L8: Capital Structure - Financial Distress, Agency Costs, Benefits of Debt

Question 1

What are agency costs of debt?

Answer 1

• Debtors have an incentive to not pay when they can
• Reject NPV>0 projects (debt overhang)
• Accept NPV<0 projects (risk shifting)

Question 2

What can we use to think about the intuition for debt overhang?

Answer 2

The basic accounting identity: E = A - L

Question 3

What is debt overhang according to Myers, S. C. (1977), and what are some solutions?

Answer 3

Existence of debt can decrease the value of the firm by undermining its incentive to take on NPV>0 projects

Some solutions:
- Outside monitoring
- Dividend restrictions (having sufficient cash inside the firm mitigates the problem - debt overhand can’t occur when debt is safe)
- Renegotiation

Question 4

How does capital structure affect the agency problem?

Answer 4

• Equity financing (relative to debt financing) makes it more likely that the managers choose the “correct” amount of risk.
• Debt financing (relative to equity financing) makes it more likely that the managers take actions that improve the quality (e.g. probability of higher payoffs) of the project.

Question 5

What does Jensen, M. C., & Meckling, W. H. (1976) suggest about agency problems and capital structure?

Answer 5

• Agency issues mean that capital structure is not irrelevant.
• Owners of firms that are financed with debt have an incentive to risk shift, i.e. to ex-post take on projects that are too risky because much of the down-side risks are absorbed by debt holders
• Outside equity financing can result in too small a stake for owner-managers (e.g. debt helps concentrate ownership).

Question 6

What is risk shifting?

Answer 6

To ex-post take on projects that are too risky because much of the down-side risks are absorbed by debt holders

Question 7

What are covenants?

Answer 7

Clauses in a debt contract that place restrictions on what actions the debtor can take (mitigate risk shifting)

The restricted actions are only proxies for risk-shifting and may be under- or over-inclusive.

Question 8

What are common examples of covenants?

Answer 8

• Limit the paying of dividends
• Limit the issue of new (senior) debts
• Limit investments
• Stipulate cash holdings

Question 9

What is the agency benefit of debt?

Answer 9

Makes the value of equity more sensitive to value-destroying actions (incentive compatibility is easier to satisfy - make owner pursue “right” option)