Capital Structure: Non-Tax
Determinants Of Corporate
Leverage
Professor XXXXX
Course Name / Number
Optimal Capital Structure
Total firm
value
Most firms do not
use anything close
to 100% debt.
Why?
100% equity
100% debt
In perfect markets, capital structure is irrelevant.
2
If markets are perfect except for corporate taxes,
then the optimal capital structure is 100% debt.
Optimal Capital Structure
There are costs of debt that we’ve missed. At some point,
those costs must outweigh debt’s tax benefits:
– Personal taxes on debt, bankruptcy costs, agency
costs, and asymmetric information
Total firm
value
3
Optimal capital structure
100% equity
100% debt
The optimal
capital structure,
the one that
maximizes the
value of the firm,
is in between the
extremes.
Bankruptcy Cost
It is not the event of going bankrupt that matters, it is the
costs of going bankrupt that matter.
If ownership of the firm’s assets was transferred costlessly
to its creditors in the event of bankruptcy,
The optimal capital structure would still be 100% debt.
4
When the firm incurs costs in bankruptcy that it would otherwise
avoid, bankruptcy costs become a deterrent to using leverage.
Example
An example…
– Suppose Firm 1 and Firm 2 have the following capital structure
(assume no bankruptcy costs):
Market value of assets
Debt
Equity
Firm 1
Firm 2
$40,000,000
$100,000,000
$0
$0
$40,000,000
$100,000,000
$0
$50,000,000
$50,000,000
$40,000,000
$100,000,000
$40,000,000
$50,000,000
Recession hits and the value of both firms’ assets drops to $40 million.
Firm 2 goes bankrupt because there are not enough assets to cover
the debt. Bondholders become stockholders and own the company.
5
If there is a tax advantage to debt, that tax advantage is still decisive
because the firm that uses more debt can shelter more income and
incurs no additional costs than does the firm that has no debt.
Example
– Assume if firm goes bankrupt, $10 million in assets
are lost in the process of transferring ownership from
stockholders to bondholders:
Market value of assets
Debt
Equity
Firm 1
Firm 2
$40,000,000
$100,000,000
$30,000,000
$100,000,000
$0
$0
$50,000,000
$40,000,000
$100,000,000
$30,000,000
$50,000,000
When the recession hits, Firm 1 has $40 million in assets, but Firm 2
has $30 million in assets.
Firm 2 will calculate the tax advantage of debt and weigh that against
the cost of bankruptcy times the probability of bankruptcy at each
debt level.
6
We are now looking not at bankruptcy costs per se, but at expected
bankruptcy costs.
Bankruptcy Costs
Direct Costs
Costs of bankruptcy-related litigation
Cost of management time diverted to
bankruptcy process
Loss of customers who don’t want to deal with
a distressed firm
Indirect
Costs
Loss of employees who switch to healthier firms
Strained relationships with suppliers
Lost investment opportunities
7
Bankruptcy Costs
Indirect costs are likely to be much larger, and are likely to
vary a great deal depending on the type of firm in distress.
Indirect costs may be high:
When the firm’s product requires that the firm stay in
business (e.g., when warranties or service are important)
When the firm must make additional investments in product
quality to maintain customers
8
For example, think of customers worrying that a bankrupt
airline might try to save $ by cutting spending on safety.
Bankruptcy Costs
Direct costs of
bankruptcy
Legal, auditing and administrative costs
(include court costs)
Large in absolute amount, but only 12% of large firm value
Financial distress also gives managers adverse incentives.
– Asset substitution problem: Incentive to take large risks
– Under-investment problem: shareholders refuse to contribute funds
Trade-off model of corporate capital structure:
9
V L = V U + PV Tax Shields - PV Bankruptcy Costs
U.S. Bankruptcy Practices And
Costs
Bankruptcy governed by Federal law and filings are made
in Federal bankruptcy courts
Two types of bankruptcy filings in US for corporations:
Chapter 7 (Liquidation)
Chapter 11 (Reorganization)
In liquidation, a trustee is usually appointed to liquidate
firm’s assets.
10
In reorganization, firm’s management continues to operate
firm, can propose reorganization plan.
Agency Costs And Capital Structure
Agency costs arise as soon as an entrepreneur sells
a fraction  of her firm to outside investors.
– Entrepreneur enjoys private benefits of control
(perquisites), but bears only (1-  ) of the cost of “perks.”
• An
–
–
–
example…
Assume the manager of a firm owns 10% of the firm’s stock.
Outsiders (non-managers) own 90%.
The firm buys an expensive Van Gogh to hang in the manager’s
office.
– The manager pays 10% of the cost of this painting but enjoys
100% of the benefit!
11
Separation between ownership and control of a firm gives rise to
agency costs of outside equity.
Agency Costs Of Outside Debt
Debt helps mitigate these costs, but debt has its
own agency costs:
Expropriate bondholders wealth by paying
excessive dividends
Agency costs of
outside debt
Bait And Switch: Promise to use
borrowed money for safe investment, then
use to buy high/risk, high/return asset
Bondholders protect themselves with positive and negative
covenants in lending contracts.
12
Agency costs of debt are burdensome, but so are solutions.
The Agency Cost / Tax Shield TradeOff Model Of Corporate Leverage
Companies trade off tax and agency cost benefits of debt
against the costs of bankruptcy and agency costs of debt.
Firm V maximized at a unique optimal debt level:
V L = V U + PV tax shields - PV bankruptcy costs
+ PV agency costs of outside equity - PV agency costs of outside debt
Empirical research offers support for the model, but the
model is far from perfect in its predictions.
Weaknesses lead to development of Pecking Order Theory.
13
The Pecking Order Theory Of
Corporate Capital Structure
Trade-off theory cannot explain three empirical
capital structure facts:
Most profitable firms in an industry use least debt.
Stock market responds to leverage-increasing events
strongly positive; negative reaction to leverage-decreasing
events.
Firms issue debt frequently, but rarely issue equity.
14
Myers (1984), Myers & Majluf (1984) propose pecking order theory of
corporate leverage.
The Pecking Order Theory Of
Corporate Capital Structure
Assumptions
Manager acts in best interests of
existing shareholders.
Information asymmetry between managers
and investors.
Two key predictions about managerial behavior
Firms hold financial slack so they don’t have to
issue securities.
15
Firms follow pecking order when issuing
securities: sell low-risk debt first, equity only as
last resort.
Signaling And Other Asymmetric
Information Models
• Third group of models, based on asymmetric information
between managers and investors, predict managers will use a
costly signal:
– A simple statement of high firm value not credible
– Must take action that is too costly for weak firm to mimic
– Crude signal: burn $100 bills; only wealthy can afford
• If signaling can differentiate between strong and weak firms
based on signal, a signaling equilibrium results.
– Investors identify stronger firms, assign higher market value
• If signaling cannot differentiate between strong and weak firms,
a pooling equilibrium results.
– Investors assign low average value to all firms.
• Models predict high value firms use high leverage as signal.
– Makes sense, but empirics show the opposite—most
profitable & highest market/book firms use least leverage.
16
A Checklist for Capital Structure
Decision-Making
Variable
17
Documented relationship
between variable and leverage
Profitability
Negative
Market-to-book ratio
Negative
Earnings volatility
Negative
Non-debt tax shields
Negative
Effective (marginal) corp tax rate
Positive
Regulation (regulated industry?)
Positive
Firm size
Positive
Asset tangibility
Positive
A Checklist for Capital Structure
Decision-Making
Variable
18
Documented relationship
between variable and leverage
Growth rate of firm’s assets
Ambiguous
Insider share ownership
Ambiguous
Managerial entrenchment
Negative
Creditor power in bankruptcy
Negative
Corporate income tax rate
Positive
Personal tax rate, equity income
Positive
Personal tax rate, debt income
Negative
State ownership
Positive
Non-Tax Determinants Of Corporate
Leverage
Personal taxes on debt, bankruptcy costs, agency
costs, and asymmetric information influence level
of debt the firm chooses to have.
Agency costs arise between corporate managers
and outside investors and creditors.
Trade-off theory, pecking order theory, signaling
theory try to explain corporate leverage levels.