There are many reasons why debt can be attractive, but it can also be unattractive. Increasing the proportion of debt funding can decrease the value of the firm because:
it increases investors’ exposure to a loss of value if bankruptcy occurs (direct bankruptcy costs);
x x x
it also exposes investors to the loss of value if financial distress arises due to challenges in meeting high interest payments (indirect bankruptcy costs); and
it encourages management to pass up value-decreasing investment opportunities where the benefit flows only to debt-holders, and it encourages high-risk investments – ‘betting the bank’ (agency costs).
I.A.5.4.3.1 Exposure to bankruptcy costs
Bankruptcy can be expensive. Court and legal costs use up the resources of a firm which otherwise belong to the debt-holders and shareholders. Such costs are only incurred because of debt, and the more debt the higher the probability of incurring these costs. Thus there is a trade-off occurring as proportionately more debt financing is employed. On one hand, increasing the Copyright© 2004 S. Bishop and the Professional Risk Managers’ International Association 18
proportion of debt leads to the benefits described above, but on the other hand it exposes the firm to a greater probability of incurring bankruptcy costs. Thus there ought to be an optimal proportion of debt occurring when the marginal benefit is offset by the marginal cost, as indicated in Figure I.A.5.3.
There have been studies examining whether this trade-off can explain the proportions of debt financing employed by firms.5 Unfortunately the size of bankruptcy costs is small relative to the tax benefit of debt and cannot explain the debt–equity mixes we observe. That is, the size of these costs is so relatively small that debt–equity mixes ought to be of the order of 90–100%. As we typically observe much lower levels of debt, this led researchers to focus on a broader view of costs incurred by having debt in capital structure, viz. distress costs.
Figure I.A.5.3: Trade-off of benefit and costs of increasing the proportion of debt funding
I.A.5.4.3.2 Exposure to financial distress costs
Indirect financial distress costs arise because customers and investors are frightened by the prospect that a company might cease to exist. As a result sales can fall dramatically, leading to loss of cash flow and even greater difficulty in meeting interest payments. Opler et al. (1997) cite two examples of this. Chrysler’s share of the motor car market dropped from 30% to 13% when consumers learned that it was in trouble in 1979. Caldor (a US retailer) lost the support of its
5 Warner (1977) measured the direct costs of bankruptcy for a number of railway companies undergoing bankruptcy between 1933 and 1955. These costs averaged 1% of the market value of the firm for 7 years before bankruptcy and rose to 5.3% just before bankruptcy. Pham and Chow (1989) found them to average 2.5% and 3.5% of firm value the year before and the year of bankruptcy.
Copyright© 2004 S. Bishop and the Professional Risk Managers’ International Association 19
trade creditors when its sales fell after another retailer (Bradlee’s) had filed for Chapter 11 bankruptcy protection. This ‘reflected’ outcome led to Caldor facing bankruptcy itself. In Australia, customers deserted OneTel, a telecommunications company, when news broke that it was having cash-flow difficulties. This added to the company’s woes and it ended up being wound up.
In addition to loss of sales, the cash-flow difficulties can lead to cutting costs such as essential maintenance and otherwise value-creating activities, for example research and development, leading to even further difficulties.
Pham and Chow (1989) found these costs to be non-trivial for their sample of firms. Both direct and indirect costs were estimated to be over 20% of the value of the firm.
The distress costs associated with banks are expected to be very high and the cost to society is also seen to be very high. If a bank fell into financial difficulty there is an expectation that depositors would rush to withdraw funds, thereby creating a liquidity crisis. Consequently, this is probably a significant driver of capital structure choice for them. Further, because of the potential contagion effect, regulatory authorities in many countries adhere to the Basle Accord (see the introductory Chapter III.0 in Section III).
I.A.5.4.3.3 Agency costs
Agency costs of debt can be very high when a firm is in technical default of its debt obligations, that is, it has not yet defaulted on its debt obligations but default is most likely when a debt-servicing payment falls due. Note that these circumstances do not arise when a firm has no debt, thus these are clearly a cost of debt financing. Two examples of management behaviour that make sense when a firm is experiencing financial distress are explained below.
Bet the bank when under duress: If equity is technically of zero value, the value of debt is less that its face value but the firm has not yet liquidated, there is an incentive to ‘gamble’. Rather than pay out the remaining resources to the debt-holders, managers might invest in high-risk activities. If the gamble pays off, equity-holders can then payout the debt and have a positive value from their investment. Note that here the managers (acting on behalf of shareholders) have nothing to lose.
Without taking on the gamble, the equity has zero value. If the gamble does not pay off, the debt-holders will bear the consequences. Offering to restrict these activities though covenants can decrease the flexibility management has and can lead to loss of positive NPV investments.
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Under-invest when benefits flow to debt-holders: Consider a firm that finds itself in the circumstances described above: the value of debt is below the principal amount it has to pay out and the value of equity is zero. In these circumstances it may forgo undertaking value-increasing investments, and this opportunity cost is an agency cost of debt. For example, suppose there is a payment on debt of $100,000 due in 6 months’ time but the current value of the firm is $90,000, so that debt-holders face a loss of $10,000. In these circumstances the value of equity is zero as sharedebt-holders will get nothing from the value of the business. Suppose, further, that there is an investment opportunity that has a positive NPV of $9,000. In this case, there in no incentive for management, operating in the interest of shareholders, to undertake the value-increasing investment. Shareholders would be asked to contribute more capital to help fund the investment project yet they do not share in the positive NPV – it all goes to make up the $10,000 deficiency in debt value. Consequently, value-enhancing investment opportunities can be forgone when a firm is facing default. Some, among them Myers (1977), argue that this is a substantive agency cost of debt.