Debt and Taxes Flashcards
The Bankruptcy code
- 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 firm’s 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.
Direct costs of bankruptcy
- The bankruptcy process is complex, time-consuming, and costly. – Outside experts are often hired by the firm to assist with the
- bankruptcy process.
– Creditors also incur costs during the bankruptcy process. - § They may wait several years to receive payment.
- § They may hire their own experts for legal and professional advice.
- The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive.
– The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets and could get to 12% in the case of liquidation. - Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy by first negotiating directly with creditors to reorganize
- Workout could include a Prepackaged Bankruptcy
– A method for avoiding many of the legal and other direct costs of bankruptcy in which a firm first develops a reorganization plan with the agreement of its main creditors and then files Chapter 11 to implement the plan.
Indirect costs of Bankruptcy
- Although the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy.
– Loss of Customers – Loss of Suppliers
– Loss of Employees – Loss of Receivables – Fire Sale of Assets – Delayed Liquidation – Costs to Creditors
Overall impact of indirect costs
- The indirect costs of financial distress may be substantial
– It is estimated that the potential loss due to financial distress is 10% to 20% of firm value.
Who pays for financial distress
If the debt holders initially pay less for the debt, less money is available for the firm to pay dividends, repurchase shares, and make investments.
– This difference comes out of the equity holders’ pockets.
When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress.
Tradeoff Theory
States that firms should increase their leverage until it reaches the level for which the firm value is maximized.
– The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.
* That is: total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs
- The Tradeoff theory can help explain
- – Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the presence of financial distress costs).
- – Differences in the use of leverage across industries (due to differences in the magnitude of financial distress costs and the volatility of cash flows).
Factors affecting the present value of financial distress costs
- The probability of financial distress
* The probability of financial distress increases with the amount of a firm’s liabilities (relative to its assets).
* The probability of financial distress increases with the volatility of a firm’s cash flows and asset values. - The magnitude of the costs after a firm is in distress
* Financial distress costs will vary by industry.
* – Technology firms will likely incur high financial distress costs due to the potential for loss of customers and key personnel, as well as a lack of tangible assets that can be easily liquidated.
* – Real estate firms are likely to have low costs of financial distress because the majority of their assets can be sold relatively easily. - The appropriate discount rate for the distress costs
* Depends on the firm’s market risk (beta)
* The present value of distress costs will be higher for high beta firms.
Agency costs of leverage
– Costs that arise when there are conflicts of interest between the firm’s stakeholders
* Management will generally make decisions that increase the value of the firm’s equity.
– However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.
Common agency costs of leverage include:
- Excessive risk-taking and asset substitution
- Debt Overhang and Under-Investment
- Cashing Out and the Leverage Ratchet Effect
The asset substitution problem
When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a negative-NPV project, if it is sufficiently risky
Debt overhang problem
When a firm faces financial distress, it may choose not to finance new, positive-NPV projects
* Because bond holders will benefit from the value of such project rather than equity holders
Cashing out and the Leverage Ratchet effect
- When a firm is in financial distress, shareholders have an incentive to withdraw money from firm.
This maybe through assets sales below market value to fund cash dividends
– For example, if it is likely the company will default, the firm may sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders.
§ This is another form of under-investment that occurs when a firm faces financial distress.
Leverage ratchet effect refers to the observation that once an existing debt is in place:
* Shareholders may have an incentive to increase leverage even if it decreases the firm’s value
Shareholders will not have an incentive to decrease leverage by buying back shares even if it increases firm’s value
debt maturity
- Agency costs are highest for long-term debt and smallest for short-term debt
Debt covenants
- Conditions of making loans where creditors place restrictions on actions firms can take
Debt overhang and under investment
- This is a situation in which equity holders choose not to invest in a positive N P V project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.
Agency costs and the value of leverage
- Leverage can encourage managers and shareholders to act in ways that reduce firm value.
- – It appears that the equity holders benefit at the expense of the debt holders.
- – However, ultimately, it is the shareholders of the firm who bear these agency costs.
Adding leverage to capital structure effects on the share price.
* – The share price benefits from equity holders’ ability to exploit debt holders in times of distress.
* – The debt holders recognize this possibility and pay less for the debt when it is issued, reducing the amount the firm can distribute to shareholders.
* – Debt holders lose more than shareholders gain from these activities, and the net effect is a reduction in the initial share price of the firm.
Agency benefits of leverage
- Concentration of Ownership
- Reduction in Wasteful Spending
- Leverage and Commitment
Concentration of ownership
- One advantage of using leverage is that it allows the original owners of the firm to maintain their equity stake.
- As major shareholders, they will have a strong interest in doing what is best for the firm.
Reduction of wasteful investment
- A concern for large corporations is that managers may make large, unprofitable investments.
– What would motivate managers to make negative-NPV investments? - Managers may engage in empire building
– Managers often prefer to run larger firms rather than smaller ones, so they will take on investments that increase the size, but not necessarily the profitability, of the firm.
§ Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms.
– Thus, managers may expand unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees. - Managers may over-invest because they are overconfident.
– Even when managers attempt to act in shareholders’ interests, they may make mistakes.
§ Managers tend to be bullish on the firm’s prospects and may believe that new opportunities are better than they actually are. - When cash is tight, managers will be motivated to run the firm as efficiently as possible.
– Managers may be more concerned about their performance and less likely to engage in wasteful investment. - In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight
Free cash flow hypothesis
- – The view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making all positive-N P V investments and payments to debt holders.
- – According to the free cash flow hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.
Leverage and committment
- Leverage may also tie managers’ hands and commit them to pursue strategies with greater vigor than they would without the threat of financial distress.
- A firm with greater leverage may also become a fiercer competitor and act more aggressively in protecting its markets because it cannot risk the possibility of bankruptcy.
Asymmetric information and capital structure
- Asymmetric Information
- – A situation in which parties have different information.
- – For example, when managers have superior information to investors regarding the firm’s future cash flows.
- – We consider how information asymmetry may motivate managers to alter a firm’s capital structure
Leverage as a credible sign
- Assume a firm has a large new profitable project but cannot discuss the project for 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.
§ 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.
Leverage as a credible sign
- Assume a firm has a large new profitable project but cannot discuss the project for 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.
§ 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.
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.