Fin 6212 Financial Policy

LECTURE 6
PROF. NICHOLAS CHEN
Two prominent theories

• Trade-Off Theory
o Theory that capital structure is based on trade-off
between tax savings and distress costs of debt
• Pecking-Order Theory
o Theory stating firms prefer to issue debt over equity
if internal finances are insufficient
Today’s plan

• Tradeoff theory
o Fixed investments (covered last lecture)
o Tax benefits (quick review)
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
International Leverage and Tax
Hong Kong Corporate Tax
Tax-Deductible Interest

The tax deductibility of interest increases the total income that can be paid out
to bondholders and stockholders
The Interest Tax Shield and Firm Value

• The cash flows a levered firm pays to investors

will be higher than they would be without
leverage by the amount of the interest tax
shield.
 Cash Flows to Investors   Cash Flows to Investors 
      (Interest Tax Shield)
 with Leverage   without Leverage 
The Cash Flows of the Unlevered and
Levered Firm
Capital Structure & Corporate Taxes

Interest payment  return on debt  amount borrowed

 rD  D

corporate tax rate  interest payment

PV (tax shield) 
expected return on debt
T ( r  D)
 C D  TC  D
rD
The Interest Tax Shield
and Firm Value (cont'd)

• MM Proposition I with Taxes

o The total value of the levered firm exceeds the
value of the firm without leverage due to the present
value of the tax savings from debt.
V L  V U  PV (Interest Tax Shield)
Capital Structure & Corporate Taxes

Exercise
You own all the equity of Space Babies Diaper Co. the
company has no debt. The company’s annual cash
flow is $900,000 before interest and taxes. The
corporate tax rate is 35%. You have the option to
exchange half of your equity position for 5% bonds
with face value of $2,000,000. Should you do this and
why?
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The
company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is
35% You have the option to exchange half of your equity position for 5% bonds with a face
value of $2,000,000. Should you do this and why?

($1,000s) All Equity 1/2 Debt Total Cash Flow to both

equity and debt holders
EBIT 900 900
All equity = 585
Interest pmt 0 100
Pretax income 900 800 *1/2 Debt = 620
Taxes @ 35% 315 280 (520 + 100)
Net cash flow 585 520
Capital Structure & Corporate Taxes

D × 𝑟𝐷 × 𝑇𝑐
PV of tax shield = = 𝐷 × 𝑇𝑐
𝑟𝐷

Example:
Tax benefit = 2,000,000 × .05 × .35 = $35,000

35,000
PV of $35,000 in perpetuity = =$700,000
.05
Or
PV of tax shield =
Capital Structure & Corporate Taxes

Firm value =
value of all equity firm + PV tax shield

Example
585
All equity value = = 11,700,000
.05

PV tax shield = 700,000

Firm value with 50% debt = $12,400,000

Today’s plan

• Tradeoff theory
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or

distorted business decisions before bankruptcy

Market value = value if all equity financed

+ PV tax shield
- PV costs of financial distress
The Bankruptcy Code

• The U.S. bankruptcy code was created so that

creditors are treated fairly and the value of the
assets is not needlessly destroyed.
o U.S. firms can file for two forms of bankruptcy
protection: Chapter 7 or Chapter 11.
The Bankruptcy Code (cont'd)

• Chapter 7 Liquidation
o A trustee is appointed to oversee the liquidation of
the firm’s assets through an auction. The proceeds
from the liquidation are used to pay the firm’s
creditors, and the firm ceases to exist.
The Bankruptcy Code (cont'd)

• Chapter 11 Reorganization
o Chapter 11 is the more common form of bankruptcy
for large corporations.
o With Chapter 11, all pending collection attempts are
automatically suspended, and the firm’s existing
management is given the opportunity to propose a
reorganization plan.
 While developing the plan, management continues to
operate the business.
o The reorganization plan specifies the treatment of
each creditor of the firm.
The Bankruptcy Code (cont'd)

• Chapter 11 Reorganization
o Creditors may receive cash payments and/or new
debt or equity securities of the firm.
 The value of the cash and securities is typically less than
the amount each creditor is owed, but more than the
creditors would receive if the firm were shut down
immediately and liquidated.
o The creditors must vote to accept the plan, and it
must be approved by the bankruptcy court.
o If an acceptable plan is not put forth, the court may
ultimately force a Chapter 7 liquidation.
Direct Costs of Bankruptcy

• The bankruptcy process is complex, time-

consuming, and costly.
o Costly outside experts are often hired by the firm to
assist with the bankruptcy process.
o Creditors also incur costs during the bankruptcy
process.
 They may wait several years to receive payment.
 They may hire their own experts for legal and
professional advice.
Direct Costs of Bankruptcy (cont'd)

• The direct costs of bankruptcy reduce the

value of the assets that the firm’s investors will
ultimately receive.
o The average direct costs of bankruptcy are
approximately 3% to 4% of the pre-bankruptcy
market value of total assets.
Direct Costs of Bankruptcy (cont'd)

• Given the direct costs of bankruptcy, firms may

avoid filing for bankruptcy by first negotiating
directly with creditors.
• Workout
o A method for avoiding bankruptcy in which a firm in
financial distress negotiates directly with its
creditors to reorganize
 The direct costs of bankruptcy should not substantially
exceed the cost of a workout.
Indirect Costs of Financial Distress

• While the indirect costs are difficult to measure accurately, they are often
much larger than the direct costs of bankruptcy.
o Loss of Customers
o Loss of Suppliers
o Loss of Employees
o Loss of Receivables
o Fire Sale of Assets
o Delayed Liquidation
o Costs to Creditors
Overall Impact of Indirect Costs

• The indirect costs of financial distress may

be substantial.
o It is estimated that the potential loss due to financial
distress is __________% of firm value
The Present Value of Financial Distress
Costs

Three key factors determine the present value

of financial distress costs:
1. The probability of financial distress.
 The probability of financial distress increases with the
amount of a firm’s liabilities (relative to its assets).
 The probability of financial distress increases with the
volatility of a firm’s cash flows and asset values.
The Present Value of Financial Distress
Costs (cont'd)

Three key factors determine the present value

of financial distress costs:
2. The magnitude of the costs after a firm is in
distress.
 Financial distress costs will vary by industry.
 Technology firms will likely incur high financial distress costs
due to the potential for loss of customers and key personnel, as
well as a lack of tangible assets that can be easily liquidated.
 Real estate firms are likely to have low costs of financial
distress since the majority of their assets can be sold relatively
easily.
The Present Value of Financial Distress
Costs (cont'd)

Three key factors determine the present value

of financial distress costs:
3. The appropriate discount rate for the distress costs.
 Depends on the firm’s market risk
 Note that because distress costs are high when the firm does
poorly, the beta of distress costs has the opposite sign to that
of the firm.
 The higher the firm’s beta, the more negative the beta of its
distress costs will be
 The present value of distress costs will be higher for high
beta firms.
Who Pays for Financial
Distress Costs?

• When securities are fairly priced, the original

shareholders of a firm pay the present value of
the costs associated with bankruptcy and
financial distress.
Today’s plan

• Tradeoff theory
o Fixed investments (covered last lecture)
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
Optimal Capital Structure:
The Tradeoff Theory

• Tradeoff Theory
o The firm picks its capital structure by trading off the
benefits of the tax shield from debt against the costs
of financial distress and agency costs.
Optimal Capital Structure:
The Tradeoff Theory (cont'd)

• According to the tradeoff theory, the total value

of a levered firm equals the value of the firm
without leverage plus the present value of the
tax savings from debt, less the present value of
financial distress costs.

V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)

Optimal Leverage

• For low levels of debt, the risk of default

remains low and the main effect of an increase
in leverage is an increase in the interest tax
shield.
• As the level of debt increases, the probability of
default increases.
o As the level of debt increases, the costs of
financial distress increase, reducing the value
of the levered firm.
Optimal Leverage (cont'd)

• The tradeoff theory states that firms should

increase their leverage until it reaches the level
for which the firm value is maximized.
o At this point, the tax savings that result from
increasing leverage are perfectly offset by the
increased probability of incurring the costs of
financial distress.
Optimal Leverage (cont'd)

• The tradeoff theory can help explain

o Why firms choose debt levels that are too low to
fully exploit the interest tax shield (due to the
presence of financial distress costs)
o Differences in the use of leverage across industries
(due to differences in the magnitude of financial
distress costs and the volatility of cash flows)
Agency Costs
and the Tradeoff Theory

• The value of the levered firm can now be

shown to be
V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)
 PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)
Optimal Leverage with Taxes, Financial Distress, and Agency
Costs
Today’s plan

• Tradeoff theory
o Fixed investments (covered last lecture)
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
Asymmetric Information
and Capital Structure

• Asymmetric Information
o A situation in which parties have different
information
o For example, when managers have superior
information to investors regarding the firm’s future
cash flows
Issuing Equity and Adverse Selection

• Adverse Selection
o The idea that when the buyers and sellers have
different information, the average quality of assets
in the market will be _____ the average quality
overall

• Lemons Principle (Akerlof, Nobel Prize)

o When a seller has private information about the
value of a good, buyers will discount the price they
are willing to pay due to adverse selection.
Issuing Equity
and Adverse Selection (cont'd)

• A classic example of adverse selection and the

lemons principle is the used car market.
o If the seller has private information about the quality
of the car, then his desire to sell reveals the car is
probably of low quality.
o Buyers are therefore reluctant to buy except at
heavily discounted prices.
Issuing Equity
and Adverse Selection (cont'd)

o Owners of high-quality cars are reluctant to sell

because they know buyers will think they are selling
a lemon and offer only a low price.
o Consequently, the quality and prices of cars sold in
the used-car market are both low.
Issuing Equity
and Adverse Selection (cont'd)

• This same principle can be applied to the

market for equity.
o Suppose the owner of a start-up company offers to
sell you 70% of his stake in the firm. He states that
he is selling only because he wants to diversify. You
suspect the owner may be eager to sell such a
large stake because he may be trying to cash out
before negative information about the firm becomes
public.
Issuing Equity
and Adverse Selection (cont'd)

• Firms that sell new equity have private

information about the quality of the future
projects.
o However, due to the lemon principle, buyers are
reluctant to believe management’s assessment of
the new projects and are only willing to buy the new
equity at heavily discounted prices.
Issuing Equity
and Adverse Selection (cont'd)

• Therefore, managers who know their prospects

are good (and whose securities will have a high
value) will not sell new equity.
• Only those managers who know their firms
have poor prospects (and whose securities will
have low value) are willing to sell new equity.
Issuing Equity
and Adverse Selection (cont'd)

• The lemons problem creates a cost for firms

that need to raise capital from investors to fund
new investments.
o If they try to issue equity, investors will discount the
price they are willing to pay to reflect the possibility
that managers have bad news.
SEC charges Theranos with “massive
fraud,” CEO Holmes stripped of control
(2018)

• Female “Steve Jobs”

fraud,” CEO Holmes stripped of control
(2018)

• The once-darling Silicon Valley startup that

promised to revolutionize the blood-testing industry
and fetched a valuation of $9 billion may have
finally been dealt a death blow.
• The Securities and Exchange Commission on
Wednesday charged Theranos Inc., its founder
and CEO Elizabeth Holmes, and former President
Ramesh “Sunny” Balwani with “massive fraud”
after a lengthy investigation. The SEC alleges that
they raised $700 million in investments by
orchestrating an “elaborate, years-long fraud in
which they exaggerated or made false statements
about the company’s technology, business, and
financial performance.”
SEC charges Theranos with “massive
fraud,” CEO Holmes stripped of control

• According to the SEC:

Theranos, Holmes, and Balwani made numerous false and
misleading statements in investor presentations, product
demonstrations, and media articles by which they
deceived investors into believing that its key product—a
portable blood analyzer—could conduct comprehensive
blood tests from finger drops of blood, revolutionizing the
blood-testing industry.
• In truth, according to the SEC’s complaint,
Theranos’ proprietary analyzer could complete
only a small number of tests, and the company
conducted the vast majority of patient tests on
modified and industry-standard commercial
analyzers manufactured by others.
Pecking Order Theory

• ___________and ____________ leads to

Pecking Order Theory
o Internal equity may be better than external equity
o Financial slack (cash) is valuable
o If external capital is required, debt is better. (There
is less room for difference in opinions about what
debt is worth).
The Pecking Order - Evidence

1. Size. Large firms tend to have higher debt

ratios.
2. Tangible assets. Firms with high ratios of fixed
assets to total assets have higher debt ratios.
3. Profitability. More profitable firms have lower
debt ratios.
Because Pecking order theory is Not forward-looking
4. Market to book. Firms with higher ratios of
market-to-book value have lower debt ratios
Leverage as a Credible Signal

• Credibility Principle
o One’s self-interest are credible only if they are
supported by actions that would be too costly to
take if the claims were untrue.
 “Actions speak louder than words.”
Leverage as a Credible Signal (cont'd)

• Assume a firm has a large new profitable

project, but cannot discuss the project due
to competitive reasons.
o One way to credibly communicate this positive
information is to commit the firm to large future debt
payments.
 If the information is true, the firm will have no trouble
making the debt payments.
 If the information is false, the firm will have trouble paying
its creditors and will experience financial distress. This
distress will be costly for the firm.
Leverage as a Credible Signal (cont'd)

• Signaling of Debt
o The use of leverage as a way to signal information
to investors
 Thus a firm can use leverage as a way to convince
investors that it does have information that the firm will
grow, even if it cannot provide verifiable details about the
sources of growth.
Today’s plan

• Tradeoff theory
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
Do Firms Prefer Debt?

• Do Firms Prefer Debt?

o When firms raise new capital from investors, they
do so primarily by issuing debt.
o In most years aggregate equity issues are negative,
meaning that on average, firms are reducing the
amount of equity outstanding by buying shares.
Microsoft uses debt to buy Linkedin
Net External Financing and Capital Expenditures by U.S. Corporations, 1975–
2011

Source: Federal Reserve, Flow of Funds Accounts of the United States, 2012.
Do Firms Prefer Debt?

• Do Firms Prefer Debt?

o While firms seem to prefer debt when raising
external funds, not all investment is externally
funded.
o Most investment and growth is supported by
internally generated funds.
 Even though firms have not issued new equity, the market
value of equity has risen over time as firms have grown.
For the average firm, the result is that debt as a fraction of
firm value has varied in a range from 30–45%.
Debt-to-Value Ratio
[D / (E + D)] of U.S. Firms, 1975–2011

Source: Compustat and Federal Reserve, Flow of Funds Accounts of the

United States, 2012.
Do Firms Prefer Debt?(cont'd)

• Do Firms Prefer Debt?

o The use of debt varies greatly by industry.
o Firms in ______ industries like biotechnology or
high technology carry very little debt, while airlines,
automakers, utilities, and financial firms have high
leverage ratios.
Debt-to-Value Ratio [D / (E + D)] for Select
Industries

Source: Capital IQ, 2012.

 Figure 15.7 Debt-to-Value Ratio [D / (E + D)] for
Select Industries (cont’d)

Source: Capital IQ, 2012.

Today’s plan

• Tradeoff theory
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
The Low Leverage Puzzle

• Two important facts

o Firms have used debt to shield a greater
percentage of their earnings from taxes in more
recent years (mirroring the increase in the effective
tax advantage of debt).
o Low leverage puzzle: Firms have ______leverage
than our analysis of the interest tax shield would
predict.
The Low Leverage Puzzle (cont'd)

• Firms worldwide have similar low proportions of

debt financing.
o Although the corporate tax codes are similar across
all countries in terms of the tax advantage of debt,
personal tax rates vary more significantly, leading to
greater variation in *.
International Leverage and Tax Rates (1990)
The Low Leverage Puzzle (cont'd)

• It would appear that firms, on average, are

under-leveraged. However, it is hard to accept
that most firms are acting suboptimally.
o In reality, there is more to the capital structure story
than discussed so far.
Low-leverage puzzle

• Puzzle: Expected distress costs are small,

firms could borrow more, but they do not.
o Direct cost: 2-3%
o Indirect cost: 10-20%

• “horse and rabbit stew:” Bankruptcy costs are

simply negligible compared to the tax benefits
of debt.
My answer

• Operating leverage, financial leverage and

capital structure
o By Chen, Harford and Kamara (2019)
o Key point: Operating leverage ______ financial
leverage
• Operating leverage
o Physical capital
 Maintenance costs, and rental costs
o Human capital
 Good workers left and bad worker stay
Why Microsoft started to use more debt in
2016?
Why Microsoft starts to use more debt

• Operating leverage is reduced, because the

operating costs, such as hardware storage
costs, become cheaper.
o Flash disk storage increases from 500M to 10G
o Cloud storage and computing
Today’s plan

• Tradeoff theory
o Fixed investments (covered last lecture)
o Tax benefits
o Distress costs
o Combining together
• Pecking order theory
• Debt financing choice
• Puzzle 1: Low financial leverage puzzle
• Puzzle 2: Negative relation between
profitability and financial leverage
Negative profitability-financial leverage puzzle

• Negative profitability-financial leverage puzzle

o Puzzle: Highly profitable firms have a low financial
leverage
o It is against the tradeoff theory
My Explanation

• Operating leverage, financial leverage and capital structure

o Chen, Harford, and Kamara (2017, JFQA)

• Maybe something is missing in the standard tradeoff

model…

o New ingredient: operating leverage

 Dark side: fixed costs increase the default probability due to required
operating costs, and decrease financial leverage to default probability
due to required coupons.

 Bright side: fixed costs increase profitability due to fixed operating costs

 Combining the two effects together: operating leverage causes the

negative relation between profitability and financial leverage.
Empirical measures

• Profitability = Operating Income/assets

• Financial leverage
o Book financial leverage = debt/assets
o Market financial leverage = debt/(debt + equity)

• Operating leverage = SG&A costs/assets

• Operating income = Sales – CoGs – SG&A

o CoGs: costs of goods sold
o SG&A: sales, general and admin expense
Operating leverage measure

• First job: we need to find the fixed costs from

balance sheets.

• Balance sheets give the costs of goods sold

(CoGs) and sales, general and admin expense
(SG&A).
 Table 1. Stickiness of Operating and Production Costs
This table presents the results from testing the stickiness of operating and production
costs in response to a negative change in sales. We run panel regressions to examine
the contemporaneous response of the costs to the changes in sales revenue as follows:
𝑦𝑡 = 𝛽0 + 𝛽1 𝑅𝑒𝑣𝑅𝑎𝑡𝑒𝑡 + 𝛽2 𝑅𝑒𝑣𝑅𝑎𝑡𝑒𝑡 ∗ 𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝐷𝑢𝑚𝑚𝑦𝑡 + 𝑒𝑡
where 𝑦𝑡 stands for the logarithmic changes in costs of goods sold (ProdRate) and in
SG&A costs (OperRate). RevRatet denotes the changes in the logarithmic value of net
sales. T-statistics are adjusted by the clustered standard errors.
SG&A costs costs of goods sold
OperRate ProdRate
β0 0.028 0.005
[12.724] [3.457]
β1 0.607 0.938
[55.125] [124.22]
β2 -0.192 -0.082
[-11.64] [-6.203]
β1 + β2 0.415 0.846
Message from Table 1

• Which one is stickier (or more fixed)?

o ________ that keep the firm running, even when
the firms suspend their production.

• Which costs can proxy for operating leverage?

o _____________ , because the coefficient of SG&A
(0.415) is lower than the coefficient of CoGs
(0.846), which means the cost is not less
responsive to the decrease in sales.
Positive impact of operating leverage on profitability (Table 4)

Profitability = a + b*oper Lev + e

a (Intercept) 0.15
[36.395]
b (OperLev) 0.028
[4.374]
Negative impact of operating leverage on financial leverage (Table 5)

• Financial Lev = a + b* oper lev + e

Book lev Market Lev

Intercept 0.363 0.32
[57.931] [21.730]
OperLev -0.176 -0.085
[-21.08] [-12.55]
Operating leverage is the necessary
condition (Table 6)

• Financial Lev = a + b* profitability

+e
Panel A. Book Leverage Panel B. Market Leverage

With Without With Without

Name OperLev OperLev OperLev OperLev

Intercept 0.238 0.264 0.303 0.335

[18.721] [22.627] [19.061] [20.266]

Profitability -0.284 -0.084 -0.345 -0.103

[-16.000] [-15.430] [-10.140] [-16.510]

Messages from Tables

• Table 4
o Fixed cost increased profitability.

• Table 5
o Fixed costs, like SG&A, crowd out financial
leverage.

• Table 6
o Fixed costs reduces financial leverage,
And they are the reason for the negative association
between the profitability and financial leverage.
Operating leverage, financial leverage and capital structure (Chen, Harford,
and Kamara , 2016)

• Summary: Traditional trade-off model is

missing operating leverage
o Key point: operating leverage
 Bright side: fixed costs increase profitability
 Dark side: fixed costs increase the default probability, and
decrease financial leverage.

 Combining together: operating leverage causes the

negative relation between profitability and financial
leverage.