Capital Structure Non-Tax Determinants Of Corporate Leverage by linzhengnd


									Capital Structure: Non-Tax
Determinants Of Corporate
       Professor XXXXX
    Course Name / Number
    Optimal Capital Structure
    Total firm
                                            Most firms do not
                                           use anything close
                                             to 100% debt.

                 100% equity   100% debt

     In perfect markets, capital structure is irrelevant.

     If markets are perfect except for corporate taxes,
2     then the optimal capital structure is 100% debt.
    Optimal Capital Structure
    There are costs of debt that we’ve missed. At some point,
         those costs must outweigh debt’s tax benefits:

         – Personal taxes on debt, bankruptcy costs, agency
           costs, and asymmetric information

    Total firm                                            The optimal
                      Optimal capital structure       capital structure,
                                                         the one that
                                                        maximizes the
                                                      value of the firm,
                                                      is in between the

3                100% equity              100% debt
    Bankruptcy Cost
    It is not the event of going bankrupt that matters, it is the
               costs of going bankrupt that matter.

    If ownership of the firm’s assets was transferred costlessly
            to its creditors in the event of bankruptcy,

     The optimal capital structure would still be 100% debt.

      When the firm incurs costs in bankruptcy that it would otherwise
       avoid, bankruptcy costs become a deterrent to using leverage.
    An example…
        – Suppose Firm 1 and Firm 2 have the following capital structure
          (assume no bankruptcy costs):
                                             Firm 1             Firm 2
        Market value of assets         $40,000,000
                                      $100,000,000      $40,000,000
        Debt                                    $0
                                                $0     $50,000,000$0
        Equity                      $40,000,000
                                     $100,000,000      $40,000,000

    Recession hits and the value of both firms’ assets drops to $40 million.

     Firm 2 goes bankrupt because there are not enough assets to cover
     the debt. Bondholders become stockholders and own the company.
    If there is a tax advantage to debt, that tax advantage is still decisive
     because the firm that uses more debt can shelter more income and
        incurs no additional costs than does the firm that has no debt.
     – Assume if firm goes bankrupt, $10 million in assets
       are lost in the process of transferring ownership from
       stockholders to bondholders:
                                            Firm 1           Firm 2
       Market value of assets        $40,000,000
                                    $100,000,000       $30,000,000
       Debt                                    $0               $0
       Equity                       $40,000,000
                                    $100,000,000     $30,000,000

    When the recession hits, Firm 1 has $40 million in assets, but Firm 2
                        has $30 million in assets.
    Firm 2 will calculate the tax advantage of debt and weigh that against
      the cost of bankruptcy times the probability of bankruptcy at each
                                   debt level.
     We are now looking not at bankruptcy costs per se, but at expected
                             bankruptcy costs.
    Bankruptcy Costs

    Direct Costs        Costs of bankruptcy-related litigation

                        Cost of management time diverted to
                                 bankruptcy process

                   Loss of customers who don’t want to deal with
                                 a distressed firm
       Costs       Loss of employees who switch to healthier firms

                        Strained relationships with suppliers

                            Lost investment opportunities
    Bankruptcy Costs
    Indirect costs are likely to be much larger, and are likely to
    vary a great deal depending on the type of firm in distress.

                    Indirect costs may be high:

       When the firm’s product requires that the firm stay in
     business (e.g., when warranties or service are important)

    When the firm must make additional investments in product
                  quality to maintain customers

     For example, think of customers worrying that a bankrupt
8     airline might try to save $ by cutting spending on safety.
    Bankruptcy Costs
                                 Legal, auditing and administrative costs
                                          (include court costs)
    Direct costs of
     bankruptcy                   Large in absolute amount, but only 1-
                                          2% of large firm value

    Financial distress also gives managers adverse incentives.

      – Asset substitution problem: Incentive to take large risks
      – Under-investment problem: shareholders refuse to contribute funds

          Trade-off model of corporate capital structure:

      V L = V U + PV Tax Shields - PV BankruptcyCosts
     U.S. Bankruptcy Practices And
     Bankruptcy governed by Federal law and filings are made
                  in Federal bankruptcy courts

       Two types of bankruptcy filings in US for corporations:

       Chapter 7 (Liquidation)      Chapter 11 (Reorganization)

     In liquidation, a trustee is usually appointed to liquidate
                            firm’s assets.

     In reorganization, firm’s management continues to operate
               firm, can propose reorganization plan.
     Agency Costs And Capital Structure
     Agency costs arise as soon as an entrepreneur sells
        a fraction  of her firm to outside investors.
     – Entrepreneur enjoys private benefits of control
       (perquisites), but bears only (1-  ) of the cost of ―perks.‖

     • An  example…
        –  Assume the manager of a firm owns 10% of the firm’s stock.
        –  Outsiders (non-managers) own 90%.
        –  The firm buys an expensive Van Gogh to hang in the manager’s
         – The manager pays 10% of the cost of this painting but enjoys
           100% of the benefit!

       Separation between ownership and control of a firm gives rise to
11                     agency costs of outside equity.
     Agency Costs Of Outside Debt
      Debt helps mitigate these costs, but debt has its
                     own agency costs:
                                Expropriate bondholders wealth by paying
                                          excessive dividends
     Agency costs of
      outside debt                  Bait And Switch: Promise to use
                                borrowed money for safe investment, then
                                  use to buy high/risk, high/return asset

     Bondholders protect themselves with positive and negative
                  covenants in lending contracts.

         Agency costs of debt are burdensome, but so are solutions.
     The Agency Cost / Tax Shield Trade-
     Off Model Of Corporate Leverage
      Companies trade off tax and agency cost benefits of debt
      against the costs of bankruptcy and agency costs of debt.

           Firm V maximized at a unique optimal debt level:

     V L = V U + PV tax shields - PV bankruptcy costs
     + PV agency costs of outside equity - PV agency costs of outside debt

       Empirical research offers support for the model, but the
             model is far from perfect in its predictions.

           Weaknesses lead to development of Pecking Order Theory.
     The Pecking Order Theory Of
     Corporate Capital Structure
       Trade-off theory cannot explain three empirical
                   capital structure facts:

         Most profitable firms in an industry use least debt.
        Stock market responds to leverage-increasing events
     strongly positive; negative reaction to leverage-decreasing

         Firms issue debt frequently, but rarely issue equity.

     Myers (1984), Myers & Majluf (1984) propose pecking order theory of
14                          corporate leverage.
     The Pecking Order Theory Of
     Corporate Capital Structure
                                Manager acts in best interests of
                                    existing shareholders.
                          Information asymmetry between managers
                                        and investors.

      Two key predictions about managerial behavior

     Firms hold financial slack so they don’t have to
                     issue securities.
      Firms follow pecking order when issuing
      securities: sell low-risk debt first, equity only as
15    last resort.
     Signaling And Other Asymmetric
     Information Models
      • Third group of models, based on asymmetric information
        between managers and investors, predict managers will use a
        costly signal:
         – A simple statement of high firm value not credible
         – Must take action that is too costly for weak firm to mimic
         – Crude signal: burn $100 bills; only wealthy can afford
      • If signaling can differentiate between strong and weak firms
        based on signal, a signaling equilibrium results.
         – Investors identify stronger firms, assign higher market value
      • If signaling cannot differentiate between strong and weak firms,
        a pooling equilibrium results.
         – Investors assign low average value to all firms.
      • Models predict high value firms use high leverage as signal.
         – Makes sense, but empirics show the opposite—most
             profitable & highest market/book firms use least leverage.
     A Checklist for Capital Structure
                                            Documented relationship
                                          between variable and leverage

     Profitability                                  Negative

     Market-to-book ratio                           Negative

     Earnings volatility                            Negative

     Non-debt tax shields                           Negative

     Effective (marginal) corp tax rate              Positive

     Regulation (regulated industry?)                Positive

     Firm size                                       Positive

     Asset tangibility                               Positive
     A Checklist for Capital Structure
                                          Documented relationship
                                        between variable and leverage

     Growth rate of firm’s assets                Ambiguous

     Insider share ownership                     Ambiguous

     Managerial entrenchment                      Negative

     Creditor power in bankruptcy                 Negative

     Corporate income tax rate                     Positive

     Personal tax rate, equity income              Positive

     Personal tax rate, debt income               Negative

     State ownership                               Positive
Non-Tax Determinants Of Corporate
Personal taxes on debt, bankruptcy costs, agency
 costs, and asymmetric information influence level
         of debt the firm chooses to have.
Agency costs arise between corporate managers
      and outside investors and creditors.

Trade-off theory, pecking order theory, signaling
  theory try to explain corporate leverage levels.

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