Capital Structure: Non-Tax Determinants Of Corporate

Leverage

Professor XXXXXCourse Name / Number

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Total firm value

100% equity 100% debt

In perfect markets, capital structure is irrelevant.

If markets are perfect except for corporate taxes, then the optimal capital structure is

100% debt.

Most firms do not use anything close

to 100% debt. Why?

Optimal Capital Structure

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Optimal Capital Structure

There are costs of debt that we’ve missed. At some point, those costs must outweigh debt’s tax

benefits:

– Personal taxes on debt, bankruptcy costs, agency costs, and asymmetric information

Total firm value

100% equity 100% debt

The optimal capital

structure, the one that

maximizes the value of the

firm, is in between the extremes.

Optimal capital structure

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Bankruptcy Cost

It is not the event of going bankrupt that matters, it is the costs of going bankrupt that matter.

If ownership of the firm’s assets was transferred costlessly to its creditors in the event of bankruptcy,

The optimal capital structure would still be 100% debt.

When the firm incurs costs in bankruptcy that it would otherwise avoid, bankruptcy costs become a deterrent to

using leverage.

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Example

Firm 1 Firm 2

Market value of assets $100,000,000 $100,000,000

Debt $0 $50,000,000

Equity $100,000,000 $50,000,000

An example…– Suppose Firm 1 and Firm 2 have the following capital

structure (assume no bankruptcy costs):

$50,000,000$0

$40,000,000$40,000,000

If there is a tax advantage to debt, that tax advantage is still decisive because the firm that uses more debt can shelter more income and incurs no additional costs than does the

firm that has no debt.

Recession hits and the value of both firms’ assets drops to $40 million.

Firm 2 goes bankrupt because there are not enough assets to cover the debt. Bondholders become stockholders and own the company.

$40,000,000$40,000,000

$0

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Example

Firm 1 Firm 2

Market value of assets $100,000,000 $100,000,000

Debt $0 $50,000,000

Equity $100,000,000 $50,000,000

– Assume if firm goes bankrupt, $10 million in assets are lost in the process of transferring ownership from stockholders to bondholders:

$30,000,000$40,000,000

$0$0

$30,000,000$40,000,000

Firm 2 will calculate the tax advantage of debt and weigh that against the cost of bankruptcy times the probability of

bankruptcy at each debt level.

When the recession hits, Firm 1 has $40 million in assets, but Firm 2 has $30 million in assets.

We are now looking not at bankruptcy costs per se, but at expected bankruptcy costs.

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Bankruptcy Costs

Direct Costs

Costs of bankruptcy-related litigation

Indirect Costs

Cost of management time diverted to bankruptcy process

Loss of customers who don’t want to deal with a distressed firm

Loss of employees who switch to healthier firms

Strained relationships with suppliers

Lost investment opportunities

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Indirect costs are likely to be much larger, and are likely to vary a great deal depending on the type of

firm in distress.

Indirect costs may be high:

When the firm’s product requires that the firm stay in business (e.g., when warranties or service are

important)

When the firm must make additional investments in product quality to maintain customers

For example, think of customers worrying that a bankrupt airline might try to save $ by cutting

spending on safety.

Bankruptcy Costs

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Direct costs of

bankruptcy

Legal, auditing and administrative costs (include court costs)

Large in absolute amount, but only 1-2% of large firm value

Financial distress also gives managers adverse incentives.

– Asset substitution problem: Incentive to take large risks– Under-investment problem: shareholders refuse to contribute funds

Costs Bankruptcy PV - ShieldsTax PV + V = V UL

Trade-off model of corporate capital structure:

Bankruptcy Costs

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U.S. Bankruptcy Practices And Costs

Bankruptcy governed by Federal law and filings are made in Federal bankruptcy courts

Chapter 7 (Liquidation)Chapter 11

(Reorganization)

Two types of bankruptcy filings in US for corporations:

In liquidation, a trustee is usually appointed to liquidate firm’s assets.

In reorganization, firm’s management continues to operate firm, can propose reorganization plan.

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Agency Costs And Capital Structure

Agency costs arise as soon as an entrepreneur sells a fraction of her firm to

outside investors.– Entrepreneur enjoys private benefits of control

(perquisites), but bears only (1- ) of the cost of “perks.”

• An example…– Assume the manager of a firm owns 10% of the firm’s

stock.– Outsiders (non-managers) own 90%.– The firm buys an expensive Van Gogh to hang in the

manager’s office.– The manager pays 10% of the cost of this painting but

enjoys 100% of the benefit!Separation between ownership and control of a firm gives rise

to agency costs of outside equity.

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Agency Costs Of Outside DebtDebt helps mitigate these costs, but debt has

its own agency costs:

Agency costs of outside

debt

Expropriate bondholders wealth by paying excessive dividends

Bait And Switch: Promise to use borrowed money for safe investment, then use to buy high/risk, high/return

asset

Bondholders protect themselves with positive and negative covenants in lending contracts.

Agency costs of debt are burdensome, but so are solutions.

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The Agency Cost / Tax Shield Trade-Off Model Of Corporate LeverageCompanies trade off tax and agency cost benefits of

debt against the costs of bankruptcy and agency costs of debt.

debt outside of costsagency equity outside of costsagency

costs bankruptcyshieldstax

PV - PV +

PV - PV + V = V UL

Firm V maximized at a unique optimal debt level:

Empirical research offers support for the model, but the model is far from perfect in its predictions.

Weaknesses lead to development of Pecking Order Theory.

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The Pecking Order Theory Of Corporate Capital Structure

Trade-off theory cannot explain three empirical capital structure facts:

Most profitable firms in an industry use least debt.

Stock market responds to leverage-increasing events strongly positive; negative reaction to

leverage-decreasing events.

Firms issue debt frequently, but rarely issue equity.

Myers (1984), Myers & Majluf (1984) propose pecking order theory of corporate leverage.

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The Pecking Order Theory Of Corporate Capital Structure

Assumptions

Manager acts in best interests of existing shareholders.

Information asymmetry between managers and investors.

Two key predictions about managerial behavior

Firms hold financial slack so they don’t have to issue securities.

Firms follow pecking order when issuing securities: sell low-risk debt first, equity only as last resort.

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Signaling And Other Asymmetric Information Models• Third group of models, based on asymmetric information

between managers and investors, predict managers will use a costly signal:– A simple statement of high firm value not credible– Must take action that is too costly for weak firm to mimic– Crude signal: burn $100 bills; only wealthy can afford

• If signaling can differentiate between strong and weak firms based on signal, a signaling equilibrium results.– Investors identify stronger firms, assign higher market

value • If signaling cannot differentiate between strong and weak

firms, a pooling equilibrium results.– Investors assign low average value to all firms.

• Models predict high value firms use high leverage as signal.– Makes sense, but empirics show the opposite—most

profitable & highest market/book firms use least leverage.

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A Checklist for Capital Structure Decision-Making

PositiveAsset tangibility

PositiveFirm size

PositiveRegulation (regulated industry?)

PositiveEffective (marginal) corp tax rate

NegativeNon-debt tax shields

NegativeEarnings volatility

NegativeMarket-to-book ratio

NegativeProfitability

Documented relationship between variable and leverageVariable

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A Checklist for Capital Structure Decision-Making

PositiveState ownership

NegativePersonal tax rate, debt income

PositivePersonal tax rate, equity income

PositiveCorporate income tax rate

NegativeCreditor power in bankruptcy

NegativeManagerial entrenchment

AmbiguousInsider share ownership

AmbiguousGrowth rate of firm’s assets

Documented relationship between variable and leverageVariable

Personal taxes on debt, bankruptcy costs, agency costs, and asymmetric information influence level of debt the firm chooses to

have.

Agency costs arise between corporate managers and outside investors and

creditors.

Trade-off theory, pecking order theory, signaling theory try to explain corporate

leverage levels.

Non-Tax Determinants Of Corporate Leverage