
3
N1N;
1
2;
1
@T
3
N1
,>T. @ T
3
N1 is a Aback of the envelopeB
formula. &t assumes that

1 is constant "ta shield is a perpetuity#

TaK shield and debt payments have same


systematic risk can discount the ta$ shield
at ;
1

What is the optimal level of debt for this


company?

&ho gains from ta6ing on the
debt'

.ay that the firm has ::: shares


outstanding

Gefore taking on any debt) each


share is worth
PQ::2::@P:.Q:2share

Fow the firm takes on P0:: of


debt) and buys back P0:: worth of
shares

Think about this as happening in two


steps:

"# The firm raises P0:: in debt. !irm now
consist of the ,> of future firm cash flows
plus P0:: in cash
The value of firm is 3ash I >
4
I ,>T.@ P0::
I Q:: I %:: @ P(::
The value of equity is
+ @ P(:: ' P0:: @ PE::
.hare price increased from P:.Q: to P:.E:

e-uity gets t)e ')ole .%// gain o* t)e
ne' debt ta0 s)ield1

"%# !irm does a share repo of P0:: buys back
P0::2:.E @ Q%0 shares.
>alue of the firm is now P(:: ' P0:: @
PE::
+ @ > ? 1 @ PE:: ' P0:: @ P(::
The equity market cap is lower) but e-uity
)olders 'ealt) consist o* .2// in stoc3 4
."// in cas) 5 .#//

Same argument applies to payout
policy

6eeping e$cess cash of 3 in the company gives


you a AnegativeB ta$ shield of tN3

7ssume you keep P:: of e$cess cash in the firm


and invests it in T'bonds R :=) say
,re'ta$ profits increase by P:C2yr
"perpetuity# if T
3
@*:=) after ta$ profits are
PQC2yr

What is the ,> of this P:: T'bond investment?


,> @ 3!2r @ PQ2:. @ PQ:


6eeping P:: of e$cess cash in the
firm) rather than paying it out) reduces
value of cash to PQ:H

if we keep e$cess cash of 3 in the firm


rather than paying it out) this cash is
only worth "' T
3
#N3

&.e. cash has a Anegative ta$ shieldB of


T
3
N3H


Here "and in general# keeping e$cess
cash in firm is like having negative debtH

&here do "e stand no"'

7dding corporate ta$es to CCDs world suggest firms


should be ::= debt financed and keep := e$cess cashH

.eems e$treme:
' 7verage debt ratio has been around (0= in last decades.
' Cany firms "Cicrosoft) &ntel# hoard large amount of cash.
+ither 3!-Ds are missing something) or something must be
missing from our analysis.
D/E
Firm*# value

In addition7 most firms effectively pay less
than the statutory rate in corporate ta5es

Will not make profits every year

Fet operating losses "F-5s# can be


carried back and forward to offset
profits in other years.

.ome firms have large non'debt ta$


shields) such as depreciation)
investment ta$ credits) etc.

!irms have a lower ta$ benefit of debt


if

,rofits more volatile

firm already has a lot of debt

Have F-5s and substantial non'debt ta$


shields
less likely to have profits left to shield
with additional debt

Sohn 8raham "Sournal. of !in. '::#


estimated the 4... effective corporate
ta$ rate at about (:=

Gottom line: the effect of personal ta$es and


F-5s on the value of the interest ta$ shield
is comple$.
1epends on

= of firmDs securities held by institutions and individuals

whether investors adjust portfolios in a ta$'efficient


way

the volatility of the firmDs profits) F-5s) and ta$


shelters

.till) clear that even after accounting for


personal ta$es and effective corporate ta$
rate) a substantial debt ta$ shield remains in
the 4...

Gack'of'the envelope calculations of T in the 4...


typically come in around :'%:=

Will vary from company to company) however

7s low as %= vs. as high as (0=



Debt Ta5 Shield Calculation 8
1ote9

!ormula TN1 assumes constant) perpetual


debt.

Core generally) can value ,> "debt ta$ shields# as


the discounted cash flow stream from the ta$ shield:
What should the discount rate r
dts
be?
We have used r
d
which is true if the risk of the ta$
shield is the same as the risk of the debt.

&n many instances) e.g. highly levered firms) the ta$


shield is likely to be riskier than the debt makes sense
to use a higher discount rate) closer to r
7
...
) 1 (
) 2 (
1
) 1 (
) (
2
+
+
+
+
=
dts dts
r
ear taxshieldy E
r
ear taxshieldy E
eld DebtTaxShi PV

To summari0e

&f the only CC assumption we rela$


is ta$es) we get the following

!irm should finance themselves with


::= debt

7ll e$cess cash should be paid out to


shareholders

1oes not seem to match very well


what we observe in realityM

The Dar6 Side of Debt#
Cost of :inancial Distress

&f ta$es were the only issue) "most#


companies would be ::= debt
financed.

3ommon sense suggests otherwise:


&f the debt burden is too high) the
company will have trouble paying.

The result: financial distress.


3an lead to value destruction that
would not have happened in the absence
of debt

MM and ban6ruptcy

Fote: the possibility that a firm defaults


on its debt obligations does not in itself
violate CC ? as long as this does not
impose any additional costs on the
businessH

&n the CC world) when the value of equity


falls to Kero) debt holders take over the
firm. 6)ere s)ould be no costs to
ban3rutcy ? no reduction in cash flows
generated by the company.

&hat are the costs of financial
distress and ho" big are they'

Cost obvious: 1irect costs of


bankruptcy

5egal e$penses) court costs) advisory


feesM
70a+le: 6'Cart spent more than P ::
million on lawyers) accountants)
investment bankers) and other advisors
wile in bankruptcy.

Direct costs of financial
distress

1irect costs represent "on average#


some %'0= of total firm value for
large companies and up to %:'%0=
for small ones.

Gut this needs to be weighted by


the probability of bankruptcy: "2:<=
per year for FL.+'7C+T firms#.

-verall) e0ected direct costs tend


to be very small: about .:%= of firm
valueH

Direct costs are too small

The ta$ shield represents gain of :'(0 cents


for a dollar of debt

1irect costs of bankruptcy are too small to


account for the low debt ratios we see in reality.

Gut there are other) indirect costs of financial


distress that could potentially be much more
important

7nd that would be incurred even if the distressed firm


is able to avoid outright bankruptcy or defaultH

&hat could these indirect costs
be'

&nability to invest in the right


projects

&nefficient liquidation of assets

&nability to respond to competition

5osing valuable customers)


employees) and suppliers

Time and focus wasted negotiating


with creditors rather than running
the business

The importance of liquidity
constraints

&.e. when firmDs not being able to access


enough funds to be able to make the
optimal operating decisions and still
service the debt.

Gut why do firms become liquidity


constrained when they have too much
debt?

+.g. why canDt the firm just issue more equity)


to both service the debt and cover
investments?

Well) would you invest money in a firm on


the verge of bankruptcy? Why2why not?

/ simple e5ample

!irm has assets in place which will pay off


ne$t period:

Goom: Worth :: with ,robability @ :.0

Gust: Worth %: with ,robability @ :.0

7ssume everyone risk neutral) discount


rates are Kero) and there are no ta$es

This is not important) but makes things simple

The value of the firm is then simply e$pected


cash flows ne$t period

.o: firm value > @ Q:


7ssume this firm has debt outstanding


with a face value ! @ 0:

What is the value of equity and debt?

The payoffs for debt and equity:

1ebt @ min">)!#) +quity @ ma$">'!):#

.o in the boom) the debt will be paid


off in full) in the bust the firm will
default

Goom: 1 @ ! @ 0:) + @ 0:

Gust: 1 @ > @ %:) + @ :

.o today: 1 @ (0) + @ %0

1ebt is under water: trading below par



The debt overhang problem

7ssume that this firm has a new


investment:

&nvest : today

Worth 0 tomorrow for sure "both in boom and bust#

,ositive F,> @ 0 optimal to invest

The firmDs cash flows would not be

Goom: cash flows increase to 0

Gust: cash flows increase to (0

!irm value increases from Q: to <0

7ssume firm has no liquid assets and


needs to raise cash to invest

Will equity'holders put in the money to


invest?

&f invests: > @ <0

The firm increases in value by 0) which is more


than the : the equity holders put in good thingH

Gut how is value split between equity and


debt?

Goom: 1 @ 0:) + @ Q0

Gust: 1 ? (0) + @ :

Today:

1 @ *%.0) increased by <)0

+ @ (%)0) increased by <)0

+quity will F-T invest) since would lose <.0 ?


: @ '%.0

Intuition#

Wealth transfer to debt holdersH

1ebt is senior and will get part of surplus junior


claimants will not contribute capital

,roblem arises because debt is risky

;isk'less debt no wealth transfer) since debt is already


as safe as it can be

+.g. if !@%: 1@%:) regardless of investment

&.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 distressH

&hat about raising capital
in other "ays than equity'

7s long as the new securities issued are


junior to the e$isting debt) this problem
will arise.

7 solution would be to finance the new


investment with debt that is senior to the
e$isting debt.

Then we could issue risk'free debt with a face value


of : to finance the investment.

Goom: 3ash flows of 0. Few 1 @ :) -ld 1 @ 0:) + @


00

Gust: 3ash flows of (0. Few 1@ :) -ld 1 @ %0) + @ :

+quity worth %<.0) -ld debt worth (<.0


everyone gainsH

&n the real world) debt typically has


covenants preventing issues of new debt of
the same "Apari passuB# or higher seniority

7lthough one would think that the e$isting


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 A1ebtor in possessionB "1&,# financing


rule in 4... chapter bankruptcy is meant to
alleviate the debt overhang problem

7llows a bankrupt firm to issue new senior debt.



Indirect Costs of :inancial
Distress

.o 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

7s in the e$ample above

This is probably the most common and obvious problem


firms e$perience in distress.

5ots of evidence that financially distressed


firms cut capital e$penditures and ;U1 while
in distress

Harder to say how much value was permanently lost as a


result.

-r maybe this could even be a good thing in some cases?

+.g. 8C and !ord?



:inancial distress & product
mar6et competition

!irms 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.

+.g. studies of the supermarket


industry) trucking industry

:inancial distress & customer7
supplier7 employee
relationships

!irms in financial distress have a harder


time keeping customers) employees)
suppliers

Would you want to work for a firm that is


about to go bust?

+specially costly when long'term


relationships are valuable

!irms with high'skilled labor that is hard to


retrain

!irms with long'term supplier relationships

!irms with durable goods

3ustomers rely on firm being there for warranties)


service) etc.

/ssets sold at fire(sale prices

!irms in financial distress are often forced to sell off


assets

To avoid default and bankruptcy

7s part of a bankruptcy proceeding2liquidation

,roblem: price obtained is often less than what the assets


are worth to firm

!irmDs assets are often highly specific) with a limited number


of other buyers that could use them

+.g. semiconductor wafers) oil rigs) telecom assets

.ome assets) like ;U1 and intangibles) that may be so specific


that not possible to sell them

3an e$plain why tech firms "semiconductor) software) biotech#


have e$tremely low leverage

+specially problematic when have to sell


assets fast) and other industry firms are also
facing problems

-ther industry firms are also constrained and


cannot pay as much Have to sell to a non'
industry) financial buyer

7s a result) cyclical industries face higher fire'


sale costs for this reason "airlines) cars#

+.g. airlines sell aircraft at a 0= discount when the


average airline is in financial distress

-ften used as an argument to have a


bankruptcy code that allows firms to
reorganiKe rather than liquidate assets "such
as the 4... 3hapter code#

Gankruptcy liquidations e$perience fire'sale


discounts of (:'0:=

Managerial loss of
focus;attention

;esolving bankruptcy takes considerable


effort) time) and attention of managers
and employees

Fegotiate with creditors) informing


shareholders dealing with media) etc.
5ess time and ability to run regular operationsH

-ften) firms in financial distress often hire a


new management team

-riginal managers responsible for current problems

.ome types of managers better at handling financial


distress and AturnaroundsB

<=ames> played by
shareholders at the e5pense of
creditors
Vuestion:
.uppose a levered firm is choosing
between two projects with equal
F,>) one of which is riskier than the
other. 7re equity' and debt holders
indifferent between the two?

/n option analogy

+quityDs claim: a call option with a strike price


equal to the face value of debt) !.

+quity gets man">'!):#

+quity gets the upside) but does not bear the full
downside

1ebtDs claim: risk free bond minus put option

1ebt gets !'ma$"!'>):#@min">)!#

-ptions .:: option value increases in risk

+ value increases in risk) 1 value decreases in risk


.uppose firm consists of one risky cash


flow in a year:

+quity is like a call option on the value


of the firm
alue in a
year
Face alue
+a#" flo,
in a year
Debt
Equity
Firm

Consequences
. +quity holders prefer riskier projects)
even when they may have negative F,>:
-verinvestment 2 7sset substitution 2
;isk shifting
%. +quity holders are reluctant to contribute
capital to safe projects) even when they
have positive F,>: 4nderinvestment 2
1ebt overhang
(. 7nything that increases risk of debt
without destroying value decreases value
of debt and increases value of equity

?et@s return to our previous
e5ample

!irm has payoffs ne$t period:

Goom: Worth :: with ,robability @ :.0

Gust: Worth %: with ,robability @ :.0

!irm value > @ Q:

!irm has debt with a face value ! @


0:

Goom: 1 @ ! @ 0:) + @ 0:

Gust: 1 @ > @ %:) + @ :

.o today: 1 @ (0) + @ %0

1ebt is under water: trading below


par

7ssume there is a second investment project

3osts : as before) but pays off E in good state) : in bad


state

Fegative F,> @ 9': @ ' should not investH

&n addition) assume that firm has : in cash sitting


around

Would go to debt holders in bad state

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

Goom: > @ :: ? : I E @ :E) 1 @ 0:) + @ 0E

Gust: > @ %: ? : I :) 1 @ :) + @ :

Today:

1 @ (:) decrease by 0/ + @ %9) increase by *

> ? 09) decrease by

Wealth transfer from debt to equityH

Ris3-s)i*ting problem: shareholders like risky


projects where they get upside) and debt holders pay
on the downside.

What if firm did not have any cash Alying


around)B but that there was no covenant
preventing the firm from issuing senior debt.

+quity holders decide to issue : in senior


debt to invest in project. Few debt has face
value of :.

Goom: > @ :: I E @ :E) new 1 @ :) old 1 @ 0:)


+ @ 0E

Gust: > @ %:) new 1 @ :) old 1 @ :) + @ :

.ame thing happens:

Few 1 @ :. They get their money back.

-ld 1 @ (:) decrease by 0/

+ @ %9) increase by *

7gain) wealth transfer from debt to equityH


This e$plains why creditors demand


seniority covenants

7lthough such covenants make the debt


overhang problem worse) it curbs the risk'
shifting problem

This is also a reason why the 4...


3hapter code has been criticiKed:

7llows equity to continue the firm for too


long in bankruptcy) in the hope that firm is
luck and equity gets Ain the moneyB

!amous e$ample of this: +astern 7irlines


bankruptcy.

The ris6(shifting problem in
practice

Caybe hard to find evidence of firms


literally taking on Arisky projectsB in
distress

Gut we do observe instances where firms


take more BsubtleB actions that dilute
their debt

.pin'offs of safer part of business "Carriott#

,lay for time: ,ostpone efficient liquidation in hope


of a miracle "+astern 7irlines#.

Caking e$cessive dividends or share repurchases

6G Toys and Gain 3apital article

4sing cash or senior debt to take over a "risky# firm.

&n 9EE) ;S; Fabisco announced intention to acquire


company in a leveraged buyout with new debt.

>alue of public debt sank by P%9EC "W:=#



Who pays for this risk'
shifting behavior?

&f equity holders gain from diluting debt holders)


isnDt this a benefit of debt "to equity#?

A,roblemB is that creditors arenDt stupidM


Will demand higher interest rates when firm
borrows in the firms place
Will impose covenants restricting firm behavior

&mpose restrictions on investment) payout policy) spin'


offs and asset sales.

+tc. AGrowseB .mith U Warner "packet# for e$amples.



&hy can@t "e avoid costs of financial
distress by renegotiating "ith creditors'

&f a firm faces liquidity problems) this does not


necessarily mean that the firm would have to
incur deadweight costs of distress

3ould negotiate with creditors to write down debt)


postpone interest) or ease covenants in e$change for
additional interest or some equity in the company

7lthough such debt restructuring occur) they


costly and sometimes not feasible

How can creditors know whether funds will be used for a


AgoodB project? What if the firm is really risk'shifting?

&n addition) creditors are often dispersed and face


conflicts of interest among themselves

The problem of measuring
costs of financial distress

7lthough we believe that financial


distress costs can be substantial) it
is very hard to measure e$actly how
big they are.

The problem is how to distinguish


value loss due to financial distress
from economic distress

+.g. 4... 7irlines files for bankruptcy in


7ugust %::% "and then again in
.eptember %::*#

7ndrade U 6aplan "Sournal of !in. 99<# look


at a sample of financially distressed firms

That had previously undergone leveraged buyouts


"5G-s# and recapitaliKations)

Gut operations were still generating positive cash


flows

They estimate indirect costs of financial


distress of up to %:= of firm value.

,robably best estimates we have.

.o if these firms e$pected a := chance of going


into distress) say: +"3-!1# @ :=N%:=@%=

.eems low) still) relative to ta$ benefits.

,roblems with these estimates?

Which kind of firms are likely to undergo highly


leveraged transactions) such as 5G-s?

&e no" have a trade(off
theory of capital structure

The value of a leveraged firm is:


>"with debt# @ >"all equity# I ,>"ta$ shield# ?
,>"costs of distress#
,> "costs of distress# @
,robability of distress increases with
leverage and decreases with e$cess cash.
,> "costs of distress# increases with
leverage and decreases with e$cess cash.

=
+
0
) 1 (
* ) Pr(
t
t
t t
r
Costs distress


)ractical Implications

3ompanies with AlowB e$pected distress


costs and high ta$ benefits should load
up on debt to get ta$ benefits.

3ompanies with AhighB e$pected


distress costs should be more
conservative.

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