. 30
( 39)


investors and vice-versa.
taxes, not just your own corporate income tax. You also know that investors cannot shelter
Distributions in interest
save ¬rms money, but
interest income, can modestly shelter dividend income, and can easily shelter capital gains
not investors.
income. At this point, you should also realize that you face a dilemma:
Distributions in capital
gains save investors
money, but not ¬rms. • If you plan to pay cash as interest income, you will save on your own corporate income
tax”but your investors will face the full brunt of Uncle Sam (and thus demand a relatively
higher expected rate of return).
• If you plan to convert cash into capital gains by reinvesting retained earnings, you will
pay full corporate income taxes”but your investors can then avoid most personal taxes
(and thus demand relatively lower expected rates of return).
¬le=caprest.tex: RP
Section 23·1. The Role of Personal Income Taxes and Clientele E¬ects.

To make matters even more interesting, you have to be concerned that, in real life, not every Complication: Different
investors face different
investor faces the same tax rate. There are low-tax investors, like tax-exempt charities and
personal tax rates.
pension funds, who pay low or no (personal) taxes on both dividend and interest distributions.
And there are high-tax investors, like most retail investors, who pay especially high taxes on
interest income, medium-high taxes on dividends, and lower taxes on capital gains. What
should you do?
The best way to understand what you should do is to presume for the moment that you are a SimCity Live!
puppeteer, controlling the private economy. Your opponent is the IRS. Your four pieces are:

1. High-tax corporations”like PepsiCo or R.J.R. Nabisco, bulging with earnings. Often, these
are mature “value” ¬rms.

2. Low-tax corporations”like Itar in 1985, a shell company with large tax-loss carryforwards
or net operating losses; or Nanotech, a developer of nano-technology with virtual earnings.
Growth ¬rms are often low-tax corporations.

3. High-tax investors”like retail investors earning over $100,000 per year.

4. Low-tax or tax-exempt investors”like a pension fund or the money in a tax-advantaged
retirement account, like a 401-K.

These are not perfect classi¬cations, because even low-tax investors must eventually pay some
taxes, and even low-tax corporations may run out of tax-shelters (or they can immediately use
up all their tax credits and thereby become high-tax companies!). But this classi¬cation serves
us well in thinking about the problem. How would you arrange your pieces? Would you have
the high-tax corporation ¬nance with debt or equity? Would you have the low-tax investor own
the high-tax corporation or the low-tax corporation?
¬le=caprest.tex: LP
586 Chapter 23. Other Capital Structure Considerations.

Your Solution ” Rearranging Clienteles
Clearly, this would not be a di¬cult problem if 99% of all investors were tax-exempt”you could
Who should own what is
only interesting if make all highly taxed corporations issue debt (and thereby avoid corporate income taxes). Nei-
tax-exempt investors are
ther corporations nor the almost entirely tax-exempt investor sector would end up paying any
not in practically
tax. Corporations would not have to compensate investors for personal taxes, and corporations
unlimited supply”or
else they would own
could o¬er bonds with the same yield as equivalently risky but tax-exempt entities. However,
low-tax investors are not in unlimited supply. The NYSE™s Factbook reports that there was $11
trillion in total equities outstanding in 2002, of which 49.8% was held by all institutional in-
vestors, 36% by retail investors, and 11% by foreign investors. Almost half of the institutional
money, a total 21.5% of the equities market, were tax-exempt pension funds. So, tax-exempt
institutions are indeed a force, but also a limited one.
With a limited number of tax-exempt investors, as puppeteer with the task of minimizing the
“Clientele effects” mean
different ¬rms attract IRS™ take and maximizing your private sector take, you should sort your pieces into the following
different investors.
Carried to extremes,
Uncle Sam might not get

Anecdote: Tax Reductions for the Needy? For-Pro¬t Corporations with No Tax Obligations
Are all cash-cow corporations in a high marginal tax bracket? The Washington Post reported a study by the
Institute on Taxation and Economic Policy which showed that 41 companies not only owed no taxes, but received
money back in at least one of the three years studies”1996“1998”although they reported a total of $25.8 billion
in pretax pro¬ts. 24 companies”nearly one in 10 studied”received tax rebates in 1998 alone, including such
household names as Texaco Inc., Chevron Corp., PepsiCo Inc., MCI WorldCom Inc., Goodyear Tire & Rubber Co.
and General Motors Corp. Texaco, for example, received a tax rebate of $67.7 million, which meant that it paid
taxes at a rate of negative 37.2 percent on the $182 million in pro¬t it reported in 1998. In dollar terms, the
study found that tax breaks enabled the companies to reduce their taxes by $98 billion over the three years,
with 25 companies receiving almost half of that amount. General Electric Co. topped the list, with $6.9 billion in
breaks, which cut its tax bill by 77 percent over the three years. A G.E. spokesman also questioned the report™s
methodology, noting that of the $6.9 billion in breaks cited, $2.4 billion was deferred taxes “that we will pay.”
The twenty-four companies that payed less than zero in federal income taxes in 1998 were

Company 1998 Pro¬t 1998 Tax 1998 Rate
Lyondell Chemical $80.0 “$44.0 “55.0%
Texaco $182.0 “$67.7 “37.2%
Chevron $708.0 “$186.8 “26.4%
CSX $386.6 “$102.1 “26.4%
Tosco $227.4 “$46.7 “20.6%
PepsiCo $1,583.0 “$302.0 “19.1%
Owens&Minor $46.1 “$7.9 “17.1%
P¬zer $1,197.6 “$197.2 “16.5%
J.P. Morgan $481.1 “$62.3 “12.9%
Saks $83.0 “$7.9 “9.5%
Goodyear $400.7 “$33.2 “8.3%
Ryder $227.5 “$16.4 “7.2%
Enron $189.0 “$12.5 “6.6%
Colgate-Palmolive $348.5 “$19.6 “5.6%
MCI WorldCom $2,724.2 “$112.6 “4.1%
Eaton $478.8 “$18.0 “3.8%
Weyerhaeuser $405.0 “$9.5 “2.3%
General Motors $952.0 “$19.0 “2.0%
El Paso Energy $383.7 “$3.0 “0.8%
WestPoint Stevens $142.6 “$1.2 “0.8%
MedPartners $49.6 “$0.4 “0.7%
Phillips Petroleum $145.0 “$1.1 “0.7%
McKesson $234.0 “$1.0 “0.4%
Northrop Grumman $297.7 “$1.0 “0.3%
Total $11,953.0 “$1,272.9 “10.6%
¬le=caprest.tex: RP
Section 23·1. The Role of Personal Income Taxes and Clientele E¬ects.

High-Tax Pro¬table Firms: Make your “cash cow” value ¬rms in the highest tax bracket issue High-tax, pro¬table
¬rms should pay via
debt, so that their cash ¬‚ows can be paid out as interest, thereby avoiding the high cor-
interest (thus, have
porate income tax. debt).

Low-Tax Investors: Make your tax-exempt investors hold this corporate debt, so that the in- Low-tax investors should
hold the debt.
terest receipts remain untaxed at the recipient level. (If you instead made your individual
investors hold this debt, Uncle Sam would be better o¬, and you would be worse o¬.)

You still have low-tax ¬rms and high-tax investors to allocate. What can you do with them?

High-Tax Investors: Make your high-tax individual investors hold stocks instead of bonds. High-Tax investors
should hold the equity.
They will then either receive capital gains (taxed very little) or dividends (taxed just a
little more). This way, your high-tax investors will su¬er only fairly low tax penalties, too.

Low-Tax Firms: Make your growth ¬rms and other ¬rms in the lowest corporate tax bracket Low-tax, unpro¬table
¬rms should pay via
¬nance themselves with equity, not with debt. You need this to satisfy the demand for
share repurchases (thus,
equity by your high-tax investors. You can make your low-tax ¬rms use their cash ¬‚ows have equity).
to reinvest in the corporation, repurchase their shares, or pay dividends (but only until
2007!). In any case, it would allow these ¬rms™ predominantly high-tax investors not to
su¬er much in tax. (If you instead made your low-tax ¬rms ¬nance themselves with debt,
the ¬rms would have little use for the corporate income tax shelter provided by debt,
at least compared to high corporate tax ¬rms”and your high-tax investors would have
nothing to buy.)

For simplicity, assume that the world is risk-neutral, so that you do not have to worry about
higher costs of capital for equity than for debt.
Figures 23.1 and 23.2 try to illustrate the best puppeteering choices for ¬rms and investors” Illustrative Numbers to
show our best
and Uncle Sam™s consequent take. All the numbers and tax rates are illustrative only, and not
exact. We assign 40% as the ordinary income tax rate for high-tax companies and for high-tax
investors™ interest receipts. We assign 20% as the high-tax investors™ tax on dividend receipts if
the ¬rm has paid enough in taxes (so investors receive a tax credit). And we assign 10% as the
e¬ective capital gains tax rate”partly, because it can be deferred and o¬set, and partly because
the statutory rate is lower. Finally, we fudge some numbers to re¬‚ect other freedoms”for exam-
ple, a ¬rm that reinvests its money may claim that the reinvestment is necessary maintenance
and thus not income, or it may receive tax credits for investing (a common situation). Thus, we
assign only a 20% e¬ective corporate income tax rate to cash used for reinvestment. Low-tax
¬rm may not mean zero-tax ¬rm”even tax credits have a value, so there is an opportunity cost
to using up tax credits today. So, we assign a 10% income tax rate to cash that adds to earnings,
and a 5% income tax rate to reinvested cash with its investment/maintenance tax credit.
Figures 23.1 shows that the high-tax ¬rm can pay debt from pre-tax earnings without incurring Do the high-tax ¬rm
any tax penalty. If the ¬rm reinvests all cash, we have assigned it our 20% e¬ective corporate
income tax rate. Investors get $80 in the form of capital gains. If these are taxed investors, they
su¬er only a 10% income tax rate (in present value) on this gain, for a net personal tax obligation
of $80· · 10% = $8. If the ¬rm instead uses the money to repurchase stock, it can do so only
from after-tax money. So, the IRS collects $40 in ordinary corporate income tax. Investors pay
10% capital gains tax on $60 in share repurchases (i.e., $6) and twice this on dividends ($12).
Clearly, the best choice here is the top line”the clientele e¬ect we discussed earlier, in which
the IRS receives no money.
The low-tax ¬rm in Figure 23.2 can no longer use our low-tax investors”we have already used Do the low-tax ¬rm next.
them up in Figure 23.1. Focus on our high-tax investors. They pay 10% on capital gains, and
25% rather than 20% because the ¬rm has not paid income taxes”under the Bush dividend tax
plan, the investor does not receive much of a tax credit.
Table 23.1. Taxation Chain of a High Tax Firm

Corporate Level Personal Level Net E¬ect

IRS= $0 ’ Investors=$100
Personal Tax: $0
Low-Tax Investor
Pay Interest: $100
Debt’ Corporate Tax: $0
r E
High-Tax Investor IRS=$40 ’ Investors= $60
Personal Tax: $40
¡ I
 IRS=$20 ’ Investors= $80
Personal Tax: $0
Low-Tax Investor

Reinvest: $80

¬le=caprest.tex: LP
Corporate Tax: $20
¡   (creates capital gain)
r E
¡  High-Tax Investor IRS=$28 ’ Investors= $72
Personal Tax: $8
High-Tax Firm

ed I
 IRS=$40 ’ Investors= $60
Personal Tax: $0
Low-Tax Investor

ed Repurchase Stock: $60
ed ‚

Chapter 23. Other Capital Structure Considerations.
Corporate Tax: $40
e E
(creates capital gain)
High-Tax Investor IRS=$46 ’ Investors= $54
Personal Tax: $6

 IRS=$40 ’ Investors= $60
Personal Tax: $0
Low-Tax Investor

Equity’ Pay Dividend: $60
Corporate Tax: $40
r E
High-Tax Investor IRS=$52 ’ Investors= $48
Personal Tax: $12

A high-tax ¬rm may be a value ¬rm with lots of earnings and few deductions, such as R.J.R. Nabisco. A low-tax investor may be a tax-exempt pension fund. A high-tax investor may be a
typical retail investor.

All numbers are illustrative and not exact! The ¬rm has $100 in cash. Firm Level: If paid as interest, the full $100 can be paid out. If reinvested, some investments and/or maintenance
create tax credits. If paid out to shareholders, the ¬rm incurs the full corporate income tax obligation. Personal Level: Low-tax investors never pay. High-tax investors e¬ectively pay
10% on capital gains (in PV terms), 20% on dividend receipts, and 40% on interest receipts.
Table 23.2. Taxation Chain of a Low Tax Firm

Section 23·1. The Role of Personal Income Taxes and Clientele E¬ects.
Corporate Level Personal Level Net E¬ect
 IRS= $0 ’ Investors=$100
Personal Tax: $0
Low-Tax Investor

Pay Interest: $100
Debt’ Corporate Tax: $0
r E
High-Tax Investor IRS=$40 ’ Investors= $60
Personal Tax: $40 Dumb


¡ I
 IRS= $5 ’ Investors= $95
Personal Tax: $0
Low-Tax Investor

Reinvest: $95
Corporate Tax: $5
¡   (creates capital gain)
r E
¡  High-Tax Investor Top
IRS=$14.5 ’ Investors= $85.5
Personal Tax: $9.5
¡  Choice

Low Tax Firm

err E
j I
 IRS=$10 ’ Investors= $90
Personal Tax: $0
Low-Tax Investor

e Repurchase Stock: $90
e Corporate Tax: $10
e E
(creates capital gain)
High-Tax Investor IRS=$19 ’ Investors= $81
Personal Tax: $9 Good
e Choice


¬le=caprest.tex: RP
 IRS=$10 ’ Investors= $90
Personal Tax: $0
Low-Tax Investor

Equity’ Pay Dividend: $90
Corporate Tax: $10
j E
High-Tax Investor IRS=$32.5 ’ Investors= $67.5
Personal Tax: $22.5 So-So

A low-tax ¬rm may be a ¬rm with seemingly unlimited tax-loss carryforwards or a growth ¬rm that is unlikely to earn a pro¬t for many years to come. A low-tax investor may be a
tax-exempt pension fund. A high-tax investor may be a typical retail investor.

All numbers are illustrative and not exact! The ¬rm has $100 in cash. Dark boxes indicate that we have already used up our low-tax investors on high-tax ¬rms, so that there are few or
no low-tax investors left.

Firm Level: Low-tax ¬rms pay no (debt) or almost no corporate income tax (other forms). Personal Level: High-tax investors e¬ectively pay 10% on capital gains (in PV terms), 25% on
dividend receipts, and 40% on interest receipts. (The Bush tax cut of 2002 requires the ¬rm having paid dividends, so the dividend tax rate is above the 15% rate after corporate credit.)
¬le=caprest.tex: LP
590 Chapter 23. Other Capital Structure Considerations.

Now, put the two ¬gures together: In sum, our puppets are paying $9.5 in taxes. Can you ¬nd
Can you do better?
a combination that is better? No! This is the best puppeteering that you can do!

Market Prices as Puppeteers
In the real world, you are not the puppeteer”market prices (for capital) are! This is what
The extreme tax
avoidance is illustrative, capitalist markets are really good at”they can allocate resources to their best use, and the
but not realistic.
best use of capital here is where it avoids paying taxes. By adjusting the required costs of
capital on debt and equity, capital markets induce investors and ¬rms to sort themselves to
where frictions”such as tax losses”are the lowest. (If the market did not sort, you could make
money from better rearranging ¬rms and investors by saving on aggregate taxes.) Here is an
example of how prices could adjust to accomplish clientele sorting:

Cash Cow Firm The market prices have adjusted so that a ¬rm in the 40% income tax bracket
expects a 10% rate of return before corporate income taxes.

Corporate Level
• If it pays out all net cash ¬‚ow in capital gains, it must pay corporate income tax,
and can only o¬er a 6% rate of return.
• If it pays out all net cash ¬‚ow in interest, it can pay out the full 10% rate of return.
Personal Level
• A tax-exempt investor can receive 10% in income from this company.
• A 30% taxable investor can receive 7% in income from this company.

Growth Firm The market prices have adjusted so that a ¬rm in the 0% income tax bracket
expects an 8% rate of return before corporate income taxes.

Corporate Level
• If it pays out in capital gains, it can o¬er an 8% rate of return.
• If it pays out in interest, it can still o¬er only the 8% rate of return”the ¬rm
already pays no tax, so deducting interest payments does not help any further.
Personal Level
• A tax-exempt investor can receive 8% in income from this company.
• A 30% taxable investor does not realize capital gain, and thus can keep close to
8% in income from this company.

The result of ¬rm prices, which create such expected rates of returns, will be that tax-exempt
investors will decide to invest with the debt-¬nanced cash cow ¬rms o¬ering a 10% expected
rate of return (rather than 8% that they could get from the growth ¬rms); and the taxable
investors will prefer to invest with the growth ¬rms, where they can earn a rate of return of 8%
(rather than the 7% that they could receive from the debt-¬nanced cash cow ¬rm). The ¬nancial
market has become the puppeteer!
Of course, in the real world, tax-avoidance is just one force at work”though it is a very impor-
Other forces are also at
work, so this is just a tant one. In the real world, there are many di¬erent types of investors, and they do want to
partial model.
diversify across many di¬erent companies. There are also other reasons why tax-exempt in-
vestors do not hold only or all of high-corporate-tax ¬rm™s debt; reasons why high-tax corporate
tax ¬rms have equity in their capital structures; reasons why taxable investors hold debt; and
reasons why low-tax bracket ¬rms have debt. But you should now understand the tax rationale
for how expected rates of returns will sort ¬rms and investors to minimize taxes. The ultimate
e¬ect, from your corporate managerial perspective, is that clientele e¬ects work at reducing
the e¬ective personal income tax rates, especially on interest payments. There is good empir-
ical evidence that the tax-clientele ownership e¬ects are important. For example, corporate
bonds are indeed overwhelmingly owned by tax-exempt institutions. But the clientele income
tax reduction is also not be perfect, which is why corporations ¬nd that their bonds have to
pay higher yields than they would in a world without any taxes”an e¬ect that will enter the
WACC formula in the relative costs of E(˜DT ) and E(˜EQ ).
r r
¬le=caprest.tex: RP
Section 23·1. The Role of Personal Income Taxes and Clientele E¬ects.

Digging Deeper: In equilibrium, security yields and investor holdings are jointly determined, not sequentially
as indicated by this discussion. But, pro¬t seeking means that in equilibrium, proper sorting will take place. If tax-
exempt investors were to sort themselves into the wrong stocks, the yields on corporate interest-bearing securities
would increase, and tax-exempt investors should ¬nd it irresistible to pass up on corporate bonds (which, in order
to be purchased by taxable retail investors, would really have to o¬er high rates of return). Tax-exempts would ¬nd
it in their interest to sell their equities and move into these bonds. In equilibrium, dividend and interest-bearing
securities should have lower pre-tax rates of return and higher post-tax rates of return than zero-dividend stocks.
But even in the United States, with its armies of academic ¬nance researchers, taxes remain a complex and
empirically unresolved issue. Academics are still debating who bene¬ts most from tax arbitrage”dividend-paying
issuers or tax-exempt investors. If there are many tax-exempt institutions to compete with one another for the
privilege of conducting tax arbitrage, ¬rms could borrow at rates as if all their investors were tax-exempt. Yet, if
there are too many ¬rms paying dividends, they will compete to pay a premium to ¬nd tax-exempt institutions,
up to and including the cost of paying taxes”and it would be the tax-exempt investors who would bene¬t most
from their tax-exempt status. As always, the truth is probably in the middle, where the tax-arbitrage bene¬ts are
shared by tax-exempt investors and taxed ¬rms.

I have to admit to one small sin: I have made the cost of debt and equity capital a “deus ex Can the personal income
tax rate enter a modi¬ed
machina””a number that you, as a corporate manager, should learn from the capital markets.
WACC formula?
But you can ask where these costs of capital for debt and equity really come from. I have
given you the intuition: personal income taxes matter but clientele e¬ects reduce their bites.
I have asked you to think about the personal tax issues qualitatively, not quantitatively, and I
have told you that reducing your investors™ e¬ective personal tax burden will result in a lower
cost of ¬nancing (E(˜EQ ) and E(˜DT )) for your company. Quantitatively, I have advised you
r r
that, as a corporate manager, you should work with “as if equity ¬nanced and fully corporate
income taxed” cash ¬‚ows, which are then adjusted with a WACC that re¬‚ects your corporate
income tax rate. I have not advised you to work with “as if equity ¬nanced and fully corporate
income taxed and personal income taxed” cash ¬‚ows, in which case you would need a WACC
that re¬‚ects both your corporate income tax rate and your investors™ personal income tax rate.
The latter would have dug down one more layer of depth, but it is one that I do not believe to
be very productive for most corporate managers. As a corporate manager, you would have to
determine the e¬ective personal income tax rates on both debt and equity ¬nancing, and the
clientele e¬ects in equilibrium make these e¬ective tax rates much lower than the statutory
tax rates (for ordinary taxable investors). You would have to know your own e¬ective investor
clientele, which in equilibrium depends on the size of the various corporate sectors and investor
sectors”an almost impossible task. Few managers attempt it, and in my opinion rightly so.
Solve Now!
Q 23.1 Explain the (personal and corporate) tax treatments if a company pays its operating cash
¬‚ow in interest, repurchase, or dividends.

Q 23.2 Would you expect large, stable ¬rms to be predominantly held by pension funds or by
individuals? Would you expect young, growing ¬rms to be predominantly held by pension funds
or by individuals?
¬le=caprest.tex: LP
592 Chapter 23. Other Capital Structure Considerations.

23·2. Operating Policy Distortions: Behavior in Bad Times
(Financial Distress)

Personal income taxes are not the only reason why ¬rms should not necessarily be highly
levered, thereby saving on corporate income taxes? Too much debt can make it more likely
that a ¬rm will not be able to meet its repayment obligations and go bankrupt. This can create
a whole variety of problems, both before and after a possible bankruptcy, that may limit the
amount of debt that ¬rms may want to take on.

23·2.A. The Tradeo¬ in the Presence of Financial Distress Costs

Table 23.3. Illustration of Deadweight Costs in Financial Distress

Bad Luck Good Luck Future Ex- Today™s
Prob: 1/2 1/2 pected Value Present Value

Project FM $60 $160 $110 $100

Capital Structure LD: Bond with Face Value FV=$55
Bond(FV=$55) DT $55 $55 $55 $50
Equity EQ $5 $105 $55 $50

Capital Structure MD: Bond with Face Value FV=$94 and $10 Deadweight Costs
$60 ’$10 $77 ’$5 $70 ’$4.55
Bond(FV=$94) DT $94
= $50 $94 =$72 =$65.46

Equity EQ $0 $66 $33 $30

The cost of capital in this example is 10% for all securities, which is equivalent to assuming risk-neutrality.

A ¬rm that has debt in its capital structure is more likely to experience ¬nancial distress or
Let™s rework the perfect
markets example from even go bankrupt. Table 23.3 shows how such ¬nancial distress can matter. If the ¬rm has
Table 21.1.
little debt, as in capital structure LD with its face value of $55, the ¬rm can always fully meet
its debt obligations. Consequently, we assume that it will not experience ¬nancial distress, and
our LD scenario still matches our perfect world from Table 21.1. However, if the ¬rm has much
debt, as in capital structure MD with its face value of $94, the ¬rm may not pay creditors all it
has promised. If the world were perfect, as it had been in Table 21.1, this bankruptcy condition
would merely change the payo¬ pattern. Everyone (including bondholders) would have known
that the ¬rm would be transferred to bondholders who would liquidate a full $60. The ¬rm
value would not be impacted by the ¬nancial distress and would therefore still be $100.
However, bankruptcy matters if we introduce deadweight losses”such as legal fees”that are
MD is worse than LD, so
a debt increase can triggered in ¬nancial distress. In the lower part of Table 23.3, we assume that these deadweight
lower the ¬rm value
bankruptcy costs amount to $10. How does this matter?
today. Distress per se is
not the problem ”
deadweight costs in • If you choose LD, you would borrow $50 and promise $55. Your cost of capital would be
¬nancial distress are!
10%. Your ¬rm value would be $100 today.
• If you choose MD, you would borrow $65.46 and promise $94, for an interest rate of
43.6%. The expected rate of return to creditors would not change”it would still be 10%.
¬le=caprest.tex: RP
Section 23·2. Operating Policy Distortions: Behavior in Bad Times (Financial Distress).

(Every investment has to o¬er 10% in our risk-neutral world). However, the deadweight
bankruptcy cost increases your cost of capital. You are giving up $60 or $94”for an
expected value of $77”in exchange for a payment of $65.46. Your cost of capital would
have increased from 10% to 17.6%! Thus, you could sell your ¬rm only for $95.46, not for

From your perspective, capital structure MD is worse than capital structure LD, in which the
¬rm could never go bankrupt. The important insight with respect to bankruptcy is that it is not
bankruptcy per se that is the problem, but only the deadweight losses in and around ¬nancial
distress that matter.
Who ultimately bears the cost of bankruptcy”you or creditors? It would be you, because Ceteris paribus, you can
increase value today if
creditors demand fair compensation upfront. So think about how you want to structure your
you reduce future
¬rm if you face both tax and bankruptcy losses. You should now try to reduce not only the expected ¬nancial
deadweight loss from taxes, but also the deadweight loss from ¬nancial distress: distress costs”direct
and indirect. Capital
structures with less debt
• Too little debt, and you lose too much in taxes. can do this.

• Too much debt, and you lose too much in bankruptcy costs.

Therefore, an interior amount of debt will maximize the value of your ¬rm today.
The rest of this section describes the various forms of deadweight losses in ¬nancial distress” Forms of distress costs
to be discussed.
and it is not just the legal fees if bankruptcy were to occur. It could be that you would spend
money prior to formal bankruptcy to avoid worse, or that the fear of bankruptcy will prevent
you from taking a positive NPV project if you are su¬ciently close to bankruptcy (though not
there yet). Indeed, you can think of anything that would distort your choices as a cost. If a
particular capital structure induces you to deviate from the optimal set of projects and behavior
in the future, the resulting reduction in future cash ¬‚ows reduces your ¬rm™s value. It would
be a cost arising from this capital structure. (These are often called indirect bankruptcy costs,
because they are not direct cash outlays. They can occur even before formal bankruptcy.) But
whether they are direct or indirect deadweight costs of ¬nancial distress, they all have the same
e¬ect”they increase your cost of capital and decrease your ¬rm value today. And of course we
already know that the ¬nancial distress needs never occur”the probability that it may occur
in the future is enough to reduce the value today.

Important: Financial distress costs usually favor equity over debt as a cheaper
¬nancing vehicle.

23·2.B. Direct Losses of Firm Value

The Process
Although the process and history of bankruptcy, both in the United States and worldwide, are Two forms of
fascinating, the full legal details of bankruptcy are beyond the scope of this book. In the United
States, there are two legal forms of ¬nancial distress: Chapter 7 Liquidation and Chapter 11
Reorganization. Larger ¬rms usually petition to enter Chapter 11, which gives them a stay
from creditors trying to seize their vital assets. If the court determines that the business is still
viable, the ¬rm can reorganize its ¬nancial claims and emerge from bankruptcy if its creditors
vote to agree to the reorganization. Otherwise, the case is converted into Chapter 7 and the
¬rm is liquidated. Both forms are supervised by a Federal Judge (and/or Federal Bankruptcy
Trustee) and last on average about 2-3 years. In real life, creditors in Chapter 11 sometimes
agree to modest violations from the Absolute Priority Rule”which we have always used to
construct our state-contingent tables”in order to reduce running bankruptcy costs. The ¬rm
¬le=caprest.tex: LP
594 Chapter 23. Other Capital Structure Considerations.

typically pays for most of the legal fees of all participants”but even if it did not, creditors
would ask for compensation for their expected legal fees upfront, so one way or another, the
¬rm has to carry the expected costs of bankruptcy.

Direct vs. Indirect Costs
The direct legal fees are just the most obvious costs: the legal fees that the bankruptcy process
Direct legal and
administrative direct consumes. There are also hours spent by management, employees, and experts to deal with
bankruptcy costs are
the running process. But much of the cost of ¬nancial distress is indirect and on the real
easily visible. But there
business side. For example, it may become more expensive to produce (e.g., because suppliers
are also costs that are
not cash outlays.
may charge more, fearing delayed or no payment), more di¬cult to focus (as management is
distracted with bankruptcy and more talented employees are leaving), more expensive to sell
product (e.g., customers ¬‚eeing due to loss of con¬dence), and more expensive to sell assets
(e.g., liquidation sales may mean low ¬re-auction prices). All these costs reduce the value of
the ¬rm, and are real welfare losses caused by ¬nancial distress. These costs can also arise
even before formal bankruptcy. Many of these costs originate from the fact that ¬rms can shed
promised claims in bankruptcy, even if they would like to commit themselves today (ex-ante)
not to shed them in the future. This inability to commit causes a loss of value when future
distress is possible. Consider the following examples:

• When products require customer investments, customers may be reluctant to purchase
the products and invest, knowing that their investments could turn out to be wasted if
the ¬rm were to disappear.
For example, the value of a computer is determined not only by its hardware, but also by
the manufacturer™s continued provision of hardware and software support and develop-
ment. End-of-life hardware or software, no matter how good, is often close to worthless.
Even if the ¬rm promises to continue development of faster hardware to preserve its cus-
tomers™ software investments, if the ¬rm is liquidated, it would not be able to keep such a
promise. The inability of the ¬rm to commit to honoring its promises in the future hurts
its sales to customers today”and may even cause the bankruptcy itself.
This channel also works through the product resale market. If you are deciding whether
to purchase a Saturn or a Toyota to drive for ¬ve years and then resell it, you should worry
about whether General Motors will go bankrupt”after all, in 2005, GM™s debt just dropped
below investment grade. If GM were to go bankrupt, the resale value of used Saturn cars
would then drop further. This in turn should make you less inclined to purchase the
Saturn in the ¬rst place.

• When product sales require promises of future contact, customers may be reluctant to
purchase the product, given that the future promised rebate may fail to materialize.
For example, airlines depend on frequent ¬‚ier plans to attract business travellers. When
the promise of future free ¬‚ights loses its credibility, an airline becomes severely hand-
icapped. In e¬ect, any ¬rm whose products require warranties should weigh whether
issuing debt might not alarm its customers. Such products may require future service,
and customers may be reluctant to purchase the product, knowing that the service may
become unobtainable in the future.

• When product quality is di¬cult to judge, customers become afraid that companies may
cut corners in order to avoid ¬nancial distress.
Have you ever wondered whether an airline in ¬nancial distress cuts corner on airplane
Without trustworthy
warranty programs, maintenance? (You should!) The e¬ect here is not the cutting of corners on the mainte-
competing in some
nance (which we will discuss below), but the fear of customers that the ¬rm may do so.
businesses is very
Consequently, the price at which such an airline can sell tickets may be below that of a ¬-
nancially solid airline. Similarly, wholesalers will not deliver their goods to near-bankrupt
retailers unless they are assured of payment. Because bankrupt retailers may no longer
be able to purchase credit, the costs of their goods may increase”and their competitive
advantage may erode.
¬le=caprest.tex: RP
Section 23·2. Operating Policy Distortions: Behavior in Bad Times (Financial Distress).

• Some businesses rely on trade credit, in which suppliers sell their goods to buyers in an
open credit arrangement. (It is in e¬ect a credit line that is limited to the speci¬c goods
the supplier sells.) If suppliers fear that the buyer can go bankrupt, they may not extend
trade credit. In some cases, this can hamper business operations to the point where it
can itself cause the onset of bankruptcy.

Financial Distress Costs As Transaction Cost?
But there is a limit to the importance of bankruptcy costs. We can muster an argument similar The limit to the costs™
importance is the cost of
in spirit to the M&M proof: if ¬nancial distress costs are too high, someone can purchase all
combining securities.
the securities, which eliminates the ¬nancial distress and with it all bankruptcy costs. In this
sense, distress costs can be considered a special form of transaction costs: the transaction costs
caused by bankruptcy must be bounded by the costs of purchasing all securities to eliminate
deadweight costs. But in a non-perfect world, this is not easy to do, either. One problem is that
when all other creditors agree to a bailout, you”as the ¬nal bondholder”would not want to
agree. You would insist on your full claim, hoping that the other creditors would agree if they
want to execute the bailout. Of course, every creditor realizes this, and would prefer to hold out
for the other creditors to organize. Given such bargaining considerations, it may be cheaper for
a potential saviour to wait until the ¬rm is run down more and then sold in a ¬re-sale, rather
than to try to acquire securities from in¬‚exible creditors.
One attempt to reduce the transaction cost is for ¬rms to bundle their ¬nancial claims into Disagreement and
bargaining among
units (unit securities) of debt and equity. Each creditor would also be a shareholder. If the ¬rm
creditors make ef¬cient
fails to pay interest in the future, creditors will be more inclined to compromise in order to reorganization dif¬cult.
avoid ¬nancial distress”after all, there is little reason to force bankruptcy in order to collect
assets from oneself.

Assessing the Magnitude of Direct Bankruptcy Costs
Let us estimate the magnitude of expected bankruptcy costs for the average Fortune 500 com- Orders of magnitude
pany. Fewer than ¬ve Fortune 500 companies enter ¬nancial distress (either formal or informal)
in a given year. Quadruple this number to get an estimate of 4% probability of bankruptcy at
the outset of the year. Further, presume that bankruptcy costs are 5% of the value of such
Fortune 500 companies when they enter bankruptcy. Although this is a high estimate, again
quadruple this number to presume a 20% distress cost. Finally, a Fortune 500 company would
drop by about 80% in (market) value before entering ¬nancial distress, caused not by dead-
weight losses but by the fact that the bad state has come about. So, a $1 billion company
today would be worth only $200 million in the future, and lawyers™ fees of 5% would then come
to “only” $10 million”or 1% in expectation of today™s value, rather than 5%. Put this all to-
gether. At the beginning of the typical year for the typical Fortune 500 company and before
there is any indication of ¬nancial distress, the expected ¬nancial distress costs would be about
4% · 20% · 30% ≈ 25 basis points of value today. This can still be a large amount of money for
lawyers to ¬ght over, but it is relatively modest, say, in comparison to the tax savings from
another dollar of debt. Bankruptcy costs do not loom too large when a healthy Fortune 500
¬rm considers taking on another loan in order to save on corporate income taxes.

Anecdote: Fear and Relief: Lotus and Chrysler
On May 1, 1995, the computer trade magazine PCWeek™s cover story read “Besieged by ongoing ¬nancial tur-
moil...Latest Lotus woes leave some customers skittish.” Customers aware of the possibility of bankruptcy may
choose an (inferior) product from a competing vendor with a lower possibility of bankruptcy, which in turn
reduces the value of the ¬rst ¬rm today.
On July 23, 1981, the Wall Street Journal reported on Chrysler™s ¬rst positive quarterly earnings after a long

Telegraphing even this tiny pro¬t via the nightly news to dealers and potential customers is ex-
tremely important for Chrysler, which is trying to shore up its image as a viable automaker. In the
past, every time Chrysler™s losses mounted, customers ¬‚ed its showrooms, fearing the company
would collapse.
¬le=caprest.tex: LP
596 Chapter 23. Other Capital Structure Considerations.

This argument does not, of course, apply to each and every ¬rm. Which ¬rms are likely to
The fact that some ¬rms
go bankrupt “regularly” su¬er high deadweight losses in bankruptcy? We know that many U.S. railroads have declared
speaks for their
bankruptcy dozens of times, without interruption in service. Even large retailers, like Federated
relatively low
Department Stores (Macy™s and Bloomingdales), have been in and out of bankruptcy several
bankruptcy costs.
times. Airlines have some easily transferable and collaterizable assets (airplanes), and thus may
have fewer deadweight losses”many airlines have ceased operations with their planes sold, re-
painted and turned around for another carrier. Airlines™ bankruptcy deadweight losses are
relatively modest. In contrast, ¬rms with mostly intangible assets (such as reputation or name
recognition) need to be more concerned with reducing the probability of future bankruptcy.
For example, if Chanel were to go bankrupt, Chanel Number 5 might acquire the odor of death,
rather than the odor of high style, and the entire business might disappear. Chanel should there-
fore choose a lower-leverage capital structure to avoid the loss of prestige that a bankruptcy
could bring about.
The importance of bankruptcy costs as an important determinant of capital structure remains
Expected bankruptcy
costs are probably small an empirical issue. The current academic consensus is that bankruptcy costs matter for some
for healthy, large
¬rms and some industries, particularly during recessions. They can easily be very large, but
for most healthy Fortune 500 ¬rms, their expected costs are probably small”Enron notwith-

23·2.C. Operational Distortions of Incentives

A second set of ¬nancial distress costs arises from the fact that shareholders™ incentives diverge
from bondholders™ incentives if the ¬rm gets close to ¬nancial distress.

The underinvestment problem is bondholders™ concern that managers will not make necessary
When there is debt,
equity holders may not investments if the promised debt payments end up being too large. That is, owners may prefer
properly take care of the
to pay out cash to shareholders than spend their money on maintenance and repair (or other
projects). This may be in their interest if the project proceeds would more than likely only go
to bondholders. Underinvestment in turn reduces the payo¬s bondholders will receive, and
thus the ¬rm-value that bond purchasers are willing to pay for lending to the ¬rm today.
For example, assume a ¬rm has only $50 in cash and no projects. Worse, it owes creditors a
Grab as much while you
can! promised $94 next year. (This is the MD capital structure from Table 23.3.) Fortunately for
the shareholders, in our simple example, the managers can pay $50 in dividends, and leave the
bondholders with nothing. Yet, suddenly, managers ¬nd an unexpected opportunity. They can
pay the $50 to start a project that will yield either $60 or $160 by the time the debt is due. The
¬rm should undertake this project, because it is a positive NPV project. But would managers
acting in the interest of shareholders be willing to do so?
¬le=caprest.tex: RP
Section 23·2. Operating Policy Distortions: Behavior in Bad Times (Financial Distress).

Prob: 1/2 1/2 Exp Value Present Value
Project FM $0 $0 $0 $0
Bond(FV=$94) DT $0 $0 $0 $0
Equity EQ $0 $0 $0 $0

Firm shareholders own $50 today.

Choice 1 Pay $50 to shareholders.
Choice 2 Take project that costs $50 and pays either $60 or $160.

Prob: 1/2 1/2 Exp Value Present Value
Project FM $60 $160 $110 $100
Bond(FV=$94) DT $60 $94 $72 $65.46
Equity EQ $0 $66 $33 $30

The answer is no. Managers would prefer to pay out $50 to shareholders rather than take this
positive NPV project. Most of the bene¬t of the project would go to cover the “debt overhang,”
which is something that managers who act on behalf of shareholders would not care much
Again, this “underinvestment problem” is a cost of debt to the ¬rm. If the ¬rm had chosen a Fearing future lack of
care again makes it more
zero debt capital structure ex ante, such pro¬table future investments would not be ignored,
expensive for the ¬rm to
which in turn would increase the value at which our hypothetical owner can sell the ¬rm. raise capital via debt.

Important: Ex post reluctance to do the right thing (such as additional mainte-
nance investment) favors equity over debt as the cheaper ¬nancing vehicle.

Reluctance to Liquidate
A similar problem is the no-liquidation problem. Managers acting on behalf of equity holders Managers may not want
to liquidate the ¬rm,
may not wish to liquidate the ¬rm when it has fallen onto hard times, even if this maximizes
even if they should. This
¬rm value. Equity holders always prefer more risky payo¬s because equity is essentially like an is especially bad for debt
option. If there is even a small chance of improvement and even if deterioration is more likely, holders.
equity holders are better o¬ to take their chances than to give up their options and liquidate.
For example, assume that the $60 represents the liquidation value of the factory, and the MD
debt is due in two years rather than one year. Further assume that managers can continue
running the factory, in which case it will be worth either $100 or $0 with equal probability. The
optimal uncon¬‚icted behavior would be to liquidate the factory. Unfortunately, shareholders
prefer to continue operating”they would get nothing in liquidation, but perhaps $6 if the
factory were to be worth $100. In e¬ect, equity holders have an option on the ¬rm. In fact,
they might even make running interest and principal payments in order to keep their option
alive! This ine¬cient behavior, caused by the presence of debt in the capital structure, reduces
the value of a ¬rm with both debt and equity today.

Important: Ex post reluctance to liquidate by managers not acting on behalf of
the overall ¬rm but on behalf of equity can favor equity as the cheaper ¬nancing
¬le=caprest.tex: LP
598 Chapter 23. Other Capital Structure Considerations.

So far, we have assumed that management acts on behalf of shareholders. They indeed typically
Liquidation reluctance
can also work against care more about equity than about debt, which we just argued may induce them to exploit the
debt on behalf of equity. However, managers can also act on behalf of themselves, especially
if shareholders would be best served by corporate liquidation, too. Managers may run down
the ¬rm™s equity substance in order to keep their jobs instead of returning the money to the
owners. To reduce the incidence of such behavior, ¬rms may add debt to the capital structure.
Debt can limit the ability of managers to run down the entire ¬rm and force them to liquidate
and disgorge some of the remaining assets. This can bene¬t both debt and equity.

Important: Ex post reluctance to liquidate by managers not acting on behalf
of the ¬rm but on behalf of themselves can favor debt over equity as the cheaper
¬nancing vehicle.

We discuss agency problems between managers and owners in the next section and in Chap-
ter 28. Such agency issues tend to be more dramatic in good times. But you should realize that
con¬‚icts of interest can occur in ¬nancial distress, too”in which case the presence of more
debt could be as good a cure as it often is in good times.

23·2.D. Strategic Considerations

Finally, there are some theories in which debt is a strategic commitment device. This argument
Debt can change nature
of the competition in is perhaps easiest to understand by analogy. Consider playing a game of chicken (two cars
the product market.
driving towards one another; the ¬rst to “chicken” out and get out of the way loses). How can
you make sure you win? If you can tie down your steering controls, remove the steering wheel,
and throw it visibly out the window, any smart opponent would surely chicken out! The trick
is to visibly commit yourself to not give way. (Some people have suggested that driving an old,
large and apparently unstable Buick is the equivalent of throwing out the wheel; other cars will
be in a hurry to get out of your way.)
The same argument has been made for debt”that by having debt, ¬rms can commit to squash
An argument that
leverage can make ¬rms potential entrant competitors in their product markets. Assume for a moment that a monopo-
more aggressive and
list has levered up. Consider the decision of a potential market entrant who knows this. The
better off.
market entrant also knows that it is in the interest of the shareholders to increase risk”they
will gain more of the upside than the downside. A price war is riskier than accommodation”
so the monopolist™s managers (acting on behalf of equity holders) may prefer the more risky
strategy of a price war over accommodation. Consequently, the potential entrant may chicken
out, and the monopolist may never have to start the price war. (Of course, if the market entrant
is too stupid to understand the message, both players, the monopolist and the entrant, will be
hurt badly”the two cars will crash head-on.)
This argument is clever but we do not know if it is also empirically important. We do know
The argument seems not
too important. In fact, know that industry matters”for example, ¬nancial services companies tend to rely on a lot
the opposite may be
of debt. However, we do not know whether managers have strategic intent in mind when
true. Leverage may
they pursue capital structure change. There is not much evidence that managers of highly
make ¬rms less
competitive and worse
levered companies have relatively more of a tendency to act in a more risk-seeking fashion in
the product market. There is not much evidence that they choose a price war strategy. And
there is even less clear evidence whether they consciously lever up ex ante in order to commit
themselves to a price war. Some empirical research has actually found that more debt tends to
hurt ¬rms in the product market. Owners tend to take on much debt when they are severely
cash-constrained, and this may prevent them from competing e¬ectively. Indeed, there is
some evidence that supermarkets that dramatically increased their leverage were systematically
attacked by their competitors with price wars and failed to compete as e¬ectively. To the extent
that this weakness reduced their value, it would count as a direct cost of a highly leveraged
capital structure. However, the subject of product-market related strategic capital structure
choice is still under active investigation, and the ¬nal word has not been spoken.
¬le=caprest.tex: RP
Section 23·3. Operating Policy Distortions: Behavior in Good Times.

Important: The competitive product market environment of the ¬rm could
favor either equity or debt.

Solve Now!
Q 23.3 Describe some non-tax based advantages of equity over debt.

Q 23.4 Give examples of bankruptcy costs, both direct and indirect.

Q 23.5 Give an example of an underinvestment problem.

Q 23.6 Give an example of a no-liquidation problem.

Q 23.7 Is leverage a strategic advantage? Describe the arguments on both sides.

23·3. Operating Policy Distortions: Behavior in Good Times

In most of the previous section, debt was usually worse than equity, because it made it more
likely that the ¬rm would enter ¬nancial distress. But problems in choosing the wrong projects
do not arise only when the ¬rm is in trouble. In this section, we discuss what can happen if the
¬rm operates far from ¬nancial distress. Just as too much debt can cause the ¬rm”primarily
shareholders”to make poor operating decisions when ¬nancial distress looms, too little debt
can cause the ¬rm”primarily managers”to make poor operating decision when business is
going well.

23·3.A. Agency Issues

We already covered agency con¬‚icts in Chapter 7, and will cover more agency con¬‚icts
in Chapter 28 on corporate governance.

Free Cash Flow Managers usually prefer spending money internally on their pet projects in- Managers like building
empires and consumer
stead of returning money to shareholders. For example, in the 1980s, many large oil
perks; debt restrains
companies continued exploring for oil, even though it was well known that oil companies them.
could be bought on the stock exchange for signi¬cantly less than the expected cost of ¬nd-
ing equivalent oil reserves. Free cash ¬‚ow issues are especially a problem in contracting
industries”faced with declining markets, managers often desparately search for alterna-
tive investing ventures that are not their competitive advantage, rather than returning
the money to the rightful owners. How can capital structure counterweigh this? Debt
requires coupon payments, which force managers to perform. Managers who fail to gen-
erate enough income to pay the coupon are subject to bankruptcy, and (as has been shown
empirically) almost always lose their jobs. Therefore, managers who have to service more
debt will spend less wastefully, which makes such ¬rms worth more today.
¬le=caprest.tex: LP
600 Chapter 23. Other Capital Structure Considerations.

Theft (and Veri¬cation) Another important problem is outright theft. If you are a passive
Theft and graft.
partner, you are dependent on true and accurate reporting of what pro¬ts really are. The
active partners or the managers, however, might try to avoid reporting large pro¬ts: they
might rather use corporate cash to build more of an empire, to compensate themselves
better, or just to outright steal it! Debt has the advantage that the creditor may not even
need to know what the pro¬ts are: if the agreed-upon payments are not made, the creditor
can force bankruptcy.

Stakeholder Holdup Higher potential hold-up costs are another important drawback of equity.
Holdup costs.
When a company, especially a public company, rolls in cash, anyone who has the power
to hold up business will try to extort more of a share of these pro¬ts. For example, a
supplier who delivers an important input, a wholesaler who is an important distributor,
and any key employees who can bring production to a stop, may want to pressure the
¬rm in order to renegotiate their deals. Yet if the company is ¬nanced more via debt than
equity, these third parties will recognize that there is less cash to expropriate. After all,
if the company does not pay the debt, it can go bankrupt. Thus, in a company with more
debt, the equity earnings (which parties can renegotiate) are smaller.

Important: Free cash ¬‚ow and agency concerns favor debt over equity as the
cheaper ¬nancing vehicle.

Solve Now!
Q 23.8 Give some examples of perks that management might give up when debt load increases.

Anecdote: Airlines, Unions, and Shareholders
In September 2002, American Airlines (AMR) operated over a thousand airplanes, and owned about half of them.
It had assets valued about $30 billion, and debt valued at around $15 billion. Still, its equity market value was
only $800 million”about the price of three of its forty top-of-the-line Boeing 777 airplanes. And it is not clear if
American was worth even this $800 million: bankruptcy was imminent for all other major U.S. carriers (except
In 2002, American lost a signi¬cant amount of money operating. But if American is ever to make positive
pro¬ts again, its unions will surely capture the lion share. After all, it only takes one of its unions (e.g., pilots,
¬‚ight attendants, mechanics) to ground a ¬‚eet worth $30 billion and to wreck customer loyalty. The unions will
ultimately make sure that shareholders will receive just enough for them not to kill the golden goose.
How airlines continue to exist as public corporations, instead of as employee-owned organizations, remains
a mystery to me. (In my opinion, debt may be the only chance that the major airlines have to restrain union
¬le=caprest.tex: RP
Section 23·4. Bondholder Expropriation.

23·4. Bondholder Expropriation

You already know that managers should structure the ¬rm at the outset so as to make it in If there is debt, equity
shareholders may want
their interest to optimize ¬rm value in the future. But to raise debt at an attractive interest
management to exploit
rate, managers must also take into account that bondholders know that managers might later the debt holders. This
want to transfer value from bondholders to shareholders. After all, creditors realize that it is has bad ex ante value
the shareholders who vote managers into o¬ce, not the bondholders. Managers can expropriate
bondholders on behalf of shareholders in two ways:

1. They can increase the risk of the ¬rm™s projects (a change in operating policies).

2. They can issue further bonds of equal or higher priority. (Bonds that pay cash earlier are
de facto higher priority.)

If potential bondholders believe that they can be expropriated, they will demand a higher cost
of capital today. Let™s understand this better.

23·4.A. Project Risk Changes

Table 23.4. Risk-Shifting

Bad Luck Good Luck Future Ex- Today™s
Prob: 1/2 1/2 pected Value Present Value

Project FM $60 $160 $110 $100

Capital Structure LD: Bond with Face Value FV=$55
Bond(FV=$55) DT $55 $55 $55 $50
Equity EQ $5 $105 $55 $50

Adding Risky Project “New”

Bad Luck Good Luck Future Ex- Today™s
Prob: 1/4 1/4 1/4 1/4 pected Value Present Value

Project FM $60 $60 $160 $160 $110 $100.00
Project New $50 “$60 $50 “$60 “$5 “$4.54
Total Projects $110 $0 $210 $100 $105 $95.45

Capital Structure LD: Bond with Face Value FV=$55
Bond(FV=$55) DT $55 $0 $55 $55 $41.25 $37.50
Equity EQ $55 $0 $155 $45 $63.75 $57.95

The cost of capital in this example is 10% for all securities, which is equivalent to assuming risk-neutrality.
¬le=caprest.tex: LP
602 Chapter 23. Other Capital Structure Considerations.

The ¬rst expropriation risk that creditors face is called “risk-shifting.” Table 23.4 returns to our
Adding a risky, but
negative NPV project ¬rm with an LD capital structure from Table 23.3, but allows managers to add project “New”
changes the
after the original debt has been raised. The new project is independent of the old project
state-contingent payoffs.
and pays either +$50 or ’$60 with equal probability. It is negative NPV, so it would not be
too hard for managers to ¬nd such projects”any Las Vegas casino provides better investment
opportunities. Why would a negative NPV project matter? Would the managers not reject this
negative NPV project?
The lower half of the table shows that if the new negative NPV project is taken, the value of
The ex post
redistribution. the equity would increase from $50 to $57.95. If shareholders are in ¬rm control of their
managers and vote them into and out of o¬ce, managers would indeed take this project! In
essence, the new project would eliminate $50 ’ $37.50 = $12.50 of bondholder value, waste
$4.54, and hand $7.95 extra value to shareholders. The intuition is that this risky project gives
existing shareholders relatively more of the upside and existing bondholders relatively more
of the downside.
Everyone”managers, shareholders, and bondholders”recognizes that taking the project will
Ex ante Effects.
be in the interest of the managers if a bond with a face value of $55 was originally sold. Although
ex post this is good for equity holders,ex ante it is bad for them (and the ¬rm). Skeptical creditors
would therefore assume that the debt payo¬ is only $41.25 (not $55), and thus pay no more
than $37.50. The ¬rm would have to pay a cost of capital of 46.7%, even if it wanted to ¬nance
itself with debt.
If you now conclude that it is good for the corporation to commit itself not to take other
This also works with
positive NPV Projects. projects, you would be wrong. This could back¬re, too. If a new project were to come along
that either pays o¬ “$60 or +$500, it would be highly positive NPV. If creditors had negotiated a
commitment at bond issue, they would insist that the project not be taken, because their wealth
would still decline. But this would prevent the ¬rm from taking great projects. Therefore, a
wholesale ex ante commitment not to take any more projects is not necessarily a good thing
for the value of the corporation.

23·4.B. Issuance of Bonds of Similar Priority

The second expropriation risk that creditors face is the issuance of more bonds of equal or
Managers may also
exploit bond holders by higher priority. (Paying out some cash before the original bond comes due is in e¬ect higher
issuing more debt.
priority.) Table 23.5 shows an example, in which the ¬rm issues another bond with a face
value of $20 that has equal priority. In bankruptcy (the bad state), the old bond would have
to share proceeds with the new bond of equal-priority. Being equal, the “spoils” would be
often allocated according to face-value within bonds of the same priority. So, because the
$20 bond represents $20/($20 + $55) ≈ 27% of the debt claim, it would receive 27% · $60 =
$16; and the $55 bond would receive the remaining 73% · $60 = $44. This means that when
the ¬rm announces the issuance of the new bond, the old bond would immediately drop by
$50 ’ $48.18 = $1.82 in value. Would this be in the interest of the equity? It now receives
nothing in the bad state and $85 in the good state”plus the one time dividend of $16.36. In
total, by issuing new debt of equal priority, equity holders would have increased their wealth
from $50 to $38.64+$16.36=$55.
This expropriation is not as bad as our risk-shifting example in that no value is destroyed. But
Again, fearing
expropriation, the ¬rm it is equally bad insofar as the ¬rst creditors will again assume that they will be expropriated,
has to pay a higher
and therefore demand a higher interest rate today. They would demand a quoted interest rate
interest upfront to
of $55/$48.18 ’ 1 ≈ 14.2%. To recoup this higher interest rate, the ¬rm has no choice but
potential bond holders.
to indeed issue more bonds that expropriate the ¬rst bond purchasers later. In e¬ect, before
deciding on any capital structure, the ¬rm has two choices: either issue no bonds, or be dragged
into a capital structure that requires issuing more and more leverage. (This can in turn increase
¬nancial distress costs.) As before, an ex post issue has consequences ex ante.
¬le=caprest.tex: RP
Section 23·4. Bondholder Expropriation.

Table 23.5. Issuance of Equal Seniority or Shorter Term Bonds

Bad Luck Good Luck Future Ex- Today™s
Prob: 1/2 1/2 pected Value Present Value

Project FM $60 $160 $110 $100

Capital Structure LD: Bond with Face Value FV=$55
Bond(FV=$55) DT $55 $55 $55 $50
Equity EQ $5 $105 $55 $50

Adding an Equal Priority Bond

Bad Luck Good Luck Future Ex- Today™s
Prob: 1/2 1/2 pected Value Present Value

Project FM $60 $160 $110 $100
Capital Structure LD Plus: Two Equal-Priority Bonds
73% · $60 = $44
Bond(FV=$55) DT $55 $53 $48.18
27% · $60 = $16
Bond(FV=$20) DT $20 $18 $16.36

Equity EQ $0 $85 $42.50 $38.64

The cost of capital in this example is 10% for all securities, which is equivalent to assuming risk-neutrality. 73% is
the proportional allocation, $55/($55 + $20) ≈ 73%.

Creditors may also face uncertainties if bankruptcy courts do not uphold the agreed-upon
Side Note:
Absolute Priority Rule (that bond holders are to be paid in full before equity holders receive anything). Known
deviations from promised absolute priority simply change the contingent payo¬s and thus the e¬ective values
of the securities. Such known violations do not reduce the total value of the ¬rm. Relative to strict APR, the
value of the bonds is just lower by the amount that the value of the equity is higher.

23·4.C. Counteracting Forces

Bondholders demand a premium ex ante that they would not demand if the ¬rm could commit Self-commitment can
lower interest rates.
not to expropriate them ex post. The premium may prevent the ¬rm from raising debt at fair
interest rates, and thus tilt the optimal capital structure more towards equity. Even managers
with the best intentions not to act against bondholders may not be able to shield themselves
from the pressures of expropriating creditors later. Who ultimately loses? To the extent that
smart bond investors anticipate their fate, they will demand and receive fair compensation.
Ultimately, it is the ¬rm that is robbed by itself. Its inability to commit not to expropriate
creditors may prevent from issuing debt at fair prices”which may mean it may have to forego
debt™s other advantages, such as tax savings.
¬le=caprest.tex: LP
604 Chapter 23. Other Capital Structure Considerations.

In the real world, there are a number of mechanisms that can help to reduce the fears of
How to align prospective
bondholders with the bondholders, and thereby allow the ¬rm to issue debt at acceptable interest rates”and thereby
lower the ¬rm™s cost of capital.

Managerial Risk Aversion
We noted earlier that shareholders like increases in project risk, because they help them
at the expense of bondholders. However, it is not clear if managers really act on behalf
of shareholders and thus like higher risk, too. After all, if the project fails and the ¬rm
enters ¬nancial distress, they might get ¬red themselves. Thus, managerial risk aversion
is a natural counterbalance to the shareholders™ incentives to increase risk.

Bond Covenants
A variety of bond covenants have developed to mitigate bondholder skepticism.
Bond covenants reduce
opportunities in the • Many bonds prohibit excessive dividend payouts.
future”but at a cost in
• Many bonds prohibit large new debt issues, especially of shorter-term and of equal
priority debt.
• Many bonds require the maintenance of certain ¬nancial ratios. For example, covenants
may mandate maximum debt-equity ratios, maximum payout ratios, minimum earn-
ings retention ratios, minimum liquidity ratios, and so on. These ratio restrictions
can all help prevent the ¬rm from taking on riskier projects.

If the covenant is broken, creditors can sue or demand their money back. Covenants
are never perfect. It is just impossible to enumerate all the things managers can do. In
addition, if the ¬rm enters Chapter 11 bankruptcy, the law says that any new debt issued
will automatically receive higher priority, no matter what the covenants of the original
bond stated.
Bonds with strong covenants often have a “call” feature, that allows the ¬rm to retire
the bond before maturity at an agreed-upon price”and thereby free themselves of the
covenant requirements.

Corporate Reputation
Covenants are in¬‚exible, so they impose costs, too. For example, if the ¬rm happens to
And, again, covenants
reduce the ¬‚exibility of come across a project with $1 billion in NPV, the covenants could prevent it from taking
the ¬rm to take
it. Again, a ¬rm that fails to take all pro¬table projects in the future is worth less today.
advantage of other
One alternative to formal covenants is for ¬rms to build a less formal “reputation.” This
Sometimes, reputation
is not easy to do, but ¬rms may realize that it is in their interest not to exploit current
can substitute for
bondholders, because any future bondholders would henceforth de¬nitely assume the
worst behavior. Put di¬erently, if managers were to take advantage of creditors today,
then future ¬nancing costs would be so much higher that managers would rather not do
so. Reputation is not perfect, though, especially if the advantage that can be taken of
creditors today becomes very large. The most prominent example of broken reputation
was R.J.R. Nabisco. In the 1980s, it was generally believed to be a safe investment for
bondholders. However, when it was bought out in 1988 in the largest LBO ever, R.J.R.
tripled its debt overnight, its outstanding bonds went from investment grade to junk
grade, and bondholders experienced an announcement month loss of 15%.

Convertible Bonds or Strip Financing
The ¬nal way is to try to allow creditors to partake in the upside of equity. The most
Convertible bonds allow
bondholders to common such ¬nancing vehicles are convertible bonds. Again, they can limit the ex post
participate in the upside,
expropriation of bondholders, while still preserving the ¬rm™s option to accept new pro-
and reduce
jects. Instead of straight bonds with strong covenants, “convertible bonds” with weak
exploitational incentives
in the future.
covenants allow creditors to participate if a great new project were to come along. This
reduces the risk expropriation problem. One of the following exercises will ask you to
show how a convertible bond can reduce the expropriation. Strip ¬nancing, in which
individuals purchase debt and equity in equal units, is a similar idea”it eliminates the
incentives of shareholders to exploit themselves.
¬le=caprest.tex: RP
Section 23·4. Bondholder Expropriation.

In the real world, ¬rms have to undertake a delicate balancing act. When they issue debt, it Recap: It is in the ¬rm™s
interest to commit not
can only be issued at favorable terms when the ¬rm can promise not to exploit bondholders
to take advantage of its
after the bonds are issued. Even if such promises can be credibly made, they cause a loss of creditors in the future.
¬‚exibility, which can be expensive. This can mean that the ¬rm cannot issue debt”and thus To the extent that the
¬rm fails, debt is too
that it has to forego some other bene¬cial e¬ects of debt (such as tax advantages).
expensive today.


• Creditors can lose value if

“ the ¬rm later undertakes riskier projects; or
“ the ¬rm adds more debt of equal or higher priority.

• Creditors demand higher interest rates if they fear such expropriation. Thus,
it is in the interest of the owners to assure creditors that they will not do so.
The prime mechanisms to accomplish this are

“ Bond Covenants,
“ Reputation, and
“ Bond Convertibility.

Solve Now!
Q 23.9 Why do bond covenants exist?

Q 23.10 What is the advantage of adding convertibility features to a bond?

Q 23.11 Describe the two basic mechanisms whereby unprotected bondholders can be expropri-
ated by shareholders, preferably with a numerical example.

Q 23.12 Return to a project similar to the ¬rm in Table 23.4. The risk-neutral required interest
rate is 10%. The ¬rm is worth either $100 or $120. The bond promises $90.

(a) Work out the value of the ¬rm. For the bond, create three rows for each state: if bondholders
do not convert, if bondholders always convert, if bondholders optimally convert. (Assume
project “New” is not available.)


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