Outline: Chapter 13 The Dynamics of the Capital Structure Decision

1. Outline: Chapter 13The Dynamics of the Capital Structure Decision Transactions Costs and Capital Structure Decisions • Financial distress costs • Agency costs • Impact of Capital Investment Decisions • Signalling • Capital structure impacts on firm value • Using M&M to Identify Factors Affecting Capital Structure Decisions • Financial distress and agency considerations • Signalling, capital structure and cash flow

2. Outline: Chapter 13 The Dynamics of the Capital Structure Decision (concluded) • Other Factors to Considerations • Growth options • Product or input market factors • Economic conditions • Corporate control • Factors to look for when making capital structure decisions

3. Transactions costs and Capital Structure DecisionsFinancial Distress Costs • Financial distress implies that a firm does not have enough cash on hand or readily available to meet its current financial obligations • Shareholders have an option to buy the bondholder's claim on the firm • If at the maturity of the firm's debt V > B • Shareholders exercise their option, pay off the bondholders, and claim V - B for themselves • If at the maturity of the firm's debt V < B • Because of limited liability, shareholders walk away from the firm, turning it over to the creditors • It is the loss in value that leads to bankruptcy not the other way around

4. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) • The payoff to shareholders and bondholders

5. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) • Bankruptcy costs • Direct bankruptcy costs • Legal costs • Reorganization expenses • Indirect bankruptcy costs • Risk shifting • Failing to invest • Operational and managerial inefficiencies • The sum of the direct and indirect cost associated with bankruptcy and financial difficulties are the financial distress costs

6. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) • Risk shifting • When faced with severe financial difficulties firms may invest in negative NPV projects instead of value maximizing positive NPV projects • Risk Shifting Example If a firm has the following market-value-based balance sheet: Cash $130 Debt $150 Other assets 33 Equity 13 The debt matures in one year at $260 and the following two investment projects are available

7. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) Low-Risk (LR) High-Risk (HR) Today Possible Payoffs Today Possible Payoffs Next Year Next Year $250 (Pi = 0.30) $400 (Pi = 0.20) $130 $130 $170 (Pi = 0.70) $0 (Pi = 0.80) At a discount rate of 10% NPVLR = $46.36 and NPVHR = -$57.27. Which project will the firm accept?

8. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) • Failing to invest • When the debt claims are substantial relative to the equity claims, virtually all of the gains from making positive-NPV investments are captured by the bondholders • It is only after the bondholders' claim is satisfied that the shareholders participate in the increase in the firm value created by the positive-NPV investments • Thus, it may not be in the shareholders' best interests to contribute additional capital even if "sure" NPV projects are forgone • Situation may arise when neither the shareholders or bondholders are willing to provide funds for a positive-NPV project, thus leading to an underinvestment problem

9. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(continued) • Operational and managerial inefficiencies • Key employees may leave • Worried customers may cancel orders • Tendency by the firm to skimp on • Employee training • Product quality • Research and development • As security holders perceive the probability of financial distress increasing, they will require a higher rate of return

10. Transactions costs and Capital Structure DecisionsFinancial Distress Costs(concluded) • Financial distress costs are estimated to be as high as 20% of firm value with most of these costs being indirect costs • Firms with a higher probability of experiencing financial distress tend to borrow less

11. Transactions costs and Capital Structure DecisionsAgency Costs • Unless a firm's equity is completely owned by managers, the managers have an incentive to consume perquisites • This is an agency problem and can only be resolved by incurring agency costs • Since the claims of bondholders are fixed, equity holders have an incentive to invest in more risky projects • Bondholders demand restrictive covenants and monitoring resulting in agency costs

12. Transactions costs and Capital Structure DecisionsAgency Costs(continued) • Since some forms of agency costs increase with equity and some with debt, an optimal capital structure is implied • Given bankruptcy costs and agency costs, the value of a levered firm is V’’L = VU + PV(Tax savings) - PV(Financial distress costs) - PV(Agency costs)

13. Transactions costs and Capital Structure DecisionsAgency Costs(continued) • Agency cost and financial leverage Agency costs ($) Total agency costs Agency costs of equity Agency costs of debt Financial leverage B*/S (B/S) Optimal amount of debt

14. Transactions costs and Capital Structure DecisionsAgency Costs(concluded) • Gains from leverage b) Financial Distress and Agency Costs a) Tax Aspects Total value of Total value of the firm, V($) the firm, V($) V = V + TB L U Present value of tax shelter Present value of tax shelter mimus present value of provided by interest on financial distress debt, TB and agency costs { V’ U { V’ { U V’’ U V V U U Present value of tax shelter based on interest and nondebt tax shields Financial Financial leverage (B/S) leverage (B/S) B*/S B*/S Optimal amount of debt, B* Optimal amount of debt, B*

15. Impact of Capital Investment DecisionsSignalling • The choice of capital structure can convey information about the firm to investors and cause a change in the value of the firm • Issuing debt can signal positive news about the future prospects of the firm • The firm's equity is undervalued • The only time a firm will issue equity is when it is overvalued. If a firm is undervalued by the market but can only finance a project by issuing equity it may underinvest • This can be avoided by using debt or internally generated funds • The percentage of owner financing may be a credible signal of future prospects

16. Impact of Capital Investment DecisionsSignalling(continued) • Myers' pecking order theory • Firms prefer internal financing to external financing • Lowers financing costs • Avoids market scrutiny • Firms favour a "sticky" dividend policies • Firms try to maintain constant cash dividend and seek cash flow reserves to maintain such a policy and to fund positive NPV projects • Debt is issued before equity when external financing is needed to initiate investment projects

17. Impact of Capital Investment DecisionsSignalling(concluded) • Implications of signalling • Capital structure becomes more of a dynamic, ongoing, evolving decision • There is not a single optimal level of debt, because managers continually have access to information before it is available to outside investors • Depending on the nature of the information, managers may choose to issue debt or equity in amounts that will at one time push the firm toward an optimal debt/equity ratio or range while at another time may push the firm away from an optimal debt/equity ratio or range

18. Impact of Capital Investment Decisions Capital Structure Impacts on Firm Value • The M&M no-tax model tells us where to look to determine if the firm's capital structure affects the value of the firm • If there are no taxes • If there are no transactions costs, and • If the investment (or capital budgeting) policies of the firm are fixed, Then capital structure does not affect a firm's value • Due to tax impacts, transactions costs in the form of financial distress or agency costs, and interactions between capital structure and capital investment decisions, firms choose capital structures with more than zero debt and less than 100 percent debt

19. Using M&M to Identify Factors Affecting Capital Structure DecisionsFinancial Distress and Agency Considerations • Asset uniqueness • Firms whose principal assets are intangible in nature have higher costs of financial distress • We see much less use of debt by such firms • It is not simply the probability of financial distress that is important; rather it is the potential loss in value of the assets • Convertible and subordinated debt • One way to align the interests of the parties and to avoid asset substitution or underinvestment problems is to use financing that combines elements of both debt and equity

20. Using M&M to Identify Factors Affecting Capital Structure DecisionsFinancial Distress and Agency Considerations(continued) • Protection • Four major sources of conflict between bondholders and stockholders • Asset substitution • Underinvestment • Claim dilution • Dividend payment • To reduce these problems, all bonds and loan agreements have protective covenants written into them in order to reduce financial distress and agency costs

21. Using M&M to Identify Factors Affecting Capital Structure DecisionsFinancial Distress and Agency Considerations(concluded) • Empirical evidence • Firms using more debt benefited to a greater extent than firms using less debt from provisions limiting additional debt and dividend payments • Smaller firms, for which information asymmetry is more likely, are more inclined to include restrictions of debt and dividends • Protective covenants appear less important for larger firms, due to • The larger number of financing options available to them • The greater availability of public information about the firms • The constant scrutiny they face from the financial markets, securities regulators, underwriters and bond rating agencies

22. Using M&M to Identify Factors Affecting Capital Structure DecisionsSignalling, Capital Structure, and Cash Flow • Other things constant, a firm could increase its reliance on debt either by issuing additional debt or by exchanging new debt for some of its outstanding common stock • Empirical evidence • The stock market reacts positively to leverage-increasing transactions and negatively to leverage-reducing transactions • The larger the change in financial leverage, the greater the price reaction

23. Using M&M to Identify Factors Affecting Capital Structure DecisionsSignalling, Capital Structure, and Cash Flow(continued) • The free cash flow theory • For firms with positive cash flow, stock prices will increase with unexpected increases in the payout to corporate claimholders and will decrease with unexpected increases in the demand for funds via new issues • Stock prices will increase with increasing tightness of the constraints binding the payout of future cash flow to claimants and will decrease with reductions in the tightness of these constraints

24. Using M&M to Identify Factors Affecting Capital Structure DecisionsSignalling, Capital Structure, and Cash Flow(concluded) • In practice other things are not constant, many factors can have a positive, neutral, or negative impact on the value of the firm as the financial leverage of the firm changes • Some factors are related directly to capital structure decisions • Others are related to the firm’s investment decisions • Some are related to the firm cash dividend decisions • Empirical Evidence • Suggest that the firm's capital structure decision is not independent of its investment and dividend decisions

25. Other Factors to ConsiderationsGrowth Options • One of the most important factors affecting capital structure decisions is the ability to take advantage of growth options • Where high future growth is possible firms want financial slack • They do not want to be so loaded with debt that they hamper their flexibility or future opportunity to secure additional capital as needed to make the necessary investments. • Low financial leverage in order to remain flexible

26. Other Factors to ConsiderationsProduct or Input Market Factors • Firms with general purpose products not requiring specialized service will use more debt in their capital structure • Firms that use the same technology as the majority of other firms in their industry will use less debt because it would be difficult to sell this technology to others in the industry

27. Other Factors to ConsiderationsEconomic Conditions • Firms tend to use more equity than debt financing during periods of improving economic conditions since high-quality projects are harder to find and lower-quality projects are more likely to be financed with equity • Asset liquidity is not constant over time, and therefore the amount of debt that can be effectively supported varies with economic conditions

28. Other Factors to ConsiderationsCorporate Control • During a hostile takeover attempt the target firm may increase its debt level, which should increase its stock price, thus making it less attractive as a takeover target • Corporate control motivations focus on short-run changes in capital structure taken in response to possible takeover threats • Corporate control considerations say nothing about the long-run capital structure of firms.

29. Other Factors to ConsiderationsFactors to Look for When Making Capital Structure Decisions • Empirical evidence suggests that leverage increases with • Non-debt tax shields • Growth opportunities • Fixed assets • Firm size • Empirical evidence suggests that leverage decreases with • Volatility • Advertising expenditures • Research and development expenditures • Bankruptcy probability • Profitability • Uniqueness of the product

30. Other Factors to ConsiderationsFactors to Look for When Making Capital Structure decisions(concluded) • It is safe to conclude that a firm's capital structure is affected by many factors • Available theory and empirical evidence support the notion that capital structure is a dynamic, ongoing, evolving decision.