Capital Structure: Non-Tax Determinants Of Corporate Leverage Professor XXXXX Course Name / Number Optimal Capital Structure Total firm value Most firms do not use anything close to 100% debt. Why? 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, value the one that maximizes the value of the firm, is in between the extremes. 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. 4 Example 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 $100,000,000 Debt $0 $0 $50,000,000$0 $50,000,000 Equity $40,000,000 $100,000,000 $40,000,000 $50,000,000 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 5 incurs no additional costs than does the firm that has no debt. Example – 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 $100,000,000 Debt $0 $0 $50,000,000 Equity $40,000,000 $100,000,000 $30,000,000 $50,000,000 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 6 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 Indirect Costs Loss of employees who switch to healthier firms Strained relationships with suppliers Lost investment opportunities 7 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: 9 V L = V U + PV Tax Shields - PV BankruptcyCosts U.S. Bankruptcy Practices And Costs 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 10 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 office. – 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. 12 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. 13 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 events. 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. Assumptions 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. 16 A Checklist for Capital Structure Decision-Making Documented relationship Variable 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 17 A Checklist for Capital Structure Decision-Making Documented relationship Variable 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 18 Non-Tax Determinants Of Corporate Leverage 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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