Capital Structure: Limits to the

Use of Debt
Costs of Financial Distress
Bankruptcy risk versus bankruptcy cost
• The possibility of bankruptcy has a negative effect on the value
of the 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.
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
Selfish Strategy 1: Incentive to take large risks
Value of the firm if Low-Risk Project is chosen
Probability Value of the firm = stock + Bonds
Recession 0.5 100 = 0 + 100
Boom 0.5 200 = 100 + 100
Expected Value of the firm is= 0.5*100 + 0.5*200 = 150

Value of the firm if High-Risk Project is chosen

Probability Value of the firm = stock + Bonds
Recession 0.5 50 = 0 + 50
Boom 0.5 240 = 140 + 100
Expected Value of the firm is= 0.5*50 + 0.5*240 = 145

Given the firm’s present levered state, stock holders will select high risk project, even though it has low
NPV than low-risk project.
Selfish Strategy 2: Incentive toward underinvestment

Firm without project Firm with project costing INR1000

Boom Recession Boom Recession
Firm Cash Flows 5000 2400 6700 4100
Bondholder’s Claim 4000 2400 4000 4000
Shareholder’s Claim 1000 0 2700 100

The project cost is INR 1000, and it will generate INR 1700 in either state.
Expected value of the firm without project= 0.5* 1000 + 0.5* 0 = INR 500

Project generates INR 1700 cashflows on either side.

Expected value of the firm with project= 0.5* 2700 + 0.5* 100 = INR 1400

The Project has Positive NPV. However much of its value is captured by bondholders. Rational Managers,
acting in the interest of shareholder’s will reject the project because the shareholder’s interest raises only by
INR 900 by costing INR 1000.
Can Costs of Debt Be Reduced?
Protective Covenants
Debt Consolidation:
• If we minimize the number of parties, contracting costs fall.
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.
Tax Effects and Financial Distress
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.
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 tradeoff theory:
• There is no target D/E ratio.
• Profitable firms use less debt.
• Companies like financial slack.
Personal Taxes – I
• Individuals, in addition to the corporation, must pay taxes. Thus,
personal taxes must be considered in determining the optimal
capital structure.
Personal Taxes – II
Dividends face double taxation (firm and shareholder), which
suggests a stockholder receives the net amount:
• (1−TC) × (1−TS)
Interest payments are only taxed at the individual level since they
are tax deductible by the corporation, so the bondholder
receives:
• (1−TB)
Personal Taxes – III
If TS= TB, then the firm should be financed primarily by debt
(avoiding double tax).
The firm is indifferent between debt and equity when:
1  TC 1  TS  1  TB 
Integration of all effects on Capital
structure

C(B)= Costs of Bankruptcy/Financial distress costs

Example - Bankruptcy costs
• Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use this cash
either to retire all of its outstanding debt or to repurchase equity. The firm's debt is held by one
institution that is willing to sell it back to OPC for $2.5 million. The institution will not charge OPC any
transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does
not retire the debt, the company will use the $2.5 million in cash to buy back some of its stock on the
open market. Repurchasing stock also has no transaction costs. The company will generate
$1,300,000 of annual earnings before interest and taxes in perpetuity regardless of its capital
structure. The firm immediately pays out all earnings as dividends at the end of each year. OPC is
subject to a corporate tax rate of 35 percent, and the required rate of return on the firm's unlevered
equity is 20 percent. The personal tax rate on interest income is 25 percent and there are no taxes on
equity distributions. Assume there are no bankruptcy costs.
a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?
b. What is the value of OPC if it decides to repurchase stock instead of retiring its debt?
c. Assume that expected bankruptcy costs have a present value of $400,000. How does this influence
OPC's decision?
Solution
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.
Agency Costs
• Padmini an owner- entrepreneur running a computer services firm
worth INR 1 million. She want to expand, She needs INR 2 million
• She can raise through either equity or through debt of 2 million at
12%
Debt Issue Equity Issue

Cash flow to Cash flow to

Work padmini Work padmini
intensi Cash flow to (100% of intensi Interes Cash flow to (33.33% of
ty CFs Interest equity equity) ty CFs t equity equity)
6- 6-
hours 3,00,000 2,40,000 60,000 60,000 hours 3,00,000 0 3,00,000 1,00,000
10- 10-
hours 4,00,000 2,40,000 1,60,000 1,60,000 hours 4,00,000 0 4,00,000 1,33,333

With additional equity increases the leisure time, work related perquisites and unprofitable
investments , these are called as agency costs.
Free Cash flow hypothesis
• Managers can spend on wasteful activities if they have free cash flows
available.
• Empirical research show that firms with high free cash flow are more
likely to make bad acquisitions that firms with low free cash flows.
• Firms should try to reduce the FCF.
• Since dividends have no legal obligation whereas the principal and
interest payments does, free cash flow hypothesis suggests that a
shift from equity to debt will boost the firm value.
• The free cashflow hypothesis implies that debt reduces the
opportunity for managers to waste resources.