CAPITAL STRUCTURE: AGENCY COSTS AND ASYMMETRIC INFORMATIONCapital structure so far• So far: Capital structure is determined by trading off tax benefit of debt versus financial distress costs• Now: Additional determinants of capital structure— Shareholders vs. Managers conflicts of interest— Shareholders vs. Debt Holders conflicts of interest— Asymmetric information / Adverse selection• MM assumptions:— No Taxes— Bankruptcy is not costly— Capital structure does not affect investment policy and cash-flows— Symmetric information, All securities are fairly pricedManager-Shareholder Conflicts of Interest• Managers may make decisions that benefit themselves at investors’ expense, e.g.:— Reduce their effort (“shirking”)— Avoid risk (“live the quiet life”)— Spend excessively on perks or “pet projects”— Engage in “empire building”— Outright stealing (less likely)• Corporate governance usually seeks to address these problems, but debt can help too!Free cash flow can lead to wasteful spending• Free cash flow hypothesis: Wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed to make all positive-NPV investments and payments to debt holders• Potential solution: More debt! — Debt reduces discretionary funds and therefore provides incentives for managers to run the firm more efficiently— Debt allows equity ownership to be more concentrated, improving monitoring of managementManagement Entrenchment Theory of Capital Structure• Shareholders’ Goal: Increase leverage to minimize wasteful spending• Manager’s Goal: Minimize leverage to increase discretionary funds in the company and to prevent potential job loss that would accompany financial distress• Capital structure depends on the relative power of shareholders vs. managers for determining the firm’s leverage choiceEquity-holder vs. Debt-holder Conflicts of Interest• Positive-NPV decisions usually increase the value of both equity and debt (and vice versa for negative-NPV projects)• But, some decisions have different consequences for the value of equity and the value of debt• Managers (who are appointed by shareholders) may therefore choose actions that benefit shareholders but harm creditors• This situation is more likely to occur when the firm has high leverage and is in financial distress1. Cashing out— Distribute as much cash as possible to shareholders (e.g. by selling assets or raising new debt) 2. Excessive risk-taking— Equity holders’ option is worth more when the cash flow is more volatile— Take risky projects that benefit shareholders but hurt bondholders— This is also called “Risk shifting” or “Asset substitution”3. Under-investment— Decline new projects that are positive-NPV but require new equity financing because value goes to debt-holders— Also called “Debt overhang”Three Main Types of Equity-Debt Conflicts of InterestsEquity holders don’t care if bigger losses occur once firm is in this range0204060801001200 10 20 30 40 50 60 70 80 90 100Value of Cash FlowsValue of ClaimTotalDebtEquityWhy The Conflict? Equity and Debt PayoffsExample 1: Wealth Transfer• Two periods: t = 0, and t = 1• At t = 1 the state is either boom or bust, with equal probability, value of firm goes to 150 in boom, down to 50 in bust• Assume rf= 0 and β = 0 to keep it simple— Logic the same with positive interest rates and risk• We will use D and E to represent market values• Firm has value of 100 at t = 0. Firm has debt with face value of 50 due at t = 1Example 1: Wealth TransferV = $150(D,E) = ($50, $100)V = $50(D,E) = ($50, 0)V = $100(D,E) = ($50, $50)V = $150(D,E) = ($100, $50)V = $50(D,E) = ($50, 0)V = $100(D,E) = ($75, $25)Now issue more debt with face value of 50 and equal seniority to existing debt (also called “pari passu” debt), repurchase shares:Example 1: Wealth Transfer• Value of old debt post-issue? • Value of new debt?• Value of equity post-issue?• Value of equity post-issue plus payment to shareholders?• Who won and who lost?• Was value of total claims maintained?Example 1: Wealth Transfer• Lesson: Additional debt issue dilutes existing debtholders to the benefit of shareholders— MM still holds• More blatant wealth transfers are possible— Issue new debt or sell assets to pay a dividend to shareholdersExample 2: Risk Shifting• Basic idea: equity holders’ option on the firm is worth more when cash flow is more volatile— Equity holders benefit from increasing risk of the firm— Option analogy: A call option is worth more when volatility is higher• If management is close to bankruptcy, sell all the assets and go to Vegas— Shareholder receive all the upside and none of the downside• Only arises when there is a chance that D may not be fully repaid— Requires risky debt, and hence this is an indirect cost of bankruptcy• Blatant transfers and theft may be easy to detect, but risk shifting is less soExample 2: Risk ShiftingV = $100(D,E) = ($50, $50)V = $20(D,E) = ($20, 0)V = $60(D,E) = ($35, $25)Payoff = $5Payoff = –$10Cost = $0• New investment opportunity:• NPV = –$2.5Example 2: Risk ShiftingV = $105(D,E) = ($50, $55)V = $10(D,E) = ($10, 0)V = $57.5(D,E) = ($30, $27.5)• Investment transfers $5 from D and increase E by $2.5• So do shareholders want to undertake project?• Feeling of initial creditors?• Does MM hold?Example 2: Risk Shifting• Example: Savings and Loan (S&L) crisis in the 1980s• S&Ls are banks with primarily mortgage loans as assets and primarily deposits as liabilities• Early 1980s saw a combination of bad conditions for these banks• Many S&Ls took on risky loans that would destroy capital if they went badly, but would save the firm if they paid offExample 3: Debt Overhang• If a firm’s existing debt is underwater in some states, then it may not be able to finance positive NPV projects with equity• New investors reluctant to invest because some of the returns will go to pay existing creditors• Debt overhang leads to underinvestmentNumerical Example of Debt OverhangV = $100(D,E) = ($50, $50)V = $20(D,E) = ($20, 0)V = $60(D,E) = ($35, $25)Payoff = $15Payoff = $15Cost = $10• New investment opportunity:• NPV = $5What Happens if Firm Takes Investment? V = $115(D,E) = ($50, $65)V = $35(D,E) = ($35, 0)V = $75(D,E) = ($42.5, $32.5)• This investment raises the value of D and E at t=0 by $7.5