Debt and Taxes

Question 1

The Bankruptcy code

Answer 1

• 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.

Question 2

Direct costs of bankruptcy

Answer 2

• • 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.

Question 3

Indirect costs of Bankruptcy

Answer 3

• 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

Question 4

Overall impact of indirect costs

Answer 4

• 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.

Question 5

Who pays for financial distress

Answer 5

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.

Question 6

Tradeoff Theory

Answer 6

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).

Question 7

Factors affecting the present value of financial distress costs

Answer 7

1. 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.
2. 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.
3. 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.

Question 8

Agency costs of leverage

Answer 8

– 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

Question 9

The asset substitution problem

Answer 9

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

Question 10

Debt overhang problem

Answer 10

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

Question 11

Cashing out and the Leverage Ratchet effect

Answer 11

• 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

Question 12

debt maturity

Answer 12

• Agency costs are highest for long-term debt and smallest for short-term debt

Question 13

Debt covenants

Answer 13

• Conditions of making loans where creditors place restrictions on actions firms can take

Question 14

Debt overhang and under investment

Answer 14

• 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.

Question 15

Agency costs and the value of leverage

Answer 15

• 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.

Question 16

Agency benefits of leverage

Answer 16

• Concentration of Ownership
• Reduction in Wasteful Spending
• Leverage and Commitment

Question 17

Concentration of ownership

Answer 17

• 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.

Question 18

Reduction of wasteful investment

Answer 18

• 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

Question 19

Free cash flow hypothesis

Answer 19

• – 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.

Question 20

Leverage and committment

Answer 20

• 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.

Question 21

Asymmetric information and capital structure

Answer 21

• 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

Question 22

Leverage as a credible sign

Answer 22

• 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.

Question 22

Leverage as a credible sign

Answer 22

• 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.

Question 23

Adverse selection

Answer 23

– 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.

Question 24

Lemons principle

Answer 24

– 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.

Question 25

Applying lemons principle to equity

Answer 25

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 used-car market are both low.
• This same principle can be applied to the market for equity.
• – Suppose the owner of a start-up company offers to sell
  you 70% of his stake in the firm.
• – He states that he is selling only because he wants to diversify.
• – You suspect the owner may be eager to sell such a large stake because he may be trying to cash out before negative information about the firm becomes public.
• Firms that sell new equity have private information about the quality of the future projects.

– However, due to the lemons principle, buyers are reluctant to believe management’s assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.

Question 26

Adverse selection and issuing equity

Answer 26

• 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.

Question 27

Implications for equity issuance

Answer 27

• The lemons principle directly implies the following:
• – The 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.

Question 28

Implications for capital structure

Answer 28

• Managers who perceive the firm’s equity is under-priced will have a preference to fund investment using retained earnings, or debt, rather than equity.

– The converse is also true: Managers who perceive the firm’s equity to be overpriced will prefer to issue equity, as opposed to issuing debt or using retained earnings, to fund investment.

Question 29

Pecking order hypothesis

Answer 29

– 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 investment using retained earnings.

Question 30

Market timing view of capital structure

Answer 30

• – The firm’s overall capital structure depends in part on the market conditions that existed when it sought funding in the past.

Question 31

Capital structure: the bottom line

Answer 31

• The optimal capital structure depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information.