BUS 650 Week 5 Discussions

Chapter 9

Capital Structure: Right-Hand-Side Decisions and the Value of the Firm

Exactostock/SuperStock

Learning Objectives

A�er studying this chapter, you should be able to:

Describe the characteris�cs of perfect capital markets and how they relate to capital structure. Iden�fy the characteris�cs that make capital markets imperfect, and explain how they relate to capital structure. Explain how the trade-off theory components are used to determine target capital structure. Iden�fy other factors that affect a firm's debt capacity.

Ch. 9 Introduction

Managers choose products and services that create value for shareholders. Chapters 6, 7, and 8 discussed how these investment decisions, reflected on the le�-hand side of the financial balance sheet, affect shareholders' wealth. Recall that inves�ng in posi�ve NPV projects adds to the wealth of shareholders, whereas inves�ng in nega�ve NPV projects detracts from it. In this chapter, we examine how managers choose the mix of financing required to support these investment decisions. We call this the capital structure decision. As we turn our a�en�on to the right-hand side of the balance sheet, we assume that capital budge�ng decisions have been made. Our concern is with choosing the mix of debt and equity used to fund the firm's assets, and whether this capital structure choice will affect shareholders' wealth.

You might think that there is a standard propor�on of debt that most firms use—a financial rule-of-thumb—but the debt-equity mix varies enormously across companies. Some, such as young high-tech or biotech firms use li�le or no debt, whereas public u�li�es use high levels of debt. Even private equity firms, such as Bain, KKR, the Blackstone Group and Warburg Pincus, o�en finance their purchases of companies with 60% or even 80% debt.

Why do debt ra�os vary so much from company to company? It all comes back to the financial goal of the corpora�on: Management chooses a specific capital structure in the belief that its choice will maximize the firm's worth, and ul�mately shareholder wealth. How each of these decisions can be op�mal yet so different is explained in this chapter as we explore the link between capital structure and firm value.

This figure illustrates where leakages may impact the financial balance sheet.

Just as fric�on hinders our ability to push a cart of boxes, so too does fric�on impede the movement of funds in a capital market.

9.1 Perfect Capital Markets and Capital Structure

Our discussion of the debt-equity mix begins with the assump�on that capital markets are perfect. Perfect capital markets are an ideal and do not reflect the real world, but they are very useful for developing an understanding of capital structure's impact on share value and also in understanding dividend policy, which will be covered in Chapter 10. Under the very strict (and unrealis�c) assump�ons of perfect markets, we will see that capital structure has no impact on value. That is, right-hand-side decisions are irrelevant to shareholders under perfect market condi�ons, so any mix of debt and equity results in the same overall value of the firm. Also, in perfect capital markets, the cost of borrowing is assumed to be the same for both investors and companies (which is not the case in actual capital markets). It may seem like a poor use of �me to study something that is irrelevant to firm value, but this model gives us insights about why capital structure may ma�er in the real world. As we relax the assump�ons of perfect capital markets, we will begin to iden�fy the factors that help determine a company's op�mal capital structure.

Perfect capital markets may be characterized as

being strong-form efficient, having no informa�on asymmetry, having no leakages such as taxes or transac�on costs.

Strong-form efficiency defines a market in which security prices reflect all per�nent informa�on. Prices in such markets are unbiased es�mates of value, fully reflec�ng the cash flows and risk expected to accrue to security holders. In strong-form efficient markets, securi�es offering the same cash flows with equal risk will be equally priced.

As strong-form efficiency suggests, the informa�on reflected in prices includes both insider and outsider informa�on. This is a natural outcome of the second characteris�c of perfect markets, their lack of informa�on asymmetry. Because everyone has the same informa�on, no dis�nc�on between insiders and outsiders is necessary in perfect capital markets. Furthermore, there is no agency problem in these markets. If, for example, managers were underperforming or gran�ng themselves excessive perquisites, their employers, the shareholders, would observe these ac�ons. Shareholders, in turn, would correct such inappropriate behavior—possibly firing the managers. In this perfect market, managers would foresee this shareholder response and would not act inappropriately in the first place.

The third characteris�c of perfect capital markets is that no leakages occur as cash flows move between the firm and capital suppliers. Examples of leakages include taxes (where a por�on of the cash that otherwise would flow to security holders is paid to the government) and transac�on costs (cash paid to investment bankers as part of the firm's capital acquisi�on). Figure 9.1 illustrates some common leakages.

Figure 9.1: The financial balance sheet, illustra�ng some leakages

Because such leakages do not exist in perfect capital markets, these markets are some�mes characterized as being fric�onless. In physics, fric�on refers to resistance as objects are moved. The more fric�on there is, the more energy it takes to move an object. Thus, it is easier to push a heavy box across a smooth �le floor than across a carpeted floor. The analogy to economic fric�on is straigh�orward: As cash or securi�es move from the claimants to the firm, between claimants, or from the firm to claimants, there is no loss of value in a fric�onless market. Anyone who has sold a house for $150,000 yet nets only $135,000 a�er commissions, lawyer's fees, and taxes can a�est to the fric�ons that exist in most markets.

Next we will look at capital structure in perfect capital markets.

The Irrelevance of Capital Structure in Perfect Markets

In perfect capital markets, the mix of financing used to fund investment decisions is considered irrelevant to shareholders. We illustrate capital structure's irrelevance by developing a simple example that assumes capital markets are perfect and the firm's investments are iden�fied. Suppose the firm in our example is a small, closely held corpora�on that does business as a donut shop. Further suppose that you are the sole owner of

Chris�e & Cole/Corbis

As levers are used in mechanics to amplify strength, finance also uses the concept of levers to demonstrate the strength of good and bad cash flows.

Exactostock/SuperStock

the shop, providing 100% of the corpora�on's capital. All of the shop's capital is provided via stock, so its capital structure is all equity, and you own all the shares.

In the perfect markets we have described, the value of the donut shop is unaffected by the fact that you have chosen to finance it using only equity. Had you decided to loan the company half of its capital and provided the other half in the form of equity, then the total value of your investment would be unchanged. Why doesn't capital structure ma�er? Capital structure is irrelevant because it does not affect the cash flows that the shop generates or their riskiness, and it is these characteris�cs of the shop that determine its value. To see this, ask yourself whether customers care about a donut shop's capital structure when they choose to make a purchase. No, they care about price, flavor, cleanliness, selec�on, service, and convenience. These shop characteris�cs are independent of the propor�on of debt and equity the business chooses to use as sources of capital. Customers are interested in the shop's menu, not its balance sheet.

In our example, all of the cash flows to you, the owner, whether it is an all-equity firm or a 50% debt–50% equity firm. You receive the same cash flow stream whether all the cash comes in the form of dividends or part of the return is dividend income and part is interest income. Since there are no taxes or transac�on costs, you see no advantage in receiving interest income or dividend income. As the sole owner you receive iden�cal cash flow and bear iden�cal risk with either capital structure; therefore, your business will have the same value with either structure. To put it another way, the components of value (the size and riskiness of expected cash flows) are determined by the le�-hand side of the financial balance sheet and are reflected in the values of the right-hand-side claims. Thus, the le�hand side is cri�cal to a firm's valua�on.

It follows that in a perfect capital market, capital structure has no impact on value. This is the irrelevance proposi�on we referred to at the beginning of this sec�on. It means that when capital markets are perfect, managers need not waste their �me worrying about right-hand side decisions. One capital structure is as good as another, and they all result in the same value for owners.

Irrelevance is probably best understood by recognizing that both cash and risk flow from the le�-hand side of the balance sheet (from assets and the products those assets produce) to the right-hand side of the balance sheet (to financial claims such as debt and equity). Capital structure simply determines how these cash flows and risk are distributed to claimants. A pie is a good analogy: A firm's capital budge�ng determines the size of the pie, and capital structure determines who gets the pieces of the pie. In a perfect world, capital structure has no impact on the size of the pie (i.e., the value of the firm).

Leverage and the Risk of Common Stock in Perfect Markets

The term financial leverage describes the propor�on of debt used in a firm's capital structure. The presence of debt in a firm's capital structure has a magnifying effect on financial performance; just as a lever in physics magnifies strength, financial leverage can make good cash flows to shareholders even be�er (and poor cash flows to shareholders even worse). An all-equity firm is considered unlevered because it does not use debt to finance its investment decisions. To demonstrate this property of leverage, we extend the donut shop example.

Suppose your donut company, The Whole Donut, Inc., required $1,000,000 in financing. The firm can be financed either using half debt and half equity or all equity. The company can borrow $500,000 at an interest rate of 6%. As you consider the two financing alterna�ves, your market research consultant has iden�fied three possible cash flow scenarios for the coming year: a best case of $170,000; an expected level of cash flows of $100,000; and a worst-case scenario, when cash flows total only $30,000. Table 9.1 shows the returns to shareholders on the common-stock investment for both the unlevered (all-equity) financial structure and the leveraged firm financed with $500,000 of debt and $500,000 of equity.

Table 9.1: The effect of financial leverage

Worst case Expected Best case

A. Total investment $1,000,000 $1,000,000 $1,000,000

B. Opera�ng cash flows $30,000 $100,000 $170,000

C. Return on total investment (B/A) 3% 10% 17%

All equity

D. Payments on fixed claims $0 $0 $0

E. Total residual cash flow (B – D) $30,000 $100,000 $170,000

F. Equity investment $1,000,000 $1,000,000 $1,000,000

G. Return on equity (E/F) 3% 10% 17%

Leveraged firm

H. Payments to fixed claims (6% of $500,000)

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

I. Residual cash flow (B – H) $0 $70,000 $140,000

J. Equity investment $500,000 $500,000 $500,000

K. Return on equity (I/J) 0% 14% 28%

First, let's look at the rows labeled D through G in Table 9.1. For the all-equity financed firm the ROE (return on equity) ranges from 3% under the worst-case scenario to 17% for the best case, with an expected ROE of 10%. Now, let's look at the leveraged firm; rows H through K show results for the same firm when financed with a mix of debt and equity. For the leveraged company, the ROE ranges from 0% under the worst-case scenario to 28% for the best case, with an expected ROE of 14%. The leveraged firm has a higher expected ROE, but twice the range of possible ROEs compared to the all-equity firm. The table demonstrates the trade-off between risk and return when using financial leverage. All else being equal, shareholders have a higher expected return with debt financing, but they also have a higher return variability.

This is in line with what we have already learned about risk and investment: risk-averse investors require a higher expected return if they an�cipate exposure to more risk or variability. In our example, the 4% increase in the expected ROE will compensate investors for the greater risk created by leverage, but stock prices (and thereby firm value) will remain the same.

This sec�on has shown that capital structure is irrelevant in perfect capital markets. But markets in the real world are not perfect. Therefore, in the following sec�on, we relax the perfect market assump�ons to be�er reflect reality.

9.2 Imperfect Capital Markets and Capital Structure

To be�er reflect capital structure's effect on the firm in the real world, we will relax the perfect market assump�ons made in Sec�on 9.1. In this sec�on, we introduce imperfec�ons into our model of capital markets, crea�ng an environment that is more complicated and realis�c. As with any real-world decision that involves uncertainty, capital structure choice will involve pros and cons, or trade-offs between the poten�al benefits of leverage and its poten�al adverse effects. Let's begin by relaxing the assump�on of no leakages.

Leakages

In the real world, claimants do not always receive the full cash flows; fric�ons, such as leakages, interfere. Just as fric�on lowers our ability to do physical labor, fric�ons in capital markets lower the cash flows to investors. The first leakage we will discuss is taxes.

Taxes

Let us return to the donut shop example to illustrate how tax func�ons as a leakage. Table 9.2 shows cash flows to claimholders of The Whole Donut Inc. when the firm is unlevered and when it is leveraged with $500,000 of debt bearing a 6% interest rate. We have assumed a 30% corporate tax rate. As Table 9.2 shows, the unlevered firm pays $30,000 in taxes to the government, whereas the levered firm pays only $21,000. With debt financing, the leakage to the government is $9,000 less, and cash flows to investors are $9,000 greater compared to the unlevered financing model. The $9,000 is the tax savings resul�ng from the interest being a tax-deduc�ble expense. We could compute the interest tax savings directly as the interest expense �mes the tax rate ($9,000 = $30,000 × 0.30).

Table 9.2: The effect of taxes on cash flows

Cash Flow Unlevered $500,000 of 6% debt

A. Expected opera�ng cash flow before taxes $100,000 $100,000

B. Interest payments to debtholders (6%) $0 $30,000

C. Cash flow a�er interest payments (A – B) $100,000 $70,000

D. Corporate taxes (30% of C) -$30,000 -$21,000

E. Cash flow to residual claims (C – D) $70,000 $49,000

F. Total cash flows to all claimants (B + E) $70,000 $79,000

So, why is there a tax difference between leveraged and unlevered firms? Interest payments made by the corpora�on are paid before corporate income taxes, whereas dividend payments are paid a�er. Thus, a firm may reduce taxes paid to the government by using more debt in its capital structure. Conceptually, a corpora�on could avoid taxes altogether by financing exclusively with debt. If all cash flows were distributed to claimants in the form of interest payments, the government would collect no corporate taxes because all interest would be paid before taxes. On the other hand, a corpora�on financed solely with equity would pay taxes before any distribu�ons could be made to its suppliers of capital because dividends would be paid a�er taxes. Few firms are all-equity financed, and none are all-debt financed. The Internal Revenue Service would probably claim that an all-debt financing scheme was a tax-avoidance strategy and would impose taxes on that por�on of the debt they felt was de facto equity. Normally, corpora�ons have a mix of debt and equity.

As we have shown, increasing leverage reduces taxes, which increases the cash flows available to investors, thereby increasing the value of the firm. Let's return to the pie analogy to further explore this concept. When taxes (or other leakages) are introduced into otherwise perfect markets, a piece of the cash flow pie is effec�vely given to a third party. By avoiding taxes through debt financing, less of the pie is distributed to third par�es, leaving more cash flows available for distribu�on to the capital suppliers. In either case, levered or unlevered, the corpora�on's risk is en�rely borne by these capital suppliers, so firm value will be directly linked to the amount of cash security holders can claim. Minimizing taxes will increase cash flows, thereby increasing the value of the company. Figure 9.2 illustrates this impact of debt on a firm's value.

Figure 9.2: Firm value with debt

This figure shows the decreasing relevance of leverage as the firm's tax rate goes to zero (perfect markets).

Joe discusses how he used leverage to build up his business by turning his leverage into equity, then using that equity to get more leverage. Do you think Joe could have made his business as successful if he did not con�nue to apply for leverage? Would you have made the same decision if it had been your company? As you con�nue reading this sec�on, think about how the risks associated with leverage may impact your decision.

The upper horizontal line in Figure 9.2 represents the irrelevance of leverage when capital markets are perfect. Regardless of the debt-equity mix that the corpora�on chooses for its capital structure, firm value remains unchanged. The upward-sloping line shows the benefits of leverage. As more debt is incorporated into the firm's capital structure, a greater propor�on of opera�ng cash flows is distributed before taxes are paid. The deduc�bility of interest payments allows the firm to distribute more of its cash flows, a characteris�c known as the tax shield of debt. This benefit increases firm value as the firm uses more debt.

By studying Figure 9.2, we conclude that a firm should use almost no equity in its capital structure. Indeed, in the 1980s some firms did leverage themselves to such an extent that debt represented 70%, 80%, and even 90% or more of their capital. Yet the majority of corpora�ons did not follow the lessons of Figure 9.2, choosing instead to keep a more moderate level of debt in their financing mix. Why didn't they take full advantage of the debt tax shield? We answer that ques�on next, as we study a second leakage, bankruptcy costs.

Growing Through Leverage

Bankruptcy Costs

As more and more debt is added to a firm's capital structure, that debt becomes riskier because interest payments are fixed. If a company performs poorly, it may decide not to pay dividends to stockholders, but it must pay interest to debtholders. Bonds and loans are contractual agreements, so if these claimants are not paid on �me and in full they can bring legal ac�on against the company. As debt levels rise, smaller varia�ons in performance can leave a company unable to service its debt. The possibility of default on mandatory debt service payments increases with debt levels. A default that cannot be corrected or nego�ated can lead to bankruptcy. Therefore, the probability of bankruptcy increases as debt increases.

This figure shows how the likelihood of bankruptcy changes as more debt is introduced into a firm's capital structure.

Figure 9.3 is a stylized graph showing cash flows for The Whole Donut, Inc. under different economic condi�ons. Figure 9.3a shows our firm with $500,000 of debt, which carries a 6% interest rate and requires $30,000 of annual interest payments. These required payments are represented by the do�ed horizontal line. Because the cash flows never dip below that line, we know the firm can make its interest payments regardless of the future economic scenario. Thus, at this level of leverage, our firm's debt is riskless.

Figure 9.3: Bankruptcy risk with increasing debt

Now, suppose that the firm chooses to take greater advantage of debt's tax-shielding benefits by borrowing a greater propor�on of its capital. Suppose the firm borrows $700,000, as illustrated in Figure 9.3b. At that level of debt, the loan would no longer be riskless. Even at a 6% interest rate, lenders stand the chance of not being paid under certain economic condi�ons because the cash flow curve falls below the $42,000 threshold. The shaded areas illustrate poten�al cash shor�alls when condi�ons are poor for our firm's business. Knowing this, lenders will require a higher interest rate to compensate them for this risk, say 8%. Figure 9.3c shows the interest payment threshold of $56,000 when $700,000 is borrowed at 8%.

If the economy turns sour and cash flows are insufficient to cover interest payments, The Whole Donut, Inc. stands a chance of being unable to pay its contractual interest (or other fixed obliga�ons). Firms unable to meet their fixed claims are in default, and this may lead to bankruptcy. Some firms may avoid default during these shor�alls by keeping a cash reserve on hand or having other sources of capital that can be accessed to meet these obliga�ons. They may choose to borrow funds to make the payments, or even sell more stock. However, if the shor�all is extreme, the firm may be unable to raise more cash and could be forced into bankruptcy.

Bankruptcy has many forms, but for our purposes it may be characterized as the transfer of control of assets from the residual claimants (i.e., shareholders) to fixed claimants (i.e., lenders). A simple example will help illustrate bankruptcy and its impact. Suppose a bank lends someone the cash to purchase an automobile. The bank is a fixed claimant, and the borrower is the owner of the car. Let's say the owner is unable to make the payments the loan requires and is in default. This is like bankruptcy in that the borrower must transfer ownership of the vehicle to the fixed claimant (to the bank). If this is done without fric�on, as in a perfect market se�ng, there is no loss in the value of the automobile or the bank's claim.

However, in an imperfect market, the bank incurs some costs when repossessing a car. It pays lawyers to do the legal paperwork, the state charges fees to transfer the car's �tle, and so on. These are the direct costs of this transfer. Addi�onally, the car's owner may have neglected to maintain the vehicle in an effort to conserve cash and avoid default. Once the bank has possession of the car, this deferred maintenance must be done at a cost to the bank. Bank officers will also spend considerable �me doing in- house paperwork, making phone calls, and so on in order to take possession of the car. It must also absorb the adver�sing costs associated with selling the automobile.

The figure shows forecasted cash flows across economic condi�ons, highligh�ng the impact of poten�al bankruptcy costs.

In a perfect market, even repossessing a car due to a borrower's bankruptcy does not have a nega�ve impact on the bank, but in reality, markets are far from perfect.

McClatchy-Tribune/Ge�y Images

These ac�vi�es are costly and represent the indirect costs of the transac�on. Both the direct and indirect costs of transferring ownership of the car represent fric�ons in this transac�on, and they effec�vely lower the value of the car to the bank.

Similarly, corporate bankruptcies are characterized by fric�ons. Residual claimants will not costlessly transfer their ownership rights to fixed claimants once they recognize that the firm cannot meet its fixed claims. There are costs inherent to the bankruptcy procedure.

The direct costs of bankruptcy include a�orney's fees and court fees. Indirect bankruptcy costs include management's �me spent on paperwork, phone calls, mee�ngs, and so on, which could otherwise be spent on more produc�ve ac�vi�es. Furthermore, some key employees may conclude that, given the firm's financial distress, now is a good �me to take another job, which is also costly to the corpora�on. Customers may stay away from the firm's products because they fear that the firm's guarantees will not be honored as a result of the bankruptcy. Distressed airlines, for example, o�en find demand for their services declines as customers worry about deferred aircra� maintenance or canceled flights. These represent bankruptcy's indirect costs.

All costs, direct or indirect, lower the firm's cash flows in the event of bankruptcy. Returning to our earlier example, imagine that The Whole Donut, Inc. began experiencing financial distress because of difficulty in making interest payments. It is possible that the shop would try to conserve cash by reducing labor costs. The money saved could be used to meet interest payments on the firm's debt. However, the shop's regular customers may begin to no�ce that they must wait longer to be served, that the shop isn't as clean as it used to be, and that employees aren't as friendly due to overwork. The Whole Donut, Inc. could lose business, lowering cash flows, as a result of the cost-cu�ng strategy brought on by financial distress. Had the company foregone leverage in its capital structure, these financial difficul�es and their accompanying nega�ve impact on firm value might have been avoided.

Figure 9.4 is similar to Figure 9.3, but it shows the reduc�on of cash flows in the event of bankruptcy. It is important to note that the expected cash flow for the firm is no longer $100,000. The fric�on caused by financial distress lowers the cash available to claimants in several poten�al economic condi�ons. Recognizing this, investors incorporate these costly outcomes into their cash flow es�mates, lowering their es�mate of the firm's expected cash flow. They may also require a higher return because of the greater variability of cash flows given poten�al bankruptcy costs. The value of the firm must decline since expected cash flows are lower and/or risk is higher.

Figure 9.4: Bankruptcy costs

The expected cash flows are reduced by the expected costs of bankruptcy. Expected bankruptcy costs are calculated by mul�plying the likelihood of bankruptcy �mes the poten�al costs. If there is very li�le or no debt in the firm's capital structure, the corpora�on will not be in danger of default, and no poten�al bankruptcy costs will be included when investors value the firm. This occurs because the probability of bankruptcy is zero or close to zero. Yet, as more debt is added, the likelihood that these costs will be incurred becomes greater, and the expected value of bankruptcy costs rise, lowering firm value. Figure 9.5 shows the impact of bankruptcy costs on firm value as leverage increases.

Figure 9.5: Leverage and firm value

This figure highlights leverage's effect on firm value, taking into account taxes and bankruptcy costs.

Agency cost problems are especially troublesome in industries like tobacco and oil. What are your thoughts about crea�ng debt in order to reduce agency costs?

Stockbyte/Thinkstock

The lesson here is that as leverage increases, so does the likelihood of incurring bankruptcy costs or costs associated with financial distress. These poten�al costs reduce firm value, par�ally offse�ng the tax benefit of debt. This is the first trade-off men�oned earlier: Managers must balance the tax advantage of debt against the poten�al for costly bankruptcy. Leveraging the firm reduces the leakages to the government (lowers taxes), while increasing poten�al leakages to third par�es in the form of bankruptcy proceedings or financial distress (lawyers' fees, court costs, customers lost to compe�tors, etc). The role of leverage and bankruptcy costs is an important topic. But what happens when corporate managers know more about the firm's ac�vi�es than do most corporate owners? We address this issue, informa�on asymmetry, next.

Information Asymmetry

When capital markets are perfect, no informa�on gap exists between corporate insiders and outsiders. This means that all market par�cipants have the same, or symmetric, informa�on. In such condi�ons no agency problem would exist because investors would observe the problem (excessive perquisite consump�on, growth for growth's sake, shirking behavior, etc.) and take remedial ac�on. When we drop the assump�on of symmetric informa�on, we get a much more realis�c view of how corpora�ons conduct their affairs. Next, we discuss an issue related to the informa�on asymmetry present in an imperfect market: agency costs.

Agency Costs

Asymmetric informa�on means that corporate managers know more about many of the firm's ac�vi�es than do most corporate owners—the outside shareholders. Under these condi�ons, agency problems can arise and be quite costly. How does leverage affect agency problems? The answer lies in the discipline of debt.

To understand the discipline of debt, first consider the nature of the manager–stockholder agency problem. Managers control corporate expenditures and oversee their own efforts. They may choose to invest cash in wasteful purchases—unneeded corporate jets, luxury offices, and so on—and they may choose to play a lot of golf or take two- hour lunches on company �me. These resources, corporate cash and managerial effort, could be put to be�er, wealth-producing use. In sum, agency problems can be costly for the corpora�on. Now, consider bankruptcy, the likelihood of which increases with leverage. In the event of bankruptcy, or financial distress that could lead to bankruptcy, managers are o�en fired, demoted, or re�red early. These consequences of bankruptcy are especially costly to managers who have most of their "wealth" linked to their jobs (e.g., their human capital and financial capital). Shareholders, who also suffer from bankruptcy's costs, are not affected to the same degree as managers are because investors' por�olios are diversified. With so much depending on their careers, managers are highly mo�vated to avoid bankruptcy.

But what happens to agency costs when a firm's leverage increases? Leverage increases the likelihood of financial distress, threatening management's job security. Management's fear of bankruptcy causes them to become more frugal, conserving cash to minimize the chances of a default. In order to accomplish this, managers of highly leveraged firms work hard to cut wasteful pursuits. As a result, agency costs are reduced, and firm value increases. They may play less golf during business hours and work harder to avoid financial distress. In essence, they waste less money, and they waste less �me. This is the discipline of debt. The discipline of debt argument asserts that firms become more efficient and therefore more valuable as leverage increases.

Some industries may be more suscep�ble to agency costs than others. Michael Jensen developed the discipline of debt theory, arguing that the agency cost problem would be par�cularly severe in companies with large cash flows and limited growth or investment opportuni�es. Such companies have excessive funds for managers to spend but few value-crea�ng investments to make. Industries that fit this descrip�on include the tobacco or cigare�e industry and, when oil prices are high, the oil and gas industry. Debt reduces the cash available to managers to spend by requiring it be paid to lenders. Dividends do not func�on in the same way as debt; being somewhat discre�onary, they usually don't have the same agency cost-reducing effect that debt has.

Figure 9.6 illustrates the effect of debt's discipline on firm value.

Figure 9.6: Leverage and firm value, with agency costs

This figure shows four scenarios where leverage impacts a firm's value:(1) markets are perfect, (2) taxes are introduced, (3) bankruptcy costs are included, and (4) the discipline of debt is also considered.

Now that we have discussed how informa�on asymmetry can lead to agency cost problems, and how those problems can be addressed, we can discuss another factor related to informa�on asymmetry in imperfect markets: debt signaling.

Signaling With Debt

Knowing that leverage may lead to financial distress and possibly the loss of their jobs, you might ask why a manager would ever take on more debt financing. With informa�on asymmetry, outside stockholders must es�mate firm value without all the informa�on that inside managers have. Ra�onal investors will typically assign at best an average value (but more likely a lower value) to aspects of a business about which they are uncertain. Managers don't want their companies undervalued (they own stock in the company, and their performance is o�en related to share price). Issuing debt helps address this undervalua�on problem.

Debt may be viewed as management's signal of the firm's future cash flow prospects. When firms take on greater leverage, the managers, whose decision it was to increase leverage, must believe that the firm's future cash flows are sufficiently large and steady enough to make higher interest payments. Thus, such leveraging decisions signal management's faith in the corpora�on's cash flow–producing capabili�es. Because leverage is increasing, the signal to outsiders is that the firm has a greater capacity for servicing its debt, meaning cash flows are expected to increase in management's view. Therefore, the corpora�on's value will increase in the opinion of outsiders, based on the signal from management.

But why don't managers simply announce that cash flow prospects have improved? An announcement would convey the same informa�on as the leveraging signal, so why opt for the riskier op�on? The answer lies in the faith outsiders put in the informa�on; that is, increasing leverage is a more credible signal than an announcement from management. Posi�ve announcements carry li�le weight with outsiders, as managers generally suffer few penal�es for misrepresen�ng a company's future cash flow prospects. Nega�ve announcements, however, are usually taken seriously because they are usually made only when a situa�on is so severe that there is no "glossing it over." In contrast, a leveraging signal is credible because of the poten�al penalty for managers—loss of their job if the firm can't meet its debt payments.

Consider the opposite signal, increasing the equity base. Suppose a firm issued and sold addi�onal stock using the funds to pay off debt. Such ac�on reduces fixed claims on cash flows, thereby reducing the likelihood of financial distress. Perhaps management feels the firm's future cash flows may be more variable or at a lower level than they have been in the past. In order to reduce the chance of default, management reduces leverage, signaling to stockholders that the firm has less value. Perhaps instead, management sold the stock to raise funds because, with their inside informa�on, they feel the stock's value is currently too high. In this case, the firm realizes it is wise to sell some stock to raise funds before the market discovers its error and lowers equity's price. In both cases, the signal is clear: Firm value is too high in light of management's informa�on. Leverage, therefore, may be a credible signal of management's superior informa�on about firm value: Increasing leverage signals increasing value and vice versa.

Clearly, there are trade-offs to consider when deciding which capital structure should be used to finance the firms' investments in an imperfect market. Tax benefits are par�ally offset by bankruptcy costs, which tend to be offset by the discipline of debt. Debt may also be viewed as a signal of the firms' future prospects, given the inside informa�on of management. Note that there are no formulas in this chapter that let us solve for the op�mal degree of leverage. Instead, managers must evaluate the characteris�cs of the firm and its environment in order to arrive at the best es�mate of the firm's op�mal capital structure. The next sec�on outlines factors that should be considered in making that decision.

9.3 Determining Target Capital Structure: Trade-Off Theory

So far we have discussed what is o�en called the trade-off theory of capital structure. The trade-off theory argues that companies have an op�mal level of debt (a mix of debt and equity that maximizes value). This op�mum point is a trade-off between the tax and agency cost reduc�on benefits of debt and its bankruptcy costs. This op�mum point becomes the target capital structure that companies strive to maintain. Another way to look at the target capital structure is as the company's debt capacity, or the maximum amount of debt that can be safely serviced. Debt capacity implies that debt is a valuable resource and that a company that does not u�lize its capacity to borrow may not be maximizing value for shareholders. In this sec�on, we discuss the characteris�cs that determine a company's debt capacity, as suggested by the trade-off theory: taxes, poten�al bankruptcy costs, agency costs, and signaling.

Taxes

As we have shown, taxes func�on as a leakage that can nega�vely impact the value of a firm. Tax rates can vary between states, countries, and even industries. Fortunately, there are op�ons for shielding a firm from taxes, with some firms seeing more of a benefit from these op�ons than others. The higher the tax bracket a firm finds itself in, the greater the tax-shielding benefit of debt will be for that corpora�on, and the more leverage the firm should employ in its capital structure. On the other hand, firms with large tax-loss carry-forwards or high deprecia�on expense will garner less benefit from leverage's tax shield and will choose lower levels of debt. This is also true for start-up firms that have not yet reached profitability and therefore pay no taxes. When determining target capital structure, managers must weigh a firm's tax burden against its ability to carry debt. Without proper considera�on, a firm may find itself in danger of bankruptcy.

Bankruptcy

Two considera�ons must be given to bankruptcy when determining debt capacity: the likelihood of default and the costs of bankruptcy. We will look at each of these considera�ons in turn, star�ng with what determines a firm's likelihood of default.

Likelihood of Default

To es�mate the likelihood of default, a firm must es�mate the level of expected cash flows and their variability. To illustrate this, we will compare three firms' future cash flows, as shown in Table 9.3, using a sine-wave model in Figure 9.7.

Table 9.3: Es�mated cash flows, Firms A–C

Cash Flow Firm A Firm B Firm C

Expected cash flow $200,000 $125,000 $125,000

Es�mated minimum cash flow $75,000 $30,000 -$50,000

As you can see, Firm A has a greater debt capacity than either Firm B or Firm C. Given the es�mated minimum level of cash flow, Firm A could take on fixed obliga�ons of $75,000 per year that would be virtually riskless. This is not the case for Firms B and C. Firm B could carry more debt than Firm C because its cash flows are less variable. Any amount of debt taken on by Firm C would carry a risk premium because in some economic condi�ons the firm would produce a cash flow deficit, which increases its likelihood of default.

Figure 9.7: Debt capacity, Firms A–C

This figure illustrates forecasted cash flows and debt capaci�es for Firms A–C across varying economic condi�ons.

During tough economic �mes, luxury goods shops like jewelry stores are especially impacted. When economies improve, do you think people are likely to re-indulge in luxury goods or stay prac�cal?

Associated Press

The product market in which a firm competes plays a key role in determining its cash flow characteris�cs. For example, u�li�es operate in markets where product demand is rela�vely price-inelas�c; that is, price has li�le impact on demand for the product. Consumers and businesses use a certain level of energy, regardless of the economic climate. This rela�vely stable demand enables providers to use high degrees of leverage in their capital structure. Extremely cyclical businesses, like home construc�on, would be more uncertain of their level of future cash flows, and producers of nonessen�al luxury goods may find that product demand varies radically with economic condi�ons. Such firms would carry lower propor�ons of debt than u�li�es with their more stable cash flows.

A second factor that impacts a firm's likelihood of default is its mix of opera�onal fixed costs and variable costs. This is known as the company's opera�ng leverage. Fixed costs do not vary with produc�on; these are costs such as rent or salaried workers. Variable costs are dependent on the firm's ac�vity; these include raw materials, labor, and sales commissions. Fixed costs increase a firm's poten�al for financial distress in an economic downturn; as fixed costs increase, so does the likelihood of default. On the other hand, we see the opposite effect during good economic �mes, with fixed costs benefi�ng the firm when ac�vity increases. O�en, firms may subs�tute fixed costs for variable costs in their opera�ng structure in the same way they might subs�tute debt for equity in their capital structure. Just as added debt increases financial leverage, more fixed opera�ng costs increase opera�ng leverage. Both types of leverage tend to magnify the firm's performance and risk: Leverage makes good �mes be�er and makes bad �mes worse.

To illustrate opera�ng leverage, consider the opera�ng costs for two retail clothing stores, as represented in Table 9.4. Store A pays its salesperson a 50% commission on sales, (a variable cost), while Store B pays its salesperson a salary of $2,000 a month (a fixed cost). Now, consider two possible economic environments: good and poor. In poor �mes, both firms sell $1,000 worth of goods in a month; in good �mes both stores sell $5,000 worth of goods in a month. Which store has more opera�ng leverage? Which is more likely to default on its payments to its sales staff? Which can maintain a higher degree of financial leverage? In this example, the store with lower opera�ng leverage (lower fixed costs) has greater debt capacity.

Table 9.4: The effect of opera�ng leverage on profitability

Good economic �mes Poor economic �mes

Store A Salary $0 $0

Commissions $2,500 $500

Opera�ng profit (or loss) $2,500 $500

Store B Salary $2,000 $2,000

Commissions $0 $0

Opera�ng profit (or loss) $3,000 ($1,000)

Now that we have covered the factors that impact a firm's likelihood of default, we can move on to the other aspect of bankruptcy that should be considered when establishing debt capacity: bankruptcy costs.

Cost of Bankruptcy

The costs of bankruptcy are another determinant of corporate borrowing capacity. Recall from Sec�on 9.2 that bankruptcy is essen�ally the transfer of asset ownership from residual claimants to fixed claimants. The fric�ons associated with such a transfer are somewhat predictable. For example, the liquidity of the firm's assets affects the level of expected bankruptcy costs.

Characteris�cs of the assets themselves can impact the ease of transfer, thereby affec�ng bankruptcy costs. As a general rule, tangible assets are more easily sold (more liquid) than intangible assets. This means that businesses whose assets are primarily land, buildings, and equipment would have lower bankruptcy costs than those whose value depends on intangibles, such as the firm's reputa�on or the brand value of its products. Cash and marketable securi�es are easily (almost costlessly) transferred from owner to owner, while work-in-progress inventory is o�en sold in financial distress yielding $0.50 or less per dollar invested. Asset specificity adds to cost of transfer, lowering liquidity and increasing expected bankruptcy costs. For example, an abandoned nuclear power plant, despite its tangible nature, has almost no alterna�ve use—thus it is considered a highly specific asset. This plant may have cost billions of dollars to construct, but almost no one would be willing to receive it as a gi�—free of charge. In fact, most would require compensa�on just for accep�ng such a gi�. In a bankruptcy, such an asset would have a very high transfer cost. On the other hand, a delivery truck can be more easily sold because it can be used in a variety of ways. The vehicle's use is not highly specific, a characteris�c that enhances its marketability and helps contribute to lower bankruptcy costs.

To summarize, bankruptcy's impact on leverage depends on the likelihood of its occurrence and the costs associated with the procedure, should it occur. Evalua�on of these considera�ons involves analysis of the firm's capacity to generate future cash flows and of the nature of the assets underlying the business. This explains why lenders look at two factors when considering the debt capacity of a borrower: (1) the primary source of repayment (cash flow) and (2) the collateral (the assets backing the loan) that could be sold as a secondary source of repayment. As a result, firms (or individuals) with high and steady cash flows who hold assets easily marketed for their full value can borrow more than those without these characteris�cs. By borrowing more, they are able to take greater advantage of debt's tax-shielding benefit.

Next, we discuss how agency cost problems play into determining target capital structure.

Agency Problems

We covered agency cost problems in detail in Sec�on 9.2. As you recall, mature companies with high cash flows and few posi�ve NPV investment projects o�en find themselves with excess cash on hand. Firms that are flush with free cash flow (cash not needed to fund promising projects) have a higher poten�al for wasted money and �me than those s�ll in their forma�ve stage. Addi�onally, managers of widely owned companies are less likely to be held accountable for costly ac�vi�es because no single stockholder owns sufficient stock to present a threat to incumbent management. When combined, free cash flow and widely dispersed ownership are ingredients that foster wasted resources. These firms may benefit from the discipline of debt because leveraging upward puts more pressure on management to perform effec�vely and efficiently. As fixed claims increase, free cash flow is paid out, reducing the possibility for discre�onary expenditures, like excessive perquisites. If the poten�al for costly agency problems exists within the firm, incorpora�ng debt into the target capital structure can add value.

Signaling

Another considera�on in determining target capital structure is the use of leverage as a signal to outside shareholders and analysts. If, for example, managers are confident that the firm's performance is improving, then a strong signal would be to borrow funds and use the proceeds to repurchase some shares. By taking on more debt, management is signaling the firm's ability to meet a higher level of fixed claims. Addi�onally, insiders might direct the firm to repurchase shares when the share price is below its value—in other words, when buying one's own shares is a posi�ve NPV investment. When determining debt capacity, managers must decide if the condi�ons are right for debt signaling, and how their signal will be interpreted by firm outsiders.

Field Trip: Small Business Lending

To see small business lending in ac�on, visit: h�p://www.bankrate.com/calculators/index-of-small-business-calculators.aspx (h�p://www.bankrate.com/calculators/index-of-small-business-calculators.aspx)

There are many useful links on this page for a small business owner, including free access links to calculate current ra�os, quick ra�os, debt-to-asset ra�os, return on assets, gross profit margin, and opera�ng profit percentage.

Reflec�on Ques�on

Suppose you own a florist shop and want to track your gross profit margin and opera�ng profit percentage over the course of a year. How will these figures fluctuate from season to season? What factors might impact these numbers?

Now that we have covered how the components of trade-off theory play into determining capital structure, we will look at other factors management may consider when establishing debt capacity.

9.4 Determining Target Capital Structure: Looking Beyond the Trade-off Theory

The empirical evidence doesn't support the no�on that companies constantly fine-tune their capital structure to be at or near their op�mal mix of debt and equity. Observers see companies going years between security issues that would bring them back toward their historical debt ra�os. How can this slow response be explained? In this sec�on, we look beyond trade-off theory, at other factors that also appear important to companies when determining debt capacity.

Transaction Costs

Transac�on costs may help explain the delayed response some companies have shown in issuing securi�es. Also known as issuance costs, transac�on costs are the costs associated with issuing securi�es in the public capital markets. There are two types of transac�on costs: direct and indirect. Direct costs are the fees paid to lawyers, accountants, and investment bankers; lis�ng fees paid to exchanges, prin�ng, adver�sing and marke�ng costs; and management �me spent on the issuance process rather than other ac�vi�es. Indirect costs include underpricing of security issues by underwriters and any reac�ons in the price of exis�ng securi�es to the announcement of a new issue. Table 9.5 shows the direct costs for various sizes and types of securi�es.

Table 9.5: Sample transac�on costs for corporate securi�es

Amount issued (in millions) New equity IPO Seasoned equity Conver�ble bonds Straight bonds

>$40 12.2% 8.8% 7.4% 2.9%

$40–$100 8.5% 5.5% 3.5% 2.1%

>$100 6.8% 4.0% 2.6% 2.2%

Weighted average 11.0% 7.1% 3.8% 2.2%

Source: Lee, Lochhead, Ri�er, & Zhao (1996).

Here we define the various securi�es listed in the table:

New equity IPO is the very first issuance of stock for a company; the company's ini�al public offering. Determining the market value of an IPO is difficult, so underwriters and investors tend to severely underprice these issues. This leads to large indirect issuance costs in addi�on to the high direct costs. More on this below. Seasoned equity is an issue of more common stock being offered to the public by a company that already has publicly traded common stock outstanding. These new shares will dilute exis�ng ownership, so some shares of stock have preemp�ve rights, which give exis�ng shareholders the right to buy shares in any new stock issues to maintain their original propor�onal ownership. Most states do not require companies to include preemp�ve rights in their ar�cles of incorpora�on, so this right is not guaranteed. Seasoned equity offerings are valued based on the market value of the exis�ng shares, so underwriter underpricing is much less than in IPOs. Conver�ble bonds are bonds characterized by both a debt and equity component. While the debt por�on is rela�vely easy to value the equity por�on can be complex, increasing the cost of issuance. Straight bonds are also known as nonconver�ble bonds. This debt is rela�vely easy to value. Once the bond issue is rated and a coupon rate set, it is a standard present value exercise.

Looking at Table 9.5, we observe some clear pa�erns. First, no�ce that smaller issues cost more than larger issues of the same security. This suggests higher fixed costs associated with the underwri�ng and issuance process. Second, the more difficult a security is to value, the higher the costs. Equity for a new firm is the most difficult to value because the company has a limited track record, may be offering a new product in a rela�vely new market, and may have untested managers (venture capital or private equity costs could be higher s�ll, since those valua�ons would be more complex than for companies ready to go public). On the other hand, seasoned equity is simpler because there is an exis�ng stock price, but the value of the stock (new and exis�ng) ul�mately depends on what the company plans to do with the proceeds. If investors believe that managers will make poor use of the money, they will push share prices down (increasing indirect issuance costs). Valua�on, then, is more complex than se�ng the price at or near current market value; it must also include analysis of the firm's intended use of the issuance's proceeds.

As discussed earlier in this chapter, asymmetric informa�on complicates the process of pricing equity (both new and seasoned). To illustrate, consider a company with a posi�ve NPV project it wants to finance. The firm has the op�on of issuing either debt or equity. If the CEO works for the benefit of exis�ng shareholders, she will offer only equity if it is fairly or overpriced. This means that investors may be paying too much for the new stock offerings. To combat this, investors will only buy new shares at a discount, so we see new shares selling below the price of the shares immediately before the new stock offering is announced. This is supported by the following facts:

Offerings of seasoned equity generally occur the year following steady share price increases (consistent with the stock being over valued). Stock performance tends to be subpar for five years following the issuance of a seasoned equity offering.

With the high transac�on costs related to issuing equity, companies must take careful considera�on before incorpora�ng security issues into their target capital structure. These costs have even led to the development of an alterna�ve theory of how companies make the debt-equity decision: the pecking order theory.

The Pecking Order Theory

So far, this chapter has argued that firm value can be maximized at some target amount of debt; that is, that companies have an op�mal capital structure. The pecking order theory of capital structure takes an en�rely different view of how companies choose their financing mix. This theory, developed by Stuart Myers of MIT, argues that the high costs of issuing securi�es in the capital market drives companies to fund as much of their investment as possible from internal sources (e.g., retained earnings). By using internal sources, companies hope to avoid the costs associated with issuing pricey securi�es (e.g., equity). When external funds must be used, companies will choose to use funds in order of their safety and cost effec�veness. First, they will issue safe debt. If more funds are needed for investment in produc�ve assets, companies will then issue

The pecking order theory says that companies raise funds by first using internal resources, then safe debt, risky debt, and finally equity.

Considering the pecking order theory of capital structure, applying for a bank loan would rate toward the bo�om of the ideal debt list for most companies.

Bloomberg/Ge�y Images

risky debt. Finally, if the company doesn't want to bear too much bankruptcy risk, they will issue equity. Figure 9.8 outlines the pecking order theory's process of raising funds for investment.

Figure 9.8: Pecking order theory

Companies following the pecking order theory want to avoid issuing equity unless it is absolutely necessary, as the direct and indirect costs are very high. Debt issues— par�cularly highly rated or rela�vely safe debt—will have the absolute lowest costs of all sources of external finance. Retained earnings have no issuance costs whatsoever, and for this reason they are at the top of the pecking order. This model is significantly different than the trade-off theory, as it disregards a target debt level. Instead, companies looking to invest in projects consider internally generated cash flow, their investment opportuni�es, and the costs associated with security issuance.

Next, we look at how a firm's financial flexibility plays into determining its op�mal capital structure.

Financial Flexibility

Recent research points to the importance of financial flexibility as a driving force in capital structure and debt levels. For example, companies appear to have debt targets somewhat lower than expected. DeAngelo, DeAngelo, and Whited (2011) argue that this allows companies to maintain financial flexibility, or the ability to raise funds for investment (and paying dividends) during periods when cash genera�on is low. The no�on of financial flexibility also explains why companies some�mes issue debt and exceed their es�mated target debt levels and then slowly adjust back toward the target. In a survey of about 250 global companies, Servaes and Tufano (2006) find that financial flexibility (the ability to con�nue making investments and paying dividends) are the second and fourth ranked determinants of debt levels.

One important aspect of financial flexibility is maintaining a high credit ra�ng. Having a high credit ra�ng means companies are able to issue debt at a reasonable cost at any �me. This helps support flexibility. The Servaes and Tufano survey found that corporate managers are very concerned with maintaining the firm's credit ra�ng.

Ch. 9 Conclusion

As we said at the beginning of this chapter, debt acts like a lever in finance. When the firm is doing well, financial leverage increases the return to stockholders. When �mes are tough, it magnifies the nega�ve effect on shareholders' returns. The more leverage a company uses, the greater the magnifying effect. Thus, leverage can increase expected returns, but it also increases variability or risk. In perfect capital markets, these two effects offset one another, leaving value unchanged.

In reality, there are market imperfec�ons that complicate decisions regarding capital structure. The choice can be likened to a balancing act between the benefits of debt and its value-harming effects. Debt may increase cash flows to claimants by avoiding corporate taxes, by limi�ng agency problems, and by sending a posi�ve signal to outsiders. On the other hand, added leverage increases the likelihood of a costly bankruptcy.

Although there is no precise method for finding the op�mal capital structure of a firm, certain characteris�cs of corpora�ons help to guide managers toward an appropriate target structure. First, firms with high taxable income opera�ng in areas with high corporate tax rates should consider higher leverage. Next, corpora�ons with widely dispersed ownership and excess free cash flow may find that leverage lowers poten�ally wasteful cash expenditures. Leverage may also be used as a signal of the increased debt capacity of the borrower. Finally, firms may deviate from op�mal target debt levels to maintain financial flexibility.

As firms raise new capital, they also consider the costs associated with different forms of financing. These costs can be direct, like the fees paid to banks and lawyers, or they may be indirect, like the underpricing of newly issued equity. The pecking order theory says firms will first a�empt to raise capital from sources with the lowest transac�on costs (e.g., retained earnings) before issuing securi�es associated with higher fees or risky mispricing as is o�en the case with issues of new equity.

The benefits of leverage must be balanced against the corpora�on's poten�al bankruptcy costs. Firms with more vola�le cash flows are in greater jeopardy of experiencing financial distress than firms with stable cash flows. Therefore, businesses should consider the stability of their income when targe�ng their debt level. Should a firm have financial difficulty, those with highly liquid or marketable assets should experience lower bankruptcy costs than those whose assets are unique or specific to their current use. Firms with illiquid, highly specific assets have higher poten�al bankruptcy costs and must carefully consider their levels of debt. In Chapter 10, we examine corpora�ons' dividend policy. As you will see, dividend policy and the capital structure decision share many of the same features.

Ch. 9 Learning Resources

Key Ideas

The mix of debt and equity used to finance the firm's investments is known as its capital structure. The debt-equity decision is ini�ally examined under the assump�on of perfect capital markets. Under such condi�ons, it can be shown that firm value is unaffected by capital structure. The capital structure is said to be irrelevant because the mix of debt and equity financing has no impact on either the overall cash flows or their riskiness. The use of debt in a firm's capital structure is called leverage. Just as a lever increases power, the use of debt increases the impact of good (and bad) opera�ng results. Because interest is tax deduc�ble, the use of debt protects cash flows from taxa�on. Bankruptcy costs represent a poten�al leakage of cash flows from the firm, caused by the use of debt in its capital structure. The capital structure decision involves balancing the benefits of debt, like its tax deduc�bility, against the poten�al costs associated with its use, including the poten�al for bankruptcy. The use of debt may be interpreted as a signal that the firm has improved prospects. A firm's target capital structure is affected by taxa�on, poten�al bankruptcy costs, agency costs, and signaling.

Cri�cal Thinking Ques�ons

1. Explain why there is no agency problem when there is no informa�on asymmetry. 2. Why does the Securi�es and Exchange Commission require firms with traded securi�es to have their financial statements audited by an outside accoun�ng firm according to

generally accepted accoun�ng principles? (Hint: Think of informa�on asymmetry.) Is the cost of having the firm's financial statements audited an agency cost? Why or why not?

3. Do you think a corpora�on must actually declare bankruptcy to incur costs associated with financial distress? Could rumors of financial problems lead to costs? How would these costs lower firm value? Explain your answers.

4. Suppose two countries have iden�cal economic environments except that Country X allows interest payments to be deduc�ble for corporate income tax purposes and Country Y allows only half of a firm's interest expense to be deducted. Would you expect to see, on average, greater use of leverage by corpora�ons in Country X or in Country Y?

5. Affiliated Industries Incorporated (AII) is a corporate giant. It is highly profitable, producing cash flows far beyond those required to fund its new posi�ve net present value projects because it is in a mature industry with few growth opportuni�es. Yet AII has tradi�onally retained much of this residual cash rather than paying it out as dividends. Would you, as a stockholder, be pleased or displeased if AII announced an increase in leverage by using its cash to repurchase a large propor�on of its stock? Explain using an agency-related ra�onale.

6. Total leverage describes a firm's degree of opera�ng leverage plus its degree of financial leverage. Consider two u�lity companies, each with 50% debt in their capital structure. Washington State Electric generates hydroelectric power at its dam across the Rapid River in the Pacific Northwest. Smokey Mesa Power is located in Arizona and generates its power at the coal-burning Black Cloud Power Plant. What are the raw materials for each electric genera�on process? Which u�lity is exposed to more price uncertainty regarding its cost of these raw materials? Which u�lity has more opera�ng leverage? Which one has more total leverage?

7. Managers naturally want to protect their jobs. For them, the chance of a firm's bankruptcy is more threatening than for the firm's shareholders. Given this, do you think managers are biased against certain poten�al investment projects that have high risk? Assuming they are, is this bias in the best interest of shareholders? What if the risky project has a posi�ve NPV? Could this bias affect firm value, and, if so, will its affect get stronger as the firm takes on more debt? Is this type of agency cost a pro-leverage or an�-leverage argument?

Key Terms

Click on each key term to see the defini�on.

asset specificity (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The degree to which an asset's value is �ed to a par�cular, unique func�on.

bankruptcy costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The direct (a�orney's fees and court fees) and indirect (management's �me spent on paperwork, phone calls, mee�ngs, and so on, that could otherwise be spent on more produc�ve ac�vi�es) costs of filing for bankruptcy.

capital structure (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The mix of debt and preferred equity in a company's por�olio.

debt capacity (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The maximum amount of debt that can safely be serviced by a firm.

discipline of debt (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Financial theory that asserts firms become more efficient and therefore more valuable as leverage increases.

financial flexibility (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The ability of a firm to raise funds for investment (and paying dividends) during periods when cash genera�on is low.

pecking order theory (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Theory developed by Stuart Myers of MIT that argues that the costs of issuing securi�es in the capital market is so high that companies will try to avoid these costs. Companies consider internally generated cash flow, their investment opportuni�es, and the costs associated with security issuance.

signal (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

An outward measure of the financial health of a company.

target capital structure (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

The op�mum mix of debt, preferred stock, and equity that maximizes firm value.

trade-off theory of capital structure (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro

Theory that argues that companies have an op�mal level of debt (a mix of debt and equity that maximizes value). This op�mum point is a trade-off between the tax and agency cost reduc�on benefits of debt and its bankruptcy costs.

Web Resources

For a step-by-step guide to the IPO process, see David Newton's ar�cle, "The ABC's of the IPO Process," Entrepreneur Magazine: h�p://www.entrepreneur.com/ar�cle/75252 (h�p://www.entrepreneur.com/ar�cle/75252)

Find small business tax informa�on at: h�p://www.sba.gov/content/learn-about-your-state-and-local-tax-obliga�ons (h�p://www.sba.gov/content/learn-about-your-state-and-local-tax-obliga�ons) and h�p://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed (h�p://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed)

Capital structure irrelevance was proven for perfect markets by Franco Modigliani and Merton Miller in one of the most important ar�cles ever wri�en in economics. They have both received Nobel prizes, in part for their capital structure studies. Read "The Cost of Capital, Corpora�on Finance and the Theory of Investment," American Economic Review, 48 (June 1958) here: h�ps://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1958.pdf (h�ps://www2.bc.edu/~chemmanu/phdfincorp/MF891%20papers/MM1958.pdf)

Students interested in agency problems or corporate takeover ba�les are advised to read Barbarians at the Gate, the story of the ba�le for control of RJR-Nabisco, which led to one of the largest corporate takeovers in history. It was made into a movie, which can be viewed here: h�p://youtu.be/iPhF_YwWvoM (h�p://youtu.be/iPhF_YwWvoM)