Introduction to Corporate Finance

13: Capital Structure

insolvency costs. At higher debt levels, however, the risk of insolvency rises, and some companies may

find that the tax advantages of debt are not sufficient to risk the costs of going bankrupt. This leads to

the trade-off model of capital structure in which managers try to find the optimal balance between debt’s

various costs and benefits. The optimal balance is the one that maximises the value of the company.

Recognition of insolvency costs allows us to expand the basic valuation formula first presented in Section

13-3 to express the value of a levered company, Vl, relative to the value of an unlevered company, Vu, the

present value of the benefits from debt tax shields and the present value of expected insolvency costs:

Eq. 13.7 Vl = Vu + PV(Tax shields) – PV(Insolvency costs)

Asset Characteristics and Insolvency Costs

Intuitively, it seems that insolvency will be very costly for some types of companies and less costly

for others. For example, consider a company that sells durable goods like appliances or automobiles.

Customers may hesitate to buy the company’s products if the company is at risk of becoming insolvent,

because an insolvent company might not be able to service the products that it sells. For such a company,

the loss of customers could be a very significant indirect cost of becoming insolvent, so the company has

an incentive to be very careful about the amount of debt that it issues. On the other hand, few customers

would worry about the long-term consequences of their local grocery store becoming insolvent, because

not much service after the sale is required in that business. As a general rule, producers of sophisticated

products or services have an incentive to use less debt than companies producing simple goods or

basic services.

Companies with mostly tangible assets that have well-established secondary markets should be more

willing to use debt than companies with mostly intangible assets. Companies can use tangible assets as

collateral for loans, which may reduce the cost of borrowing, and companies can sell those assets for cash

if and when financial distress occurs. Therefore, trucking companies, airlines, construction companies,

pipeline companies and railways can all employ more debt than can companies with fewer tangible

assets, such as pharmaceutical manufacturers, food distributors (what is the collateral value of week-old

tomatoes?) and pure service companies.

Financial distress may provide managers with perverse yet rational incentives to play a variety of

games, mostly at bondholders’ expense. Two such games – asset substitution and underinvestment – are

especially damaging. Both games begin when managers realise that the company will probably not fulfil

its obligations to creditors.

The Asset Substitution Problem

To illustrate how asset substitution works, assume that a company has bonds with a face value of

$10 million outstanding that mature in 30 days. These bonds were issued years ago when the company

was prospering, but since then the company has fallen on hard times. In spite of its difficulties, the

company still has $8 million in cash on hand, and the company’s managers still control its investment

policy. The company can invest this cash in either of two available projects, both of which require a cash

investment of $8 million. Alternatively, the company can simply hold the cash in reserve to partially repay

the bond issue in 30 days. The first investment opportunity is a low-risk project (code-named ‘Boring’ by

company insiders) that will return a near-certain $8.15 million in 30 days. This is a monthly return of

1.88%, or an annual return of almost 25%. In other words, it is a positive-NPV project that will increase

company value, but it does not earn enough to fully pay off the maturing bonds.

asset substitution

When shareholders choose

risky projects that benefit

themselves but reduce the

value of bondholders

John Graham, Duke

University

‘The majority of

companies follow the

trade-off model.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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