16.4How Can Firms Minimize Debt Holder–Equity Holder

Incentive Problems?

Chapter 11 bankruptcy may lessen some of the costs associated with conflicts between

debt holders and equity holders, but bankruptcy would probably not be a manager’s

preferred way to deal with the problem. This section examines other solutions to these

incentive problems. As discussed earlier, equity holders should be motivated to control

their incentive problems, since ultimately they must bear the costs that such prob-

lems create.

Grinblatt1174Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1174Hill
Markets and Corporate		Debt Holder1174Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

581

The simplest solution to debt holder–equity holder incentive problems is to elim-

inate the debt holders. The problems are of course eliminated if the firm is all equity

financed. However, there are offsetting advantages to the inclusion of debt in a firm’s

capital structure. Some of these benefits of debt (for example, tax advantages) were

discussed in earlier chapters. Other benefits will be discussed in Chapters 17, 18 and

19. Therefore, firms have incentives to include debt in their capital structures and to

design their debt in ways that minimize the potential conflicts between borrowers and

lenders.

The following discussion briefly describes six ways that owners of a firm can min-

imize the incentive costs associated with debt financing. These are as follows:

•	Protective covenants.
•	Bank and privately placed debt.
•	The use of short-term instead of long-term debt.
•	Security design.
•	Project financing.
•	Management compensation contracts.

Protective Covenants

Earlier, this chapter discussed protective covenants that specify the seniority of the debt

as well as covenants that specify the amount that firms can distribute to shareholders

as a dividend or repurchase. In addition, covenants that require the firm to satisfy

restrictions on various accounting ratios, such as the debt/equity ratio, interest cover-

age, and working capital, are often observed. Other covenants restrict the sale of assets.

Firms that violate these covenants are in technical default, which means that debt hold-

ers can demand repayment even if the firm has not missed an interest payment. (See

Chapter 2 for additional detail.)

What Covenants Do We Observe?In their study of bond covenants, Smith and

Warner (1979) reported that about 90 percent of a sample of bonds issued in 1974 and

1975 restricted the issuance of additional debt, 23 percent restricted dividends, 39 per-

cent placed constraints on merger activity, and about 35 percent placed restrictions on

how a firm can sell its assets. These covenants provide some protection to the original

debt holders against the tendency of a firm’s management to undertake high-risk

investment projects in the future. Junior debt holders, who have the lowest priority of

repayment if a firm defaults, would have an incentive to withhold financing if they

think the firm is likely to be taking on excessively risky projects. However, the

covenants are much weaker than might be expected given the potential conflicts

described earlier in this chapter.

Covenants that directly limit the types of projects that firms can undertake are less

common. For example, in a study of bonds issued by large U.S. corporations, McDaniel

(1986) found almost no restrictions on the ability of firms to increase their risk. This

is because it is very difficult to specify in a contract the exact types of investments that

are allowed over the 20- to 30-year life of a bond. In many cases, subtle changes in a

production technology (for example, making the plant more labor intensive) can lead

to important changes in risk. Even if it were possible to write contracts to prevent such

changes, firms may find that the costs of limiting management’s flexibility would

exceed the benefits of limiting the bondholders’risk.

Grinblatt1176Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1176Hill
Markets and Corporate		Debt Holder1176Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

582Part 1VCapital Structure

Covenants on Investment-Grade versus Noninvestment-Grade Debt.The studies

mentioned above focused mainly on the bonds of major companies with high credit rat-

ings. Since these firms have relatively low leverage, the debt holder–equity holder con-

flicts described in this chapter are unlikely to be severe. For this reason, investment-

grade bonds generally have relatively weak covenants.

In contrast, the potential for debt holder–equity holder conflicts in firms that issue

noninvestment-grade (that is, high-yield or junk) bonds is high. Hence, noninvestment-

grade bonds often have substantial covenants that limit the issuing firm’s operating

strategies.¹⁹

In 1992, for example, Continental Medical Systems issued $200 million of

senior subordinated notes. The prospectus for these notes included nearly 100 pages of

covenants describing what the firm could and could not do. The covenants addressed

a number of issues, including:

•	The issuance of additional debt.
•	Changes in control of the corporation.
•	Limitation of dividends and share repurchases.
•	The sale of assets.
•	Maintenance of properties.
•	The provision for insurance.

Covenants Cannot Solve All Problems.Some of the incentive problems would be

especially difficult to eliminate with contractual provisions. At the outset, for example,

the debt overhang problem leads firms to pass up positive NPVinvestments. While it

is plausible that contracts can be written to preclude certain projects, we don’t believe

it is possible to include debt covenants that prevent firms from turning down positive

NPVprojects that lower the value of the firm’s common stock. Asecond potential con-

flict concerns how an infusion of equity can help the original equity holders by allow-

ing the firm to keep operating at the expense of the debt holders, who prefer the firm

to liquidate. In this case, the gain to the equity holders is less than the loss to the debt

holders, which suggests that it would be beneficial to prevent an equity infusion of this

type. In reality, however, firms would not want to rule out equity infusions because

generally, equity issues that fund positive NPVprojects benefit both debt holders and

equity holders.

McDaniel (1986) argued that the covenants of bonds issued in the 1960s, 1970s,

and the early 1980s were entirely inadequate because they were written at a time when

actions such as leveraged recapitalizations were far less common.²⁰

The author argued

that in many cases bondholders had implicit agreements with management that subse-

quently were violated. If McDaniel is correct, one might expect to find that bonds

issued more recently are better protected. Indeed, Lehn and Poulsen (1992) found that

about 30 percent of a sample of bonds issued in 1989 included covenants that explic-

itly protected bondholders from the risks of takeovers and recapitalizations. Moreover,

they found that firms that are better candidates for takeovers tend to have covenants

that restrict takeovers and leveraged recapitalizations.

¹⁹A

recent study by Nash, Netter, and Poulsen (1999) documents the greater use of covenants for

noninvestment-grade debt.

²⁰A

leveraged recapitalizationrefers to greatly increasing a firm’s leverage and simultaneously selling

off a large fraction of its assets. See Chapter 2 for more detail.

Grinblatt1178Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1178Hill
Markets and Corporate		Debt Holder1178Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

583

It should be noted that while debt covenants may solve some incentive problems,

they come with costs. They can be costly to write and enforce, and they can limit a

firm’s flexibility. Thus, publicly traded investment-grade debt rarely has covenants that

could trigger a technical default. However, covenants of this type are observed in pri-

vate debt, whose holders can more easily monitor covenant compliance, and in nonin-

vestment-grade debt, which is more subject to the kinds of concerns discussed in this

chapter.

Bank and Privately Placed Debt

Recall that debt financing can cause either debt overhang or asset substitution, depend-

ing upon the circumstances. Bond covenants that affect the firm’s ability to issue debt

that is senior to existing debt can affect the firm’s tendency to experience these prob-

lems. As noted in Section 16.2, the ability to issue debt that is senior to existing

debteliminates the debt overhang problem, but it also increases the asset substitution

problem.

The use of bank debt may be advantageous because it solves the free-rider problem

that contributes to the debt overhang problem. Recall the situation described in Section

16.2 in which the debt holders as a group benefit from infusing new capital into a cor-

poration, but individual debt holders do not find it in their interests to provide capital

by themselves. The problem arises because the new debt by itself is not a good invest-

ment, but the capital infusion increases the value of the existing debt. It is possible to

eliminate this free-rider problem if the firm has only one lender, such as a bank, which

can take into account how its new loans affect the value of its existing loans.

Bank debt and, to a lesser extent, debt that is privately placed with insurance com-

panies and pension funds, have additional advantages over publicly traded bonds when

the incentives to increase risk are most severe. Banks and other private providers of

debt capital are better able to monitor the investment decisions of firms and enforce

protective covenants. In addition, more stringent covenants can be imposed on private

debt because it is much easier to renegotiate and to enforce a covenant with a bank

than with a group of bondholders. Consequently, bank loan covenants limit flexibility

far less than equivalent bond covenants.

Anumber of articles have argued that the conflict between debt holders and equity

holders in Japan and Germany is less of a problem than it is in the United States because

large banks not only provide most of the debt financing for firms but also own large

holdings of the firms’stocks (see Chapter 1). These articles argue that because the banks

in these countries own both debt and equity claims, they have incentives to preclude

policies that promote inefficient investment for the sake of transferring wealth between

claim holders. With the repeal of Glass-Steagall regulations (see Chapter 1), which have

historically limited the ability of U.S. banks to hold stock, this solution to the debt

holder–equity holder conflict is now much easier to use in the United States.

However, despite the advantages of bank debt and the repeal of Glass-Steagall, the

importance of banks has been diminishing over time in the United States and through-

out the world. Increasingly, firms throughout the world have been going to the bond

and commercial paper markets to raise debt capital. In 1975, more than 90 percent of

corporate debt in Japan was held by banks. By 1992, that figure had fallen to less than

50 percent, in part because of deregulation.²¹Firms raising their debt capital through

the public markets instead of through banks are primarily the larger, higher quality, less

²¹Source:

Hoshi, Scharfstein, and Kashyap (1993).

Grinblatt1180Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1180Hill
Markets and Corporate		Debt Holder1180Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

584Part 1VCapital Structure

risky firms, which are less likely to be subject to the types of financial distress costs

discussed in this chapter. For these firms, the benefits of bank debt are insufficient to

justify the added costs associated with bank loans—costs that are passed on to the bor-

rower in the form of higher interest payments.

There are a number of costs associated with bank debt that firms may be able to

avoid by going directly to the bond or commercial paper market. The first is what we

would call a pure intermediation cost that arises because banks require buildings and

labor and are unable to loan out all their funds because of reserve requirements. Asec-

ond cost has to do with potential incentive problems within banks that arise because

loan officers may extend additional credit to marginal borrowers either because they

don’t want to reveal that their initial loan to the firm was bad or because they don’t

want to face the unpleasant task of forcing a client into bankruptcy. For the reasons

discussed earlier, the costs associated with a bank’s suboptimal actions may need to be

passed on to the firm borrowing from it. Finally, there may exist what is known as a

hold up problem that makes bank debt less attractive for some borrowers. Ahold up

problem occurs if a firm relies too much on any single bank, and the bank takes advan-

tage of this reliance and charges the firm above-market rates on its subsequent loans.

In such a situation, the firm may find it difficult to access capital from other, poten-

tially cheaper, sources, since the firm’s inability to raise the capital from its bank could

be viewed as a signal that the bank believes the firm’s prospects are not favorable.²²

The Use of Short-Term versus Long-Term Debt

Most of the debt holder–equity holder conflicts discussed in this chapter are more

severe when firms use long-term rather than short-term debt financing. To understand

why this is true, recall that these conflicts arise because equity holders have an incen-

tive to implement investment strategies that are advantageous to them by lowering the

value of the firm’s outstanding debt. Hence, since the value of short-term debt is much

less sensitive to changes in a firm’s investment strategy than the value of long-term

debt, conflicts are lower for firms financed with short-term debt.

Mitigating the Debt Overhang Problem.Myers (1977) noted that it is possible to

eliminate the debt overhang problem if the firm’s existing debt matures before the time

when it must raise additional debt to fund a new project. To understand this, consider

again the example of Unitron, which had a risk-free project yielding 12 percent when

the risk-free rate was 10 percent. The firm passed up the project because its borrow-

ing costs were high enough to exceed the project’s return. If the firm’s debt was all

short-term, there would have been no debt overhang problem. In this case, the interest

payment on all of the firm’s debt would have been renegotiated simultaneously with

the selection of the new project. Thus, the addition of a risk-free project, which would

lower the overall risk of the firm, also would lower the firm’s borrowing costs, mak-

ing it attractive for the firm to accept the project.

Mitigating the Asset Substitution Problem.The use of short-term debt also makes

it more difficult for equity holders to gain at the expense of debt holders by select-

ing riskier projects. Consider the case of a firm that must decide whether to design

²²See

Rajan (1992) for a discussion of the hold up problem.

Grinblatt1182Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1182Hill
Markets and Corporate		Debt Holder1182Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

585

its production facilities so that the process is more or less risky. The equity holders

of a highly leveraged firm may prefer the risky project because the upside potential

is higher and they share any downside risk with the debt holders. However, if the

firm’s debt is primarily short term, the incentive to increase asset risk diminishes.

With short-term financing, the lending rate is renegotiated after completion of the

production process, which largely eliminates a firm’s ability to gain at the expense

of its lenders.

Disadvantages of Short-Term Debt.Of course, there also is a downside to funding

long-term projects with short-term debt. With short-term financing, unexpected

increases in interest rates could potentially bankrupt a highly leveraged firm. This has

led some authors to advocate short-term borrowing coupled with hedging interest rate

risk in the futures and swap markets.²³

Security Design: The Use of Convertibles

Aconvertible bond provides its holder with the option to exchange bonds for a pre-

specified number of the issuing firm’s shares (see Chapter 2). Some analysts view a

convertible bond as a combination of a call option on the firm’s stock and a straight

bond. While this description is not altogether correct, it does provide useful intuition.

Recall that options, and thus the option element in the convertible bond, become more

valuable as the volatility of the firm’s stock increases. This increase in the value of the

option component can offset the decrease in the value of the convertible’s straight bond

component that occurs when the firm’s volatility increases.

Designing a Convertible Bond to Make Its Value Insensitive to Volatility

Changes.Depending on the relative importance of the option and straight bond

components, the convertible bond can either increase or decrease in value with an

increase in the firm’s overall level of risk. Some researchers have suggested that it

may be possible to design a convertible bond so that its value is insensitive to

changes in the volatility of the firm.²⁴The equity holders of a firm financed with

such debt would therefore have no incentive to select high risk projects since they

would gain nothing from the debt holders and would not profit from a project’s adop-

tion unless the project has a positive NPV.

Empirical Evidence on Convertible Issuance.Empirical evidence by Mikkelson

(1981) tends to support this rationale for convertible bond issuance. Mikkelson found

that highly leveraged, high-growth firms were the most likely to issue convertible

bonds. These firms are likely to have the highest probability of bankruptcy, so the

effect of risk on the value of their straight bonds and stock is probably the greatest.

In addition, these firms are likely to have the greatest flexibility when it comes to

future investments and thus the greatest ability to increase risk. Mikkelson also

found that the maturities of the convertible bonds issued by firms were generally

longer than the maturities of their straight bonds. This probably reflects the inabil-

ity of growth firms, because of incentive problems, to obtain long-term financing

with straight debt.

23

These issues are discussed in greater detail in Chapter 21.

²⁴See

Brennan and Schwartz (1986) and Green (1984).

Grinblatt1184Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1184Hill
Markets and Corporate		Debt Holder1184Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

586Part 1VCapital Structure

The Use of Project Financing

Project financingis capital to finance an investment project for which both the proj-

ect’s assets and the liabilities attached to its financing can effectively be separated from

the rest of the firm. For example, most major U.S. oil companies structure at least some

of their foreign operations as separate operating units with their own financing. Simi-

larly, power generating plants are often structured as independently financed units of

electrical utilities.²⁵

In most cases, the parent company provides equity for the project

(in many cases along with a joint venture partner), which appears on the firm’s bal-

ance sheet. However, the parent is not responsible for the project’s debt (that is, the

project is financed with what is called non-recourse debt), which implies that the debt

need not appear on the parent firm’s balance sheet. Moreover, the project’s debt has a

senior claim on the cash flows generated by the project.

The use of project financing can mitigate the debt holder–equity holder conflicts

in a number of ways. Recall the case of Lily Pharmaceutical, considered earlier,

where a positive NPVproject was passed up because the wealth transferred from

equity holders to debt holders exceeded the project’s NPV. In this case, if project

financing were used, there would be substantially less of a wealth transfer from equity

holders to debt holders because the project’s debt would have the senior claim on the

project’s cash flows. Moreover, since project financing is tied to a specific project,

there is generally less scope for the kind of asset substitution problems discussed in

Section 16.2.

Of course, project financing is not a panacea that solves all debt holder–equity

holder conflicts. In many cases, it is difficult to define a firm’s project in a way that

allows it to be financed as a separate entity. Suppose, for example, that Ford can

upgrade its domestic manufacturing facilities at a cost of $3 billion. Since the manu-

facturing facilities are already owned by Ford, financing their renovation would be dif-

ficult to structure as a separate project.

In addition, although project financing, when it can be used, generally mitigates

the underinvestment problem, it can often exacerbate the asset substitution problem. To

understand why project financing can exacerbate the asset substitution problem con-

sider the behavior of an entrepreneur with ten diverse investment projects that can be

financed either as ten independent projects or together as one firm. If each of the ten

projects is financed with non-recourse debt, the incentive to increase the risk of any

specific project may be quite high since the entrepreneur will capture all the upside

benefits associated with the more favorable outcomes while the debt holders bear the

increased downside costs associated with the unfavorable outcomes. However, if the

projects are all financed under the umbrella of one corporation, with conventional debt

financing, part of the gain associated with the favorable outcomes in any given project

benefits the debt holders since it might offset an unfavorable outcome from another

project. Put differently, because of diversification, the value of debt is not particularly

sensitive to the fortunes or misfortunes of any one project since most of the project-

specific risk has been diversified away.

²⁵The

Hollywood film Erin Brockovichdescribes how project financing provided a measure of

protection from lawsuits for Pacific Gas and Electric. For more in-depth information about project

financing we recommend a book by Finnerty (1996) and an article by Kensinger and Martin (1988).

Grinblatt1186Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1186Hill
Markets and Corporate		Debt Holder1186Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

587

Management Compensation Contracts

Up to this point, we have assumed that managers make investment choices that maxi-

mize their firm’s share price. However, managers often have other objectives.²⁶

For

example, sometimes they are under more pressure to please their debt holders than their

equity holders. This can be seen in some highly leveraged U.S. firms, which depend

on banks to finance their day-to-day operations, and in countries like Germany and

Japan, where the banks have greater influence over managers.

In addition, some of the natural tendencies of managers are more aligned with

the interests of debt holders than equity holders.²⁷First, relative to other sharehold-

ers, managers generally have a much larger portion of their wealth tied up in the

firms they manage and thus are likely to act as though they are more risk averse.

This would increase their tendency to take on less risky and diversifying investments

which might counteract the incentive to take on too much risk. Second, prestige and

power go hand in hand with operating a growing firm, providing an incentive for

managers to overinvest. The incentive to overinvest probably counteracts the equity-

controlled firm’s incentive to underinvest, which derives from the debt overhang

problem. Thus, managers may make choices that benefit debt holders at the expense

of equity holders.

It is worth emphasizing that it is not in the equity holders’best long-term inter-

ests to have managers who act purely in the interests of either debt holders or equity

holders. To maximize the firm’s current value, a firm must commit its managers to

make future choices that are in the combined best interest of all claimants, maxi-

mizing the combined value of the firm’s debt and equity. Afirm will be able to bor-

row at more attractive rates if the manager can assure the lender that the interests

of the debt holders as well as those of the equity holders will be considered when

investment choices are made. This means that firms have an incentive to compen-

sate managers in ways that make them sensitive to the welfare of both debt holders

and equity holders.

The results of this section are summarized as follows:

Result 16.12

The adverse effects of debt financing on a firm’s unlevered cash flows arising from debtholder–equity holder conflicts may be mitigated by using

•	protective covenants,
•	bank debt and privately placed debt,
•	short-term debt instead of long-term debt,
•	convertible bonds,
•	project financing, and
•	properly designed management compensation contracts.

However, many of these remedies have downsides to them as well.

26

These will be discussed extensively in Chapter 18.

²⁷This,

however, may be changing since managers are now receiving a greater share of their

compensation from stock options. As we show in Chapter 8, the value of an executive’s stock options

increases with increased variance, which provides an incentive for managers to increase risk.

Grinblatt1188Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1188Hill
Markets and Corporate		Debt Holder1188Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

588	Part 1VCapital Structure

16.5	Empirical Implications forFinancing Choices

The preceding discussion contains important insights about which firms should have

high leverage and which should have low leverage. This section reviews empirical evi-

dence about the extent to which the issues described in this chapter affect observed

capital structure choices.

How Investment Opportunities Influence Financing Choices

Since debt financing distorts investment incentives, firms with substantial investment

opportunities should be more conservative in their use of debt financing. Existing cross-

sectional empirical studies tend to support this hypothesis. The variables used to mea-

sure future investment opportunities include, among other things, research and devel-

opment expenditures, because the point of most research is to develop new

opportunities, and the ratio of the firm’s market value to its book value, because mar-

ket value measures the combined value of a firm’s existing assets and future opportu-

nities while book value measures only the value of existing assets.

Consistent with the discussion in this chapter, both of these variables are negatively

related to the amount of debt included in a firm’s capital structure.²⁸

Firms that have

high R&D expenditures and high market values relative to their book values tend to

include little debt in their capital structures.²⁹

Consistent with the discussion in Section

16.4, empirical studies find that firms with good future opportunities tend to prefer

short-term to long-term debt.³⁰

How Financing Choices Influence Investment Choices

Asecond type of study examines whether highly leveraged firms invest less than firms

with lower debt/equity ratios. Lang, Ofek, and Stulz (1996) concluded that more highly

leveraged firms tend to invest less than firms with lower leverage ratios. The authors

argued that this reflects the fact that firms with poor investment opportunities choose

to be highly leveraged as well as the fact that debt inhibits a firm’s ability to invest.

In other words, poor investment opportunities can cause firms to be more highly lever-

aged, and high leverage might cause firms to invest less.

Direct evidence about how debt financing leads firms to invest less comes from

the study’s analysis of the investment behavior of the noncore business segments of

diversified firms. The basic idea is that a company like Mobil Oil would select its debt

ratio based on the fundamentals of the oil industry. However, the firm’s debt ratio could

have inadvertently affected the investment choices of Montgomery Ward, a retail firm

that used to be owned by Mobil. The Lang, Ofek, and Stulz study found that, on aver-

age, the level of investment in the noncore business segments of diversified firms

decreased when the overall leverage of the firms increased, supporting the idea that

debt causes firms to invest less.³¹

²⁸See

Bradley, Jarrell, and Kim (1984), Long and Malitz (1985), Titman and Wessels (1988), and

Smith and Watts (1992).

29

Other explanations for these findings are discussed in Chapter 17.

³⁰See,

for example, Barclay and Smith (1995), Stohs and Mauer (1996), and Guedes and Opler

(1996).

³¹Lamont

(1997) examined similar issues, using detailed data on the investment choices within the oil

industry, and arrived at similar conclusions.

Grinblatt1190Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1190Hill
Markets and Corporate		Debt Holder1190Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

589

Firm Size and Financing Choices

Two reasons explain why the debt holder–equity holder conflict may be worse for small

firms:

•	Small firms may be more flexible and thus better able to increase the risk oftheir investment projects.
•	The top managers of small firms are more likely to be major shareholders,which gives them a greater incentive to make choices that benefit equityholders at the expense of debt holders.

These arguments suggest that small firms should exhibit lower debt ratios. This,

however, does not seem to be the case. However, small firms do tend to choose debt

instruments that minimize conflicts between debt holders and equity holders. In par-

ticular, their long-term debt is more likely to be convertible and a greater proportion

of their total debt financing tends to be short-term debt.³²

Small firms also may avoid long-term debt because of the transaction costs of issu-

ing long-term bonds in relatively small amounts. As shown in Chapter 1 (see Exhibit

1.7), the transaction costs of a $500 million bond issue averages about 1.64 percent of

the total dollar amount while a $10 million bond issue may entail transaction costs of

about 4.39 percent of the total. As a result, smaller firms may opt for less expensive

loans from banks, which have lower fixed transaction costs than bond issues, but which

tend to provide only short-term financing.

Evidence from Japan

As noted earlier, the debt holder–equity holder conflicts are not likely to be as severe

in Japan as they are in the United States.³³In Japan, banks play a much larger role in

the financing of corporations. They hold both corporate debt and stock in the compa-

nies to which they lend, and their representatives typically sit on corporate boards of

directors. Thus, debt holders have more control of the day-to-day operations of com-

panies in Japan, and, with bank debt more prevalent, free-rider problems have less rel-

evance in Japan. This suggests that variables like R&D expenditures, which serve as a

proxy for future investment opportunities, may be less related to financial leverage

ratios in Japan than in the United States. Prowse (1990) found that the negative rela-

tionship between R&D expenditures and leverage is weak in Japan. These findings

stand in sharp contrast to those in the United States.

Astudy by Flath (1993) provides further evidence about how Japanese banks mit-

igate the debt holder–equity holder conflicts. He found that, as in the United States,

Japanese growth firms, which potentially have the greatest conflicts, are generally less

highly levered than other Japanese firms. However, Japanese growth firms that have

a close banking relationship, characterized by the bank’s holding of a significant frac-

tion of the firm’s stock, tend to be more levered than their counterparts without a bank-

ing relationship of this type. His evidence suggests that because banks are able to exer-

cise more control when they hold more shares, they can better protect their interests

and can thus offer greater amounts of debt financing in situations where potential con-

flict exists.

32

See Titman and Wessels (1988).

³³See

Chapter 1 for more detail on the Japanese financial system.

Grinblatt1192Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1192Hill
Markets and Corporate		Debt Holder1192Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

590	Part 1VCapital Structure

16.6	Summary and Conclusions

This chapter discussed some of the costs a firm might bearin the event that it becomes too highly leveraged. We beganwith a brief discussion of the direct legal and administra-tive costs of bankruptcy, which are likely to be a relativelysmall proportion of the assets of most large corporations.The chapter’s main focus was on the indirect costs of fi-nancial distress that arise because of conflicts of interestbetween debt holders and equity holders. These conflictsof interest create the following investment distortions:

•Highly leveraged firms tend to pass up positive net

present value investment projects.

•Debt creates an incentive for firms to increase risk.

•Debt creates an incentive for firms to take on

projects that pay off quickly, leading them to pass

up projects with higher net present values that take

longer to pay off.

•Debt creates an incentive for equity holders to keep

a firm operating when it might be worth more if it

were liquidated.

To the extent that lenders anticipate how debt distortsinvestment incentives, equity holders will bear the costsof the investment distortions caused by their firm’s finan-cial structure. Afirm with an incentive to make invest-ment decisions that reduce the value of its debt will besubject to higher borrowing costs and may at times beunable to obtain debt financing. Given this, firms have an

incentive to design their financial structures and in otherways position themselves to minimize these investmentdistortions.

This chapter provided the following suggestions forfirms wanting to minimize the costs associated with in-vestment distortions that arise from debt financing.

•Use debt covenants that limit dividend payouts, the

amount of new debt financing, and investments

substantially outside the firm’s main line of business.

•Use short-term debt instead of long-term debt.

•Use bank debt (or private placements) instead of

public bonds.

•Use convertible debt or bonds with attached

warrants.

•Design management compensation contracts that

eliminate the incentives of managers to distort

investments.

The last suggestion requires further elaboration.Lenders may be more concerned about the preferences ofmanagers than of shareholders. Therefore, the underin-vestment problem may not be significant if managershave a preference to overinvest to maximize the growthrates of their firms. Chapter 18, which takes a more care-ful look at large management-run firms, concludes thatthe kinds of distortions created by debt financing cansometimes be beneficial rather than costly.

Key Concepts

Result 16.1:Debt holders charge an interest premiumResult 16.5:With risky debt, equity holders have an

that reflects the expected costs they mustincentive to pass up internally financed

bear in the event of default. Therefore,positive net present value projects when

equity holders indirectly bear thethe funds can be paid out to equity

expected costs of bankruptcy and mustholders as a dividend.

consider these costs when choosing theirResult 16.6:Firms with large amounts of debt tend to

optimal capital structures.pass up high NPVprojects in favor of

Result 16.2:Firms acting to maximize their stocklower NPVprojects that pay off sooner.

prices make different decisions whenResult 16.7:The equity holders of a levered firm may

they have debt in their capital structuresprefer a high-risk, low (or even negative)

than when they are financed completelyNPVproject to a low-risk, high NPV

with equity.project.

Result 16.3:Selecting projects with positive netResult 16.8:With sophisticated debt holders, equity

present values can at times reduce theholders must bear the costs that arise

value of a levered firm’s stock.because of their tendency to substitute

Result 16.4:Firms that have existing senior debthigh-risk, low NPVprojects for low-risk,

obligations may not be able to obtainhigh NPVprojects.

financing for positive NPVinvestments.

Grinblatt1194Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1194Hill
Markets and Corporate		Debt Holder1194Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

591

Result	16.9:	Firms with the potential to select high-	However, the provision also may allow
		risk projects may be unable to obtain	some firms to continue operating when
		debt financing at any borrowing rate	they would be better off liquidating.
		when risk-free interest rates are high.	Result 16.12:The adverse effects of debt financing on
Result	16.10:	Since debt holders have priority in the	a firm’s unlevered cash flows arising
		event of liquidation, they have a stronger	from debt holder–equity holder conflicts
		interest in liquidating the assets of a	may be mitigated by using
		distressed firm than the firm’s equity
			•protective covenants,
		holders, who profit from the possible
			•bank debt and privately placed debt,
		upside benefits that may be realized if
		the firm continues to operate. As a result,	•short-term debt instead of long-term
		a firm’s financial structure partially	debt,
		determines the conditions under which it	•convertible bonds,
		liquidates.
			•project financing, and
Result	16.11:	In Chapter 11 bankruptcy, firms are able
			•properly designed management
		to obtain debtor-in-possession (DIP)
			compensation contracts.
		financing. To some extent, this provision
			However, many of these remedies have
		of the bankruptcy code mitigates the debt
			downsides to them as well.
		overhang/underinvestment problem.

Key Terms

absolute priority rule559	hold up problem584
asset substitution problem563	impaired creditors559
Chapter 7559	indirect bankruptcy costs558
Chapter 11559	liquidation costs576
cramdown560	liquidation value576
debtor-in-possession (DIP) financing580	nonfinancial stakeholders558
debt overhang problem563	non-recourse debt586
default premium561	project financing586
direct bankruptcy costs558	reluctance to liquidate problem563
financial distress costs562	reorganization plan559
financially distressed firms558	shortsighted investment problem563
free-rider problem565	technical default581
going concern value576	underinvestment problem563

Exercises

16.1.Afirm has $100 million in cash on hand and ab.Which project will equity holders want the

debt obligation of $100 million due in the nextmanagers to take? Why?

period. With this cash, it can take on one of two16.2.Nigel decides he can make zippers at night for one

projects—Aor B—which cost $100 million each.period and will have cash flows next period of

Assume that the firm cannot raise any additional$210 if the economy is favorable, and $66 if the

outside funds. If the economy is favorable,economy is unfavorable. One-third of these

project Awill pay $120 million and project B willproceeds must be paid out in taxes if the firm is all

pay $101 million. If the economy is unfavorable,equity financed; however, because of the tax

project Awill pay $60 million and project B willadvantage of debt, Nigel saves $0.05 in taxes for

pay $101 million. Assume that investors are riskevery $1.00 of debt financing that he uses.

neutral, there are no taxes or direct costs ofAssume investors are risk neutral, the riskless rate

bankruptcy, the riskless interest rate is zero, andis 10 percent per period, and the probability of

the probability of each state is .5.each state is .5. Also assume that if Nigel’s firm

a.What is the NPVof each project?goes bankrupt and debt holders take over, the legal

fees and other bankruptcy costs total $20.

Grinblatt1196Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1196Hill
Markets and Corporate		Debt Holder1196Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

592Part 1VCapital Structure

a.If Nigel organizes his firm as all equity, what16.5.Sigma Design, a computer interface start-up firm

will it be worth?with no tangible assets, has invested $50,000 in

b.Suppose Nigel’s firm sold a zero-coupon bondR&D. The success of the R&D effort as well as

worth $44 at maturity next period. How muchthe state of the economy will be observed in one

would the firm receive for the debt?year. If the R&D is successful (prob.90%),

c.With the debt level above, how much would theSigma requires a $53,000 investment to start

equity be worth?manufacturing. If the economy is favorable

d.How much would the firm be worth?(prob.90%), the project is worth $153,000, and

e.Would the firm be worth more if it had a debtif it is unfavorable, the project will have a value of

obligation of $70 next period?$61,000. Demonstrate how the value of Sigma is16.3.Afirm has a senior bond obligation of $20 dueaffected by whether or not it was originally

this period and $100 next period. It also has afinanced with debt or equity. Assume no taxes, no

subordinated loan of $40 owed to Jack and Jill anddirect bankruptcy costs, all investors are risk

due next period. It has no projects to provide cashneutral, and the risk-free interest rate is zero.

flows this period. Therefore, if the firm cannot get16.6.In Japan, financial institutions hold significant

a loan of $20, it must liquidate. The firm has aequity interests in the borrowing firms. How does

current liquidation value of $120. If the firm doesthis affect the costs of financial distress and

not liquidate, it can take one of two projects withbankruptcy?

no additional investment. If it takes project A, it16.7.Describe the relation between the zero-beta

will receive cash flows of $135 next period, forexpected return on common stock and the zero-

sure. If the firm takes project B, it will receivebeta expected return on corporate bonds in an

either cash flows of $161 or $69 with equaleconomy where stock returns are taxed more

probability. Assume risk neutrality, a zero interestfavorably than bond returns, interest payments are

rate, no direct bankruptcy costs, and no taxes.tax deductible, and bankruptcy costs are important

a.What has a higher PV: liquidating, project A, ordeterminants of a firm’s capital structure choice.

project B?

16.8.ABC Corp., which currently has no assets, is

b.Should Jack and Jill agree to loan the firm the

considering two projects that each cost $100.

$20 it needs to stay operating if they receive a

Project Apays off $120 next year in the good state

(subordinated) bond with a face value of

of the economy and $90 in the bad state of the

$20.50?

economy. Project B pays off $140 next year in the

c.If the firm does receive the loan from Jack and

good state of the economy and $60 in the bad state

Jill, which project will the managers choose if

of the economy. If the two states are equally

they act in the interest of the equity holders?

likely, there are no taxes or direct bankruptcy16.4.Hiroko Fashion Corporation (HFC) can pursuecosts, the risk-free rate of interest is zero, and

either project Dress or project Cosmetic, withinvestors are all risk neutral, which project would

possible payoffs at year-end as follows:equity holders prefer if the firm is 100 percent

equity financed? Which project would equity

holders prefer if the firm has an $85 bond

Bad EconomyGood Economy

obligation due next year?

(prob. 30%)(prob. 70%)

(in $ millions)(in $ millions)16.9.Suppose you are hired as a consultant for

Tailways, Inc., just after a recapitalization that

Project Dress$2$9

increased the firm’s debt-to-assets ratio to 80

Project Cosmetic76percent. The firm has the opportunity to take on a

risk-free project yielding 10 percent, which you

must analyze. You note that the risk-free rate is 8

Each project costs $6 million at the beginning of

percent and apply what you learned in Chapter 11

the year. Assume there are no taxes, there are no

about taking positive net present value projects;

direct bankruptcy costs, all investors are risk

that is, accept those projects that generate

neutral, and the risk-free interest rate is zero.

expected returns that exceed the appropriate risk-

a.Which project should HFC pursue if it is all

adjusted discount rate of the project. You

equity financed? Why?

recommend that Tailways take the project.

b.If HFC has a $5 million bond obligation at the

Unfortunately, your client is not impressed with

end of the year, which project would its equity

your recommendation. Because Tailways is highly

holders want to pursue? Why?

leveraged and is in risk of default, its borrowing

Grinblatt1198Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1198Hill
Markets and Corporate		Debt Holder1198Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

Chapter 16

Bankruptcy Costs and Debt Holder–Equity Holder Conflicts

593

	rate is 4 percent greater than the risk-free rate.	manufacturing process, it can produce a greater
	After reviewing your recommendation, the	number of widgets at a lower variable cost. Given
	company CEO has asked you to explain how this	the greater fixed costs, the cash flows are only $5
	“positive net present value project” can make him	million in an unfavorable economy with the
	money when he is forced to borrow at 12 percent	capital-intensive process but are $170 million in a
	to fund a project yielding 10 percent. You wonder	favorable economy. Hence, equity holders would
	how you bungled an assignment as simple as	receive $100 million in the good state of the
	evaluating a risk-free project. What have you done	economy ($170 million $70 million) and zero
	wrong?	in a recession because $5 million is less than the
16.10.	In the event of bankruptcy, the control of a firm	$70 million debt obligation. Can the firm issue
	passes from the equity holders to the debt holders.	equity to fund the project?
	Describe differences in the preferences of the	16.14.With debtor in possession (DIP) financing,
	equity holders and debt holders and how decisions	bankrupt firms are able to obtain additional
	following bankruptcy proceedings are likely to	amounts of debt that is senior to the firm’s existing
	change.	debt. Explain how the firm’s existing debt holders
16.11.	Why are debt holder–equity holder incentive	can benefit from this.
	problems less severe for firms that borrow short	16.15.You have been hired as a bond analyst for Bull
	term rather than long term?	Sterns. Ahighly leveraged firm, Emax Industries,
16.12.	Consider the case of Ajax Manufacturing which	has switched to a more flexible management process
	just completed an R&D project on widgets that	that enables it to change its investment strategy
	required a $70 million bond obligation. The	more quickly. How do you expect this change in
	R&D effort resulted in an investment	the management process to affect bond values?
	opportunity that will cost $75 million and	16.16.Atways Industries is involved in two similar
	generate cash flows of $85 million in the event	mining projects. The Wyoming project was
	of a recession (prob.20%) and $150 million	financed through the firm’s internal cash flows
	if economic conditions are favorable (prob.	and appears as an asset on its balance sheet. The
	80%). What is the NPVof the project assuming	Montana project was set up as a wholly owned
	no taxes, no direct bankruptcy costs, risk	subsidiary of Atways. The subsidiary was financed
	neutrality, and a risk-free interest rate of zero?	20 percent with equity provided by Atways and 80
	Can the firm fund the project if the original debt	percent with non-recourse debt.
	is a senior obligation that doesn’t allow the firm	How do the different ways that these projects
	to issue additional debt?	were originally financed and structured affect
16.13.	Assume now that if Ajax Manufacturing (see	future investment and operating decisions?
	exercise 16.12) uses a more capital-intensive

References and Additional Readings

Altman, Edward. “AFurther Empirical Investigation ofThe Revolution in Corporate Finance.New York:

the Bankruptcy Cost Question.” Journal of FinanceBasil Blackwell Inc., 1986.

39, no. 6 (1984), pp. 1067–89.Bulow, Jeremy, and John Shoven. “The BankruptcyAng, James; Jess Chua; and John McConnell. “TheDecision.” Bell Journal of Economics9, no. 3

Administrative Costs of Bankruptcy: ANote.”(1978), pp. 437–56.

Journal of Finance37, no. 1 (1982), pp. 219–26.DeAngelo, Harry, and Linda DeAngelo. “Dividend PolicyBarclay, Michael, and Clifford Smith. “The Maturityand Financial Distress: An Empirical Investigation of

Structure of Corporate Debt.” Journal of Finance50Troubled NYSE Firms.” Journal of Finance45, no. 5

(1995), pp. 609–31.(1990), pp. 1415–32.

Bradley, Michael; Gregg Jarrell; E. Han Kim. “On theDhillon, U., and Herb Johnson. “The Effect of Dividend

Existence of an Optimal Capital Structure: TheoryChanges on Stock and Bond Prices.” Journal of

and Evidence.” Journal of Finance39, no. 3 (1984),Finance49 (March 1994), pp. 281–89.

pp. 857–78.Finnerty, John. Project Financing: Asset-Based FinancialBrennan, Michael, and Eduardo Schwartz. “The Case forEngineering.New York: Wiley, 1996.

Convertibles.” Reprinted in J. Stern and D. Chew, Jr.,

Grinblatt1200Titman: Financial	IV. Capital Structure	16. Bankruptcy Costs and	© The McGraw1200Hill
Markets and Corporate		Debt Holder1200Equity Holder	Companies, 2002
Strategy, Second Edition		Conflicts

594Part 1VCapital Structure

Flath, David. “Shareholding in Keiretsu, Japan’s Financial

Groups.” Review of Economics and Statistics75,

no. 2 (May 1993), pp. 249–57.

Franks, Julian, and Walter Torous. “An Empirical

Investigation of U.S. Firms in Reorganization.”

Journal of Finance44 (1989), pp. 747–70.

Galai, Dan, and Ronald Masulis. “The Option Pricing

Model and the Risk Factor of Stock.” Journal of

Financial Economics3, nos. 1/2 (1976), pp. 53–81.Gertner, Robert, and David Scharfstein. “ATheory of

Workouts and the Effects of Reorganization Law.”

Journal of Finance46 (1991), pp. 1189–1222.Green, Richard. “Investment Incentives, Debt, and

Warrants.” Journal of Financial Economics13

(1984), pp. 115–36.

Guedes, Jose, and Tim Opler. “The Determinants of the

Maturity of Corporate Debt Issues.” Journal of

Finance51 (1996), pp. 1809–33.

Haugen, Robert, and Lemma Senbet. “The Insignificance

of Bankruptcy Costs to the Theory of Optimal

Capital Structure.” Journal of Finance33, no. 2

(1978), pp. 383–93.

Hoshi, T.; David Scharfstein; and Anil Kashyap. “The

Choice between Public and Private Debt: An

Analysis of Post-Deregulation Corporate Financing

in Japan.” NBER Working Paper4421 (August

1993).

Hotchkiss, Edith. “Postbankruptcy Performance and

Management Turnover.” Journal of Finance50

(1995), pp. 3–21.

Jensen, Michael, and William Meckling. “Theory of the

Firm: Managerial Behavior, Agency Costs, and

Ownership Structure.” Journal of Financial

Economics(October 1976), pp. 305–60.

Kensinger, John, and John Martin. “Project Financing:

Raising Money the Old Fashioned Way.” Journal of

Applied Corporate Finance 3(Fall 1988), pp. 69–81.Lamont, Owen. “Cash Flow and Investment: Evidence

from Internal Capital Markets.” Journal of Finance

52, no. 1 (March 1997), pp. 83–109.

Lang, Larry; Eli Ofek; and Rene Stulz. “Leverage,

Investment, and Firm Growth.” Journal of Financial

Economics40 (1996), pp. 3–29.

Lehn, Kenneth, and Annette Poulsen. “Contractual

Resolution of Bondholder-Stockholder Conflicts in

Leveraged Buyouts.” Journal of Law and Economics

34, no. 2 (October 1992) Part 2, pp. 645–73.

Long, Michael, and Ileen Malitz. “Investment Patterns

and Financial Leverage.” In B. Friedman, ed.,

Corporate Capital Structure in the United States.

Chicago: University of Chicago Press, 1985.

Long, Michael, and Ileen Malitz. “The Investment-

Financing Nexus: Some Empirical Evidence.”

Midland Finance Journal(Fall 1985), pp. 53–59.

Long, Michael; Irene Malitz; and Stephen Sefcik. “An

Empirical Examination of Dividend Policy

Following Debt Issues.” Journal of Financial and

Quantitative Analysis(March 1994), pp. 131–44.

McDaniel, M. “Bondholders and Corporate Governance.”

Business Lawyer41 (1986), pp. 413–60.

Mikkelson, Wayne. “Convertible Calls and Security

Returns.” Journal of Financial Economics9, no. 3

(1981), pp. 237–64.

Myers, Stewart. “Interactions of Corporate Financing and

Investment Decisions—Implications for Capital

Budgeting.” Journal of Finance29, no. 1 (1977),

pp. 1–25.

Nash, Rob; Jeff Netter; and Annette Poulsen.

“Determinants of Contractual Relations Between

Shareholders and Bondholders—Investment

Opportunities and Restrictive Convenants.” (1999)

University of Georgia working paper.

Prowse, Stephen. “Institutional Investment Patterns and

Corporate Financial Behavior in the United States

and Japan.” Journal of Financial Economics27,

no. 1 (1990), pp. 43–66.

Rajan, Raghuram. “Insiders and Outsiders: The Choice

Between Informed and Arm’s Length Debt.” Journal

of Finance (1992), pp. 1367–400.

Smith, Clifford, and Jerold Warner. “On Financial

Contracting: An Analysis of Bond Covenants.”

Journal of Financial Economics7, no. 2 (1979),

pp. 117–62.

Smith, Clifford, and Ross Watts. “The Investment

Opportunity Set and Corporate Financing, Dividend,

and Compensation Policies.” Journal of Financial

Economics32, no. 3 (December 1992), pp. 263–92.

Stiglitz, Joseph, and Andrew Weiss. “Credit Rationing in

Markets with Imperfect Information.” American

Economic Review71, no. 3 (June 1981),

pp. 393–410.

Stohs, Mark, and David Mauer. “The Determinants of

Corporate Debt Maturity Structure.” Journal of

Business69 (1996), pp. 279–312.

Stulz, Rene, and H. Johnson. “An Analysis of Secured

Debt.” Journal of Financial Economics14, no. 4

(December 1985), pp. 501–21.

Titman, Sheridan. “The Effect Of Capital Structure on the

Firm’s Liquidation Decision.” Journal of Financial

Economics13 (1984), pp. 137–52.

Titman, Sheridan, and Roberto Wessels. “The

Determinants of Capital Structure Choice.” Journal

of Finance 43 (1988), pp. 1–19.

Warner, Jerold. “Bankruptcy Costs: Some Evidence.”

Journal of Finance 32, no. 2 (1977), pp. 337–47.Weiss, Lawrence. “Bankruptcy Resolution: Direct Costs

and Violation of Priority of Claims.” Journal of

Financial Economics 27, no. 2 (1990), pp. 285–314.

Grinblatt1202Titman: Financial	IV. Capital Structure	17. Capital Structure and	© The McGraw1202Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

CHAPTER

Capital Structure

17

and Corporate Strategy

Learning Objectives

After reading this chapter you should be able to:

1.Describe how a firm’s financial situation is likely to affect its sales and its ability

to attract employees and suppliers.

2.Understand how financial distress can benefit some firms by inducing

employees, suppliers, and governments to make financial concessions to the

firm.

3.Explain how a firm’s financial condition affects the way its competitors price their

products.

4.Describe how the past profitability of a firm affects its current capital structure.

5.Understand empirical research relating a firm’s characteristics to its capital

structure choices.

Massey-Ferguson, International Harvester, and John Deere & Company were the

three largest producers of heavy farm equipment in North America in the 1970s,

capturing virtually the entire market on that continent. In 1976, Massey-Ferguson

had about 34 percent of the market, International Harvester about 28 percent, and

John Deere about 38 percent. International Harvester and Massey-Ferguson were

relatively highly leveraged at this time and Massey-Ferguson in particular had a

large amount of short-term debt. John Deere, in contrast, was somewhat more

conservatively financed.

In 1979, the Federal Reserve Board raised interest rates to unprecedented

levels in an attempt to reduce inflation. This contributed to a large drop in the

demand for farm equipment because the interest rate increase raised the cost of

financing purchases of farm equipment, like tractors. The interest rate increase

simultaneously increased the farm equipment makers’cost of servicing their short-

term debt. As a result, Massey-Ferguson and International Harvester found it

difficult to meet their debt payments. However, John Deere, being more conservatively

financed, continued to make its debt payments in a timely fashion. Customer

concerns about the long-term viability of International Harvester and Massey-

Ferguson contributed to the downfall of these two companies, and John Deere

gained at their expense. By 1980, John Deere’s market share increased to almost

595

Grinblatt1204Titman: Financial	IV. Capital Structure	17. Capital Structure and	© The McGraw1204Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

596Part IVCapital Structure

50 percent while that of Massey-Ferguson fell to 28 percent and International

Harvester fell to 22 percent.¹

Chapter 16 discussed direct bankruptcy costs (for example, legal and administrative

expenses) as well as the indirect bankruptcy costs that arise because of conflicts

of interest between equity holders and debt holders. These indirect costs can occur

whenever a firm faces financial difficulties, or what we have been calling financial dis-

tress, regardless of whether the firm eventually becomes bankrupt.

Financial distress costs that arise because of debt holder–equity holder conflicts

may explain why emerging growth firms like Amgen and Sun Microsystems use so lit-

tle debt. As the previous chapter illustrated, lenders are unlikely to provide significant

amounts of debt capital to these emerging growth firms at attractive terms because of

the way that debt distorts the firm’s investment incentives. For most of the largest firms

in the United States, however, the indirect bankruptcy costs stemming from the con-

flicts between debt holders and equity holders do not appear to be a major deterrent to

debt financing. Many of these large firms have access to eager lenders, willing to pro-

vide them with additional debt financing on reasonable terms.

This chapter builds on the framework developed in Chapter 16 and examines other

financial distress costs that limit a corporation’s desire to use debt financing. The

financial distress costs examined in this chapter, in contrast to those considered in

Chapter 16, explain why many firms choose to maintain low debt ratios even when

lenders are willing to provide debt capital at attractive terms.

Consider, for example, the IBM of the 1970s, which had little long-term debt and

could have borrowed substantially more at AAArates. The company also was pay-

ing a substantial amount in taxes, suggesting that from a tax perspective the firm

would certainly have been better off with more debt. Costs associated with debt

holder–equity holder conflicts were apparently not an important issue to IBM because

lenders were willing to provide debt at attractive terms. Clearly, lenders were not

concerned about IBM changing its investment strategy in a way that would do them

serious harm.

The ideas presented in the last three chapters suggest that IBM could have

improved its value in the 1970s by increasing its leverage ratio. However, if IBM had

chosen to be much more highly leveraged, it would have faced serious financial diffi-

culties in the early 1990s. We will suggest in this chapter that financial distress would

have been especially costly for IBM, and that a highly leveraged IBM might not have

survived.

The first topic addressed here is how financial distress can affect the ability of a

firm like IBM to operate its business profitably. Would a financially distressed IBM

lose customers in the same way that International Harvester and Massey-Ferguson

(described in the chapter’s opening vignette) lost customers when they became finan-

cially distressed? How would financial difficulties affect IBM’s ability to attract and

retain key employees? Would it affect the quality of service provided by its suppliers?

How would competitors react to IBM’s financial difficulties?

To address these types of questions, we present the “stakeholders” theory of capi-

tal structure. Nonfinancial stakeholdersare the associates of a firm, such as customers,

employees, suppliers, and the community in which the firm operates, who do not have

¹For more information on the Massey-Ferguson case, see Case Problems in Finance,11th ed. (Burr

Ridge, IL: Richard D. Irwin, 1997), pp. 165–182.

Grinblatt1206Titman: Financial	IV. Capital Structure	17. Capital Structure and	© The McGraw1206Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 17

Capital Structure and Corporate Strategy

597

debt or equity stakes in the firm, but nonetheless, have a stake in the financial health

of the firm. The stakeholdertheoryof capital structure suggests that the way in which

a firm and its nonfinancial stakeholders interact is an important determinant of the

firm’s optimal capital structure. We argue that these nonfinancial stakeholders may be

less willing to do business with a firm that is financially distressed; and that this is

especially true for a firm like IBM that sells computers or other equipment whose qual-

ity is difficult to evaluate or that may need to be serviced in the future. Indeed, in dis-

cussing the bankruptcy of Wang, a computer firm, The Wall Street Journalreported:

“The biggest challenge any marketer can face [is] selling the products of a company

that is on the ropes.”²Because of this, firms may choose to be conservatively

financed even when they can obtain substantial amounts of debt financing at attrac-

tive rates.

The interaction between how a corporation is financed and how it is viewed by its

stakeholders suggests that the capital structure decision must be incorporated into the

overall corporate strategy of the firm. For example, a firm that wants to project a rep-

utation as a stable firm that produces quality products does not want to be too highly

leveraged. Similarly, the way that a firm interacts with its suppliers and employees and

how it competes within its industry determine its capital structure choice.

This chapter also analyzes dynamic aspects of the capital structure decision such

as how a firm’s history affects its current capital structure. In IBM’s case, for exam-

ple, the firm used almost no debt financing until the 1980s, partially because the firm

was so profitable that it was able to fund most of its investments from retained earn-

ings. However, its leverage ratio subsequently increased as it accumulated losses in the

early 1990s. IBM could have counteracted this leverage increase by issuing equity, but

for a variety of reasons it chose not to do this. Earlier in this text we noted that taxes

may have played some role in this decision. This chapter and the two that follow will

discuss other reasons that might explain why IBM did not issue equity to counteract

the leverage effect of these losses.

Finally, the chapter analyzes the empirical evidence on the theories of capital struc-

ture presented in this part of the text. We conclude that the empirical evidence is largely

supportive of these theories.