Effects of Default and Bankruptcy in a
Perfect Market (no costs of financial
distress)
There are no effects of default and bankruptcy
on firm value in a perfect market
Example: Armin Industries
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Armin is introducing a new product.
If success, Armin’s value in one year = 150
If failure, Armin’s value in one year = 80
Comparing two capital structures:
All-equity
Debt that matures in one year with 100 due
Scenario 1. Success
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Without leverage equityholders get 150
With leverage they get 50
What if there’s not enough cash to pay to
creditors? (150 can be a PV of future cash
flows not available right now)
No problem with perfect cap market. The
money to repay can be raised by issuing new
debt or equity as claims against future cash
flows
Ex: selling equity for 100 and using the proceeds
to repay the debt
Scenario 2. Failure
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Without leverage equityholders get 80
With leverage there will be default and bankruptcy.
The shareholders get 0 (limited liability). The creditors
suffer loss of 20.
Comparing two scenarios:
The total value that goes to all investors in any state of
nature is independent of the capital structure, hence the
ex-ante total firm value is independent of the cap
structure too (MM proposition I)
Introducing the costs of bankruptcy
and financial distress
Direct costs
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Fees to lawyers, consultants, appraisers,
etc…
E.g., for Enron the total cost of fees was above
$750 mln = 10% of the assets value
Usually, 3-4% of the pre bankruptcy market value.
But higher for small firms (e.g. 15%)
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Time
Indirect costs (difficult to measure but seem
much larger than direct ones (10-20%))
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Loss of customers
Loss of suppliers
Loss of employees
Loss of receivables
Fire sales of assets
Indirect costs to creditors (they can suffer distress too)
Inefficient investment (NPV < 0) when in distress (see
below)
Inability to raise finance for positive NPV projects
when in distress
Armin Industries: The Impact of
Financial Distress Costs
Assume in case of failure debt holders
receive only 60 < 80 because they bear
the bankruptcy costs.
MM I does not hold anymore
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E.g. assuming that success and failure are
equally likely, that the risk is diversifiable (or
that agents are risk-neutral), and that the riskfree interest rate = 1.05, we get:
PV(financial distress costs) = ((1/2)*20 +
(1/2)*0)/1.05 = 9.52 – this is the difference
between the value of the unlevered firm and
levered firm
(VU = ((1/2)*150 + (1/2)*80)/1.05 = 109.52;
VL = ((1/2)*150 + (1/2)*60)/1.05 = 100)
New MM I:
Who bears financial distress costs eventually?
When securities are fairly priced, the original
shareholders pay the whole PV(financial distress cost)
Suppose at the beginning of the year Armin has 10 mln
shares and no debt. It wants to issue one-year debt with
a face value of $100 mln and use the proceeds to
repurchase shares.
If there are no bankruptcy costs the total value that goes
to equityholders should not change:
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Debt = ((1/2)*100 + (1/2)*80)/1.05 = 85.71 – this is how much the
firm can raise through debt with face value 100.
Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how much the
remaining shares will cost.
Hence, the total value that goes to equityholders = Equity +
money paid in the repurchase = 109.52 – exactly the same as VU
If there are bankruptcy costs, the total value that
goes to equityholders changes:
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Debt = ((1/2)*100 + (1/2)*60)/1.05 = 76.19 – this is
how much the firm can raise now through debt with
face value 100.
Equity = ((1/2)*50 + (1/2)*0)/1.05 = 23.81 – this is how
much the remaining shares will cost.
Hence, the total value that goes to equityholders =
Equity + money paid in the repurchase = 100 = VU –
PV(financial distress cost) – shareholders bear the
whole cost
Optimal Capital Structure: The Tradeoff
Theory
VL = VU + PV(Interest Tax Shield) + PV(Financial Distress Costs)
Agency Costs
Remember: one of the key assumptions behind
MM I was that they way the firm is financed has
no effect on the cash flows it generates
In reality this is not true due to conflicts of
interest between debt holders and shareholders
( agency costs of debt) and between
managers and shareholders ( agency costs of
equity)
Hence, the capital structure will matter
Agency Costs of Debt
Assume Baxter Inc. has a loan of $1 mln
due at the end of the year. Without
changing strategy the market value of its
assets will be only $900,000  default
We will see how the following problems
can arise:
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Overinvestment (asset substitution)
Underinvestment (debt overhang)
Cashing out (excessive dividends)
Overinvestment (asset substitution
(Jensen and Meckling (JFE, 1976))
New strategy. Success with prob 50%
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If success, assets value = $1.3 mln  no
default
If failure, assets value = $300,000  default
Assuming no discounting, expected assets
value A = $800,000 < $900,000
Why would the management follow a
value reducing strategy?
If it cares only about the interest of the shareholders, it
would, because the shareholders gain.
The debt holders lose and the firm value decreases
Hence, when a firm faces financial distress,
shareholders are tempted to gain by gambling at the
expense of debt holders, even if such gambles have
NPV < 0!
Note: this problem exists not only in distress, but in
distress it becomes especially serious
Eventually, the cost is again born by the initial
shareholders
Underinvestment (debt overhang,
Myers (JFE, 1977))
Suppose instead of pursuing risky strategy, the manager considers a
positive NPV opportunity that requires initial investment of 100 and
generates 150 in one year.
Could the firm raise 100 by issuing new equity? No.
End of year values:
Equityholders receive only 50 – they will not agree to invest 100!
Hence, when a firm faces financial distress, it
may fail to implement projects with NPV > 0!
Note: this problem exists not only in distress, but
in distress it becomes especially serious
Note: the firm is unable to raise funds not only
through selling equity, but through selling any
security that is junior to the existing debt
This cost is again born by the initial
shareholders
Cashing out (excessive dividends)
Suppose Baxter has equipment it can sell for 25 at the
beginning of the year and pay out this cash as dividend.
Assume without the equipment the firm will be worth only
800 at the year-end.
This behavior reduces value by 100 – 25. But the
shareholders do not care – the firm will default anyway
and they are protected by limited liability
Again this cost would initially be born by the initial
shareholders.
Note: this problem exists not only in distress, but in
distress it becomes especially serious
Example: benefits of lower leverage
Debt maturity, Covenants and Convertible
Debt as ways to mitigate the above
problems
Short term debt leaves fewer possibilities
for shareholders to profit at the
debtholders’ expense.
Covenants – restrictions in a debt contract:
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Limiting dividend payments
Limiting the scope for risky investments
Limiting the ability to issue more senior debt
Convertible bonds (e.g. in case stock price
reaches some level)
Agency Costs of Equity (benefits of
debt)
Extracting private benefits at the expense
of shareholders (Jensen and Meckling
(JFE, 1976))
Free cash flow problem (Jensen (AER,
1986))
Extracting private benefits at the expense of
shareholders (Jensen and Meckling (JFE,
1976))
Managers do not fully internalize shareholder
value because they own 100% of the shares
Imagine an initial owner (entrepreneur) who
needs to raise funds from outside but wants to
keep managing the company
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If he sells equity he is left with < 100% of shares 
he can be tempted to do things that benefit him
privately at the expense of other shareholders (“pet”
projects, perks, profit diversion, asset diversion,
simply underprovision of effort)
If he sells debt he still owns 100% and fully bears the
consequences of his actions for the equity value
Free cash flow problem
Managers can be tempted to use available cash
for projects that they like but are investments
with NPV < 0 (e.g. empire building through
acquisitions)
Hence, the available cash should be reduced
The way to do it is trough debt financing. Then
the managers have lower discretion over cash
because they must pay part of it to creditors as
interest.
Agency Costs and the Tradeoff
Theory
Tradeoff theory and observed
leverage for different types of firms
Young, R&D intensive firms usually have
low leverage because:
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Low current free cash flow – little benefit from
tax shield
High human capital – large loss in case of
bankruptcy
Easy to increase risk of business strategy –
danger of the asset-substitution problem
Often need to raise additional capital – debt
overhang problem
Low-growth, mature firms usually have
high leverage because:
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Stable current free cash flow – benefit from
tax shield
Tangible asses – low loss in case of
bankruptcy
Seldom need to raise additional capital – debt
overhang problem is unlikely