Professional Documents
Culture Documents
Corporate Finance
of the firm and may even take legal ownership of the firms assets
through bankruptcy.
bankruptcy.
Equity financing does not carry this risk. While equity holders hope
Armin Industries:
Leverage and the Risk of Default
Armin is considering a new project.
While the new product represents a significant advance over
capital structures.
It can use all-equity financing.
It can use debt that matures at the end of the year with a total of
million.
Without leverage, equity holders own the full amount.
With leverage, Armin must make the $100 million debt payment,
and Armins equity holders will own the remaining $50 million.
Even if Armin does not have $100 million in cash available at the end of
Scenario 1:
New Product Succeeds (cont'd)
With perfect capital markets, as long as the value of the
Scenario 1:
New Product Succeeds (cont'd)
If a firm has access to capital markets and can issue new
solvent.
will default.
Because the assets the debt holders receive have a value of $80 million, they
will suffer a loss of $20 million.
With leverage, equity holders lose $50 million, and debt holders
lose $20 million, but the total loss is the same, $70 million.
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have the same total value and will be able to raise the
same amount initially from investors with either choice of
capital structure.
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or Chapter 11.
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corporations.
business.
the firm.
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each creditor is owed, but more than the creditors would receive if the
firm were shut down immediately and liquidated.
The creditors must vote to accept the plan, and it must be approved
a Chapter 7 liquidation.
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costly.
Costly outside experts are often hired by the firm to assist with the
bankruptcy process.
Creditors also incur costs during the bankruptcy process.
They may wait several years to receive payment.
They may hire their own experts for legal and
professional advice.
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The direct costs of bankruptcy should not substantially exceed the cost
of a workout.
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be considered.
Losses to total firm value (and not solely losses to equity holders or
above and beyond any losses that would occur due to the firms
economic distress, must be identified.
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Distress Costs
With all-equity financing, Armins assets will be worth $150 million if
its new product succeeds and $80 million if the new product fails.
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Distress Costs
With debt of $100 million, Armin will be forced into bankruptcy if the
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Distress Costs
now less with leverage than it is without leverage when the new
product fails.
The difference of $20 million is due to financial
distress costs.
These costs will lower the total value of the firm with leverage, and
MMs Proposition I will no longer hold.
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fails and the firm defaults, they will not be able to get the
full value of the assets.
As a result, they will pay less for the debt initially (the present value
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pay the present value of the costs associated with bankruptcy and
financial distress.
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tax shield from debt against the costs of financial distress and
agency costs.
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VL
VU
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2.
Technology firms will likely incur high financial distress costs due to
the potential for loss of customers and key personnel, as well as a
lack of tangible assets that can be easily liquidated.
Real estate firms are likely to have low costs of financial distress since
the majority of their assets can be sold relatively easily.
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Note that because distress costs are high when the firm does poorly,
the beta of distress costs has the opposite sign to that of the firm.
The higher the firms beta, the more negative the beta of its distress
costs will be
The present value of distress costs will be higher for high beta
firms.
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Optimal Leverage
For low levels of debt, the risk of default remains low and
increases.
As the level of debt increases, the costs of financial distress
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leverage until it reaches the level for which the firm value
is maximized.
At this point, the tax savings that result from increasing leverage
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firms stakeholders
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financial distress.
Baxter has a loan of $1 million due at the end of the year.
Without a change in its strategy, the market value of its assets will
be only $900,000 at that time, and Baxter will default on its debt.
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fall to $300,000.
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Equity holders have nothing to lose if Baxter tries the risky strategy.
payoff is $150,000.
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Table 16.3 Outcomes for Baxters Debt and Equity Under Each
Strategy ($ thousands)
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If the project succeeds, debt holders are fully repaid and receive $1
million.
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holders money.
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Anticipating this bad behavior, security holders will pay less for the firm
initially.
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Howard: Solution
A)
NPV S = 10
B)
NPV R = 5
R
Unfav.
Fav.
CF
60
20
90
50
20
50
40
10
20
C) Expected payoff to 50
nave debt holders
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Howard: Solution
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There are many bankruptcy procedures under which firms are reorganized and
continue operating (for example Chapter 11 in the U.S.)
Liquidation costs are the difference between the firms going concern value
(the present value of the future cash flows that the firms assets would
generate if it were to continue operating), and its liquidation value, which is
what the firm could collect by liquidating its assets and selling them.
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investment?
Could Baxter raise $100,000 in new equity to make the
investment?
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Table 16.4 Outcomes for Baxters Debt and Equity with and
without the New Project ($ thousands)
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The other $100,000 from the project goes to the debt holders,
The debt holders receive most of the benefit, thus this project is a
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NPV project because the firm is in financial distress and the value
of undertaking the investment opportunity will accrue to
bondholders rather than themselves.
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Liability
Debt
Equity
Total
BV MV
$300 $200
$300 $0
$600 $200
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Example: Underinvestment
Consider a project that guarantees $350 next year.
The project costs $300 and the firm only has cash for
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$300
$272.73 =
(1.10)
$50
$100
-$54.55 =
(1.10)
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An Example: Lester
Lester Inc. has debt obligations that are due both next
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An example: Lester
Year 1
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Lester
Year 2
No project allows Lester to meet its debt obligation in the
unfavorable state.
Favorable state:
Project A: $20 (60-40-0)
Project B: $10 (60-40+40-50)
Thus, the firms equity holders are better off selecting the
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Lester
Why?
Because there is a wealth transfer from debt holders
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Cashing Out
When a firm faces financial distress, shareholders have
assets below market value and use the funds to pay an immediate
cash dividend to the shareholders.
This is another form of under-investment that occurs when a firm faces
financial distress.
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NPV D D
>
I
E E
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holders.
However, ultimately, it is the shareholders of the firm who bear
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the net effect is a reduction in the initial share price of the firm.
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the firms leverage that will affect the firms optimal capital
structure choice.
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place:
1.
2.
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maturity of debt.
Agency costs are highest for long-term debt and smallest for short-
term debt.
Debt Covenants
Conditions of making a loan in which creditors place restrictions on
actions that a firm can take
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Motivating Managers:
The Agency Benefits of Leverage
Management Entrenchment
A situation arising as the result of the separation of ownership and
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Concentration of Ownership
One advantage of using leverage is that it allows the
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personal effort.
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negative-NPV investments?
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so they will take on investments that increase the size, but not
necessarily the profitability, of the firm.
Managers of large firms tend to earn higher salaries, and they may also
have more prestige and garner greater publicity than managers of small
firms.
Thus, managers may expand unprofitable divisions, pay too much for
acquisitions, make unnecessary capital expenditures, or hire unnecessary
employees.
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are overconfident.
Even when managers attempt to act in shareholders interests, they
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business downturns.
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message?
The answer is: risk. Higher leverage increases a firms
incentive to invest in risky projects (we are only interested
in the upside of the investment project).
Higher output can be seen as a risky investment project.
Higher output increases risk because it leads to higher
profits when product demand is high, but lower profits
when demand is low.
If the firm has a high debt level, shareholders do not care about
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lead firms to reduce their level of investment, and thus, to act less
aggressively.
Lets consider a firm that can increase its market share lowering
prices.
This firm will have smaller profits in the short-run because of lower
prices, but it will realize greater profits in the long run because of
the higher market share.
Gaining market share is thus an investment that becomes more or
less attractive as the relevant discount rate increases or
decreases. If the discount rate increases, the incentive to gain
market share decreases.
We already saw that highly levered firms use higher discount rates
to evaluate investments (because of the debt overhang problem).
Thus, this implies that highly levered firms will compete less
aggressively in the product market.
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VL
VU
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business strategies.
investment opportunities.
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avoid the discipline of debt and maintain their own job security
Managers seek to minimize leverage to prevent the job loss that
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they are supported by actions that would be too costly to take if the
claims were untrue.
Actions speak louder than words.
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If the information is true, the firm will have no trouble making the debt
payments.
If the information is false, the firm will have trouble paying its creditors
and will experience financial distress. This distress will be costly for the
firm.
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have information that the firm will grow, even if it cannot provide
verifiable details about the sources of growth.
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Good firms will use the less costly signal that permit them to separate themselves
increases the probability of bankruptcy more for bad firms than good firms.
To convince investors, good firms often take on much more debt than it
otherwise would have found optimal.
The amount of debt that firms must use to send a credible signal depends
on the managers incentive to increase the firms current stock price (to the
detriment of the future one).
If there is a big incentive to choose hit-and-run strategies, the amount of debt will
be higher.
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prices.
Owners of high-quality cars are reluctant to sell because they know
buyers will think they are selling a lemon and offer only a low price.
Consequently, the quality and prices of cars sold in the used-car
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equity.
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whose securities will have a high value) will not sell new equity.
Only those managers who know their firms have poor
prospects (and whose securities will have low value) are willing
to sell new equity.
The lemons problem creates a cost for firms that need to raise
capital from investors to fund new investments (Myers and
Majluf, 1984). As a result, firms can pass up good investment
projects because they do not want to issue equity (and disclose
this information).
If they try to issue equity, investors will discount the price they are
willing to pay to reflect the possibility that managers have bad news.
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Example
A firm has assets whose value is $100m and 1m shares
outstanding. A new project costs $70m and its value is $90m. The
companys share is selling at $70 (Pm) on the market .
P=100 without new investment project.
To raise $70m, the firm must issue one 1m shares.
P with investment project is: (100+90)/(1+1)= $95
The firm will reject a positive NPV project. Why?
Because if they issue new shares at $70, there is a wealth transfer
from old shareholders to new shareholders of $5 a share.
Old shareholders lose $25 million if they finance the project at these
conditions. The loss is only partially compensated by the NPV of the
project.
Managers (who run the firm on behalf of OLD shareholders) know
that they are giving the new shareholder a claim to $95m ($50
existing assets +$45 from the new project) for the bargain price of
$70m!!!
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equity is underpriced.
With debt financing, the intrinsic value of a share is
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Definition
P: market value of existing shares (old shares) if the firm
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following:
Issue &
Investment
No Issue & No
Investment
Good State
144.42
150
Bad State
85.58
50
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Shareholders decision
Old shareholders will behave in this way:
Good state: No investment (and no issue)
Bad state: Issue & Investment.
But if they choose issue & investment, then the
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Shareholders decision
V=160
P=60
Va=
[P/(P+E)] *V=[60/(60+100)]*160=60
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issue.
Firms tend to issue equity when information asymmetries are
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using retained earnings, then debt and equity only as a last resort
However, this hypothesis does not provide a clear prediction
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