Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

The second investment opportunity (called ‘project Gold Coast’) is basically a gamble. It offers a 40%

chance of a $12-million payoff and a 60% chance of a $4-million payoff. Because its expected value is

only $7.2 million [(0.4 × $12,000,000) + (0.6 × $4,000,000)], project Gold Coast is a negative-NPV

‘investment’ that the company’s managers would reject if the company did not have debt outstanding.

However, if Gold Coast is successful, the project’s $12-million payoff will allow the company to fully pay

off the bonds and pocket a $2-million profit.

Consider the incentives facing this company’s managers. Clearly, bondholders want the managers

to either select the low-risk project or retain the company’s cash in reserve. But because shareholders

will lose control of the company unless they can pay off the bonds in full when they mature,

shareholders want the company’s managers to accept project Gold Coast. If successful, the project

will yield enough for shareholders to pay off the creditors and retain ownership of the company.

However, if Gold Coast is unsuccessful, the shareholders will simply hand over the company and

any remaining assets to bondholders, after defaulting on the maturing bonds. (Because of limited

liability, the corporation’s shareholders do not have to repay the bonds themselves.) This is also

what will happen if the company plays it safe by either retaining cash in the company or accepting

project Boring. Shareholders therefore have everything to gain and nothing to lose from accepting

project Gold Coast, and their agents (the managers) control the company’s investment policy until

default actually occurs.

The Underinvestment Problem

The second game related to financial distress is underinvestment. To demonstrate this, assume that the

company described above gains access to a very profitable, but short-lived investment opportunity. A

longtime supplier offers to sell its excess inventory to the company at a sharply discounted price, but

only if the company will pay for the inventory immediately with cash. The additional supplies will cost

$9 million today, but will allow the company to increase production and profitability dramatically over

the next 30 days. In fact, the company will be able to sell the additional product so profitably that in

30  days, it will build up the $10 million cash needed to pay off the maturing bond issue. However,

because the  company has only $8 million in cash on hand today, the company’s shareholders must

contribute  the additional $1 million needed to buy the supplier’s inventory. Accepting this project

would maximise overall company value and would clearly benefit the bondholders. But the shareholders

would rationally choose not to accept the project, because the shareholders would have to finance the

investment and all the investment’s payoff would accrue to the bondholders.

An all-equity company is not vulnerable to either of these two games associated with financial distress.

Managers acting in the interests of shareholders have the incentive to choose the project that maximises

company value, in the first example, and shareholders have the incentive to choose to contribute cash

for positive-NPV projects, in the second example. Because these costs of financial distress are related to

conflicts of interest between the two groups of security holders, they are also referred to as agency costs

of the relationship between bondholders and shareholders.

13 - 4b AGENCY COSTS AND CAPITAL STRUCTURE

In addition to taxes and the costs of financial distress, several other forces influence the corporate capital

structure choice. In 1976, Michael Jensen and William Meckling proposed an agency cost model of

underinvestment
When shareholders decide
not to invest in a positive
NPV project, and therefore
‘underinvest’ relative to
choosing all positive NPV
projects