Caracterización docente del colegio Erasmo Valencia

Debt financing leads to the cost of financial distress as increasing a firm’s debt-equity ratio will increase the risk that the firm will default on its debt. According to Baxter (1967), the expected costs of involuntary bankruptcy and re- organisation have significant impacts on the value of a leveraged firm. These costs include direct costs such as legal and accounting fees, court costs; and indirect costs such as cost of managerial time consumed in bankruptcy and re-organisation proceedings. In general, bankruptcy costs rise when profitability declines, and push less profitable firms towards lower leverage targets. Expected bankruptcy costs are higher for firms with high growth or more volatile earnings.

The theory of bankruptcy costs states that bankruptcy costs reduce the value of the assets of the firm because they reduce the cash flows generated by the assets. Increasing the level of debt increases the likelihood of distress and, hence, the expected costs of distress. If there are no offsetting benefits associated with debt financing (i.e., if there are no taxes), firms should not use any debt (Baxter, 1967).

Despite the fact that a recent survey undertaken by Deutsche Bank (2006) observes that financial distress, other than the loss of flexibility, was not considered particularly important when making debt financing decisions. It is likely, however, that the bankruptcy costs are very small for low levels of debt, increase gradually as more debt is added, and increase substantially at high levels of debt when the probability of bankruptcy is high.

Figure 2.8: Firm Value with Financial Distress Costs and No Taxes

Source: Servas and Tufano (2006)

Figure 2.8 illustrates that when effects of taxes are not present, the value of a leveraged firm decreases while the value of an unleveraged firm remains constant. The more debt employed the faster the value of the leveraged firm decreases as the probability of bankruptcy increases (Servas and Tufano, 2006).

While few would dispute the argument that the costs associated with financial distress can reduce firm value, there is some dispute about whether these costs are large enough to have an economically significant effect on firm value. While Scott (1977) suggests that the issuance of secured debt can increase the firm value, due to

0 1 2 3 4 5 6 1 2 3 4 5 Debt F ir m val u e Firm value without debt Firm value with debt

the low probability of bankruptcy, Smith and Warner (1979) find that secured debt does not change the firm value.

While expected direct costs of financial distress appear to be very small, firms considered likely to fail may incur significant indirect costs. Warner (1977) estimated that the out-of-pocket expenses incurred in the administration of the bankruptcy process for failed US railroad companies averaged only 5.30 percent of the market value of their assets at the date of bankruptcy. This figure falls to 1.00 percent if company value is measured 7 years before the bankruptcy. Pham and Chow (1987) support this view and report the direct costs averaging 3.60 percent of company value at the date of bankruptcy for a sample of Australian companies. In recent study, Green and Hollifield (2003) simulate an economy to investigate the degree to which capital gains deferral on the tax benefits of debt. They

On the other hands, Altman (1984) estimates the direct and indirect costs of financial distress for a sample of twenty-six bankrupt US companies and finds that, in many cases, the aggregate costs exceeded 20 percent of the value of the company just before the bankruptcy. Adopting Altman’s methodology to study a sample of fourteen failed Australian companies, Pham and Chow (1987) find that the aggregate costs of financial distress averaged 22.4 percent of company value just before the bankruptcy. These results are much greater than the level of direct costs reported by Warner (1977) and later studies.

calculate the cost of financial distress and find that the bankruptcy costs account for about 3 percent of pre-tax firm value or 4.6 percent of after-tax.

2.3.4 Agency Costs

The agency costs model, initiated by Jensen and Meckling (1976), identifies two types of conflicts: conflict between managers and equity-holders and conflict between debt-holders and equity-holders. Conflict between managers and equity- holders occurs since managers capture only a fraction of the gain from their profit enhancement activities. While managers bear the entire cost of these activities, there is a conflict resulting from managerial prerequisites. Thus, the relative increases in the managers’ fractional ownership caused by the increase in debt financing, mitigates the loss from the conflict. Moreover, as pointed out by Jensen (1986) and Stulz (1990), since debt forces the firm to pay out more of the firm’s excess free cash, debt reduces the managers’ discretion over free cash flow. As dividend and debt are substitutes for controlling free cash flow problems, the relationship between the target leverage ratio and the target payout ratio is negative.

The conflict between bondholders and equity-holders arises when debt employed is risky. As Jensen and Meckling (1976) suggest, by exchanging higher- risk for lower-risk assets, equity-holders may benefit from the risky projects at the expense of bondholders, which is called the asset substitution problem. Myers (1977) also argues that if most of the benefits from a profitable investment opportunity are to accrue to the debt-holder, then equity-holders may not invest the project, which is called the under-investment problem. He suggests that shortening the maturity of debt reduces the under-investment problem. Berkovitch and Kim (1990) show that increasing seniority of new debt decreases the incidence of the under-investment problem.

Various empirical studies on the effects of agency costs produce conflicting results. Considering agency costs, Jensen and Meckling (1976) argue that an optimal

structure can be obtained by trading-off the agency costs of debt against the relevant benefit. In the context of agency costs, Barclay et al., (2001) assess the importance of investment opportunities when they studied a sample of more than 6700 U.S industrial companies over a 30-year period, from 1963 to 1993. Their result provides strong support for the importance of investment opportunities as a determinant of leverage. In addition, while Harris and Raviv (1990), Rajan and Zingales (1995) and Morellec and Smith (2007) suggest that leverage is positively related to firm value, Jensen (1986) and Stult (1990) predict leverage is positively related to cash flows.

On the other hand, Fama and Miller (1972), and Myers (1977) suggest that firms with more investment opportunities have less leverage to minimise agency costs, and Jensen and Meckling (1976), and Peyer and Shivdasani (2001) argue that leverage is negatively related to growth opportunities. In addition, a recent survey undertaken by Deutsch Bank (2006) finds that firm managers do not employ debt to improve the way they manage the firm’s assets.