FM212 Lecture 6

Capital Structure III: How much should a firm borrow? (Part 2)

BMA Ch 18, 19

LSE

Jojo Paul Lecture 6: Capital Structure III 1/50

List of topics this term

1 Capital budgeting and the NPV rule

2 Real options
3 Payout policy
4 Does debt policy matter?
5 How much should a firm borrow?
6 The many different types of debt
7 Mergers, corporate governance, and control
8 Initial Public Offerings
9 Risk management and hedging

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Lecture 5 & 6 Roadmap: Capital Structure II & III
How much should a firm borrow?
1 Taxes and value

Corporation tax and the interest tax shield

After-tax WACC
Adjusted Present Value (APV)
Personal Taxes

2 Costs of Financial Distress and Trade-off Theory

Direct bankruptcy costs
Indirect bankruptcy costs
Risk shifting
Debt overhang

3 Asymmetric Information
Signaling
Pecking Order Theory

4 Other Agency Costs (next week)

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Indirect Bankruptcy costs
Indirect bankruptcy costs can be considerably larger than the
direct costs. Indirect costs include:

Deterioration of business environment in expectation of

bankruptcy:
Poorer prices for products (no guarantees)
Poorer prices from suppliers (no trade credit)
Problems hiring and retaining employees

Fire sale of assets

Poor investment decisions arising from conflicts of interest

between stakeholders of the firm
Asset substitution
Debt overhang
Can be facilitated by bankruptcy laws

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Lecture 5 & 6 Roadmap: Capital Structure II & III
How much should a firm borrow?
1 Taxes and value

Corporation tax and the interest tax shield

After-tax WACC
Adjusted Present Value (APV)
Personal Taxes

2 Costs of Financial Distress and Trade-off Theory

Direct bankruptcy costs
Indirect bankruptcy costs
Risk shifting
Debt overhang

3 Asymmetric Information
Signaling
Pecking Order Theory

4 Other Agency Costs

Jojo Paul Lecture 6: Capital Structure III 5/50
MM Assumptions

1 Investment is held constant

2 No transaction costs

3 No taxes

4 No bankruptcy costs

5 Efficient capital markets

6 Managers maximise shareholders’ wealth

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Conflicts of Interest
Agency costs: costs arising from conflicts of interest between
stakeholders in a firm

In firms with leverage, conflicts of interest can emerge

between shareholders and debtholders when projects have
different consequences for their respective payoffs.

Debtholders prefer safer projects:

They have priority in cash flow
They only care about the first X dollars

Equityholders prefer risky projects:

They are a residual claimant with limited liability.
Potentially unlimited upside

The costs created by this conflict can be especially acute when

a firm is already in or facing a high risk of financial distress
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Conflict between debt and equity investors: Example

A firm owes its bondholders $120 next year

This year’s earnings were less than expected, only $100
The firm’s only assets are this cash and three potential
investment projects
All three projects produce cash flows next year when the debt
is due
The discount rate for all projects is 30%

Jojo Paul Lecture 6: Capital Structure III 8/50

Conflict between debt and equity investors: Example

Project Cashflow & Probability

Invest Bad Good E[CF] NPV Rank

Project 1: -100 110 50% 160 50% 135 3.8

Project 2: -100 50 80% 240 20% 88 -32.3

Project 3: -100 120 80% 130 20% 122 -6.2

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Conflict between debt and equity investors: Example

Firm valuation:

Project Cashflow & Probability

Invest Bad Good E[CF] NPV Rank

Project 1: -100 110 50% 160 50% 135 3.8 1

Project 2: -100 50 80% 240 20% 88 -32.3 3

Project 3: -100 120 80% 130 20% 122 -6.2 2

Jojo Paul Lecture 6: Capital Structure III 10/50

Conflict between debt and equity investors: Example

Equityholder valuation:

Equityholder Cashflow & Probability

Invest Bad Good E[CF] Rank

Project 1: -100 0 50% 40 50% 20 2

Project 2: -100 0 80% 120 20% 24 1

Project 3: -100 0 80% 10 20% 2 3

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Conflict between debt and equity investors: Example

Debtholder valuation:

Debtholder Cashflow & Probability

Invest Bad Good E[CF] Rank

Project 1: -100 110 50% 120 50% 115 2

Project 2: -100 50 80% 120 20% 64 3

Project 3: -100 120 80% 120 20% 120 1

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Conflicts between debt and equity investors

Due to the conflict of interest, no one has the incentive to pick the
best project. In our example, if managers act in the interests of
shareholders, they will pick Project 2 (NPV = −32!).
The negative effects can be big
This is a real cost of financial distress

There are two well-known agency problems of debt:

Asset substitution/Overinvestment/Risk shifting: when
debt is in place, equity has the incentive to take excessive and
inefficient risks
Debt overhang/Underinvestment: when debt is in place,
equity has the incentive to refuse positive NPV projects

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Intuition

Why do equity investors prefer more risk?

Levered equity → call option on the firm’s assets
Exercise price: Face value of debt
An option is more valuable if volatility/risk of the underlying
(i.e. the assets) increases

Why are shareholders’ incentives to increase risk greater in

financial distress?
Limited liability/downside-risk
Win: shareholders reap most of the gains
Lose: debtholders suffer most of the losses

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Risk Shifting: Example

Assume your company has $50 (face value) of debt maturing

next year.
After poor performance, the market value of assets has
dropped to 30, with the following cash flows in 1 year.
Assume zero interest/no discount.

60 (D: 50, E: 10)

0.5

30

0.5

0 (D: 0, E: 0)

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Risk Shifting: Example cont.

The firm is in financial distress:

Market value of assets < face value of debt

Market Value Balance Sheet:

Assets 30 Debt 25
Equity 5
Total Assets 30 Total Liabilities 30

Why does equity have any value?

Recall levered equity is a call option on assets with strike price
at face value
Even though it’s out of the money now, the option still has
time value.

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Risk shifting: Example cont.
Suppose the assets can be alternatively used for another
project with the following cash flows:

100 (D: 50, E: 50)

0.25

25
0.75
0 (D: 0, E: 0)

Assets 25 Debt 12.5 (↓ by 12.5)

Equity 12.5 (↑ by 7.5)
Total Assets 25 (↓ by 5) Total Liabilities 25

Firm value falls but the value of equity increases!

Shareholders are essentially gambling with debtholders’ money
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Lecture 5 & 6 Roadmap: Capital Structure II & III
How much should a firm borrow?
1 Taxes and value

Corporation tax and the interest tax shield

After-tax WACC
Adjusted Present Value (APV)
Personal Taxes

2 Costs of Financial Distress and Trade-off Theory

Direct bankruptcy costs
Indirect bankruptcy costs
Risk shifting
Debt overhang

3 Asymmetric Information
Signaling
Pecking Order Theory

4 Other Agency Costs

Jojo Paul Lecture 6: Capital Structure III 18/50
Debt Overhang: Example

In the previous example, suppose you can spend 9 to hire a

better manager. This better manager can make the terminal
cash flow 60 for sure.
The incremental cash flows to the firm from hiring this new
manager are:
0
0.5

0.5
60

Therefore, the incremental NPV of the new manager is

−9 + 60 × 0.5 = 21 > 0. The firm should hire the manager.

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Debt Overhang: Example
Will they?
If the new hire goes ahead, debtholders receive their face value (50)
with certainty, so a good deal for them!
Will equityholders agree to fund the hire (assume from existing
assets)? The incremental cash flows to equityholders from the new
hire are:
0.5 0

0.5 10

NPV for equityholders is −9 + 0.5 × 10 = −4 < 0. Refuse!

Market value balance sheet if hire were to go ahead:

Assets 51 Debt 50 (↑ by 25)

Equity 1 (↓ by 4)
Total Assets 51 Total Liabilities 51

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Debt Overhang: Intuition

Positive NPV projects require inputs.

Equity pays the costs.

Improved cash flow largely goes to paying back debt.

Payoff to debt increases.

Gross terminal payoff to equity also increases, but net of the

costs, it can decrease.

Equity pays the costs, but benefit accrues to debt.

As a result, some +NPV projects are passed up.

Jojo Paul Lecture 6: Capital Structure III 21/50

Quick Question

In the previous example, who gains and who loses if the following
cases happen?

1 Company halts its operations, liquidates all of its assets into

$26 cash.

2 Company encounters an opportunity with NPV = 0, requiring

an investment of $10. The firm borrows (same seniority debt)
to finance the project.

3 The lenders agree to extend the maturity of their loan by two

years in order to give the firm a chance to recover.

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Answers to Quick Questions

1 Bondholder wins. The bondholder gets $26. Stock value is

zero.

2 Bondholder loses. The firm adds assets worth $10 and debt
worth $10. Increased debt ratio makes old bondholders more
exposed. Old bondholders loss is stockholders gain.

3 Bondholder loses because they are at risk for longer.

Stockholders win.

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Other Games

Cash In and Run:

When default is likely, sell assets and pay out the proceeds as
big dividends. The decline in market value is shared with
creditors.

Playing for Time:

Accounting manipulations to hide problems

Bait and Switch:

Issue bond, saying this is the most senior bond I issue.
Subsequently renege and issue more senior bond. (with higher
priority)

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CFD Summary

What are the costs of financial distress (CFD)?

Direct costs (lawyer’s fees, court fees) are small
Indirect costs can be large and can arise before bankruptcy

Indirect costs also vary across firms/industries and the type of

company’s assets:
e.g. Much lower if they are, for instance, real estate or tangible
assets. Higher if assets are intangible.
Industries in which firms can more easily increase risk (e.g.
growth firms) may face higher indirect costs from risk-shifting
behaviour

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So how much should firm borrow?

Trade-off Theory: The optimal leverage (amount of debt)

should balance the benefits and costs of debt.

How to quantify this trade-off? Use APV:

VL = VU + PV(tax shields) − PV(costs of financial distress)

where:
VL : levered value of project/firm
VU : all-equity value of project/firm
PV(tax shields): value of all tax savings from debt
PV(costs of financial distress): value of all direct and indirect
costs of financial distress

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Present value of CFD

Inputs required are estimates of:

Probability of bankruptcy (p):
Use bond rating and empirical estimates of default probability
for each rating
Costs of bankruptcy (CFD):
Empirical studies of direct (3% of book assets) and indirect
costs (only qualitative studies; difficult to measure)
Bond expected return (rD )

A model of default:
∞
X p (1 − p)t−1 CFD pCFD
PV(CFD) = t =
(1 + rD ) rD + p
t=1

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Trade-off Theory

1
1
Source: Berk and DeMarzo
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Trade-off Theory and Prices

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Trade-off Theory in Real Life

Most companies have target debt ratios, which is consistent

with trade-off theory

High-tech growth companies with risky assets normally use

relatively little debt

But why do some of the most profitable companies with large

income tax bills thrive with little debt?

Debt ratios have not increased since the time when corporate
income tax rates were low

Trade-off theory cannot explain these phenomena

Jojo Paul Lecture 6: Capital Structure III 30/50

Lecture5 & 6 Roadmap: Capital Structure II & III
How much should a firm borrow?
1 Taxes and value

Corporation tax and the interest tax shield

After-tax WACC
Adjusted Present Value (APV)
Personal Taxes

2 Costs of Financial Distress and Trade-off Theory

Direct bankruptcy costs
Indirect bankruptcy costs
Risk shifting
Debt overhang

3 Asymmetric Information
Signaling
Pecking Order Theory

4 Other Agency Costs

Jojo Paul Lecture 6: Capital Structure III 31/50
MM Assumptions

1 Investment is held constant

2 No transaction costs

3 No taxes

4 No bankruptcy costs

5 Efficient capital markets

6 Managers maximise shareholders’ wealth

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Signaling

Asymmetric information: one party to a transaction has

more/better information than the other.
Managers know more about their companies’ prospects, risks,
and values than do outside investors.

The actions of the better informed party can help the

uninformed party infer the informed party’s private
information → ‘signaling’

The actions of managers can act as signals, causing the

market (i.e. investors) to react.
Remember, stock prices tend to rise on the announcement of
an increase in the regular dividend as investors interpret this as
a credible sign of management’s confidence in future earnings

Capital structure decisions can be a signal too.

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Equity Issues Evidence

Asquith and Mullins (1986) performed an event study on the

announcement of both primary and secondary issues (i.e. sale) of
stock:

A primary offering is when a firm issues stock.

The number of shares, the total value of equity, and the total
value of the firm increases

A secondary offering is when one shareholder sells a large

block of stock to another shareholder.
The firm is not involved in this transaction, so no change in
the number of shares.

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Empirical evidence: Results

All Issues Primary Secondary

Day before announcement -1.8% -2.3% -1.0%
Announcement Day -0.9% -0.7% -1.0%
Two day return -2.7% -3.0% -2.0%
T-statistic 14.8 12.5 9.1
N observations 266 128 85

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Empirical Evidence: Conclusions

Problem: Is the −3% primary issue price fall due to the

revelation of negative information or other effects related to
changes in capital structure?

Solution: Look at secondary issues, which do NOT impact the

capital structure.
The −2% drop is price is most likely due to the negative
information conveyed by the transaction

Conclusion: At most 1% of the primary issue price change is

attributable to capital structure changes. The rest must be
due to signaling.
Signaling: large sell order tells the market that the seller has
some negative private information about the company.

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Signaling Implications: Theory

Outline: Myers and Majluf (1984)

Benchmark case: Managerial decisions under symmetric

information

Asymmetric case: Managers have relevant information before

other investors and prior to making investment and financing
decisions.

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Myers and Majluf (1984) Example: Setup

A firm with some assets in place is considering a positive

NPV project. This project will require an investment of 100
cash.

Assumptions:
The firm does not have this cash and can only issue equity.
No taxes, transactions costs or other market imperfections.
Managers maximise the wealth of the old (current)
shareholders
Old shareholders do not purchase the new stock issue

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Example: Deterministic Benchmark Case
Benchmark Case (deterministic, symmetric):
As a warm-up, assume no uncertainty and everyone is equally informed.
The firm’s assets in place are worth 150 and the project has NPV = 20.
How much equity, as fraction of the new company, does the firm need to
sell?
Firm value after issue:

Vfirm = 150 (Existing assets) +100 (New equity) +20 (NPV) = 270

Need to raise 100, so sell (100/270) ≈ 37% of new firm’s equity

Ownership after issuance: New shareholders = 37%; Old = 63%.

Payoffs:
New: 37% × 270 = 100 (they break even, i.e. fair value)
Old: 63% × 270 = 170 = 150 + 20 (old shareholders capture the
NPV of the project)
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Example: Uncertain Benchmark Case

Benchmark Case (uncertain, symmetric):

Now assume that asset values and NPV are uncertain (i.e.
random) but everyone is still equally informed (or uninformed).
There are two possibilities, both equally likely:

State 1 (Good) State 2 (Bad) E(Value)

Assets in place 150 50 100
20 10 15
Investment opportunity (NPV)
(= 120 − 100) (= 110 − 100) (115 − 100)
Value of Firm Post-Issue 270 160 215

Since the expected NPV is positive the investment should be taken

in both states
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Example: Uncertain Benchmark Case
How much equity should be issued?

Since no one knows the true state, valuation is based on

expected values.

Expected value of the firm after issuance is 215

To raise 100, sell (100/215) ≈ 46.5% of new firm’s equity.

Old shareholders retain 53.5%

Payoffs:
New: 46.5% × 215 = 100 (fair value)
Old: 53.5% × 215 = 115 = 100 + 15 (i.e. old shareholders
capture the expected value of the existing assets and NPV)

Even with uncertainty, +NPV projects are implemented and

financial markets are efficient (securities purchases are
zero-NPV)
Jojo Paul Lecture 6: Capital Structure III 41/50
Example: Asymmetric Information Case

Asymmetric Case (uncertain, asymmetric):

Now introduce asymmetric information:

Managers know the true state before the investing and
financing decision is taken.
Outside investors don’t know the state, but know that
managers know

Remember: managers act optimally to maximise the wealth of old

shareholders (outside investors know this too)

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Example: Asymmetric Information Case

Suppose managers issue stock and undertake the project regardless

of the true state:
New investors can’t learn anything from this strategy, so price
by expectation (same as previous case)
Expected firm value: 215
Ownership structure: New: 46.5%. Old: 53.5%

What is the payoff to old shareholders under this strategy?

State 1 (Good): 53.5% × 270 ≈ 144
State 2 (Bad): 53.5% × 160 ≈ 86

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Example: Asymmetric Case
Compare these payoffs to the alternative where managers do
nothing (i.e. don’t raise equity to invest in the project):

State 1 (Good) State 2 (Bad)

Issue equity 144 86
Do nothing 150 50

Managers acting optimally will not issue and invest in State

1! Old shareholders wealth is maximised by issuing stock and
investing only in State 2.
So, if the firm announces a share issue, outside investors learn
that it must be State 2!
Outside investors will revise their post-issue valuation of the
company down to 160 (State 2 value) and demand a
(100/160) = 62.5% stake in the company’s equity.

Jojo Paul Lecture 6: Capital Structure III 44/50

Example: Asymmetric Case
We still need to check if managers have the incentive to issue stock
once investors figure out it’s State 2:
Old shareholders: 37.5% × 160 = 60 > 50 (do nothing). Yes!

Also need to check that managers would not issue in State 1 under
these terms:
Old shareholders: 37.5% × 270 = 101.25 < 150 Don’t issue!

Equilibrium outcome:
If State 1: no issuance
Old shareholders worth 150
If State 2: sell 62.5% of company priced at 160.
Old shareholders worth 60
Expected wealth of old shareholders: (150 + 60)/2 = 105 < 115
(symmetric case with uncertainty)
Loss = 10 = 20 × 0.5, i.e. the NPV = 20 project in State 1
that is foregone (50% prob.)
Jojo Paul Lecture 6: Capital Structure III 45/50
Example: Conclusions

Under symmetric information, regardless of risk:

All +ve NPV projects can be implemented
When uncertainty is realised, old shareholders may win or lose,
but there is no efficiency loss. They get the full NPV in
expectation.

Under asymmetric information:

Investors can’t tell the quality of the firm
Pooling together with bad firms gives a low price for good
firms.
This creates an adverse selection problem: when quality is
unobserved, only poor quality goods are sold. In this example,
only bad firms issue equity.
Efficiency loss: good firms with +ve NPV projects can’t be
financed

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Potential solutions: Retained Earnings or Debt

Cash on hand: Retained earnings are cheaper than external

financing because then the firm isn’t forced to forego positive
NPV projects.

Risk-free debt: Suppose the company borrowed 100 risk-free

to fund the project (zero discount rate)
Borrow 100, pay back 100
State 1: Shareholder payoff: 270 − 100 = 170 > 150
State 2: Shareholder payoff: 160 − 100 = 60 > 50
In both states, the firm has the incentive to borrow and invest
in the project.
Intuition: the value of debt is less sensitive to private
information than equity.

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Lecture5 & 6 Roadmap: Capital Structure II & III
How much should a firm borrow?
1 Taxes and value

Corporation tax and the interest tax shield

After-tax WACC
Adjusted Present Value (APV)
Personal Taxes

2 Costs of Financial Distress and Trade-off Theory

Direct bankruptcy costs
Indirect bankruptcy costs
Risk shifting
Debt overhang

3 Asymmetric Information
Signaling
Pecking Order Theory

4 Other Agency Costs

Jojo Paul Lecture 6: Capital Structure III 48/50
Pecking Order Theory

Pecking order theory: When financing projects, firms prefer

to use the least information-sensitive securities first.

Logic: if the value of a security depends a lot on your private

information, it suffers from adverse selection problems. The
issue of securities is a signal that those securities are
overpriced.

Pecking order:
1 Least sensitive: Retained earnings (cash), risk-free debt
2 Median: Risky debt
3 Most sensitive: Equity

Jojo Paul Lecture 6: Capital Structure III 49/50

Pecking Order Theory
Aggregate Sources of Funding for CAPEX, US Corporations:

2
Source: Federal Reserve Flow of Funds (in Berk & DeMarzo)
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