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Lecture 7_Chapter 17

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sarahhaphuong0506
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 17

Because learning changes everything.

Corporate Finance Thirteenth Edition


Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 17

Capital Structure: Limits to the Use of Debt

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Key Concepts and Skills
Define the costs associated with bankruptcy.
Understand the theories that address the level of debt a firm
carries:
• Trade-off.
• Signaling.
• Agency cost.
• Pecking order.

Know real-world factors that affect the debt to equity ratio.

© McGraw Hill, LLC 2


Chapter Outline
17.1 Costs of Financial Distress
17.2 Description of Financial Distress Costs
17.3 Can Costs of Debt Be Reduced?
17.4 Integration of Tax Effects and Financial Distress Costs
17.5 Signaling
17.6 Shirking, Perquisites, and Bad Investments: A Note on
Agency Cost of Equity
17.7 The Pecking-Order Theory
17.8 How Firms Establish Capital Structure

© McGraw Hill, LLC 3


17.1 Costs of Financial Distress
• Debt provides tax benefits to the firm. However, debt puts
pressure on the firm because interest and principal
payments are obligations.
• If these obligations are not met, the firm may risk some
sort of financial distress. The ultimate distress is
bankruptcy.
• Leverage increases the likelihood of bankruptcy.
• However, bankruptcy does not, by itself, lower the cash
flows to investors. Rather, it is the costs associated with
bankruptcy that lower cash flows.

© McGraw Hill, LLC 4


Bankruptcy costs
The Knight Corporation plans to be in business for one more year.
It forecasts a cash flow of either $100 or $50 in the coming year,
each occurring with 50% probability. The firm has no other assets.
Previously issued debt requires payments of $49 of interest and
principal.
The Day Corporation has identical cash flow prospects but has
$60 of interest and principal obligations.

© McGraw Hill, LLC 5


17.2 Description of Financial Distress
Costs
Direct Costs
• Legal and administrative costs.
Indirect Costs
• Impaired ability to conduct business (e.g., lost sales).

Agency Costs
• Selfish Strategy 1: Incentive to take large risks.
• Selfish Strategy 2: Incentive toward underinvestment.
• Selfish Strategy 3: Milking the property.

© McGraw Hill, LLC 6


17.3 Can Costs of Debt Be Reduced?
Protective Covenants
• A negative covenant limits or prohibits actions that the
company may take.
• A positive covenant specifies an action that the company
agrees to take or a condition the company must abide by.
Debt Consolidation:
• If we minimize the number of parties, contracting costs fall.

© McGraw Hill, LLC 7


17.4 Tax Effects and Financial Distress
There is a trade-off between the tax advantage of debt and
the costs of financial distress.
It is difficult to express this with a precise and rigorous
formula.

© McGraw Hill, LLC 8


Tax Effects and Financial Distress

The tax shield increases the value of the levered firm.


Financial distress costs lower the value of the levered firm.
The two offsetting factors produce an optimal amount of debt at B*.
Access the text alternative for slide images
© McGraw Hill, LLC 9
The Pie Model Revisited
Taxes and bankruptcy costs can be viewed as just another
claim on the cash flows of the firm.
Let G and L stand for payments to the government and
bankruptcy lawyers, respectively.
VT S  B  G  L

The essence of the M&M intuition is that VT depends on the


cash flow of the firm; capital structure just slices the pie.
© McGraw Hill, LLC 10
17.5 Signaling
The firm’s capital structure is optimized where the marginal
subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value.
• Firms with low anticipated profits will take on a low level of
debt.
• Firms with high anticipated profits will take on a high level
of debt.
A manager that takes on more debt than is optimal in order to
fool investors will pay the cost in the long run.

© McGraw Hill, LLC 11


17.6 Agency Cost of Equity
An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.

© McGraw Hill, LLC 12


17.7 The Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if
internal financing is insufficient.
Rule 1
• Use internal financing first.

Rule 2
• Issue debt next, new equity last.

The pecking-order theory is at odds with the trade-off theory:


• There is no target D/E ratio.
• Profitable firms use less debt.
• Companies like financial slack.

© McGraw Hill, LLC 13


17.8 How Firms Establish Capital Structure

Most corporations have low debt-asset ratios.


Changes in financial leverage affect firm value.
• Stock price increases with leverage and vice-versa; this is
consistent with M&M with taxes.
• Another interpretation is that firms signal good news when
they lever up.
There are differences in capital structure across industries
and even through time.
There is evidence that firms behave as if they had a target
debt-equity ratio.

© McGraw Hill, LLC 14


Factors in Target D/E Ratio
Taxes:
• Since interest is tax deductible, highly profitable firms
should use more debt (i.e., greater tax benefit).

Types of Assets:
• The costs of financial distress depend on the types of
assets the firm has.
Uncertainty of Operating Income:
• Even without debt, firms with uncertain operating income
have a high probability of experiencing financial distress.

© McGraw Hill, LLC 15


Quick Quiz
What are the direct and indirect costs of bankruptcy?
Define the “selfish” strategies stockholders may employ in
bankruptcy.
Explain the trade-off, signaling, agency cost, and pecking
order theories.
What factors affect real-world debt levels?

© McGraw Hill, LLC 16


End of Main Content

Because learning changes everything. ®

www.mheducation.com

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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