NOTE: How to unlever?

Samenvatting hoofdstuk 16, Caput Corporate Finance If too much debt and company is sensitive to economic shocks, risk of bankruptcy increases This cost of financial distress offsets the benefit of a ta! shield "efault: a firm that fails to make the re#uired interest or principal payments on debt $odi%liani and $iller: &ankruptcy results from a firm havin% levera%e, but it does not lead to a %reater reduction in the total value to all investors 'd(e investors) &ankruptcy is costly Therefore, instead of a li#uidation 'a trustee is appointed to oversee this), firm can %o trou%h a reor%ani*ation by e!istin% mana%ement +reditors may receive new debt or e#uity of the firm +reditors must vote to accept the plan, else firm will be li#uidated If a financially distressed firm can reor%ani*e outside of bankruptcy, this is called a workout Indirect costs of financial distress: ,oss of customers 'future support - service), ,oss of suppliers, loss of employees, loss of receivables 'debtors think they have opportunity to avoid their obli%ations), fire sales of assets '#uick sellin% for lower price), delayed li#uidation 'mana%ement could continue to make ne%ative N./ investments), cost to creditors 'financial distress to creditor) +onclusion: costs of financial distress are an important departure from $0$ assumption of perfect capital markets 1 levered firms risk incurrin% financial distress costs If a firm announces a debt issue, firm value will decrease The cost of financial distress is paid by e#uity holders 2%ency cost of levera%e 'in case of financial distress) Over-investment (risky): E#uity holders like to increase risk if they are sure they will not %ain without additional risk This is at the e!pense of debt holders Under-investment: if return of a pro3ect first %oes to debt holders, firm mi%ht not invest in positive N./ pro3ects anymore, as shareholders are not willin% to invest if they do not %et all returns Cashing out: sell assets and pay cash dividend 1 because debt holders loose more than shareholder %ain: reduction initial share price 2%ency benefits of levera%e Concentration of ownership: 'Owner will loose e#uity): $otivation 'owner will %et 4556 of every value increase), no corporate perks that other e#uity holders will pay for 1 ,evera%e does not have this problem, but investors will pay less for e#uity due to this cost Free cash flow hypothesis: empire buildin% or overconfidence 'ne%ative N./ pro3ects) "ebt holders monitor firms better, and mana%ers are scared to be fired due to possible financial distress More commitment: E!cuse for lowerin% wa%es, better competition 7ormula: /l 8 /u ( ./'Interest Ta! 9hield) : ./'7inancial "istress +osts) : ./'2%ency costs of "ebt) ( ./'2%ency &enefits of "ebt) ./'Interest Ta! 9hield) 8 t;" 't; is effective ta! advanta%e) 2symmetric information < ,evera%e as credible si%nal 'commit firm to lar%e future debt payment) < If firm is worth more than market thinks, issuin% new shares is costly to current shareholders 'lemons problem: if you want to sell, investors will pay less) Implications e#uity issue:

4 9tock price declines 'si%nal: it is overpriced) = 9tock price tends to rise prior to announcement e#uity issue 'mana%ers will delay stock issue as lon% as possible, so %ood news can come out) > 7irms tend to issue e#uity when information asymmetries are minimi*ed 'after earnin% announcement) 1 ,ess underpricin% for low risk debt, no underpricin% for own cash +onclusion: optimal capital structure depends on market imperfections, such as ta!es, financial distress costs, a%ency costs, and asymmetric information

?emedies a%ainst lemons: Trade between family and friends @uarantees E!<ante monitorin% e!penditure by the potential buyer ?eputation 'dealer) .eckin% order theory: 9EOs are rare 'investors assume that company is overvalued) 1 note that this only holds for 9EO, not for other forms of finance 1 no problem with e!ecutive compensation, private placements 'sheet =A)? "ebt issue: nothin% happens 'e#uity: stock falls) .ass positive N./ pro3ects Oefenen met somB 'op sheets is lasti% %edaan, uit boek doen 9heet 4C,4D, week = ?evertin% bond: &ond will be e!chan%ed for stock at time 4, when private info becomes public 9o, at time 5, bond has value E4, and at time 4, too &ond is always converted, so no costs of distress +apital structure: <7irst cash, then debt, then e#uity <Fith cost of distress, more willin%ness to use e#uity when levera%e hi%h or investment prospects stron% <,evera%e ratio not stable: reflects cumulation of past profitability and investment decisions <hoard cash durin% %ood times makes sense Investment: < underinvestment relative to first best 'if debt no frictionless solution) < level of investment increasin% function of: cash, cashflow, capacity to issue lowrisk debt

Incentive si%nalin%: week =, sheet =A