Week 3 Flashcards
Financial distress costs:
As interest and principal payments are obligations of a company, every form of debt puts pressure on the firm. The costs of bankruptcy include:
Direct costs - lawyer expenses, accounting expenses.
Indirect costs - lost sales, debt becomes more expensive, suppliers want cash.
Financial distress costs take up a part of the return and leave less for bondholders and shareholders. The higher the financial distress, the higher the return bondholders require.
expected Bankruptcy costs = Probability of going bankrupt * direct costs as % of total value
Agency costs:
Conflict between shareholders and bondholders, as shareholders are interested in pursuing selfish strategies at the expense of bondholders. These internal costs arise from information asymmetry and conflict of interest between shareholders and bondholders.
Selfish shareholder strategies:
Incentive to take large risks - for high-risk projects, shareholders at least have the chance to receive residual in case of success, while in low-risk projects bondholders will be fully paid, but shareholders receive less or nothing. Loses in recession are only applicable to bondholders anyway.
Incentive towards underinvestment - will not accept positive NPV projects, as the shareholders pay the full investment but share the benefits with bondholders.
Milking the property by paying out dividends - paying out money to shareholders while decreasing money left for bondholders.
Result of agency costs:
Shareholders suffer from the selfish strategies, as bondholders cannot trust them. The solution is to raise interest rates, and shareholders must pay these high rates, incurring losses for them and bearing the costs of selfish strategies.
Protective covenants:
To avoid paying higher interest rates, shareholders and bondholders can incorporate an agreement as a part of a loan document, called a protective covenant.
1)Positive protective covenants - specify actions that the company agrees to undertake or a condition to abide by. For example, minimum working capital level, or to provide financial statements.
2) Negative covenant - limits actions the company may take. For example, may not pledge assets to other lenders, have limitations on dividends, may not sell or lease assets without approval, cannot fulfill a merger, no additional long-term debt.
How can the shareholders reduce financial distress costs?
1) Issue debt with no restrictive and protective covenants, in this case however bondholders will demand high interest rates.
2) Protective and restrictive covenants in the loan contracts - could lead to lower interest rates
3) Issue no debt (costly as no tax shield)
Consolidation of debt:
Bondholders competing with each other increases bankruptcy costs, and many bondholders, lead to higher negotiation costs. A way to avoid these issues is to consolidate debt to one or only a few lenders. This way the agency costs are reduced.
The static trade-off theory of capital structure:
The theory relates to the trade-off between the tax benefits of debt and the costs of financial distress. Bankruptcy costs rise at an increasing rate as debt is increased. This means there is a certain optimal level of debt, after which the bankruptcy costs upset tax benefits, increasing the WACC and decreasing the company’s value.
Debt signaling:
Investors often view debt as a signal of firm value. A firm that is expecting high profits will take on a lot of debt to profit from the tax subsidy, while bankruptcy costs will increase slightly for such a firm.
An increase in debt signals an income increase, attracting investors.
Managers who try to fool investors with such an approach will drive the share value below what it currently is, as the investors will realize that the firm is not really valuable and its capital structure is no longer optimal.
Agency costs of equity:
People with an interest in the company tend to work harder than employees. Interest can be increased through equity ownership. If someone is expected to work less due to lower ownership, they are said to shirk.
Less ownership also leads to higher expenditure on private privileges, as the person is less affected by costs.
This can also lead to acceptance of negative NPV, as the firm’s size increases and the salary can offset the loss in share price.
This can be reduced by surveillance and monitoring, as well as leveraged buyouts, increasing the ownership of managers.
Change in company value = tax shield + reduction of agency costs - costs of financial distress
Free cash flow hypothesis:
Wasteful activity can be observed in companies that have larger cash flows. Because managers with lower ownership have an incentive for wasteful behavior. Increasing debt resolves this issue as less cash flow is available.
Pecking order theory:
States that the only consideration of a manager is the timing. New equity will be issued when it is overvalued, and when shares are undervalued new debt will be issued.
This means that investors will wait for the share price to fall when the company issues new equity.
1) Use internal financing (retained earnings)
2) Issue the safest securities
3) Only when the debt capacity is reached issue new equity
As opposed to the trade-off theory, the company has no leverage ratio, it is rather based on financing needs.
Second, profitable firms use less debt, as they are capable finance internally.
Lastly, companies like financial slack (available cash), but there is a limit.
The market timing theory:
High market-to-book value ratios cause equity financing, while low market-to-book value ratios cause debt financing.
Empirical regularities:
1) Many companies have low debt-asset ratios.
2) Some firms use no debt.
3) Most corporations use target-debt ratios, determined by taxes, types of assets, and uncertainty of operating income.
4) Peer firms influence capital structure.
5) Capital structures are unstable over time.
Summary of benefits and costs of debts:
Benefits:
1) Reduced tax liability
2) Reduced discretionary spending
3) More efficient monitoring of managers by banks
Costs:
1) Financial distress costs
2) Agency costs as underinvestment, incentive to focus on risky projects
3) Personal tax costs
