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Advanced Corporate Finance

(Econm 2032)

Capital structure 1

Piotr Korczak
P.Korczak@bristol.ac.uk

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Outline of the lecture

• Revision of MM
• Agency conflicts and their impact on capital
structure
– Conflicts between equityholders and managers
– Conflicts between equityholders and bondholders
• Distortions in investment strategies
• Possible solutions

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MM – no taxes

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MM with corporation tax

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Capital structure – MM assumptions

1. Capital markets are frictionless

2. Individuals can borrow and lend at the risk-free rate
3. There are no costs to bankruptcy or to business disruption
4. Firms issue only two types of claims: risk-free debt and
(risky) equity
5. All firms are assumed to be in the same risk class
(operating risk)
6. Corporate taxes are the only form of government levy (i.e.
no wealth taxes on corporations, no personal taxes)

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Capital structure – MM assumptions – cont’d

7. All cash flow streams are perpetuities (i.e. no growth)

8. Corporate insiders and outsiders have the same information
(i.e. no signaling opportunities)
9. Managers always maximise shareholders’ wealth (i.e. no
agency costs)
10. Operating cash flows are completely unaffected by changes
in capital structure

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Taxes Market timing

Managers –
EH conflicts Competitors
Capital
structure
DH – EH
conflicts Nonfinancial
stakeholders
Managers better
informed than
investors

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Agency conflicts

• Conflicts of interests
• Source of conflict between shareholders and
managers (e.g. Jensen and Meckling, 1976):
– Managers hold less than 100% of equity
– They can capture the entire private benefit of control,
but do not bear the entire (financial) cost
– They bear the entire cost of effort, but do not capture
the entire (financial) benefit
– [More on this in lecture 4]

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Benefits of debt financing
• Increases managerial ownership, if the manager’s absolute
investment in the firm is constant (Jensen and Meckling,
1976)
• Reduces the amount of ‘free’ cash (Jensen, 1986; Stulz 1991)
• Gives investors the option to force liquidation if cash flows
are poor and the managers want always to continue the firm’s
operations (Harris and Raviv, 1990)
• Also, creates incentives to work harder to avoid bankruptcy
(Grossman and Hart, 1982)

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Points to remember about equity and debt

• Value of the firm = value of equity + value of

debt
• Debtholders have priority when the firm is
liquidated
– Equity as ‘a residual claim’
• Conflicts arise between EH and DH when
managers make decisions that benefit EH at the
cost of DH

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EH – DH conflict arising from the
dividend payout decision – illustration (1)
• Assets in place valued today at 220
– 20 of these are in cash (0% return)
– 200 is the value of a project with expected return
in one period of 20% or -10% (equal prob)
• Debt that matures in one period, face value of 200
• Scenario 1 – no dividend paid today
• Scenario 2 – dividend of 10 paid today
• What are the implications for debtholders?

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EH – DH conflict arising from the
dividend payout decision – illustration (2)

Scenario 1 Scenario 2

240 240
+ 20 + 10
200 200
+ 20 + 10
180 180
+ 20 + 10

• Would the implications for debtholders be the same if the

leverage was lower, e.g. debt of 100?

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Maxwell and Stephens (2003)

• Analysis of abnormal stock, bond and firm returns

around repurchase announcements
• Test of the signalling and wealth transfer
hypotheses
• Pure signalling: stocks↑, bonds ↑, firm↑
• Pure wealth transfer: stocks↑, bonds↓, firm→
• Can be at play at the same time

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Maxwell and Stephens (2003) – Table III

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Maxwell and Stephens (2003) – Table V

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16 Corporate securities as options on the
assets of the firm
• Vt – value of the firm at time t
• The firm consist of equity and zero-coupon debt
with a face value of D and a maturity of T
• No dividends
• Maturity date payoff on debt:

17 Corporate securities as options on the

assets of the firm – cont’d
• Thus payoff on risky debt is a combination of the
payoff on risk-free debt and a written put option
on the firm’s assets (exercise price D, maturity T)
• The value of risky debt:

18 Corporate securities as options on the

assets of the firm – cont’d
• The impact of a decrease in firm value on debt:

• Since put values decrease with increases in the

value of the underlying:

• The value of risky debt increases with firm value

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Distortions in investment strategies
• Debt overhang problem – underinvestment
problem
• Asset substitution problem
• Shortsighted investment problem
• Reluctance to liquidate problem

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Debt overhang problem
• EH may pass up +ive NPV investments
• Example
– 4,000 debt repayment due at the end of the year
– Value of assets in boom: 5,000; in recession: 2,400
(equal prob)
– Note: recession = bankruptcy
– New equity-financed project (equity contributed by
existing shareholders) costs 1,000, brings 1,700 in
either state = positive NPV

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Debt overhang problem – example (1)

• What is the expected value of debt holders’

interest in both scenarios?
• What is the expected value of equity holders’
interest in both scenarios?
• Would EH undertake the project?

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Debt overhang problem – example (2)

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Asset substitution problem
• EH tend to take on overly risky projects, even if
they have lower NPV
• Intuition
– Recall the idea of debt contracts and limited liability
of EH
– Substituting riskier projects for less risky projects
– ‘Going for broke’

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Asset substitution – option approach
• Payoffs for equity holders (notation as before)

• Equity as a call option on the firm’s assets

– A call option to buy the firm’s asset, exercise price D
(face value of debt)
– Option values increase with increases in the volatility
of the underlying

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Asset substitution – option approach – cont’d
• Option approach to debt – see previous slides

– The value of the risky debt decreases with the

volatility of the returns on the firm

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Asset substitution – Example (1)
• Two mutually exclusive projects: low-risk and
high-risk project
• Value of the firm with low-risk project: 100 in
recession, 200 in boom (equal prob)
• Value of the firm with high-risk project: 50 in
recession, 240 in boom
• 100 debt repayment due in one year

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Asset substitution – Example (2)

• What is the expected value of the firm, equity

and debt in low vs. high-risk strategy?
• Which project would EH undertake?

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Asset substitution – Example (3)

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Shortsighted investment problem
• Firms with large amounts of debt tend to pass up
high NPV projects in favour of lower NPV
projects that pay off sooner
• Intuition
– Rational DH know that if financial distress is
imminent EH will choose strategies that reduce value
of debt
– Hence DH will increase the cost of new borrowing
– Consequently, EH will favour projects that generate
cash quickly to minimise future financing needs at
higher rates

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Reluctance to liquidate problem
• EH may want to keep a firm operating when its
liquidation value exceeds its operating value
• Problem if the face value of debt exceeds the
firm’s liquidation value
– EH are the most junior claimants
– It is more attractive to take the riskier alternative to
continue operations
– Intuition – equity as an option – not to exercise an
out-of-the-money option – worth nothing now, still
might pay off in the future

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31 Some implications of DH-EH conflicts for
the capital structure
• Firms with substantial investment opportunities
should be more conservative in their use of debt
financing
• Small firms should have lower debt ratios
– They are more flexible and better able to increase the
risk of their investment projects
– Also, managers are usually major shareholders and
have incentives to benefit EH at the expense of DH

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How to minimise DH-EH incentive problems
• Eliminate/reduce debt
– What about other benefits of debt?
• Protective covenants
• Bank and privately placed debt
• The use of short-term instead of long-term debt
• Security design
• Project financing
• Management compensation contracts

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Protective covenants

• Greater use for noninvestment grade debt

• Issues addressed, examples
– The issuance of additional debt
– Limitation of dividends and stock repurchases
– The sale of assets
– Maintenance of properties
– The provision for insurance
– Accounting ratios (leverage, interest coverage)
– Merger activity

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34 Bank and privately placed debt
• Better monitoring and enforcement of covenants
• Solves the free-riding problem

Short-term vs. long-term debt

• Short-term debt is much less sensitive to
changes in a firm’s investment strategy

Security design
• Convertible bonds – intuition: similar to a
combination of a bond and a call option on the
firm’s stock

35 Project financing
• Project’s assets and liabilities attached to its
financing separated from the rest of the firm
• Debt has a senior claim on the project’s cash flows
• Less scope for asset substitution

Management compensation contracts

• Managers maximise share price to please EH
• But have incentives similar to BH
– Overinvestment (vs. underinvestment – see debt
overhang)
– Risk aversion – security of the job (see asset
substitution)

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