Estratégia Financeira

Part 9 - Ch 16 Financial Distress, Managerial Incentives, and Information

Henrique C. Martins

14-05-2024

Chapter Outline

16.1 Default and Bankruptcy in a Perfect Market

16.2 The Costs of Bankruptcy and Financial Distress

16.3 Financial Distress Costs and Firm Value

16.4 Optimal Capital Structure: The Tradeoff Theory

16.5 Exploiting Debt Holders: The Agency Costs of Leverage

16.6 Motivating Managers: The Agency Benefits of Leverage

16.7 Agency Costs and the Tradeoff Theory

16.8 Asymmetric Information and Capital Structure

16.9 Capital Structure: The Bottom Line

16.1 Default and Bankruptcy in Perf. Mkt

An important consequence of leverage is the risk of bankruptcy.

Equity financing does not carry this risk.
Although equity holders hope to receive dividends, the firm is not legally obligated to pay them.

Financial Distress

When a firm has difficulty meeting its debt obligations: payment delay or default.

Default

When a firm fails to make the required interest or principal payments on its debt or violates a debt covenant (see next slide).
After the firm defaults, debt holders are given certain rights to the assets of the firm and may even take legal ownership of the firm’s assets through bankruptcy.

16.1 Default and Bankruptcy in Perf. Mkt

Debt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor).
In other words, debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders.
They are also called banking covenants or financial covenants.

When a debt covenant is violated, depending on the severity, the lender can do several things:

Demand penalty payment.
Increase the predetermined interest rate.
Increase the amount of collateral.
Demand full immediate repayment of the loan.
Terminate the debt agreement.

16.1 Default and Bankruptcy in Perf. Mkt

Positive debt covenants are covenants that state what the borrower must do.

Achieve a certain threshold in certain financial ratios.
Ensure facilities and factories are in good working condition.
Perform regular maintenance of capital assets.
Provide yearly audited financial statements.
Ensure accounting practices are in accordance with GAAP (Generally Accepted Accounting Principles).

16.1 Default and Bankruptcy in Perf. Mkt

Negative debt covenants are covenants that state what the borrower cannot do.

Pay cash dividends over a certain amount or predetermined threshold.
Sell certain assets.
Borrow more debt.
Issue debt more senior than the current debt.
Enter into certain types of agreements or leases.

16.1 Default and Bankruptcy in Perf. Mkt

Example

Let’s discuss an example of default.

Armin is considering a new project.

Although the new product represents a significant advance over Armin’s competitors’ products, the product’s success is uncertain.
If it is a hit, revenues and profits will grow, and Armin will be worth 150 million at the end of the year.
If it fails, Armin will be worth only 80 million.

Armin may employ one of two alternative capital structures:

It can use all-equity financing.
It can use debt that matures at the end of the year with a total of 100 million due.

16.1 Default and Bankruptcy in Perf. Mkt

	Without Lev.	Without Lev.	With Lev.	With Lev.
	Success	Failure	Success	Failure
Debt Value	-	-	100	80
Equity value	150	80	50	0
All investors	150	80	150	80

Both debt and equity holders are worse off if the product fails rather than succeeds.

Without leverage, if the product fails equity holders lose $70 million (150 million − 80 million)
With leverage, equity holders lose 50 million, and debt holders lose 20 million, but the total loss is the same, 70 million.

The firm is in default if the project fails with leverage.

16.1 Default and Bankruptcy in Perf. Mkt

Note, the decline in value is not caused by bankruptcy:

The decline is the same whether or not the firm has leverage.

If the new product fails, Armin will experience economic distress, which is a significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

16.1 Default and Bankruptcy in Perf. Mkt

The takeaway of first subsection is:

With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all investors does not depend on the firm’s capital structure.

There is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.

16.1 Default and Bankruptcy in Perf. Mkt

Problem

Consider the following outcomes for the following scenarios both with and without leverage for Moon Industries’ new venture:

	Without Lev.	Without Lev.	With Lev.	With Lev.
	Success	Failure	Success	Failure
Debt Value	-	-	150	90
Equity value	250	90	100	0
All investors	250	90	250	90

Moon’s new venture is equally likely to succeed or to fail.
The risk-free rate is 4%.
The venture has a beta of 0, and the cost of capital is equal to the risk-free rate.
Compute the value of Moon’s securities at the beginning of the year with and without leverage.

16.1 Default and Bankruptcy in Perf. Mkt

Problem

\[V^U = \frac{0.5 \times 250 + 0.5 \times 90}{1.04} = 163.46 million\]

\[V^L = \frac{0.5 \times 100 + 0.5 \times 0}{1.04} = 48.08 million\]

\[Debt = \frac{0.5 \times 150 + 0.5 \times 90}{1.04} = 115.38 million\] \[V^L + Debt = 48.08 million + 115.38 million = 163.46 million\]

16.2 Bankruptcy Costs & Fin. Distress

With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt; rather, bankruptcy shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors (this is basically the previous section).

In reality, the bankruptcy process is complex, time-consuming, and costly.

Costly outside experts are often hired by the firm to assist with the bankruptcy.
Creditors also incur similar costs during the bankruptcy process.
- They may wait several years to receive payment.
- They may hire their own experts for legal and professional advice.

The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive.

The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.

16.2 Bankruptcy Costs & Fin. Distress

Although the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy.

Loss of Customers
Loss of Suppliers
Loss of Employees
Loss of Receivables
Fire Sale of Assets
Delayed Liquidation
Costs to Creditors

It is estimated that the potential loss due to financial distress is 10% to 20% of firm value.

16.3 Fin. Distress Costs and Value

Remember previous example

With all-equity financing, Armin’s assets will be worth 150 million if its new product succeeds and 80 million if the new product fails.
This example assumes there are no financial distress costs.

Remember previous example

Assuming financial distress costs of 20 million.

With debt of $100 million, Armin will be forced into bankruptcy if the new product fails.
In this case, some of the value of Armin’s assets will be lost to bankruptcy and financial distress costs. As a result, debt holders will receive less than 80 million.
Let’s say debt holders receive only 60 million after accounting for the costs of financial distress.

16.3 Fin. Distress Costs and Value

That is, the total value to all investors is now less with leverage than it is without leverage when the new product fails.

The difference of $20 million is due to financial distress costs.
These costs will lower the total value of the firm with leverage, and MM’s Proposition I will no longer hold.

	Without Lev.	Without Lev.	With Lev.	With Lev.
	Success	Failure	Success	Failure
Debt Value	-	-	100	60
Equity value	150	80	50	0
All investors	150	80	150	60

16.3 Fin. Distress Costs and Value

Problem

Extending the previous example, assume now that the costs of financial distress are $15 million:

	Without Lev.	Without Lev.	With Lev.	With Lev.
	Success	Failure	Success	Failure
Debt Value	-	-	150	75
Equity value	250	90	100	0
All investors	250	90	250	75

Compute the value of Moon’s securities at the beginning of the year with and without leverage, given that financial distress is costly.

16.3 Fin. Distress Costs and Value

Problem

\[V^U = \frac{0.5 \times 250 + 0.5 \times 90}{1.04} = 163.46 million\]

\[V^L = \frac{0.5 \times 100 + 0.5 \times 0}{1.04} = 48.08 million\]

\[Debt = \frac{0.5 \times 150 + 0.5 \times 75}{1.04} = 108.17 million\]

\[V^L + Debt = 48.08 million + 108.17 million = 156.25 million\]

The difference, ($163.46 − 156.25 = 7.21$), is the present value of the 15 million in financial distress costs

\[PV(FDC) = \frac{0.5\times 0 + 0.5 \times 15}{1.04} = 7.21\]

16.3 Fin. Distress Costs and Value

Who Pays for Financial Distress Costs?

For Armin, if the new product fails, equity holders lose their investment in the firm and will not care about bankruptcy costs.
However, debt holders recognize that if the new product fails and the firm defaults, they will not be able to get the full value of the assets.
As a result, they will pay less for the debt initially (the present value of the bankruptcy costs less).
If the debt holders initially pay less for the debt, less money is available for the firm to pay dividends, repurchase shares, and make investments.
This difference comes out of the equity holders’ pockets.

When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress.

16.4 The Tradeoff Theory

Tradeoff Theory

The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.

According to the Tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs:

\[V^L = V^U + PV(Interest\;tax\;shield) - PV(Financial\;distress\;costs)\]

16.4 The Tradeoff Theory

Three key factors determine the present value of financial distress costs:

1) The probability of financial distress

The probability of financial distress increases with the amount of a firm’s liabilities (relative to its assets).
The probability of financial distress increases with the volatility of a firm’s cash flows and asset values.

2) The magnitude of the costs after a firm is in distress

Financial distress costs will vary by industry.

3) The appropriate discount rate for the distress costs

Depends on the firm’s market risk
The present value of distress costs will be higher for high beta firms.

16.4 The Tradeoff Theory

It is easy to see that each firm will have an optimal leverage level

For low levels of debt, the risk of default remains low, and the main effect of an increase in leverage is an increase in the interest tax shield.
As the level of debt increases, the probability of default increases. Then, the costs of financial distress increase, reducing the value of the levered firm.

The Tradeoff theory states that firms should increase their leverage until it reaches the level for which the firm value is maximized. At this point, the tax savings that result from increasing leverage are perfectly offset by the increased probability of incurring the costs of financial distress.

16.4 The Tradeoff Theory

Problem

Holland, Inc. is considering adding leverage to its capital structure. Holland’s managers believe they can add as much as 50 million in debt and exploit the benefits of the tax shield. They estimate $T_c = 39\%$. However, they also recognize that higher debt increases the risk of financial distress. Based on simulations of the firm’s future cash flows, the CFO has made the following estimates (in millions of dollars):

Debt	10	20	30	40	50
PV(Int. Tax. Shield)	3.9	7.8	11.7	15.6	19.5
PV(Fin. Dis. Costs)	0	0	3.38	19.23	23.47
Net Benefit	3.9	7.8	8.32	-3.63	-3.97

The level of debt that leads to the highest net benefit is 30 million. Holland will gain 11.7 million due to tax shields and lose 3.38 million due to the present value of financial distress costs, for a net gain of 8.32 million.

16.5 The Agency Costs of Leverage

Agency Costs

Costs that arise when there are conflicts of interest between the firm’s stakeholders
Management will generally make decisions that increase the value of the firm’s equity.
However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.

Risk-taking & Asset substitution
Debt overhang & Under-investment
Cashing out
Leverage Ratchet effect

16.5 The Agency Costs of Leverage

Consider Baxter, Inc., which is facing financial distress

Baxter has a loan of 1 million due at the end of the year.
Without a change in its strategy, the market value of its assets will be only 900,000 at that time, and Baxter will default on its debt.

Baxter is considering a new strategy

The new strategy requires no upfront investment, but it has only a 50% chance of success.
If the new strategy succeeds, it will increase the value of the firm’s asset to $1.3 million.
If the new strategy fails, the value of the firm’s assets will fall to $300,000.

Should Baxter execute this strategy?

16.5 The Agency Costs of Leverage

Certainly not!

The expected value of the firm’s assets under the new strategy is 800,000, a decline of 100,000 from the old strategy

\[50\% \times 1.3 million + 50\% \times 0,3 million = 0,8 million\]

However, despite the negative expected payoff, some within the firm have suggested that Baxter should go ahead with the new strategy

Can shareholders benefit from this decision? What would be the rationale?

16.5 The Agency Costs of Leverage

If Baxter does nothing, it will ultimately default and equity holders will get nothing with certainty.

Equity holders have nothing to lose if Baxter tries the risky strategy.
If the strategy succeeds, equity holders will receive $300,000 after paying off the debt.
Given a 50% chance of success, the equity holders’ expected payoff is 150,000.

\[50\% \times 0 + 50\% \times 300.000 = 150.000\]

16.5 The Agency Costs of Leverage

	Old Strat.	New Success	New failure	New Expected
Value of assets	900	1300	300	800
Debt	900	1000	300	650
Equity	0	300	0	150

If project succeeds, debt holders receive 1 mil. If fails, debt holders receive 300,000.
The debt holders’ expected payoff is 650,000, a loss of 250,000 compared to the old strategy.
- $50\% \times 1 million + 50\% \times 300,000 = 650,000$
The debt holders 250,000 loss corresponds to the 100,000 expected decline in firm value due to the risky strategy and the equity holder’s 150,000 gain.
Effectively, the equity holders are gambling with the debt holders’ money.

16.5 The Agency Costs of Leverage

Asset Substitution Problem

When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a negative-NPV project, if it is sufficiently risky.
- Also called risk-shifting problem
Shareholders have an incentive to invest in negative-NPV projects that are risky, even though a negative-NPV project destroys value for the firm overall.
Anticipating this bad behavior, security holders will pay less for the firm initially.

16.5 The Agency Costs of Leverage

Debt Overhang and Under-Investment

Now assume Baxter does not pursue the risky strategy, but instead the firm is considering an investment opportunity that requires an initial investment of $100,000 and will generate a risk-free return of 50%.

If the current risk-free rate is 5%, this investment clearly has a positive NPV.

What if Baxter does not have the cash on hand to make the investment?
Could Baxter raise $100,000 in new equity to make the investment?

16.5 The Agency Costs of Leverage

Debt Overhang and Under-Investment

	Without project	With new project
Existing assets	900	900
New project		150
Total firm value	900	1050
Debt	900	1000
Equity	0	50

If equity holders contribute 100,000 to fund the project, they get back only 50,000.
The other 100,000 from the project goes to the debt holders, whose payoff increases from 900,000 to 1 million.
Debt holders receive most of the benefit, thus this project is a negative-NPV investment opportunity for equity holders, even though it offers a positive NPV for the firm.

16.5 The Agency Costs of Leverage

Debt Overhang and Under-Investment

A situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.

When a firm faces financial distress, it may choose not to finance new, positive-NPV projects.

This is also called a debt overhang problem.

16.5 The Agency Costs of Leverage

Cashing Out

When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm, if possible.

For example, if it is likely the company will default, the firm may sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders.

Covenants may prevent this type of strategy.

16.5 The Agency Costs of Leverage

These are examples of Agency costs of Leverage

Leverage can encourage managers and shareholders to act in ways that reduce value.

It appears that the equity holders benefit at the expense of the debt holders.
However, ultimately, it is the shareholders of the firm who bear these agency costs.

16.6 The Agency Benefits of Leverage

Management Entrenchment

A situation arising as the result of the separation of ownership and control in which managers may make decisions that benefit themselves at investors’ expenses.

Entrenchment may allow managers to run the firm in their own best interests, rather than in the best interests of the shareholders. For instance, spending on perks.

Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress.

In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight.

16.6 The Agency Benefits of Leverage

Concentration of Ownership

One advantage of using leverage is that it allows the original owners of the firm to maintain their equity stake.
They will likely have a strong interest in doing what is best for the firm.

Assume Ross is the owner of a firm and he plans to expand. He can either borrow the funds needed for expansion or raise the money by selling shares in the firm.
If he issues equity, he will need to sell 40% of the firm to raise the necessary funds.
Suppose the value of the firm depends largely on Ross’s personal effort.
By financing the expansion with borrowed funds, Ross retains 100% ownership in the firm. Therefore, Ross is likely to work harder, and the firm will be worth more because he will receive 100% of the increase in firm value.

16.6 The Agency Benefits of Leverage

Concentration of Ownership

However, if Ross sells new shares, he will only retain 60% ownership and only receive 60% of the increase in firm value.
With leverage, Ross retains 100% ownership and will bear the full cost of any “perks,” like country club memberships or private jets.
By selling equity, Ross bears only 60% of the perks cost; the other 40% will be paid for by the new equity holders.

16.6 The Agency Benefits of Leverage

Reduction of Wasteful Investment

Another concern for large corporations is that managers may make large, unprofitable investments.
Managers may engage in empire building.
Managers often prefer to run larger firms rather than smaller ones, so they will take on investments that increase the size, but not necessarily the profitability, of the firm.
Thus, managers may expand unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.

16.6 The Agency Benefits of Leverage

Managerial Overconfidence

Managers may over-invest because they are overconfident.
Managers tend to be bullish on the firm’s prospects and may believe that new opportunities are better than they actually are.
Debt forces managers to be more realistic with the true prospects of the firm because they have the commitment to pay back debtholders.

16.6 The Agency Benefits of Leverage

Free Cash Flow Hypothesis

The view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders.
When cash is tight, managers will be motivated to run the firm as efficiently as possible.
Leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

16.6 The Agency Benefits of Leverage

The takeaway of this section is:

Leverage also has benefits that might increase firm value.

The net effect is an empirical matter and is not trivial to find.

Firms would pursue an optimal debt level.

16.7 Agency Costs and the TT

We can now write that:

\[V^L = V^U + PV(Interest\;tax\;shield) - PV(Financial\;distress\;costs)\] \[- PV(Agency\;costs\;of\;debt) + PV(Agency\;benefits\;of\;debt)\]

16.7 Agency Costs and the TT

The Optimal Debt Level

Again, the optimal level is not the same to all firms.

R&D-Intensive Firms

Firms with high R&D costs and future growth opportunities typically maintain low debt levels.
These firms tend to have low current free cash flows and risky business strategies.

Low-Growth, Mature Firms

Mature, low-growth firms with stable cash flows and tangible assets often carry a high-debt load.
These firms tend to have high free cash flows with few good investment opportunities.

16.8 Asymmetric Info. and Cap. Struc.

Asymmetric Information

A situation in which parties have different information. For example, when managers have superior information to investors regarding the firm’s future cash flows.

Signaling Theory of Debt

The use of leverage as a way to signal information to investors.
Thus a firm can use leverage as a way to convince investors that it does have information that the firm will grow, even if it cannot provide verifiable details about the sources of growth.

16.8 Asymmetric Info. and Cap. Struc.

Adverse Selection : The idea that when the buyers and sellers have different information, the average quality of assets in the market will differ from the average quality overall.

Lemons Principle

When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection.
An example of adverse selection and the lemons principle is the used car market.
If the seller has private information about the quality of the car, then her desire to sell reveals the car is probably of low quality.
Buyers are therefore reluctant to buy except at heavily discounted prices.
Owners of high-quality cars are reluctant to sell because they know buyers will think they are selling a lemon and offer only a low price.
Consequently, the quality and prices of cars sold in the market are both low.

16.8 Asymmetric Info. and Cap. Struc.

This same principle can be applied to the market for equity.

Firms that sell new equity have private information about the quality of the future projects.
However, due to the lemons principle, buyers are reluctant to believe management’s assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.

In other words,

If the firm is issuing equity at market prices, it must be that managers think the stock is expensive.

If the firm is buying back shares at market prices, it must be that managers think the stock is cheap.

16.8 Asymmetric Info. and Cap. Struc.

Problem

You are an analyst who follows Great Windows’ stock. Although the current stock price is 37.50, you believe the stock is worth either 25 or 50, depending on the success of a new product launch.

If Great Windows’ CEO announces that she plans to buy 10,000 additional shares in the company, how will the share price change?

Solution

If the CEO knows the new product launch is a failure, she would sell the stock at 37.50 given that the she knows true value is 25.

If the CEO announces that she is buying 10,000 additional shares, she must know that the new product launch is a success and the true value is 50 per share. Thus, the stock price should rise to 50.

16.8 Asymmetric Info. and Cap. Struc.

The Pecking Order of Financing Choices

Firms prefer to finance investments with internally-generated funds.
If external finance is required, firms issue the safest security first.
They start with debt, then possibly hybrid securities, such as convertible bonds, then equity as a last resort.

16.8 Asymmetric Info. and Cap. Struc.

Problem

Nesbat Industries needs to raise 25 million for a new investment project. If the firm issues one year debt, it may have to pay an interest rate of 10%, although Nesbat’s managers believe that 8% would be a fair rate given the level of risk.
However, if the firm issues equity, they believe the equity may be underpriced by 7.5%.
What is the cost to current shareholders of financing the project out of retained earnings, debt, and equity?

16.8 Asymmetric Info. and Cap. Struc.

Solution

If the firm spends 25 million out of retained earnings, rather than paying that money out to shareholders as a dividend, the cost to shareholders is 25 million.

Using debt costs the firm $25 \times 1.10 = 27.5$ million in one year, which has a present value based on management’s view of the firm’s risk of $\frac{27.5}{1.08} = 25.46$

Finally, if equity is underpriced by 7.5%, then to raise 25 million, the firm will need to issue $\frac{25}{1-0.075} = 27.03$ million of new equity. Thus, the cost to existing shareholders will be 27.03 million.

16.9 The Bottom Line

With perfect capital markets, a firm’s security choice alters the risk of the firm’s equity, but it does not change its value or the amount it can raise from outside investors
The optimal capital structure depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information.
- the most clear-cut, and possibly the most significant, is taxes
Financial distress may lead to other consequences that reduce the value of the firm
Agency costs and benefits of leverage are also important determinants of capital structure.
A firm must also consider the potential signaling and adverse selection consequences of its financing choice
Actively changing a firm’s capital structure entails transactions costs.

Now it is your turn…

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Henrique C. Martins