The after-tax value of the company (the sum of debt and equity as shown in a normal market value balance sheet) increases with PV (tax shield). Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48 (June 1958), pp. Given poor business performance, the right to declare bankruptcy – the right to default – is a valuable privilege.
Evidence on Bankruptcy Costs
By issuing subprime debt, Ace Limited gave lawyers and the court system a claim against the company if it failed. The market value of the company is reduced by the present value of this claim. It is easy to see how increased leverage affects the present value of the cost of financial distress.
If Ace Limited borrows more, it increases the likelihood of default and the value of the lawyers' claims. For this, they demand compensation in advance in the form of higher payouts when the company does not default; that is, they demand a higher promised interest rate. This reduces the possible payouts to shareholders and reduces the current market value of their shares.
Direct versus Indirect Costs of Bankruptcy
The funds complained bitterly about the terms of the sale of the bankrupt company's assets to Fiat, claiming they would get just $0.29 on the dollar, while other, smaller investors fared better.
Financial Distress without Bankruptcy
Debt and Incentives
But suppose that the bond actually matures in a year, that there is enough cash for Circular to run for one year, and that the bondholder cannot "call" and force bankruptcy before then. Its owner is betting on a stroke of luck that will save the firm, so that it can pay off the debt with something left over.
Risk Shifting: The First Game
This perverse capital budgeting strategy is clearly costly to the firm and to the economy as a whole.
Refusing to Contribute Equity Capital: The Second Game
And Three More Games, Briefly
Because the temptation to gamble is strongest when the odds of default are high. Play for time When the company is in financial trouble, creditors want to save what they can by forcing the company to settle. Bait and Switch This game is not always played in financial distress, but it is a quick way to get into trouble.
A dramatic example of bait and switch occurred in October 1988, when RJR Nabisco's management announced its intention to acquire the company in a leveraged buyout (LBO). This put the company "in play" for a transaction in which the existing shareholders would be bought out and the company would be "taken private". The cost of the acquisition would be financed almost entirely by debt.
What the Games Cost
Ketchup accepts project 1, the bank debt will definitely be paid in full; if he accepts project 2, there is only a 50% chance of payment and the expected payoff to the bank is only $5. Ketchup will prefer to take project 2, because if things go well, she gets most of the profit, and if things go bad, the bank bears most of the loss. Ketchup can convince the bank not to play with her money, the bank will limit the amount it is willing to lend.
Debt contracts often limit dividends or equivalent transfers of wealth to shareholders; for example, the firm may not be allowed to pay out more than it earns. The risks of playing for time are reduced by specifying accounting procedures and by giving lenders access to the firm's books and its financial projections. For example, an attempt to prevent the risk-shifting game may also prevent the firm from pursuing good investment opportunities.
Lenders are tempted to play their own game, forcing the company to stay in cash or low-risk assets even if good projects have disappeared. Debt contracts cannot cover every possible manifestation of the games we have just discussed.
Costs of Distress Vary with Type of Asset
Enron was one of the most glamorous, fast-growing and (apparently) profitable companies of the 1990s. It played a leading role in the deregulation of electricity markets, both in the United States and internationally. In retrospect, we see that Enron played many of the games we described earlier in this section.
The collapse of Enron didn't really destroy $60 billion in value because that $60 billion wasn't there in the first place. It provided an important service for wholesale energy customers and suppliers who wanted to buy or sell contracts that locked in the future prices and quantities of electricity, natural gas and other commodities. What happened to this business when it became clear that Enron was in financial trouble and probably headed for bankruptcy.
None of the clients were willing to enter into a new transaction with Enron because it was far from clear that Enron would be there to fulfill its side of the bargain. It turned out that Enron's trading activities were more like Fledgling Electronics than a tangible asset like Heartbreak Hotel.
The Trade-off Theory of Capital Structure
The answer is "yes and no". On the "yes" side, trade-off theory successfully explains many industry differences in capital structure. According to trade-off theory, high profits should mean more capacity for debt service and more taxable income to protect and thus should yield a higher debt ratio. 27 Also, there are large and long-lived differences between the debt ratios of firms in the same industry, even after controlling for the attributes that trade-off theory says should be important.
One final point on the "no" side to the trade-off theory: debt ratios today are no higher than they were in the early 1900s, when income tax rates were low (or zero). Debt ratios in other industrialized countries are equal to or higher than those in the US. Many of these countries have imputed tax systems, which should eliminate the value of interest tax shields.
Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Journal of Financial Economics 60 (May/June 2001), p. 25 Here we mean debt as a fraction of the book or replacement value of the firm's assets.
Debt and Equity Issues with Asymmetric Information
New capital issues are the last resort when the company runs out of debt capacity, that is, when the threat of financial distress costs brings regular insomnia to existing creditors and the financial manager. First, you need to appreciate how asymmetric information might force the financial manager to issue debt rather than common stock. to the press and security analysts. Jones, Inc., will issue $120 million of senior five-year notes. announced today plans to issue 1.2 million new shares of common stock.
Second, Smith's CFO is also naive to think investors would pay $100 per share. Jones, Inc. issues debt because its CFO is optimistic and does not want to issue undervalued capital. A smart but pessimistic financial manager at Smith issues debt because attempting to issue equity would force the stock price down and negate any advantage of doing so.
For example, if Smith was already heavily borrowed and would risk financial distress by borrowing more, it would have a good reason to issue common stock. If investors see equity being issued for these reasons, problems of the kind faced by Smith's financial manager become much less severe.
Implications of the Pecking Order
None of this is to say that firms should strive for high debt ratios—only that it is better to raise capital by repatriating earnings than by issuing stock. They interpret the market-to-book ratio as a measure of growth opportunities and argue that growing companies may face high costs of financial distress and are expected to borrow less. Proponents of the order emphasize the importance of profitability, arguing that profitable firms use less debt because they can rely on internal financing.
The pecking order seems to work best for large, mature companies that have access to public bond markets. There is also some evidence that debt ratios incorporate the cumulative effects of market timing. Thus, lucky companies with a history of high share prices will issue less debt and more shares, ending up with low debt ratios.
Unlucky and unpopular companies will avoid share issues and end up with high debt ratios. Market timing can explain why companies tend to issue stock after rallies in stock prices, and also why total stock issuance is concentrated in bull markets and falls sharply in bear markets.
The Bright Side and the Dark Side of Financial Slack
Traders note that large companies with tangible assets are less exposed to the costs of financial distress and are expected to borrow more. Smaller, younger and growing firms are more likely to rely on equity issues when external financing is required. Assume that investors are sometimes irrationally (as in the late 1990s) and sometimes irrationally depressed.
If the CFO's views are more stable than those of investors, then he or she can profit by issuing equity when the stock price is too high and switching to debt when the price is too low. For example, Bertrand and Schoar tracked the careers of individual CEOs, CFOs, and other top executives. 34 For example, older CEOs tended to be more conservative and pressured their companies to lower debt.
In general, financial decisions depended not only on the nature of the company and its economic environment, but also on the personality of the company's top management.
FINANCE IN PRACTICE
Shareholders acting out of their narrow self-interest can make profits at the expense of creditors by playing “games” that reduce the overall value of the company. The value of the interest tax shield would be easy to calculate if we only had to worry about corporate taxes. The trade-off theory weighs the tax benefits of borrowing against the costs of financial distress.
Visit us at www.mhhe.com/bma S. Myers, “Financing of Corporations”, in G. eds.), Handbook of the Economics of Finance (Amsterdam: Elsevier North-Holland, 2003). The Winter 2005 issue of the Journal of Applied Corporate Finance contains several articles on capital structure decisions in practice. How much of the firm's value is accounted for by the tax shield generated by the debt.
Explain how conflicts of interest between bondholders and shareholders can lead to costs of financial distress. Masulis, "The Effects of Capital Structure Change on Security Prices: A Study of Exchange Offers," Journal of Financial Economics 8 (June 1980), pp.