Corporate finance - Riassunti

Corporate finance: Modigliani-Miller

The last argument of Corporate Finance 1 was Modigliani-Miller. The results of the Modigliani-Miller theorem, when we don’t consider corporate taxes, are that:

• The value of the company with and without debt is the same
• The way in which the company finances itself is irrelevant (through equity or debt)

Assumptions

• We don’t have asymmetric information
• There are no costs associated to financial distress (when a firm has difficulties meeting its debt obligations)

Now, we are going to remove these assumptions.

Default and bankruptcy in a perfect market

Financial distress is when a firm has difficulties meeting its obligations. A default is when a firm fails to make the required interest or principal payments on its debt. An important consequence of leverage is the risk of bankruptcy.

Example

Armin is considering a new project:

• If it is a hit, Armin will be worth 150 million at the end of the year
• If it fails, Armin will be worth 80 million

Armin can use:

• All equity financing
• A debt that matures at the end of the year with a total of 100 million due (if the project fails, we won’t be able to pay back the debt)

Scenario 1: Successful project

• Without leverage: the equity holders own the full amount
• With leverage: Armin must make the 100 million debt payment, and Armin’s equity holders will own the remaining 50 million.

Even if Armin does not have 100 million in cash, it will not be forced to default on its debt: in a perfect market, as long as the value of the assets exceeds the liabilities, the company will be able to repay the loan (by selling the securities).

Scenario 2: Failed project

Armin is worth 80 million:

• Without leverage: the equity holders will lose 20 million
• With leverage: Armin will experience financial distress and the firm will default. Debt holders will receive legal ownership of the firm’s assets, leaving shareholders with nothing.

So:

• Without leverage, if the product fails, equity holders lose 70 million (150 million – 80 million = 70 million)
• With leverage, the equity holders lose 50 million and the debt holders lose 20 million

We can see that the total loss is the same; there is no cost of distress. With perfect capital markets, MM proposition I applies: “the total value to all investors does not depend on the firm’s capital structure.”

The bankruptcy code

The U.S. bankruptcy code was created so that creditors are treated fairly and the value of the assets is not needlessly destroyed. U.S. firms can file for two forms of bankruptcy protection: Chapter 7 or Chapter 11.

Chapter 7: Liquidation

A trustee is appointed to oversee the liquidation of the firm’s assets through an auction. The proceeds from the liquidation are used to pay the firm’s creditors, and the firm ceases to exist.

Chapter 11: Reorganization

Chapter 11 is the more common form of bankruptcy for large corporations. With Chapter 11, all pending collection attempts are automatically suspended, and the firm’s existing management is given the opportunity to propose a reorganization plan. Chapter 11 is debtor-friendly. Creditors may receive cash payments and/or new debt or equity securities of the firm. The value of the cash and securities is typically less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated. The creditors must vote to accept the plan, and it must be approved by the bankruptcy court. If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation.

The bankruptcy process is complex, time-consuming, and costly.

• Direct costs: expensive outside experts are often hired by the firm to assist with the bankruptcy process, creditors may wait several years to receive their money. The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive. The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.
• Indirect costs: while the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy. It is estimated that the potential loss due to financial distress is 10% to 20% of firm value. Indirect costs can be agency costs, conflicts between shareholders and debt holders, weakened ability to operate (e.g., decrease in sales, loss of customers or suppliers).

When estimating indirect costs, two important points must be considered:

• Losses to total firm value (and not solely losses to equity holders or debt holders, or transfers between them) must be identified
• The incremental losses that are associated with financial distress must be identified

Example

With debt of $100 million, Armin will be forced into bankruptcy if the new product fails. In this case, some of the value of Armin’s assets will be lost to bankruptcy and financial distress costs. As a result, debt holders will receive less than $80 million. Assume debt holders receive only $60 million after accounting for the costs of financial distress. We are not in an MM situation anymore.

Who pays for financial distress costs

If debt holders recognize that, if the new product fails and the firm defaults, they will not be able to get the full value of the assets, they will pay less for the debt initially. This will cause less money available for the firm to pay dividends, repurchase shares, make investments. So, the equity holders are the ones that pay for financial distress costs.

Tradeoff theory

The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs. The original formula was V = V + T * D_L U C. The value of the leveraged firm is equal to the value of the unleveraged firm + the tax shield (the corporate tax rate times the value of the debt). It’s a positive element because debt reduces the amount of taxes that we have to pay every year. The new model, that takes into account the costs of financial distress and agency costs, is called trade-off theory. The new formula is V = V + PV (Interest Tax Shield) – PV (Financial Distress Costs)_L U.

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

• The probability of financial distress. The probability of financial distress increases with the amount of a firm’s liabilities. The probability of financial distress increases with the volatility of a firm’s cash flows and asset values.
• The magnitude of the costs after a firm is in distress. Financial distress costs will vary by industry.
• The appropriate discount rate for the distress costs. The discount rate depends on the firm’s market risk. The present value of distress costs will be higher for high beta firms.

Optimal leverage

In the MM model there is not an optimal leverage, because the company should increase the debt as much as possible. In the trade-off theory there is an optimal level: we need to avoid a high debt to reduce the financial distress costs. We can see this trade-off graphically. The MM model is the straight line: we increase the debt, we increase the V. We can see that, if we have low distress costs, we can have a larger debt. Finding D* is easy in theory, but it is very difficult in practice.

Example

If we add leverage and we have just by doing a simple subtraction we can see that the firm’s value is maximized when the debt is 20. This might be a short exercise that we will find in the exam.

Exploiting debt holders: the agency cost of leverage

Agency Costs: costs that arise when there are conflicts of interest between the firm’s stakeholders. Management will generally make decisions that increase the value of the firm’s equity. However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. Remember that shareholders are only interested in the equity and that the value of any firm is V = E + D.

Example

Baxter has a loan of $1 million due at the end of the year. Without a change in its strategy, the market value of its assets will be only $900,000 at that time, and Baxter will default on its debt. Baxter is considering a new strategy. The new strategy requires no upfront investment, but it has only a 50% chance of success. If the new strategy succeeds, it will increase the value of the firm’s asset to $1.3 million. If the new strategy fails, the value of the firm’s assets will fall to $300,000.

The expected value of the firm’s assets under the new strategy is $800,000, a decline of $100,000 from the old strategy. 50% × $1.3 million + 50% × $300,000 = $800,000. Despite the negative expected payoff, some within the firm have suggested that Baxter should go ahead with the new strategy.

Payoff for the equity holders:

• Under the old strategy: as the firm defaults, it is 0
• Under the new strategy: equity holders will receive 300,000 if the strategy succeeds. Given the 50% chance of success, the equity holders’ expected payoff is 150,000.

The equity holders have a positive payoff even if the overall value of the firm is reduced (from 900,000 to 800,000). This can only be possible if D reduces.

Payoff for the debt holders:

• Under the old strategy: the expected payoff is 0.9
• Under the new strategy: the expected payoff is 0.5 * 1 + 0.5 * 0.3 = 0.65

The payoff has been reduced by 250,000, of which 150,000 are going to the equity holders and the remaining 100,000 is the reduction of the value of the firm.

The change is this strategy will be accepted by the shareholders, that are the ones who make the decisions. We can affirm that there is excessive risk-taking and over-investment. If we have high risk it is better for the equity holders: it’s just like having a call option, if the firm defaults the equity holders get 0 but, if the project is successful, we have a positive payback. Equity holders have an unlimited downside and have an incentive to increase the risk and to invest in negative-NPV projects that are risky (even though a negative-NPV project destroys value from the firm overall).

NOTE: this is true only when we consider the assumption that shareholders have limited liability (equity holders don’t have to pay with their own money if the firm defaults). This arises a problem called asset substitution: a firm substitutes safe assets with risky assets.

Example

This can be a long exercise in the exam. Howard Inc. has 2 mutually exclusive investment opportunities, R and S, which it plans to fund with debt. Each investment costs $50 million. Project S pays off $60 million for certain, and Project R pays off only $20 million when the economy is poor and $90 million when the economy is good. Assume risk neutral investors.

Questions

1. What is the NPV of each project, assuming that the economy is equally likely to be favorable or unfavorable and the discount rate is 0 percent?
2. Which project will Howard’s shareholders prefer?
3. What is the expected payoff to the naive lenders?
4. Now assume that the debt holders are sophisticated. What must the debt holders be promised, which project will the company select, and what do the shareholders gain?

S = 60 – 50 = 10

R = (20 * 0.5 + 90 * 0.5) – 50 = 5 (note that we don’t discount them as the discount rate is 0)

B & C

• S CF 60
• Debt Holders payoff 50
• Equity Holders payoff 10

B) Expected payoff to Equity holders 10

C) Expected payoff to naive debt holders 50

R

• Unfav. Fav CF 20 90
• Debt Holders payoff 20 50
• Equity Holders payoff 0 40

B) Expected payoff to Equity holders 20

C) Expected payoff to naive debt holders 35

As shareholders are risk-neutral, project B will be chosen, as the expected payoff for the equity holders is higher. The debt holders will have a lower payoff.

D) Sophisticated debt holders

Know that equity holders have an incentive to invest in project R. Thus, they will demand a future payment of 80 as we know that the payoff in the bad state is 20 50 = 0.5 * 20 + 0.5 * D D = (50 – 20 * 0.5) / 0.5 = 80

The result will be:

• R Unfav. Fav CF 20 90
• Debt Holders payoff 20 80
• Equity Holders payoff 0 10

B) Expected payoff to Equity holders 5

C) Expected payoff to debt holders 50

With sophisticated debt holders, S is the best project BUT, if a payment of 80 is required:

• S CF 60
• Debt Holders payoff 80
• Equity Holders payoff 0

B) Expected payoff to Equity holders 0

C) Expected payoff to naive debt holders 60

The company will default: we are stuck with project R even if it’s not the best. Thus, shareholders are better off if they find a way to commit themselves to select project S (10>5).

The reluctance to liquidate problem

One of the most difficult decisions a firm must make is whether to remain in business. It is optimal to liquidate if the net proceeds from liquidation exceed the present value of the future cash flows that the firm would generate if it were to continue operating. Bankruptcy and liquidation are not the same thing: bankruptcy doesn’t imply liquidation, in fact there are many bankruptcy procedures under which firms are reorganized and continue operating.

Capital structure can affect liquidation policy. Managers of financially sound firms, as representatives of their equity holders, have an incentive to continue operating their firm even when the liquidation values of the firm exceed its going concern value, because:

• Shareholders are residual claimants and are likely to receive nothing in a liquidation
• Managers are also interested in keeping the firm operating because they are likely to lose their jobs if the firm liquidates

Debt overhang and under-investment

Baxter is considering an investment opportunity that requires an initial investment of $100,000 and will generate a risk-free return of 50%. If the current risk-free rate is 5%, this investment clearly has a positive NPV. What if Baxter does not have the cash on hand to make the investment? Could Baxter raise $100,000 in new equity to make the investment?

• We have 150 because we have a risk-free return of 50%

For the shareholders, this project is not good because, even if the equity increases from 0 to 50, we have to invest 100 (remember that Baxter doesn’t have the money and in this case the shareholders pay for the new project).

We have - 100 + 50/1.05 which is negative. The firm loses an investment opportunity, we have an under-investment problem (also called debt overhang): a situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.

Example

BV = Book Value
MV = Market Value
What happens if you liquidate the firm today?
Debt holders get $200; Equity holders get nothing. We have to look at Market Values.

Second Example

Consider a project that guarantees $350 next year. The project costs $300 and the firm only has cash for $200. Thus, shareholders must finance the remaining $100. Assume that the discount rate for similar projects is 10%. Expected CF from the project: 350

• To Bondholders = 300
• To Stockholders = 50 (350 – 300)
• PV of debt without project = 200
• PV of equity without project= 0

In this case as well we have a negative value for the shareholders. Accepting the project implies a wealth transfer from shareholders to bond holders of 54.55. Bond holders also obtain the project’s NPV of 18.18 (54.55 + 18.18 = 72.73).

We have assumed equity financing. What happens if the project is paid for with debt? We have the same situation as before:

Expected CF from the project: 350

• To Bondholders = 300
• To junior bondholders = 50 (350 – 300)
• PV of debt without project = 200
• PV of junior b. without project= 0

The only way in which we can finance the project is with senior debt, but the debt contract needs to be renegotiated (which is a difficult operation).

The short-sighted investment problem

The short-sighted investment problem is a situation in which debt can lead firms to prefer lower NPV projects that pay off quickly than higher NPV projects.

Example

Lester Inc. has debt obligations that are due both next year ($100) and in two years ($40). Lester can choose between two projects:

• Project A: short-term project generating cash flows of $50 in year 1 and 0 in year 2
• Project B: long-term project generating cash flows of $20 in year 1 and $40 in year 2

The risk-free rate is 0. All cash flows are certain. The cash flow from existing assets is $50 in year 1. In year 2, the cash flow is:

• In the favorable state (prob.= ½), CF=$60
• In the unfavorable state (prob.= ½), CF=$10

The best project is B, because the total CF is 60, but it gives money later in time.

Year 1

• Lester chooses A: Lester is able to pay its 100 debt obligation in Year 1 (50 + 50).
• Lester chooses B: Lester cannot meet its debt obligation with its cash flows (20 + 50 = 70). It needs additional $30 of new debt. If it wants to issue junior debt, Lester has to offer to pay the new lenders $50 in year 2 to raise $30.

This is because 30 = 0.5 * 10 + 0.5 * x

Year 2

No project allows Lester to meet its debt obligation in the unfavorable state.

• Project A: cash for 10 but debt for 40
• Project B: cash for 50 (10 + 40) but debt for 90 (40 + 50 new junior)