. 8
( 14 .)


You have been asked to assess the after-tax cost of debt for a firm that has $ 2 billion in
net operating losses to carry forward, and operating income of roughly $ 2 billion this
year. If the company can borrow at 8%, and the marginal corporate tax rate is 40%, the
after-tax cost of debt this year is
a. 8%
b. 4.8%


What would your after-tax cost of debt be next year?

2. Debt may make managers more disciplined

In the 1980s, in the midst of the leveraged buyout boom, a group of practitioners
and academics, led by Michael Jensen at Harvard, developed and expounded a new
rationale for borrowing, based upon improving firms™ efficiency in the utilization of their
free cash flows. Free cash flows represent cash Free Cash Flows (Jensen™s): The free
cash flows referred to here are the
flows made on operations over which managers
operating cash flows after taxes, but before
have discretionary spending power “ they may use
discretionary capital expenditures.
them to take projects, pay them out to
stockholders or hold them as idle cash balances. The group argued that managers in firms
that have substantial free cash flows and no or low debt have such a large cash cushion
against mistakes that they have no incentive to be efficient in either project choice or
project management. One way to introduce discipline into the process is to force these
firms to borrow money, since borrowing creates the commitment to make interest and
principal payments, increasing the risk of default on projects with sub-standard returns. It
is this difference between the forgiving nature of the equity commitment and the
inflexibility of the debt commitment that have led some to call equity a cushion and debt
a sword.
The underlying assumptions in this argument are that there is a conflict of interest
between managers and stockholders, and that managers will not maximize shareholder
wealth without a prod (debt). From our discussion in chapter 2, it is clear that this
assumption is grounded in fact. Most large U.S. corporations employ managers who own
only a very small portion of the outstanding stock in the firm; they receive most of their
income as managers rather than stockholders. Furthermore, evidence indicates that
managers, at least sometimes, put their interests ahead those of stockholders.
The argument that debt adds discipline to the process also provides an interesting
insight into management perspectives on debt. Based purely upon managerial incentives,
the optimal level of debt may be much lower than that estimated based upon shareholder
wealth maximization. Left to themselves, why would managers want to burden
themselves with debt, knowing fully well that they will have to become more efficient


and pay a larger price for their mistakes? The corollary to this argument is that the debt
ratios of firms in countries in which stockholder power to influence or remove managers
is minimal will be much lower than optimal because managers enjoy a more comfortable
existence by carrying less debt than they can afford to. Conversely, as stockholders
acquire power, they will push these firms to borrow more money and, in the process,
increase their stock prices.
Do increases in leverage lead to improved efficiency? The answer to this question
should provide some insight into whether the argument for added discipline has some
basis. Do increases in debt lead to improved efficiency and higher returns on
investments? The answer to this question should provide some insight into whether the
argument for added discipline has some basis. A number of studies have attempted to
answer this question, though most have done so indirectly.
Firms that are acquired in hostile takeovers are generally characterized by poor

performance in both accounting profitability and stock returns. Bhide (1993), for
instance, notes that the return on equity of these firms is 2.2% below their peer group,
while the stock returns are 4% below the peer group™s returns. While this poor
performance by itself does not constitute support for the free cash flow hypothesis,
Palepu (1986) presents evidence that target firms in acquisitions carry less debt than
similar firms that are not taken over.
There is evidence that increases in leverage are
± Leveraged Recapitalization: In

followed by improvements in operating a leveraged recapitalization, a firm
borrows money and either buys
efficiency, as measured by operating margins and
back stock or pays a dividend,
returns on capital. Palepu (1990) presents
thus increasing its debt ratio
evidence of modest improvements in operating substantially.
efficiency at firms involved in leveraged buyouts.
Kaplan(1989) and Smith (1990) also find that firms earn higher returns on capital
following leveraged buyouts. Denis and Denis (1993) present more direct evidence on
improvements in operating performance after leveraged recapitalizations14. In their
study of 29 firms that increased debt substantially, they report a median increase in


the return on assets of 21.5%. Much of this gain seems to arise out of cutbacks in
unproductive capital investments, since the median reduction in capital expenditures
of these firms is 35.5%.
Of course, we must consider that the evidence presented above is consistent with a
number of different hypotheses. For instance, it is possible that the management itself
changes at these firms, and that it is the change of management rather than the additional
debt that leads to higher investment returns.

7.12. ˜: Debt as a Discplining Mechanism
Assume that you buy into this argument that debt adds discipline to management. Which
of the following types of companies will most benefit from debt adding this discipline?
a. Conservatively financed, privately owned businesses
b. Conservatively financed, publicly traded companies, with a wide and diverse stock
c. Conservatively financed, publicly traded companies, with an activist and primarily
institutional holding.
(By conservatively financed, we mean primarily with equity)

The Costs of Debt
As any borrower will attest, debt certaintly has disadvantages. In particular,
borrowing money can expose the firm to default and eventual liquidation, increase the
agency problems arising from the conflict between the interests of equity investors and
lenders, and reduce the flexibility of the firm to take actions now or in the future.

1. Debt increases expected bankruptcy costs
The primary concern when borrowing money is the increase in expected
bankruptcy costs that typically follows. The expected bankruptcy cost can be written as a
product of the probability of bankruptcy and the direct and indirect costs of bankruptcy.

14In a leverage recapitalization, firms replace a substantial portion of their equity with debt, increasing
debt ratios.


The Probability of Bankruptcy
The probability of bankruptcy is the likelihood that a firm™s cash flows will be
insufficient to meet its promised debt obligations (interest or principal). While such a
failure does not automatically imply bankruptcy, it does trigger default, with all its
negative consequences. Using this definition, the probability of bankruptcy is a function
of the following “
(1) Size of operating cash flows relative to size of cash flows on debt obligations: Other
things remaining equal, the larger the operating cash flows relative to the cash flows on
debt obligations, the smaller the likelihood of bankruptcy. Accordingly, the probability of
bankruptcy increases marginally for all firms, as they borrow more money, irrespective of
how large and stable their cash flows might be.
(b) Variance in Operating Cash Flows: Given the same cash flows on debt, a firm with
completely stable and predictable cash flows has a lower probability of bankruptcy than
does another firm with a similar level of operating cash flows, but with far greater
variability in these cash flows.

The Cost of Bankruptcy
The cost of going bankrupt is neither obvious nor easily quantified. It is true that
bankruptcy is a disaster for all involved in the firm ““ lenders often get a fraction of what
they are owed, and equity investors get nothing ““ but the overall cost of bankruptcy
includes the indirect costs on operations of being perceived as having high default risk.

a. Direct Costs
The direct, or deadweight, cost of bankruptcy is that which is incurred in terms of
cash outflows at the time of bankruptcy. These costs include the legal and administrative
costs of a bankruptcy, as well as the present value effects of delays in paying out the cash
flows. Warner (1977) estimated the legal and administrative costs of 11 railroads to be,
on average, 5.3% of the value of the assets at the time of the bankruptcy. He also
estimated that it took, on average, 13 years before the railroads were reorganized and
released from the bankruptcy costs. These costs, while certaintly not negligible, are not
overwhelming, especially in light of two additional factors. First, the direct cost as a
percentage of the value of the assets decreases to 1.4% if the asset value is computed five


years before the bankruptcy. Second, railroads, in general, are likely to have higher
bankruptcy costs than other companies, because of the nature of their assets (real estate
and fixed equipment).

b. Indirect Costs
If the only costs of bankruptcy were the direct costs noted above, the low leverage
maintained by many firms would be puzzling. There are, however, much larger costs
associated with taking on debt and increasing default risk, which arise prior to the
bankruptcy, largely as a consequence of the perception that a firm is in financial trouble.
The first is the perception on the part of the customers of the firm that the firm is in
trouble. When this happens, customers may stop buying the product or service, because
of the fear that the company will go out of business. In 1980, for example, when car
buyers believed that Chrysler was on the verge of bankruptcy, they chose to buy from
Ford, GM, and other car manufacturers, largely because they were concerned about
receiving service and parts for their cars after their purchases. Similarly, in the late 1980s,
when Continental Airlines found itself in financial trouble, business travelers switched to
other airlines because they were unsure about whether they would be able to accumulate
and use their frequent flier miles on the airline. The second indirect cost is the stricter
terms suppliers start demanding to protect themselves against the possibility of default,
leading to an increase in working capital and a decrease in cash flows. The third cost is
the difficulty the firmmay experience trying to raise fresh capital for its projects ““ both
debt and equity investors are reluctant to take the risk, leading to capital rationing
constraints, and the rejection of good projects.
Shapiro and Titman point out that the indirect costs of bankruptcy are likely to be
higher for the following types of firms:
Firms that sell durable products with long lives that require replacement parts and

service: Thus, a personal computer manufacturer would have higher indirect costs
associated with bankruptcy than would a grocery store.
Firms that provide goods or services for which quality is an important attribute but is

difficult to determine in advance: Since the quality cannot be determined easily in
advance, the reputation of the firm plays a significant role in whether the customer


will buy the product in the first place. For instance, the perception that an airline is in
financial trouble may scare away customers who worry that the planes belonging to
the airline will not be maintained in good condition.
Firms producing products whose value to customers depends on the services and

complementary products supplied by independent companies: Returning to the
example of personal computers, a computer system is valuable only insofar as there is
software available to run it. If the firm manufacturing the computers is perceived to
be in trouble, it is entirely possible that the independent suppliers that produce the
software might stop providing it. Thus, if Apple Computers gets into financial
trouble, many software manufacturers might stop producing software for its
computers, leading to an erosion in its potential market.
Firms that sell products that require continuous service and support from the

manufacturer: A manufacturer of copying machines for which constant service seems
to be a necessary operating characteristic, would be affected more adversely by the
perception of default risk than would a furniture manufacturer, for example.

Implications for Optimal Capital Structure
If the expected bankruptcy cost is indeed the product of the probability of
bankruptcy and the direct and indirect bankruptcy cost, interesting and testable
implications emerge for capital structure decisions “
Firms operating in businesses with volatile earnings and cash flows should use debt

less than should otherwise similar firms with stable cash flows. For instance,
regulated utilities in the United States have high leverage because the regulation and
the monopolistic nature of their businesses result in stable earnings and cash flows. At
the other extreme, toy manufacturing firms such as Mattel can have large shifts in
income from one year to another, based upon the commercial success or failure of a
single toy15; These firms should use leverage far less in meeting their funding needs.
If firms can structure their debt in such a way that the cash flows on the debt increase

and decrease with their operating cash flows, they can afford to borrow more. This is

15In years past, a single group of toys such as the Teenage Mutant Ninja turtles or the Power Rangers,
could account for a substantial proportion of a major toy manufacturer™s profits.


because the probability of default is greatest when operating cash flows decrease, and
the concurrent reduction in debt cash flows makes the default risk lower. Commodity
companies, whose operating cash flows increase and decrease with commodity prices,
may be able to use more debt if the debt payments are linked to commodity prices.
Similarly, a company whose operating cash flows increase as interest rates (and
inflation) go up and decrease when interest rates go down may be able to use more
debt if the debt has a floating rate feature.
If an external entity provides protection against bankruptcy, by providing either

insurance or bail outs, firms will tend to borrow more. To illustrate, the deposit
insurance offered by the FSLIC and the FDIC enables savings & loans and banks to
maintain higher leverage than they otherwise could. While one can argue for this
insurance on the grounds of preserving the integrity of the financial system, under
charging for the insurance will accentuate this tendency and induce high risk firms to
take on too much debt, letting taxpayers bear the cost. Similarly, governments that


. 8
( 14 .)