Chapter 16: Debt policy Flashcards
What is the goal of the capital structure decision? What is the financial manager trying to do? When would capital structure not matter? (LO16-1)
The goal is to maximize the overall market value of all the securities issued by the firm. Think of the financial manager as taking all the firm’s real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all-equity financing. Others end up issuing dozens of types of debt and equity securities. The financial manager must try to find the particular combination that maximizes the market value of the firm. If firm value increases, common stockholders will benefit.
But capital structure does not necessarily affect firm value. Modigliani and Miller’s (MM’s) famous debt-irrelevance proposition states that firm value can’t be increased by changing capital structure. Therefore, the proportions of debt and equity financing don’t matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.
Of course, MM’s argument rests on simplifying assumptions. For example, it assumes efficient, well-functioning capital markets and ignores taxes and costs of financial dis- tress. But even if these assumptions are incorrect in practice, MM’s proposition is important. It exposes logical traps that financial managers sometimes fall into, particularly the idea that debt is “cheap financing” because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has an implicit cost, too, because increased borrowing increases financial risk and the cost of equity. When both costs are considered, debt is not cheaper than equity. MM show that if there are no corporate income taxes, the firm’s weighted-average cost of capital does not depend on the amount of debt financing.
How do corporate income taxes modify MM’s leverage-irrelevance proposition? (LO16-2)
Debt interest is a tax-deductible expense. Thus borrowing creates an interest tax shield. The present value of future interest tax shields can be large, a significant fraction of the value of outstanding debt. Of course, interest tax shields are valuable only for companies that are making profits and paying taxes.
If interest tax shields are valuable, why don’t all taxpaying firms borrow as much as possible? (LO16-3)
The more firms borrow, the higher the odds of financial distress. The costs of financial distress can be broken down as follows:
∙ Direct bankruptcy costs, primarily legal and administrative costs.
∙ Indirect bankruptcy costs, reflecting the difficulty of managing a company when it is in bankruptcy proceedings.
∙ Financial decisions that are distorted by the threat of default and bankruptcy, including poor investment decisions caused by the conflicts of interest between debtholders and stockholders. These conflicts create potential risk-shifting and debt-overhang problems.
Combining interest tax shields and costs of financial distress leads to a trade-off theory of optimal capital structure. The trade-off theory says that financial managers should increase debt to the point where the value of additional interest tax shields is just offset by additional costs of possible financial distress.
The trade-off theory says that firms with safe, tangible assets and plenty of taxable income should operate at high debt levels. Less profitable firms, or firms with risky, intangible assets, ought to borrow less.
What’s the pecking order theory? (LO16-4)
The pecking order theory says that firms prefer internal financing (i.e., earnings retained and reinvested) over external financing. If external financing is needed, they prefer to issue theory? (LO16-4)
debt rather than issue new shares. The pecking order theory says that the amount of debt a firm issues will depend on its need for external financing. The theory also suggests that financial managers should try to maintain at least some financial slack, that is, a reserve of ready cash or unused borrowing capacity.
On the other hand, too much financial slack may lead to slack managers. High debt levels (and the threat of financial distress) can create strong incentives for managers to work harder, conserve cash, and avoid negative-NPV investments.
Is there a rule for finding optimal capital structure? (LO16-5)
Sorry, there are no simple answers for capital structure decisions. Debt may be better than equity in some cases, worse in others. But there are at least four dimensions for the financial
manager to think about.
∙ Taxes. How valuable are interest tax shields? Is the firm likely to continue paying taxes over the full life of a debt issue? Safe, consistently profitable firms are most likely to stay in a taxpaying position.
∙ Risk. Financial distress is costly even if the firm survives it. Other things equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt.
∙ Asset type. If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets. Such firms generally borrow less than firms with safe, tangible assets.
∙ Financial slack. How much is enough? More slack makes it easy to finance future investments, but it may weaken incentives for managers. More debt, and therefore less slack, increases the odds that the firm may have to issue stock to finance future investments.
