Chapter 13: Capital Structure Incremental Benefits and Costs of Leverage

1. Chapter 13:Capital StructureIncremental Benefits and Costs of Leverage Corporate Finance, 3e Graham, Smart, and Megginson

2. Trading Off Debt’s Benefits and Costs The optimal capital structure occurs where the marginal benefit of additional debt is equal to the marginal cost. How do managers trade-off the benefits and costs of debt to establish a target capital structure that maximizes firm value?

3. Debt Tax Shields and Firm Profitability 3 Interest deductions only lower taxes to the extent that the firm is profitable. Using more debt financing increases the probability that the firm will experience losses.

4. Costs of Bankruptcy and Financial Distress Bankruptcy costs are distinct from the decline in firm value that leads to financial distress. Poor management, unfavorable movements in input and output prices, and recessions can push a firm into bankruptcy, but they are not examples of bankruptcy costs. Bankruptcy costs refer to direct and indirect costs of the bankruptcy process itself.

5. Bankruptcy Costs If ownership of the firm’s assets were transferred costlessly to its creditors in the event of bankruptcy… The optimal capital structure would still be 100% debt. It is not the event of going bankrupt that matters; it is the costs of going bankrupt that matter. When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to using leverage.

6. Direct Costs Costs of bankruptcy-related litigation (e.g. legal, auditing, and administrative costs) 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 Bankruptcy Costs

7. Asset Characteristics and Bankruptcy Costs Producers of complex products or services tend to use less debt than do firms producing nondurable goods or basic services. Companies whose assets are mostly tangible and have well-established secondary markets should be less fearful of financial distress than companies whose assets are mostly intangible.

8. Asset Characteristics and Bankruptcy Costs • Financial distress can be particularly damaging to firms that produce research and development-intensive goods and services, for two reasons: • First, most of the production expenses are sunk costs, which can be recovered only with a long period of profitable sales. • Second, “cutting-edge” goods require ongoing R&D spending to ensure market acceptance.

9. Agency Costs and Capital Structure • Jensen and Meckling (1976): agency cost theory of financial structure • Agency costs of outside equity • Managers who own less than 100% of the firm have an incentive to expropriate wealth from the firm’s investors.

10. Using Debt to Overcome the Agency Costs of Outside Equity Using debt means a firm can sell less external equity and still finance its operations. Using debt reduces managerial perquisite consumption. External debt serves as a bonding mechanism. Debt subjects managers to direct monitoring by public capital markets.

11. Agency Costs of Outside Debt • Bondholders begin taking on an increasing fraction of the firm’s risk as firms use more debt. • Shareholders and managers still control the firm’s investment and operating decisions, so managers have incentives to transfer wealth from bondholders to themselves and other shareholders.

12. Asset substitution (bait and switch) Problems with outside debt Underinvestment Agency Costs of Outside Debt Bondholders protect themselves with positive and negative covenants in lending contracts. Agency costs of debt are burdensome, but so are solutions.

13. Agency Costs of Outside Debt Asset substitution: the promise to invest in a safe asset to obtain an interest rate reflecting low risk, and then substituting a riskier asset promising a higher expected return. Underinvestment: occurs when a firm’s shareholders refuse to invest in a positive-NPV project because most of the benefits would be realized by bondholders.

14. Implications of the Trade-off Model Profitable firms should borrow more than unprofitable firms because they are more likely to benefit from interest tax shields. Firms that own tangible, marketable assets should borrow more than firms whose assets are intangible or highly specialized. Safer firms should borrow more than riskier firms. Companies should have a target debt ratio.

15. Empirical Observations on Leverage Some studies find that the most profitable firms in an industry have the lowest debt ratios. Leverage-increasing events, such as stock repurchases and debt-for-equity exchange offers, almost always increase stock prices Leverage-decreasing events reduce stock prices Firms issue debt securities frequently, but seasoned equity issues (equity issues from firms that already have stock) are rare.

16. Assumptions Underlying the Pecking-Order Theory • Dividend policy is “sticky.” • Firms prefer internal financing (retained earnings and depreciation) to external financing of any sort, debt or equity. • If a firm must obtain external financing, it will issue the safest security first. • As a firm requires more external financing, it will work down the “pecking order” of securities: • Safe debt • Risky debt • Convertible securities • Preferred stock • Common stock (as a last resort)

17. Manager acts in best interests of existing shareholders. Assumptions Information asymmetry between managers and investors. Assumptions Underlying the Pecking-Order Theory 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 last resort.

18. Limitations of the Pecking-Order Theory It implies that firms have no target capital structure and that the debt ratios observed in the real world ought to fluctuate randomly. The theory also seems at odds with evidence that firms owning more tangible assets typically use more leverage.

19. How Signaling with Capital Structure Can Convey Information A firm’s managers can adopt a heavily leveraged capital structure, committing the firm to pay out large sums to bondholders. In equilibrium, firms signal good news by issuing debt. Investors know that with good prospects can afford to take on debt, they recognize a debt issuance as good news, and they bid up the firm’s shares.

20. The Market-Timing Model Baker and Wurgler (2002) argue that firms time the market by issuing equity when share prices are high and issuing debt when they are low. As a consequence, a firm’s capital structure simply reflects the cumulative effects of its managers’ past market-timing activities. Relatively new theory; still being tested

21. Finding The Optimal Capital Structure For a Specific Company • As more debt is added and the probability of losses increases, the marginal benefit of debt curve slopes downward. • Graham (2000) shows how to estimate the present value of tax shields for any firm by running simulations that allow the firm’s earnings to fluctuate over time. 21