1、,Corporate Finance Ross Westerfield Jaffe,Sixth Edition,Chapter Outline,16.1 Costs of Financial Distress16.2 Description of Costs16.3 Can Costs of Debt Be Reduced?16.4 Integration of Tax Effects and Financial Distress Costs16.5 Shirking,Perquisites,and Bad Investments:A Note on Agency Cost of Equity
2、16.6 The Pecking-Order Theory16.7 Growth and the Debt-Equity Ratio16.8 Personal Taxes16.9 How Firms Establish Capital Structure16.10 Summary and Conclusions,16.1 Costs of Financial Distress,Bankruptcy risk versus bankruptcy cost.The possibility of bankruptcy has a negative effect on the value of the
3、 firm.However,it is not the risk of bankruptcy itself that lowers value.Rather it is the costs associated with bankruptcy.It is the stockholders who bear these costs.,16.2 Description of Costs,Direct CostsLegal and administrative costs(tend to be a small percentage of firm value).Indirect CostsImpai
4、red ability to conduct business(e.g.,lost sales)Agency CostsSelfish strategy 1:Incentive to take large risksSelfish strategy 2:Incentive toward underinvestmentSelfish Strategy 3:Milking the property,Balance Sheet for a Company in Distress,AssetsBVMVLiabilitiesBVMVCash$200$200LT bonds$300Fixed Asset$
5、400$0Equity$300Total$600$200Total$600$200What happens if the firm is liquidated today?,The bondholders get$200;the shareholders get nothing.,$200,$0,Selfish Strategy 1:Take Large Risks,The GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is$200(all the firms cash)Required retur
6、n is 50%Expected CF from the Gamble=$1000 0.10+$0=$100,Selfish Stockholders Accept Negative NPV Project with Large Risks,Expected CF from the GambleTo Bondholders=$300 0.10+$0=$30To Stockholders=($1000-$300)0.10+$0=$70PV of Bonds Without the Gamble=$200PV of Stocks Without the Gamble=$0PV of Bonds W
7、ith the Gamble=$30/1.5=$20PV of Stocks With the Gamble=$70/1.5=$47,Selfish Strategy 2:Underinvestment,Consider a government-sponsored project that guarantees$350 in one periodCost of investment is$300(the firm only has$200 now)so the stockholders will have to supply an additional$100 to finance the
8、projectRequired return is 10%,Should we accept or reject?,Selfish Stockholders Forego Positive NPV Project,Expected CF from the government sponsored project:To Bondholder=$300To Stockholder=($350-$300)=$50PV of Bonds Without the Project=$200PV of Stocks Without the Project=$0PV of Bonds With the Pro
9、ject=$300/1.1=$272.73PV of Stocks with the project=$50/1.1-$100=-$54.55,Selfish Strategy 3:Milking the Property,Liquidating dividendsSuppose our firm paid out a$200 dividend to the shareholders.This leaves the firm insolvent,with nothing for the bondholders,but plenty for the former shareholders.Suc
10、h tactics often violate bond indentures.Increase perquisites to shareholders and/or management,16.3 Can Costs of Debt Be Reduced?,Protective CovenantsDebt Consolidation:If we minimize the number of parties,contracting costs fall.,Protective Covenants,Agreements to protect bondholdersNegative covenan
11、t:Thou shalt not:Pay dividends beyond specified amount.Sell more senior debt&amount of new debt is limited.Refund existing bond issue with new bonds paying lower interest rate.Buy another companys bonds.Positive covenant:Thou shall:Use proceeds from sale of assets for other assets.Allow redemption i
12、n event of merger or spinoff.Maintain good condition of assets.Provide audited financial information.,16.4 Integration of Tax Effects and Financial Distress Costs,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
13、 and rigorous formula.,Integration of Tax Effects and Financial Distress Costs,Debt(B),Value of firm(V),0,Present value of taxshield on debt,Present value offinancial distress costs,Value of firm underMM with corporatetaxes and debt,VL=VU+TCB,V=Actual value of firm,VU=Value of firm with no debt,B*,M
14、aximumfirm value,Optimal amount of debt,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+LThe essence of the M capital structure just slic
15、es the pie.,S,G,B,L,16.5 Shirking,Perquisites,and Bad Investments:The 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”.Who bears the burden of these agency costs?While managers may have motive to partake in perquisites,th
16、ey 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
17、 reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.,16.6 The Pecking-Order Theory,Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.Rule 1Use internal financing first.Rule 2Issue debt next,equity
18、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,16.7 Growth and the Debt-Equity Ratio,Growth implies significant equity financing,even in a world with low bankruptcy costs.Thus,high-growth f
19、irms will have lower debt ratios than low-growth firms.Growth is an essential feature of the real world;as a result,100%debt financing is sub-optimal.,16.8 Personal Taxes:The Miller Model,The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:,Where
20、:TS=personal tax rate on equity incomeTB=personal tax rate on bond incomeTC=corporate tax rate,Personal Taxes:The Miller Model,The derivation is straightforward:,Continued,Personal Taxes:The Miller Model(cont.),The first term is the cash flow of an unlevered firm after all taxes.Its value=VU.,A bond
21、 is worth B.It promises to pay rBB(1-TB)after taxes.Thus the value of the second term is:,The total cash flow to all stakeholders in the levered firm is:,The value of the sum of these two terms must be VL,Personal Taxes:The Miller Model(cont.),Thus the Miller Model shows that the value of a levered
22、firm can be expressed in terms of an unlevered firm as:,In the case where TB=TS,we return to M&M with only corporate tax:,Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes,Debt(B),Value of firm(V),VU,VL=VU+TCB when TS=TB,VL(1-TC)(1-TS),VL=VU when(1-TB)=(1-TC)(1-TS),VL
23、 VU when(1-TB)(1-TC)(1-TS),Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs,Debt(B),Value of firm(V),0,Present value of taxshield on debt,Present value offinancial distress costs,Value of firm underMM with corporatetaxes and debt,VL=VU+TCB,V=Actual valu
24、e of firm,VU=Value of firm with no debt,B*,Maximumfirm value,Optimal amount of debt,VL(1-TC)(1-TS),16.9 How Firms Establish Capital Structure,Most Corporations Have Low Debt-Asset Ratios.Changes in Financial Leverage Affect Firm Value.Stock price increases with increases in leverage and vice-versa;t
25、his 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.There is evidence that firms behave as if they had a target Debt to Equity ratio.,Factors in Target D/E Ratio,TaxesIf corporate
26、tax rates are higher than bondholder tax rates,there is an advantage to debt.Types of AssetsThe costs of financial distress depend on the types of assets the firm has.Uncertainty of Operating IncomeEven without debt,firms with uncertain operating income have high probability of experiencing financia
27、l distress.Pecking Order and Financial SlackTheory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.,16.10 Summary and Conclusions,Costs of financial distress cause firms to restrain their issuance of debt.Direct costsLawyers and accountants feesIndirect
28、 CostsImpaired ability to conduct businessIncentives to take on risky projectsIncentives to underinvestIncentive to milk the propertyThree techniques to reduce these costs are:Protective covenantsRepurchase of debt prior to bankruptcyConsolidation of debt,16.10 Summary and Conclusions,Because costs
29、of financial distress can be reduced but not eliminated,firms will not finance entirely with debt.,Debt(B),Value of firm(V),0,Present value of taxshield on debt,Present value offinancial distress costs,Value of firm underMM with corporatetaxes and debt,VL=VU+TCB,V=Actual value of firm,VU=Value of fi
30、rm with no debt,B*,Maximumfirm value,Optimal amount of debt,16.10 Summary and Conclusions,If distributions to equity holders are taxed at a lower effective personal tax rate than interest,the tax advantage to debt at the corporate level is partially offset.In fact,the corporate advantage to debt is
31、eliminated if(1-TC)(1-TS)=(1-TB),Debt(B),Value of firm(V),0,Present value of taxshield on debt,Present value offinancial distress costs,Value of firm underMM with corporatetaxes and debt,VL=VU+TCB,V=Actual value of firm,VU=Value of firm with no debt,B*,Maximumfirm value,Optimal amount of debt,VL(1-T
32、C)(1-TS),16.10 Summary and Conclusions,Debt-to-equity ratios vary across industries.Factors in Target D/E Ratio TaxesIf corporate tax rates are higher than bondholder tax rates,there is an advantage to debt.Types of AssetsThe costs of financial distress depend on the types of assets the firm has.Uncertainty of Operating IncomeEven without debt,firms with uncertain operating income have high probability of experiencing financial distress.,