Week 6 - How much should a firm borrow (Capital Structure III)

Question 1

Indirect bankruptcy costs + 3 main causes

Answer 1

= Losses that arise from changes in a firm’s stakeholders’ behaviours b/c stakeholders know the firm is in FINANCIAL DISTRESS, ie. difficulty meeting its debt obligations
- can be considerably larger than the direct bankruptcy costs

1. Deterioration of business environment in expectation of bankruptcy
   - poorer prices for products
   - poorer prices from suppliers
   - problems hiring and retaining employees
2. Fire sale of assets
3. Poor investment decisions arising from conflicts of interest between stakeholders of the firm
   - Asset substitution
   - Debt overhang
   - Can be facilitated by bankruptcy laws

Question 2

Agency costs

2 reasons why managers always act in the interest of shareholders instead of debt holders?

Answer 2

Costs arising from conflicts of interest between stakeholders (debt holders vs shareholders) in a firm

1. Managers of the firm are essentially employees of the shareholders. They’re hired by the Directors, who have been appointed by shareholders.
2. Most managers are shareholders themselves, compensated with stock.

Question 3

Preference of project riskiness between debt holders & equity holders & why

Answer 3

1. Debt holders prefer safer projects
   - they have priority in cash flow
   - they only care about the first X dollars
2. Equity holders prefer risky projects
   - they are a residual claimant with limited liability
   - potentially UNLIMITED UPSIDE
3. Due to the conflict of interest, no one has the incentive to pick the best project
   - in the lecture eg. managers will pick the -ve NPV project if they act in the interest of shareholders,
   ie. SUBOPTIMAL investment decision, COST of FINANCIAL DISTRESS

Question 4

2 well-known agency problems of debt

Answer 4

1. Asset substitution/Overinvestment/Risk shifting
   - when debt is in place, equity has the incentive to take excessive & inefficient risks
   - As the amount of leverage increases, the firm’s equity holders prefer that the firm adopts riskier strategies, even though these riskier strategies reduce the total value of the firm
2. Debt overhang/Underinvestment
   - when debt is in place, equity has the incentive to refuse +ve NPV projects

Question 5

Intuition for Risk shifting
1. Why do equity investors prefer more risk?
2. Why are shareholders’ incentives to increase risk greater in financial distress?

Answer 5

1. Levered EQUITY is a CALL OPTION on the firm’s ASSETS
   - Exercise price is the Face value of debt
   - At maturity (the time the loan falls due), payoff to equity holders = asset value - face value of debt
   - An option is more valuable if VOLATILITY/risk of the underlying (ie. the assets) increases

> At the time the loan falls due, equity holders have a greater incentive to take risk b/c they have nothing to lose due to ASYMMETRY OF PAYOFFS
eg. even if 90% don’t make a large gain, equity holders are still getting 0

2. Limited liability/downside-risk
   - If win, shareholders reap most of the gains
   - If lose, debt holders suffer most of the losses

Question 6

Intuition for Debt overhang

Answer 6

1. +ve NPV projects require inputs
2. EQUITY PAYS the costs
3. Improved cash flow largely goes to paying back debt
4. Payoff to debt increases
5. Gross terminal payoff to equity also increases, but net of the costs, it can decrease
6. Equity pays the costs, but “too much” of the benefit accrues to debt
   - Equity holders are not getting enough from the +ve project so they will refuse it
7. As a result, some +ve NPV projects are passed up

The amount they gave up is effectively an indirect cost of financial distress; agency cost

Question 7

3 other games relating to agency costs

Answer 7

1. Cash in and run
   - When default is likely, sell assets and pay out the proceeds as big dividends.
   - The decline in market value is shared with creditors
   (Giving up all +ve NPV projects & paying as dividends. Equity holders get everything and nothing left for debt holders.
   Extreme version of debt overhang)
2. Playing for time
   - Accounting manipulations to hide problems
   (To hide evidence that they’re in financial distress / hide their high amount of debt, more time for risk shifting)
3. Bait and switch
   - Issue bond, saying this is the most senior bond I’ll issue. Subsequently renege and issue a more senior bond, ie. w/ higher priority
   (Firm needs more financing, Goes against what the original creditor was told that he/she is the most senior creditor.
   If firm defaults, old creditors need to share the same assets with new ones.)

Question 8

Trade-off theory

Quantify using APV {updated formula from before}

Answer 8

The optimal leverage (amount of debt) should balance the benefits and costs of debt

VL = VU + PV(tax shields) - PV(costs of financial distress)

Question 9

3 inputs required for calculating the Present Value of CFD + the formula

Answer 9

1. Probability of bankruptcy, p
2. Costs of bankruptcy, CFD
3. Bond expected return, rD (ie. the risk of default, appropriate discount rate)

PV(CFD) = pCFD / (rD + p)

Question 10

What type of firms may face higher indirect costs?

Answer 10

Firms that can risk-shift most easily, eg. small, growth firms

• Indirect costs are higher if intangible assets
• much lower if real estate or tangible assets

Question 11

Ratchet effect of debt overhang

Answer 11

Once leverage is in place, shareholders are resistant to reducing leverage even if it would improve firm value b/c the benefits from lowering leverage accrue to DEBT HOLDERS