Capital structure and financial stress

Credit & Financial Management Review, Second Quarter 2000 by Joyce, William B

Abstract:

Debt policy is an important part of capital structure. Legal bankruptcy can be expensive, time-consuming, and painful. There are costs associated with financial distress even if legal bankruptcy is ultimately avoided. Additionally, potential conflicts of interest between the firm's security holders may arise and information problems may arise when new securities are issued or when there is a change in investment policy. Finally, there may be incentive effects of financial leverage on management's investment and dividend decisions.

Financial Distress Cost

The costs of financial distress depend on the probability of distress and the magnitude of costs encountered if distress occurs.

The trade-off between the tax benefits and the costs of distress determines optimal capital structure. The present value of the tax shield initially increases as the firm borrows more. At moderate debt levels the probability of financial distress is trivial; so the present value of the cost of financial distress is small and tax advantages (interest expenses deduction) dominate (Modigliani and Miller, 1963, 1966; Miller, 1977; and DeAngelo and Masulis, 1980). But at some point the probability of financial distress increases rapidly with additional borrowing; the costs of distress begin to take a substantial bite out of firm value. Also, if the firm is not certain of gaining from the corporate tax advantage, the tax advantage of debt is likely to diminish and eventually disappear. The theoretical optimum is reached when the present value of tax savings due to additional borrowing is just offset by increases in the present value of costs of distress. This is called the trade-off theory of capital structure. Costs of financial distress cover several specific items, which are identified and discussed next.

Bankruptcy Costs

Rarely is anything nice said about corporate bankruptcy. However, there is some good in almost everything. Corporate bankruptcies occur when stockholders exercise their right to default. That right is valuable; when a firm gets into trouble, limited liability allows stockholders simply to walk away from it, leaving all its troubles to its creditors. The former creditors become the new stockholders; and the old stockholders are left with nothing.

The legal system in the United States allows stockholders in corporations to automatically enjoy limited liability. However, imagine a world without limited liability. For example, assume there are two firms with identical assets and operations. Each firm has debt outstanding, and each has promised to repay $1,000 (principal and interest) next year. But only one of the firms enjoys limited liability. The other firm does not enjoy limited liability, so its stockholders are personally liable for its debt. Next year's possible payoffs to the creditors and stockholders of these two firms can be compared. The only differences occur when next year's asset value turns out to be less than $1,000. Assume that next year the assets of each company are worth only $500. In this case the limited liability firm defaults; its stockholders walk away; their payoff is zero. Bondholders get the assets worth $500. On the other hand, the unlimited liability firm's stockholders are not able to "walk away"; rather, they have to pay the $500 difference between asset value and the bondholders' claim. The debt is paid whatever happens.

Assume that the firm with limited liability does go bankrupt. Certainly, its stockholders are disappointed that their firm is worth so little, but that is an operating problem having nothing to do with financing. Given poor operating performance, the right to go bankrupt (the right to default) is a valuable privilege. The stockholders with the firm with limited liability are in better shape than those stockholders without limited liability.

The example illuminates a mistake often made in considering the costs of bankruptcy. Bankruptcies are thought of as tragedies. The creditors and stockholders look at the firm's present sad state; they think of how valuable their securities used to be and how little is left. Moreover, they think of the lost value as a cost of bankruptcy. That is the mistake. The decline in the value of assets is what the tragedy is really about, which has no necessary connection with financing. The bankruptcy is merely a legal mechanism for allowing creditors to take over when the decline in the value of assets triggers default. Bankruptcy is not the cause of the decline in value. It is the result. Caution should be used in order not to get cause and effect reversed.

Bankruptcy is a legal mechanism allowing creditors to take over when a firm defaults. Bankruptcy costs are the costs of using this mechanism. Only firms with limited liability can default and go bankrupt. Yet, regardless of what happens to asset value, the total payoffs to the bondholders and stockholders of a limited liability firm is always the same as the total payoffs to the bondholders and stockholders of an unlimited liability firm. Because the total payoffs from each of the firms are the same, the overall market values of the two firms now (this year) must be the same. The stock of the limited liability firm is worth more than that of the limited firm stock because of the right to default, and its debt is worth correspondingly less.