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step in and regularly bail out firms on social grounds (e.g., to save jobs) will
encourage all firms to overuse debt.
Since the direct bankruptcy costs are higher, when the assets of the firm are not easily

divisible and marketable, firms with assets that can be easily divided and sold should
be able to borrow more than firms with assets that do not share these features. Thus, a
firm, such as Weyerhauser, whose value comes from its real estate holdings should be
able to borrow more money than a firm such as Coca Cola, which derives a great deal
of its value from its brand name.
Firms that produce products that require long-term servicing and support generally

have lower leverage than firms whose products do not share this feature, as we
discussed above.

7.13. ˜: Debt and Bankruptcy
Rank the following companies on the magnitude of bankruptcy costs from most to least,
taking into account both explicit and implicit costs:
a. A Grocery Store
b. An Airplane Manufacturer


c. High Technology company

There is a data set on the web that summarizes, by sector, variances in operating

2. Debt creates agency costs

Equity investors, who receive a residual claim on the cash flows, tend to favor
actions that increase the value of their holdings, even if that means increasing the risk that
the bondholders (who have a fixed claim on the cash flows) will not receive their
promised payments. Bondholders, on the other hand, want to preserve and increase the
security of their claims. Since the equity investors generally control the firm™s
management and decision making, their interests will dominate bondholder interests
unless bondholders take some protective action. By borrowing money, a firm exposes
itself to this conflict and its negative consequences and it pays the price in terms of both
higher interest rates and a loss of freedom in decision making.
The conflict between bondholder and stockholder interests appears in all three aspects
of corporate finance: (1) deciding what projects to take (making investment decisions),
(2) choosing how to finance these projects and (3) determining how much to pay out as
Risk Shifting: Risk shifting refers
Risky projects: In the section on investment
± to the tendency of stockholders in
analysis, we argued that a project that earn a return firms and their agents (managers) to
take on much riskier projects than
that exceed the hurdle rate, adjusted to reflect the
bondholders expect them to.
risk of the project, should be accepted and will
increase firm value. The caveat, though, is that
bondholders may be hurt if the firm accepts some of these projects. Bondholders lend
money to the firm with the expectation that the projects accepted will have a certain
risk level, and they set the interest rate on the bonds accordingly. If the firm chooses
projects that are riskier than expected, however, bondholders will lose on their


existing holdings because the price of the holdings will decrease to reflect the higher
Subsequent Financing: The conflict between stockholder and bondholder interests

also arises when new projects have to be financed. The equity investors in a firm may
favor new debt, using the assets of the firm as security and giving the new lenders
prior claims over existing lenders. Such actions will reduce the interest rate on the
new debt. The existing lenders in a firm, obviously do not want to give new lenders
priority over their claims, because it makes the existing debt riskier (and less
valuable). A firm may adopt a conservative financial policy and borrow money at
low rates, with the expectation of keeping its default risk low. Once it has borrowed
the money, however, the firm might choose to shift to a strategy of higher debt and
default risk, leaving the original lenders worse off.
Dividends and Stock Repurchases: Dividend payments and equity repurchases also

divide stockholders and bond holders. Consider a firm that has built up a large cash
reserve but has very few good projects available. The stockholders in this firm may
benefit if the cash is paid out as a dividend or used to repurchase stock. The
bondholders, on the other hand, will prefer that the firm retain the cash, since it can
be used to make payments on the debt, reducing default risk. It should come as no
surprise that stockholders, if not constrained, will pay the dividends or buy back
stock, overriding bondholder concerns. In some cases, the payments are large and can
increase the default risk of the firm dramatically.
The potential for disagreement between stockholders and bondholders can show
up in as real costs in two ways:
a. If bondholders believe there is a significant chance that stockholder actions might
make them worse off, they can build this expectation into bond prices by demanding
much higher interest rates on debt.
b. If bondholders can protect themselves against such actions by writing in restrictive
covenants, two costs follow “
the direct cost of monitoring the covenants, which increases as the covenants

become more detailed and restrictive.


the indirect cost of lost investments, since the firm is not able to take certain

projects, use certain types of financing, or change its payout; this cost will also
increase as the covenants becomes more restrictive.
As firms borrow more and more and expose themselves to greater agency costs, these
costs will also increase.
Since agency costs can be substantial, two implications relating to optimal capital
structure follow. First, the agency cost arising from risk shifting is likely to be greatest in
firms whose investments cannot be easily observed and monitored. For example, a lender
to a firm that invests in real estate is less exposed to agency cost than is a lender to a firm
that invests in people or intangible assets. Consequently, it is not surprising that
manufacturing companies and railroads, which invest in substantial real assets, have
much higher debt ratios than service companies. Second, the agency cost associated with
monitoring actions and second-guessing investment decisions is likely to be largest for
firms whose projects are long term, follow unpredictable paths, and may take years to
come to fruition. Pharmaceutical companies in the United States, for example, which
often take on research projects that may take years to yield commercial products, have
historically maintained low debt ratios, even though their cash flows would support more

7.14. ˜: Risk Shifting and Bondholders
It is often argued that bondholders who plan to hold their bonds until maturity and collect
the coupons and the face value are not affected by risk shifting that occurs after they buy
the bonds, since the effect is only on market value. Do you agree?
a. Yes
b. No


3. Using up excess debt capacity reduces financial flexibility
As noted earlier, one of the by-products of the Financial Flexibility: Financial
conflict between stockholders and bondholders is the flexibility refers to the capacity
of firms to meet any unforeseen
introduction of strict bond covenants that reduce the
contingencies that may arise
flexibility of firms to make investment, financing, or
(such as recessions and sales
dividend decisions. It can be argued that this is part of a
downturns) and take advantage
much greater loss of flexibility arising from taking on of unanticipated opportunities
debt. One of the reasons firms do not use their debt (such as great projects), using
the funds they have on hand and
capacity is that they like to preserve it for a rainy day,
any excess debt capacity that
when they might need the debt to meet funding needs or
they might have nurtured.
specific contingencies. Firms that borrow to capacity lose
this flexibility and have no fallback funding if they do get into trouble.
Firms value financial flexibility for two reasons. First, the value of the firm may
be maximized by preserving some flexibility to take on future projects, as they arise.
Second, flexibility provides managers with more breathing room and more power, and it
protects them from the monitoring that comes with debt. Thus, while the argument for
maintaining flexibility in the interests of the firm is based upon sound principles, it is
sometimes used as camouflage by managers pursuing their own interests. There is also a
trade-off between not maintaining enough flexibility (because a firm has too much debt)
and having too much flexibility (by not borrowing enough).
So, how best can we value financial flexibility? If flexibility is needed to allow
firms to take advantage of unforeseen investment opportunities, its value should
ultimately be derived from two variables. The first is access to capital markets. After all,
firms that have unlimited access to capital markets will not need to maintain excess debt
capacity since they can raise funds as needed for new investments. Smaller firms and
firms in emerging markets, on the other hand, should value financial flexibility more. The
second is the potential for excess returns on new investments. If a firm operates in a
mature business where new investments, unpredictable though they might be, earn the
cost of capital, there is no value to maintaining flexibility. Alternatively, a firm that
operates in a volatile business with high excess returns should attach a much higher value
to financial flexibility.


7.15. ˜: Value of Flexibility and Firm Characteristics
Both Ford and Microsoft have huge cash balances (as a percent of firm value), and you
are a stockholder in both firms. The management of both firms claim to hold the cash
because they need the flexibility. Which of the two managements are you more likely to
accept this argument from?
a. Microsoft™s management
b. Ford™s management

The Trade-off in a Balance Sheet Format
Bringing together the benefits and the costs of debt, we can present the trade off
in a balance sheet format in table 7.3:
Table 7.3: Trade off on Debt versus Equity
Advantages of Borrowing Disadvantages of Borrowing
1. Tax Benefit: 1. Bankruptcy Cost:
Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost
2. Added Discipline: 2. Agency Cost:
Greater the separation between managers Greater the separation between stock-
and stockholders --> Greater the benefit holders and lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
Overall, if the marginal benefits of borrowing exceed the marginal costs, the firm should
borrow money. Otherwise, it should use equity.
What do firms consider when they make capital structure decisions? To answer
this question, Pinegar and Wilbricht surveyed financial managers at 176 firms in the
United States. They concluded that the financial principles listed in Table 7.4 determine
capital structure decisions, in the order of importance in which they were given.
Table 7.4: Financial Principles Determining Capital Structure Decisions


The foremost principles the survey participants identified were maintaining financial
flexibility and ensuring long term survivability (which can be construed as avoiding
bankruptcy). Surprisingly few managers attached much importance to maintaining
comparability with other firms in their industries or maintaining a high debt rating.

Illustration 7.4: Evaluating the Debt Trade off “ Disney, Aracruz and Bookscape
In table 7.5, we summarize our views on the potential benefits and costs to using
debt, instead of equity, at Disney, Aracruz and Bookscape.

Table 7.5: The Debt Equity Trade Off: Disney, Aracruz and Bookscape
Item Disney Aracruz Bookscape
Tax Benefits Significant. The firm has a Significant. The firm has a Significant. The owners of
marginal tax rate of 35%. marginal tax rate of 34%, Bookscape face a 40% tax
It does have large as well. It does not have rate. By borrowing
depreciation tax shields. very much in non-interest money, the income that
tax shields. flows through to the
investor can be reduced.
Added Discipline Benefits will be high, Benefits are smaller, since Benefits are non-existent.
since managers are not the voting shares are This is a private firm.
large stockholders. closely held by insiders.
Bankruptcy Cost Movie and broadcasting Variability in paper prices Costs may be small but
businesses have volatile makes probability of the owner has all of his
earnings. Direct costs of bankruptcy high. Direct wealth invested in the
bankruptcy are likely to be and indirect costs of firm. Since his liability, in
small, but indirect costs bankruptcy likely to be the event of failure, is not
can be significant. moderate. limited, the costs will
viewed as very large.
Agency Costs High. While theme park Low. Assets are tangible Low. Prime asset is
assets are tangible and and liquid. leasehold, which is liquid.
fairly liquid, is is much
more difficult to monitor
movie and broadcasting
Flexibility Needs Low in theme park Low. Business is mature Low. Book store is
business but high in media and investment needs are established and additional


businesses because well established. investments are limited.
technological change


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