TotalAgencyAgencyCAPITAL STRUCTURE: PART IIThe Magnitude of Indirect and Direct Costs of Financial Distress:EBIT $20,000 $22,000Exhibit IValueExhibit IIAgencyCORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #151CAPITAL STRUCTURE: PART IIIn addition to corporate taxes considered above, the additional market imperfections we willconsider are:· Costs of Financial Distress (CFD), including the Agency Costs of Debt,· Personal Taxes, and.· Agency Costs of Equity. After we consider these additional market imperfections, we will address other factors that seemto affect a firm's capital structure, specifically:· The Probability of Using the Interest Tax-Shield,· Non-Debt Tax-Shield Substitutes, and· Financial Slack.We will then explore some of the systematic differences in capital structure found acrossindustries and countries, along with how they might be explained. We will discuss someempirical studies of abnormal returns surrounding increases and decreases in leverage as a clueto how some of the market imperfections might "trade off" against other imperfections, e.g., taxsavings versus CFD.Unfortunately, we will discover that we cannot develop a precise equation for use by thefinancial manager in determining the optimal capital structure for his/her firm. Too many of therelevant parameters defy precise quantification, e.g., the costs of financial distress. However, asa partial substitute for an explicit answer on how to design a firm's capital structure, we developa checklist on how managers might go about making the capital structure decision for their firm.V. The Costs of Financial Distress (CFD):As we have observed, we do not see firms as highly leveraged as suggested by the relation:VL = VU + tc*B. One obvious reason relates to the costs of financial distress, CFD. As firmsbecome more highly levered, the chances that they will run into financial difficulties increase.We will categorize the types of problems that firms can have in financial distress and the costsassociated with these problems. Obviously, the ultimate case of financial distress is bankruptcy.2However, financial stress sets in well before a firm might be forced into filing for bankruptcy.1 This lecture module is designed to complement Chapter 16 in B&D.2 If a firm files for bankruptcy, it seeks court protection from its creditors. The law related to bankruptcy is contained in various "chapters" in the Federal Bankruptcy Code. The two most important chapters of the Code for corporations are Chapter 11and Chapter 7. In Chapter 11, a firm seeks to restructure its financial obligations while under court protection from creditors. The objective is to emerge from bankruptcy as a financially restructured and viable firm. In Chapter 7, the assets of a firm are liquidated in an orderly fashion and the proceeds used to pay off claimholders in the order of their “priority” to the firm’s assets. 1Indirect Costs of Financial Distress:Prior to hitting the extreme limit of financial distress, or bankruptcy, firms may gradually feel the"noose" tighten around their necks when they begin having difficulties meeting their financialobligations, e.g., making payments to trade creditors. For instance:- Management may become preoccupied with survival. When managers are worriedabout making their debt payments, they are not attending to the main business of thefirm. Accordingly, the day-to-day affairs of the firm may go unattended as managersscramble to keep the firm afloat financially. Management distractions can haveserious short- and long-term negative consequences.- Relationships with trade creditors deteriorate. As the firm becomes shaky financially,trade creditors may curtail or cancel normal trade credit provisions. In the extreme,they may put the firm on a "cash only" basis. This curtailment of normal trade creditwill hamper the firm’s normal production process as material shortages occur.- Customers may become concerned that the business will survive. As customersobserve the firm's difficulties, they begin to worry about the firm's ability to be areliable supplier, or its ability to live up to product guarantees or warranties. In theprocess, they may shift their business elsewhere. - Valuable employees may seek jobs elsewhere for fear the firm will go out of business.All else equal, few want to work for a firm that is about to or actually declaresbankruptcy.- The Agency Costs of Debt also adversely impact firms that are in financial distress.By Agency Costs of Debt, we are referring to the costs of the conflicts of interest thatarise between managers/stockholders versus bondholders when a firm is in troublefinancially. Managers are the "agents" of the shareholders, hence the term agencycosts. Managers, on behalf of the shareholders, may begin to make decisions thatfavor shareholders at the expense of bondholders. These temptations are especiallylarge under conditions of financial distress. Examples of these activities include:- Overinvestment, i.e., take (-) NPV projects.- Underinvestment, i.e., reject (+) NPV projects.- Taking the money and running, i.e., selling important assets and paying out alarge dividend ("milking the property," to use the label in the textbook.).Ex ante (at the time the debt is issued), bondholders realize the possibility that shareholders andmanagers might collude and take detrimental actions if the firm gets into financial distress.Seeking compensation in advance for these detrimental activities, bondholders will demandhigher rates of return before they will bear these risks. To the extent that debt agency costs can2be anticipated, therefore, shareholders will pay for the agency costs of debt in advance by payinghigher interest rates.If shareholders wish to avoid the "penalty" of higher interest rates, they will be willing to writeprotective covenants into their contract with the bondholders, or the bond indenture. Thesecontractual provisions can limit the adverse activities of the shareholder/managers in times offinancial distress, thus protecting the bondholders' interests. In some indenture agreements up to30 protective covenants have been observed. Examples of these covenants include provision tokeep debt-to-equity levels below certain levels, keeping current ratios above certain levels, limitson asset sales without