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					Financing Policy (Capital Structure) or
How much debt should a firm use?

What is the goal of a financial manager?

     What about the goals of maximizing:
           Earnings (EBIT)
           Market share
           Shareholder value (residual claiments)

 How does a financial manager accomplish this goal?

  The firm can get its funding from a variety of sources including using
  retained earnings, debt and equity issues. Which source is best for the
  firm? Which source will maximize firm value?

M&M Proposition 1

1. Assume:           a)   No Taxes

                     b)   No Transactions/Information Costs

                     c)   Fixed Real Investment Policy**

2.        Then

 The market value of the firm is independent of the choice of
     financing policy (i.e., there is no unique capital structure which
     maximizes firm value.)

   **
          Note on Fixed Real Investment Policy : Means use the NPV rule
     and pre-commit to always use this rule on all projects at all times in
     any state of the world. Point (c) basically means that the financing
     decision does not change any future investment decisions.

“Proving the Theorem”
 More intuitively with the following:

 Investment Policy fixes the size of the pie. No taxes or transactions
   cost means none of the pizza is lost in slicing. The value of the firm
   is unaffected by how the potential cash flows generated by the firm
   are carved up.

 More mathematically (an arbitrage example), an individual can create
   leverage just as easily as the firm (Modigliani and Miller, AER 1958)

Example: Imagine the following firm (000)
                    Balance Sheet
Debt                                        $4,000
Equity (200 shares at $20/share)             4,000
Firm Value                                  $8,000

                Income Statement
EBIT                                        $1,200
Interest exp at 10%                          (400)
Taxes                                             0
EAT (my cash flow)                            $800

What is the cost to me if I buy this firm in its entirety?

Instead of the firm having 50% debt and 50% equity, what if the firm
were 100% equity (unlevered) with a value of $8,000.

I could buy 400 shares of the unlevered firm, using my capital ($4,000)
and a bank loan ($4,000) and received the same cash flows at the same
cost. Assume I can borrow at 10%, just like the firm.

EBIT                                  $1,200
Taxes                                       0
EAT                                    1,200
My interest exp from loan                400
My cash flow                            $800

The payoffs are the same, based on arbitrage theory, their values should
be the same, and they are. In either case, I used $4,000 of my own cash.
The point: Given a world with no taxes, it doesn’t matter whether the
firm used debt or equity. Investors can leverage and unleveraged firms
by using personal borrowing and lending and it does not affect their cash

  Another example:
                            Unlevered firm   Levered firm
  Assets                         8,000           8,000
  Debt                             0             2,400
  Equity                         8,000           5,600
  EBIT                           1,500           1,500
  Interest Exp @ 10%               0              240
  EAIT                           1,500           1,260

1. Buy 50% of the levered firm.
  a. Calculate your cost.

  b. Calculate your CF.

  c. Now replicate this cost and these cash flows by buying 50% of the
     unlevered firm and using borrowing/lending to create your homemade
     leverage. Assume you can borrow on your account at 10%.

                            Unlevered firm   Levered firm
  Assets                         8,000           8,000
  Debt                             0             2,400
  Equity                         8,000           5,600
  EBIT                           1,500           1,500
  Interest Exp @ 10%               0              240
  EAIT                           1,500           1,260

2. Buy 100% of the unlevered firm.
  a. Calculate your cost.

  b. Calculate your CF.

  c. Now replicate this cost and these cash flows by buying 100% of the
     levered firm and using borrowing/lending to create your homemade
     leverage. Assume you can borrow on your account at 10%.

Is it a reasonable assumption that I would pay the same interest rate as
the firm?

Perhaps it is. I could have borrowed money from a margin account and
they are liquid accounts associated with lower interest rates. The firm
borrowing is based on illiquid assets and could have a higher interest

The point: M&M prop I suggests that any capital structure is fine.

Yet, we see that some industries, such as banks, hotels and utilities
choose high debt-to-equity ratios. Other industries, like
pharmaceuticals, and other high tech companies choose low debt-to
equity ratios. What you’re your hypotheses for this?

              The Importance of the M&M Theorems

 Let’s look at taxes
 Consider the firm as having 3 claims on it
               Equity holders
               Debt holders
               Uncle Sam wants a big slice of pizza


                                Equity    Debt

      Any action which reduces the government’s claim against the firm
must increase the value of the firm to shareholders.

 Important Fact: Interest paid on debt is tax deductible at the corporate

 Issuing debt allows the firm to reduce its taxable income and
     therefore, its tax payments.

 Firm value increases by the present value of all future tax shielded
Example: Suppose there is a firm with the following information, no
debt (see table) and a discount rate to equity of 15%.

                          No debt company
EBIT                       $100
Interest expense               0
EBT                         100
Taxes @ 35%                  35
EAT                         $65

What is the cash flow to the claiments and the value of the company if
cash flows are into perpetuity?

Now assume this company decides to retire $60 in equity and replace it
with $60 of debt. The debt has a YTM of 10%.

                                Company after debt for
                                    equity swap
EBIT                                    $100
Interest expense @ 10%
Taxes @ 35%
  1. How much less in taxes did the company pay?

  2. The interest tax shield is defined as D(rd)(tc), what is the amount of
       the interest tax shield for one year of operation?

The value of the firm before it had debt was $433.33. Since debt is
leverage, this is the value of the unlevered firm. Technically it can be
written as: VU = EBIT (1- tc )/rtn equity or 100(1-.35)/.15 = $65/.15.

Since the firm that uses debt has the benefit of interest tax shields as
shown in 1 & 2 above, it can be written as:

                 VL = VU + (PV Tax Shield)

OR               VL =

OR               VL = VU +

What is the value of the company after the debt for equity swap?

Assume the price per share before the announced swap is $10.00.
Therefore, before the swap there are 43.333 shares outstanding. How
did I arrive at 43.333?

When the firm announces the swap what will happen to the stock price?
How quickly would the price jump? Based on what theory?

What is the stock price just after the announcement?

If the firm completes the swap after the price increase, how many shares
would they purchase in the exchange?

What would the balance sheet look like? I.E. The value to the debt
holder, equity holder and company value? Show the pie both before and
after the swap.

Capital Structure Problem

Imagine you have an all equity company. It’s operating income (EBIT)
is 100,000 per year into perpetuity. The company has 35% marginal tax
rate. Assume equity return is .15.

1. What is the firm value?

Now you decide your company plans to issue 200,000 in debt at a 10%
interest rate, in exchange for 200,000 in equity.

2. What is the value of the interest tax shield?

3. What is the value of the newly levered company?

4. What is the after tax income to the equity holders?

5. What is the value of the equity holders’ claims?

6. Just after the announcement, how many share would the company
buy back?

Capital structure continued

Tax shields encourage firms to use 100% debt financing. Yet, we do
not see 100% debt financing. Why not?

The use of debt has costs. The most notable is the cost of financial

Financial distress occurs when the probability is great that a firm cannot
meet its debt obligations—the risk the firm will default on its interest
payments. The likelihood of financial distress increases as firms use
more debt. Financial distress is costly when it creates conflicts that get
in the way of running the business.
Examples of financial distress costs include (but are not limited to):

1. Direct costs:
      Legal and administrative costs associated with bankruptcy or debt
      restructuring. Bankruptcy, when the bondholders

Bankruptcy process in more detail to follow (liquidation vs
     A. Chapter 7 – straight liquidation of assets.
           a. A trustee attempts to liquidate assets.
           b. Creditors receive cash up to the amount of their loan
             values, after liquidation and bankruptcy
             administration costs are covered.
           c. Absolute priority rule: Bankruptcy administration,
             employees, consumers, government, unsecured
             creditors, stockholders
     B. Chapter 11 – Corporate reorganization – the corporation
        secures the approval of a bankruptcy plan from creditors
        and then files for bankruptcy. The company enters
        bankruptcy and reemerges almost immediately. The firm
        does NOT have to be insolvent.
           a. Creditors create a plan to keep the company
             operating to maximize cash flow.
           b. The company submits a formal reorganization plan.
           c. Sometimes debt terms are adjusted so the company
             can continue operation.

           C. Benefits of Bankruptcy
                  a. Buys time -- bankruptcy means payments to
                    creditors will cease until the outcome of bankruptcy
                  b. Firm can strategically choose to reorganize in
                    response to changes in the industry environment.
                    (Continental Airlines 1983 example)

2. Indirect costs (costs where the company struggles but avoids

     Restraint by creditors to loan money
     Restrain by customers to purchase goods
     Restraint by suppliers to deliver goods
     Loss of experienced employees

So far we have:     VL = VU + PV tax shields – cost of financial distress.
Graph the value of the levered firm as the firm uses more debt.

Given this information, what types of firms are most likely to use more
debt, and what types of firms are less likely to use more debt?
Example: Greentea industries is considering adding leverage to its
capital structure. They believe that they can add up to 35 million in debt
and achieve the benefits of the interest tax shield. They also understand
that more debt will lead to increased probability of financial distress.
Based on a simulation of cash flows they have made the following

Debt amt                      0     10     20    25    30     35
PV of interest tax shield     0.00 1.50 3.00 3.75 4.50 5.25
PV of financial distress      0.00 0.00 0.38 1.62 4.00 6.38
Net benefit

Financial Distress in more detail

Financial Distress – Cash flows are insufficient to pay current

Bankruptcy – legal process, firm is not required to demonstrate a
financial problem, need only fill out paperwork.

Bankruptcy gives debtor firms a bargaining advantage. Prior to
bankruptcy, creditors may threaten aggressive collection actions.
Bankruptcy relieves the debtor of immediate threats.

Bankruptcy chapters
Chapter 7 – Liquidation of debtor’s assets by a trustee.
Chapter 9 – Bankruptcies of cities and municipalities.
Chapter 11 – Reorganization. Management remains in control.
Chapter 12 – Bankruptcy for farmers.
Chapter 13 – Permits consumers to repay all or a part of their debts over
time rather than go through liquidation.
Chapter 15 – Multinationals, U.S. assets of firms that file in another

Most common for a firm – chapter 11.

When a firm files for chapter 11, an automatic stay immediately takes
effect. The automatic stay is the protective legal fence that drops around
the firm to prevent efforts by creditors to collect on claims. Then the
firm has time to work out a reorganization plan.

The logic – over the long term, creditors as a whole will be better off if
the firm is allowed to survive, even though individual credotrs might not
receive as much as they would by pursuing their individual claims.

Illiquidity – a firm entering into chapter 11 faces questions of liquidity.
Cash and credit are depleted, lenders may threaten default. Bankruptcy
code authorizees the company to offer sweeteners to lenders willing to
        1. Super-priority – the right to be paid ahead of everyone else.
        2. Critical vendor – some “critical” vendors get paid before other
          creditors, encouraging them to continue shipping on credit.
          Otherwise, code requires all vendors to receive the same
          percentage distribution on their claims, and to wait for a
          confirmation plan.

Valuation – High priority creditor have incentive to argue a firm’s value
is low, implying their claims constitute a substantial share of the firm’s
value. The lower the value, the larger the share that high-priority
creditors can argue should be awarded to them. Low-priority creditors
have an incentive to argue that firm value is large, making it more likely
that some value will be left for them after high-priority creditors are

The firm must also propose a plan that is in the best interests of
creditors. A plan that pays more to creditors via chapter 11 restructuring
than they would receive in liquidation under chapter 7. The firm will try
to minimize the proposed liquidation value.

Firms reorganizing under chapter 11 have the right to terminate
underfunded pension plans, and the U.S. government’s Pension Benefit
Guaranty Corporation picks up the uncovered pension costs.

Reorganized firms retain most of their accrued tax loss carryforwards,
which would be lost if they liquidated. These carryforwards both
improve profitability if the firm becomes profitable and makes the firm a
more viable acquistion target.

Firms do not have an obligation to pay interest to unsecured
prebankruptcy creditors. The firm will have to start paying interest
again after the reorganization plan is approved.

Firms in reorganization can reject their collective bargaining labor

A recent study by Kalay, Singha, and Tashjian (2007) finds that 459
firms filing for chapter 11 between 1991 and 1998 experienced, on
average, significant improvements in operating performance after

The Bankruptcy Abuse Prevention and Consumer Protection Act of
2005. This act made filing for bankruptcy more expensive for firms.
For one, it limits bonuses that can be paid to retain key emploees while
in chapter 11.

Out of court workouts as an alternative to chapter 11.

Here, the firm must receive unanimous approval from the creditors,
rather than the majorty or two-thirds of creditors needed in chapter 11.

Out of court workouts usually take less time and are less costly, often
times requiring a renegotiation of credit terms by bankers or other

Prepackaged bankruptcy.

This is when the firm prepares a reorganization plan that is negotiated
and voted on by creditors and stockholders before the company actually
files for chapter 11 bankruptcy. This simplifies and speeds the
reorganization process.

Chapter 7 – liquidation and priority of claims.
     1. Expenses of administering the bankruptcy.
     2. Wages of not more than $2,000 per worker earned in the 90
        days before the bankruptcy.
     3. Unsecured customer deposits/advances for work up to $900.
     4. Taxes.
     5. Secured creditors.
     6. Unsecured creditors.
     7. Stockholders.

Agency Costs of Financial Distress Financial distress can also
magnify agency costs. It can create a conflict in incentives between
shareholders and bondholders. These are also costs of financial distress.
We look at three agency conflicts.

   1. The incentive to take large risks. (benefits SHs) Management
      could have incentive to take high risk projects with a lower NPV
      than projects that have less risk and a higher NPV. Imagine a firm
      where managers can choose just one project. It can take a low risk
      project, or a high risk project.
                        Low risk project            High risk project
            Prob Value Value Value                Value Value Value
                     Stock Bond Firm              Stock Bond Firm
Recession    0.5       0      100      100          0       50      50
Boom         0.5      100     100      200         140     100     240
Average value of firm       300/2= 150                   290/2= 145
How much value does each project provide the BHs and SHs?
Are managers to act in shareholders’ interests, or should they focus on
firm value?
What will happen to the managers if they focus on shareholders, if they
focus on firm value?

Would bondholders expect managers to act in shareholders’ interests and
set up rules to eliminate this possibility?

A real world example: Frederick Smith, founder of Fed Express took
$20,000 to Vegas when Fed Express was near bankruptcy. He won at
the tables and the firm survived. Had he lost the banks would simply
have received $20,000 less when the firm reached bankruptcy.

2. Incentive toward Underinvestment. This is when the stock holders
  would contribute the full investment for a project but shareholders
  and bondholders would share the benefit.

Imagine there is an equal 50% probability of a boom or bust and no
debt holders: Shareholders can invest $1,000 and take the project.
Should they?
                       Boom         Bust      Expected Value
W/Out project Firm CFs 5000         2400      3700
With project Firm CFs  6700         4100      5400

Now imagine there are bondholders.
                 Boom     Bust         Expected Value
Without project
Firm CFs         5000     2400         3700
Bondholder CFs 4000       2400         3200
Shareholder CFs 1000      0            500
With project
Firm CFs         6700     4100         5400
Bondholder CFs 4000       4000         4000
Shareholder CFs 2700      100          1400

By using $1,000 in SH capital you increase firm value by $1,700, bond
value by $800 and SH value by $900.

Yet SHs wouldn’t want to fund this project because they would not
recoup the full $1,000. Bondholders weren’t getting paid in full before,
but now they are.

   3. Milking the property. Using a dividend on existing assets to drain
      the CFs knowing the company will go into bankruptcy. Here
      shareholders circumvent their status as residual claimants, getting
      their cash before the bondholders can get theirs.

                          W/out SH dividend        W/SH dividend
Firm cash                 1,000                    1,000
Dividend (equity holders) 0                        500
Bondholders               800                      500
Equity holders            200                      (here they get the 500
                                                   in dividends)

Since these games only occur in cases of financial distress, to avoid
them, the companies most inclined to have financial distress are the
same companies that use low levels of debt to avoid these games. These
are smaller companies where cash flows are uncertain and where
financial flexibility is needed.

Bondholders knows the cost of these games so they create rules
(protective covenants) to protect themselves. Shareholders welcome
these rules because they know that since bondholders are aware of the
games they discount the bond value when it is issued and ultimately
shareholders are the ones paying the costs of these games.

Protective Covenant examples
  1. Financial statements requiring (these aim to avoid financial
        a. A certain level of working capital
        b. A minimum net worth
  2. Restrictions on asset disposition (this limits the ability of
     shareholders to transfer assets themselves)
        a. Limiting dividends
        b. Limiting the sale of assets
  3. Restrictions on switching assets (this blocks shareholders’ ability
     to shift investment into higher risk projects that might have a big
     payoff but might also have a large chance of failure.)

Agency Benefits of Debt

Agency conflicts leading to entrenchment and self interest. High debt
ratios reduce the free cash flow managers have to spend, making them
more diligent in how they spend it. Examples of ways managers
sometimes squander cash include:

  A. Overspending on personal perks, including planes and travel,
     office furniture, etc.

  B. Overinvesting by choosing:
        a. Bad investment decisions (Negative NPV acquisitions).
           Empire building, or a manager’s preference to run a large
           firm rather than a smaller firm.

        b. Bad investment decisions because the manager is
A firm that higher leverage might also act more aggressively in
protecting its markets because it cannot risk the possibility of
bankruptcy. This aggresstive behavior can scare off potential rivals.

In conclusion we have:
VL = VU + PV (Tax shields) – PV (Cost of financial distress) –
PV(Agency cost of debt) + PV(Agency benefits of debt).

Asymmetric Information and Signaling theory of capital structure

I might go to a job interview and I have information about myself that
the employer doesn’t have. I can tell the employer how great I am, but it
isn’t credible.

A firm can tell the investing public how great they are and how rosy the
future looks, but it isn’t credible. They have to give a credible signal.
That is, they must take actions that the market understands they would
be unwilling to do unless the statements about how rosy the future is are
        Claims are credible only if they are supported by actions that
        would be too costly to take if the claims were untrue.

The firm could issue more debt and make greater interest payments.
They firm would only take this action if it was confident that it had the
cash flows to support the higher amount of leverage. Hence, this shows
that they have confidence in their future cash flows.

We see that debt increases are usually associated with higher stock

Pecking order Theory (this is another play on asymmetric
information—severe asymmetric information)
The logic is as follows:
  1. The manager knows more about a firm’s prospects than the

  2. Investors assume that the firm would issue debt when the stock is
     undervalued and issue equity if the stock is overvalued. Adverse
     selection – the managers know more about the firm’s prospects
     than investors do and would only issue equity if the stock price is
     too high.

  3. Managers know investors infer that the stock is overvalued if they
     issue equity and that the stock price will fall if they issue equity.
     Because the stock price will fall by some amount, it only makes
     sense to managers to issue equity if the stock is most overvalued.

  4. If managers of moderately overpriced stock issue equity, investors
     infer that it is the most overvalued equity and the stock price falls
     more than it should.    Pg 474.

  5. Firms would never issue equity if they can avoid it. Instead, firms
     would issue debt and this would signal that equity is either
     correctly priced or is perhaps undervalued.

Conclusion: If the firm issues debt, the stock price will increase because
the stock was undervalued. We see this.
If the firm issues equity the stock price will decrease because it is
overvalued. We see this.

The firm should issue debt whenever possible, but then it would be
100% debt financed, so we must also consider taxes, financial flexibility
and financial distress.

We could use this same logic to compare debt with internal financing
(retained earnings).

Therefore, issue safest securities first I.E. use internal financing, then
use debt, then use equity.

How the pecking order theory is at odds with the tradeoff theory

  1. Pecking order does not set a target level of debt.

  2. Pecking order suggests that more profitable firms are more likely
     to use internal financing and have lower levels of debt. Tradeoff
     theory suggest that these firms should use more debt and use
     potential tax shields.

  3. Companies like financial slack and pecking order implies that
     companies might issue debt even when it isn’t needed to have cash
     around ahead of time for future positive NPV projects.

What we see
  1. Most firms have relatively low debt/assets ratios. D/BA = 0.60
     and D/MA = 0.40

  2. Firms with high equity ownership are even less inclined to use
     debt. Often it is zero. Possibly these managers are less diversified
     and are loathed to accept additional risk associated with leverage.

  3. Firms in industries with more tangible assets use more debt.
     Perhaps these assets suffer less loss in value in case of bankruptcy.

  4. Firms in high growth industries (with lots of positive NPV
     projects) use less debt and have larger cash balances. Perhaps they
     need more financial flexibility.

  5. About 70% of firms state they have some sort of D/E target.
     Larger firms are more likely than smaller firms.

What about the ”Market timing theory of capital structure?”


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