Lesson 11: Other Factors Affecting Optimal Debt-Equity Ratio

Question 1

Factor 1: bankruptcy and Financial Distress

Answer 1

A company that cannot pay its debt will file for bankruptcy
In real world, bankruptcy has additional costs

Question 2

Financial distress

Answer 2

which is the potential of bankruptcy, lowers the value of a company due to potential of the additional cost of bankruptcy

Question 3

2 types of bankruptcies

Answer 3

• Chapter 7 liquidation: a trustee supervises the liquidation of the assets, the assets are sold at auction and the firm ceases to exist
• Chapter 11 reorganization: the company’s management gets 120 days to propose a reorganization plan. This time may be extended.
  + During this time the company continues to run.
  + The creditors vote on this plan. The plan must be approved by bankruptcy court. If no plan is acceptable, a Chapter 7 may be forced
  + Chapter 11is more common

Question 4

Direct costs of bankruptcy

Answer 4

fees of the various professionals needed: lawyers, accountants, auctioneers, appraisers, these costs are fixed -> higher percentage of assets for smaller companies

Question 5

Alternative to bankruptcy

Answer 5

1. Workout: the company deals directly with the creditors and works out an agreement
2. Prepackaged bankruptcy (prepack): the company first works out a reorganization plan with the biggest creditors, then files a Chapter 11 reorganization and pressures the remaining creditors to accept it

Question 6

Indirect costs of bankruptcy

Answer 6

1. Loss of customers
2. Loss of suppliers
3. Loss of employees
4. Loss of receivables: sometimes customers that owe money may not pay
5. Fire sale of assets: companies may sell assets at low prices to raise cash in order to avoid bankruptcy
6. Inefficient liquidation: companies may run inefficient or sell assets at low prices while they are in Chapter 11 reorganization
7. Costs to creditors: creditors may need to hire lawyers during Chapter 11 reorganization, creditors may take this into account when lending money to the company raising the cost of the loan

Question 7

Trade-off theory states that the value of a leveraged company

Answer 7

Vl = Vu + PV(tax shield) - PV(financial distress costs)

Question 8

The optimal amount of leverage

Answer 8

at the point at which the incremental value of the tax shield equals the incremental cost of financial distress costs

Question 9

Financial distress costs increase

Answer 9

with additional leverage, vary by industry

Question 10

Factor 2: Agency costs and benefits

Answer 10

Many times there are conflicts in interest between management and creditors. Key personnel own shares of the company and benefit from increases in share price
-> they may make decisions that benefit equity at the expense of debt

Question 11

Making risky investment with negative NPV

Answer 11

replacing safe investments with negative-NPV risky investments is called the asset substitution problem (engage in projects that are valuable to shareholders at the expense of creditors)

Question 12

Failing to make investments with positive NPV

Answer 12

The failure to invest in positive-NPV projects due to debt is called the debt overhang or under-investment problem
Eg: a company has 9 million in assets and 10 million in debt, it is considering a investment of 1 mil that will definitely return 2 mil , the company will not invest in it, since it has no benefit for equity, the entire gain will go to creditors
Selling assets at low prices and using the proceeds to pay div when the company is in financial distress

Question 13

Equity holders benefit when

Answer 13

NPV/I > βd*D / (βe * E) with I: amount invested, NPV: NPV of the invested project

Question 14

Leverage ratchet effect

Answer 14

Once a company has debt, it has an incentive to take on more dent and not to reduce debt, due to agency costs

Question 15

Agency costs are lower for

Answer 15

shorter maturity bonds since there is less opportunity to make suboptimal decisions. Sometimes debt covenants, which are conditions written into the bond contract, prevent a company from making suboptimal decisions, eg: a covenant may restrict a company’s ability to pay dividends

Question 16

Agency benefit of leverage

Answer 16

1. Control of the company is in fewer hands, allowing greater control = those who own shares
2. Since management has a greater share in the equity, it is less likely to waste money on perks such as grand office suites
3. With less free cash, management won’t waste money on empire building (management likes empires because larger companies pay higher executive salaries)
4. With more leverage management is less entrenched, they are more likely to be fired if there is financial distress
5. The threat of financial distress may result in wage concessions
6. With more leverage there is more incentive to compete, since the company is closer to bankruptcy otherwise

Question 17

Factor 3: Asymmetric information

Answer 17

• credibility principle:
  + claims are credible only if backed up = action
  + Eg: the company may issue a high amount of debt, high enough that it risks bankruptcy if it doesn’t perform well enough
  -> this debt: signal that company is expecting to perform well
• lemons principle: when a seller has private information about the value of what he’s selling, the buyer discounts the price since it is assumed that the item is worth less than it seems to be worth
• adverse selection: a seller with private information is likely to sell you worse-than-average goods

Question 18

Result of asymmetric information

Answer 18

1. Stock prices go down when additional equity is issued
2. Stock prices rise before the announcement of an equity issue (management postpones releasing bad news before an equity issue but releases any good news)
3. Equity issues are timed for when asymmetry of information is minimized, such as after a quarterly report is released

Question 19

Pecking order hypothesis

Answer 19

when funding project, management prefers to use retained earnings, followed = debt, with equity as a last resort