Capital Structure

FINC 361 Fall 2016

Professor Mahdi Mohseni

Capital structure
A. Modigliani-Miller
Perfect capital markets
Capital structure irrelevant

B. For capital structure to become relevant, we

need to introduce market imperfections
1.
2.
3.
4.

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

Trade-off theory of capital structure

Other important effects:

3. Manager-shareholder conflict: Disciplinary effect
4. Asymmetry of information: Signaling effect

Capital structure with taxes

1. Introduction of biggest market imperfections
Taxes
Tax shield benefits of debt

VLev =

VUnlev + PV (Interest Tax Shield)

Under certain assumptions, we showed:

VLev
=

VUnlev + D

Consequences?
To maximize shareholder value:
A firm should lever up to the max!

Empirical evidence, however, suggests that firms

have some sort of target leverage

Target = Implicit trade off between pros and cons of debt

Most important cost of debt:

Financial distress
Leverage can lead to financial distress and bankruptcy
Recall
1. Stocks

Investors would like dividends but they might not occur

2. Bonds

Obligation to make fixed payments

Failure to do so leads to default

Financial distress situation

In default:

Debtholders are given more control on the firms assets

A.

Most benign case: Only a minor technical covenant violation

Debtholders usually fine the firm (slap on the wrist)

Worst case: Bankruptcy
Debtholders take control of the firm (become new equity holders)

B.

Why is financial distress costly?

You could view financial distress as:
Simple transfer of ownership
From shareholders to bondholders
Due to the poor performance of the underlying business
In that case, leverage per se does not add extra costs

However, in reality, bankruptcy is rarely simple

and straightforward
Often long and complicated process
Imposes both direct and indirect costs on the firm

The Bankruptcy Code

The U.S. bankruptcy code was created so that
creditors are treated fairly and the value of the
assets is not needlessly destroyed.
U.S. firms can file for two forms of bankruptcy
protection: Chapter 7 or Chapter 11.

The Bankruptcy Code (cont'd)

Chapter 7 Liquidation
A trustee is appointed to oversee the liquidation of the
firms assets through an auction. The proceeds from the
liquidation are used to pay the firms creditors, and the
firm ceases to exist.

The Bankruptcy Code (cont'd)

Chapter 11 Reorganization
Chapter 11 is the more common form of bankruptcy for
large corporations.
With Chapter 11, all pending collection attempts are
automatically suspended, and the firms existing
management is given the opportunity to propose a
reorganization plan.
While developing the plan, management continues to operate
the business.

The reorganization plan specifies the treatment of each

creditor of the firm.

The Bankruptcy Code (cont'd)

Chapter 11 Reorganization
Creditors may receive cash payments and/or new debt
or equity securities of the firm.
The value of the cash and securities is typically less than the
amount each creditor is owed, but more than the creditors
would receive if the firm were shut down immediately and
liquidated.

The creditors must vote to accept the plan, and it must

be approved by the bankruptcy court.
If an acceptable plan is not put forth, the court may
ultimately force a Chapter 7 liquidation.

Financial distress costs

Financial distress costs take two forms:
1. Direct costs of financial distress

All your legal and professional fees to deal with the bankruptcy
and reorganization

3% - 10% of the pre-bankruptcy market value of total assets

2. Indirect costs of financial distress

Negative spillover effects on operations due to uncertainty

related to bankruptcy
Examples:
1.
2.
3.
4.
5.

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

Tradeoff theory of capital structure

Now firms need to balance:
1. Tax shield benefits of debt
2. Financial distress costs of debt

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

Mathematically, the levered firm value VL is equal to:

VL =
V U + PV (Interest Tax Shield) PV (Financial Distress Costs)

Tradeoff theory with a picture:

When D is low, probability of distress is basically zero and
hence PV(distress costs) are negligible
Value of firm (V)

Value of firm under

MM with corporate
taxes and debt

Present value of tax

shield on debt

VL = VU + D
Present value of
financial distress costs

Maximum
firm value

V = Actual value of firm

VU = Value of firm with no debt

D*

Debt (D)

Optimal amount of debt

WACC with financial distress

Clearly, there is an
optimum capital
structure, which is
also reflected in a
minimized WACC
Beyond this point,
WACC increases as the
financial distress costs
outweigh the tax
shield benefits

Determinants of PV(distress costs)

1. Probability of distress occurring

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!

2. The costs of distress when distress occurs

Recall the two types of costs: Direct and indirect

For some firms the indirect costs can be very large

Industry matters
Probability of distress occurring

Depends on industry in which the firm operates

Key factors that affect probability of financial distress:

A.

B.

C.

Volatility of operating cash flows

In any given year, a firm with more volatile earnings has a higher risk of generating less than what
it owes
Examples:

Cyclical industries (e.g. airlines, etc.)

Young firms (e.g. small biotech)

Higher need for external financing

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

Some industries can easily collateralize/pledge their asset

Tangible assets (oil reserves, planes, etc.)

IT business is not in good shape on that dimension. Why?

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:

The indirect costs depend on industry factors

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.

The case of apple

Today: Apple has one of the highest market capitalization in US!

But, in 1997, it was perceived to be close to financial distress!!
What was one of the biggest threat to Apple in terms of indirect costs?
Think of its partnerswho might stop working with them?
Can you think of similar more recent examples in this industry?!
Hint: Blackberry

Now we can understand better this picture!

Survey of CFOs: Consistent with trade-off theory

Most factors are related to the tradeoff theory of capital structure

#1 factor: Financial Flexibilitynotion of debt capacity
Implicitly: Financial distress considerations
If new growth opportunities arise, firms want to access financial markets
If bloated balance sheet (i.e. already too much debt), it makes it harder to do so

Other benefit of debt:

Disciplinary effect
Recall:
Shareholders hire managers to run the business
Principal-Agent (agency) conflicts
If managers are entrenched, they may pursue actions
detrimental to shareholder value
Problem is more severe when excess cash is around
Hence also called agency costs of free cash flow

Debt can be used as a disciplinary tool

Where is the disciplinary use of debt

seen the most?
Goal:

Force management to generate and spend efficiently cash flows

Examples:
1. Private-equity firms
LBOs

Deal financed with massive amounts of debt

Induce financial constraints to discipline management!

2.

Management

Leveraged recapitalization

Dividend or share repurchase combined with large debt issuance

Reasons:
1.

Self-induced financial constraints (create sense of emergency)

2.

Shark repellent (scorched earth strategy)

Positive stock price reaction

Stock price reaction varies from negative to positive

Why negative in this case?

Next imperfection that matters for leverage:

Asymmetry of information
1. Insiders: Management and CEO
2. Outsiders: Shareholders/Bondholders/Markets
Insiders know more about the firm than outsiders
Management can use debt and equity issuances to
signal something about the firms prospects

Stock market reaction on announcements

of equity and debt issuances
Type of issuance
1 Common Stock (SEO)
2 Convertible Preferred Stock
3 Convertible Bonds
4 Preferred Stock
5 Privately Placed Debt
6 Straight Bonds
7 Bank Loans
* = statistical significance at 5%;

Asymmetry of information Two-day Abnormal Return of the Stock

Highest
Ret: -3.14%*
Ret: -1.44%*
Ret: -2.07%*
Medium
Ret: -0.19%
Ret: -0.90%
Ret: -0.26%
Lowest
Ret: 1.93%*

Positive reaction to debt issuances: Why?

Negative reaction to equity issuances : Why?

Leverage as a Credible Signal

Assume a firm has a large new profitable
project, but cannot discuss the project due
to competitive reasons.
One way to credibly communicate this positive
information is to commit the firm to large future debt
payments.
If the information is true, the firm will have no trouble making
the debt payments.
If the information is false, the firm will have trouble paying its
creditors and will experience financial distress. This distress will
be costly for the firm.

Leverage as a Credible Signal

Signaling Theory of Debt
The use of leverage as a way to signal information to
investors
Thus a firm can use leverage as a way to convince
investors that it does have information that the firm will grow,
even if it cannot provide verifiable details about the sources of
growth.

An Example

An Example

Issuing Equity and Adverse Selection

Adverse Selection
The idea that when the buyers and sellers have different
information, the average quality of assets in the market
will differ from the average quality overall.
Lemons Principle
When a seller has private information about the value of
a good, buyers will discount the price they are willing to
pay due to adverse selection.

Issuing Equity and Adverse Selection

A classic example of adverse selection and the lemons
principle is the used car market.
If the seller has private information about the quality of the
car, then his desire to sell reveals the car is probably of low
quality.
Buyers are therefore reluctant to buy except at heavily
discounted prices.
Owners of high-quality cars are reluctant to sell because they
know buyers will think they are selling a lemon and offer only
a low price.
Consequently, the quality and prices of cars sold in the usedcar market are both low.

Issuing Equity and Adverse Selection

This same principle can be applied to the market
for equity.
Firms that sell new equity have private information
about the quality of the future projects.
Due to the lemon principle, buyers are reluctant to
believe managements assessment of the new
projects and are only willing to buy the new equity
at heavily discounted prices.

Issuing Equity and Adverse Selection

Therefore, managers who know their prospects are
good (and whose securities will have a high value) will
not sell new equity.
Only those managers who know their firms have poor
prospects (and whose securities will have low value)
are willing to sell new equity.
The lemons problem creates a cost for firms that need
to raise capital from investors to fund new investments.
If they try to issue equity, investors will discount the price
they are willing to pay to reflect the possibility that managers
have bad news.

Implications for Equity Issuance

The lemons principle directly implies that:
Stock price declines on the announcement of an
equity issue.
The stock price tends to rise prior to the announcement
of an equity issue.
Firms tend to issue equity when information
asymmetries are minimized, such as immediately after
earnings announcements.

Stock Returns Before and After an Equity Issue

Implications for Capital Structure

Managers who perceive the firms equity is
underpriced will have a preference to fund
investment using retained earnings, or debt, rather
than equity.
The converse is also true: Managers who perceive the
firms equity to be overpriced will prefer to issue equity,
as opposed to issuing debt or using retained earnings, to
fund investment.

Implications for Capital Structure

Pecking Order Hypothesis
The idea that managers will prefer to fund investments by first
using retained earnings, then debt and equity only as a last resort
However, this hypothesis does not provide a clear prediction
regarding capital structure. While firms should prefer to use
retained earnings, then debt, and then equity as funding sources,
retained earnings are merely another form of equity financing.
Firms might have low leverage either because they are unable to issue
additional debt and are forced to rely on equity financing or because
they are sufficiently profitable to finance all investments using retained
earnings.

Capital Structure: Summary

With market imperfections, there is such a concept as
optimal capital structure
1. Tax benefits
2. Financial distress costs

Trade-off theory of capital structure

Other important effects:

3. Manager-shareholder conflict: Disciplinary effect
4. Asymmetry of information: Signaling effect and pecking order
hypothesis