Lecture 8 - Debt and Leverage

Question 1

Debt – Why Study?

Answer 1

• Lender Influence/ Interactive corporate governance

* Effect of bankruptcy overhang on manager behavior

Question 2

Different forms of borrowing:

Answer 2

o Bank loans

o Bonds

Question 3

Bank Loans - lender influence

Answer 3

• Information
• Incentives
• Expertise
• Enforcement
“Lenders commonly influence— sometimes even dictate—critical corporate policy choices, especially as to financial and investment policy and management turnover.”

Question 4

Bank Loans - lender influence - information

Answer 4

Contractual right to receive information about the companies’ financial condition, cash management services. Lenders enjoy important informational advantages over the board (the directors receive filtered information form the officers whenever there is a meeting (not daily).

Question 5

Bank Loans - lender influence - incentives

Answer 5

Incentives to monitor the managers? Lenders want to be repaid. Directors have weaker incentives to monitor (fiduciary duties not enforced by courts + directors have other jobs).

Question 6

Bank Loans - lender influence - expertise

Answer 6

Lenders are institutions that have specific departments – loan department dealing with the automotive industry – significant expertise about the companies that they are monitoring.

Question 7

Bank Loans - lender influence - enforcement

Answer 7

Avoid mismanagement – lenders have significant tools for enforcement, even without calling the borrower into default, they can threaten to renegotiate the contract by adding covenants to the contract that would constrain managements behaviour even more.

Question 8

Bank Loans - Typical Covenants:

Answer 8

• Financial covenants
• Investment constraints
• Fundamental changes

Question 9

Bonds - Rights of Bondholders:

Answer 9

• Contained in contract known as an “indenture”
• Indenture trustee to mitigate collective action problem
• Indenture contains covenants similar to bank loan agreements
• No implied rights for bondholders

Question 10

Shareholder limited liability and shareholder – creditor agency problems

Answer 10

Upside benefit combined with limited liability give shareholders incentive to take actions that benefit shareholders but harm creditors, such as:
o Increasing the riskiness of the corporation’s business
o Siphoning of assets
o Increasing borrowing

Question 11

Creditor Protections - Healthy Companies

Answer 11

Creditors do not benefit from any fiduciary duties. The contract is going to contain the principle protections for creditors. MBCA has a provision restricting the company to pay dividends to shareholders that would render the corporation insolvent, there is also a financial statement test. There are also restrictions on fraudulent transfers (strip value of the company to the detriment of the creditors).

Question 12

Creditor Protections - Insolvent Companies

Answer 12

Insolvency is a financial concept. When a company is insolvent the director’s duties can be invoked by the creditors. Upon insolvency the creditors take the place of shareholders as residual beneficiaries of fiduciary duties – residual owners of the corporation.

Question 13

Advantages of Debt

Answer 13

o Tax benefits, cheaper than equity, leverage
o No statutory limit on amount (generally) or
need for SH approval
o No legal control rights, no fiduciary duties
o Disciplines management – reduces slack and risk-taking
o Lender monitoring and influence (?)

Question 14

Lender monitoring and influence?

Answer 14

♣ Lender influence is salutary in that the officers do have a counter weight in the lenders office.
♣ Lenders monitor to make sure that they are repaid – lender concerns do not coincide with those of the SH and lenders interest may not be in the best interest of the company.

Question 15

Disadvantages of Debt

Answer 15

o Loss of management flexibility
o Repayment obligations
o Bankruptcy risk
o Risk of creditor opportunism

Question 16

Creditor opportunism

Answer 16

Avoiding risky projects, governing the corporation in a conservative way to make sure that the company has the money to repay, even though a riskier strategy would be better for the company in the long-term. “Distress investors” such as hedge funds, private equity funds, and investment banks are opportunistic when they use debt to obtain control of a financially troubled firm and extract improper gains at the expense of the firm and its other stakeholders.

Question 17

Capital Structure – Wrap Up - Equity/Debt:

Answer 17

 How external financing reduces managerial flexibility
 The relative riskiness of equity vs. debt
 The equity “contract” and management’s power over creation of new shares
 The structure of the investment affects shareholder/lender influence
 The benefits and risks of lender influence/monitoring