Financial Distress, Managerial Incentives, and Information PDF

CH APTE R Financial Distress, Managerial Incentives, and Information 16...

CH APTE R Financial Distress, Managerial Incentives, and Information 16 NOTATION MODIGLIANI AND MILLER DEMONSTRATED THAT CAPITAL E market value structure does not matter in a perfect capital market. In Chapter 15, we found a of equity tax benefit of leverage, at least up to the point that its interest expense remains tax D market value deductible. Yet we saw that the average U.S. firm shields much less of its earnings of debt than is allowed. Why don’t firms use more debt? PV present value We can gain some insight by looking at United Airlines (UAL Corporation). βE equity beta For the five-year period 1996 through 2000, UAL paid interest expenses of β D debt beta $1.7 billion, relative to EBIT of more than $6 billion. During this period, it ­reported I investment a total provision for taxes on its income statement exceeding $2.2 billion. The NPV net present value company appeared to have a level of debt that did not fully exploit its tax shield. Even so, as a result of high fuel and labor costs, a decline in travel following the V U value of the unlevered firm terrorist attacks of September 11, 2001, and increased competition from discount carriers, UAL filed for bankruptcy court protection in December 2002. United V L value of the firm with leverage ultimately emerged from bankruptcy in 2006; after a profitable 2007, it suffered losses and renewed creditor concerns in the wake of the financial crisis in 2008. τ * effective tax advantage of debt The airline returned to profitability in 2010 when it announced plans to acquire Continental Airlines. A similar fate soon befell American Airlines, whose parent company declared bankruptcy in 2011 with over $29 billion in debt, emerging from bankruptcy 2 years later as part of a merger with US Airways. As these ex- amples illustrate, firms such as airlines whose future cash flows are unstable and highly sensitive to shocks in the economy run the risk of bankruptcy if they use too much leverage. When a firm has trouble meeting its debt obligations we say the firm is in ­financial distress. In this chapter, we consider how a firm’s choice of capi- tal structure can, due to market imperfections, affect its costs of financial dis- tress, alter managers’ incentives, and signal information to investors. Each of these consequences of the capital structure decision can be significant, and each may offset the tax benefits of leverage when leverage is high. Thus, these ­imperfections may help to explain the levels of debt that we generally observe. 589 M16_BERK6318_06_GE_C16.indd 589 26/04/23 8:31 PM  590 Chapter 16 Financial Distress, Managerial Incentives, and Information In addition, because their effects are likely to vary widely across different types of firms, they may help to explain the large discrepancies in leverage choices that exist across industries, as documented in Figure 15.7 in the previous chapter. 16.1 Default and Bankruptcy in a Perfect Market Debt financing puts an obligation on a firm. A firm that fails to make the required inter- est or principal payments on the debt is in default. After the firm defaults, debt holders are given certain rights to the assets of the firm. In the extreme case, the debt holders take legal ownership of the firm’s assets through a process called bankruptcy. Recall that equity financing does not carry this risk. While equity holders hope to receive dividends, the firm is not legally obligated to pay them. Thus, it seems that an important consequence of leverage is the risk of bankruptcy. Does this risk represent a disadvantage to using debt? Not necessarily. As we pointed out in Chapter 14, Modigliani and Miller’s results continue to hold in a perfect market even when debt is risky and the firm may default. Let’s review that result by considering a h ­ ypothetical example. Armin Industries: Leverage and the Risk of Default Armin Industries faces an uncertain future in a challenging business environment. Due to increased competition from foreign imports, its revenues have fallen dramatically in the past year. Armin’s managers hope that a new product in the company’s pipeline will restore its fortunes. While the new product represents a significant advance over Armin’s competi- tors’ products, whether that product will be a hit with consumers remains uncertain. If it is a hit, revenues and profits will grow, and Armin will be worth $150 million at the end of the year. If it fails, Armin will be worth only $80 million. Armin Industries may employ one of two alternative capital structures: (1) It can use all-equity financing or (2) it can use debt that matures at the end of the year with a total of $100 million due. Let’s look at the consequences of these capital structure choices when the new product succeeds, and when it fails, in a setting of perfect capital markets. Scenario 1: New Product Succeeds. If the new product is successful, Armin is worth $150 million. Without leverage, equity holders own the full amount. With leverage, Armin must make the $100 million debt payment, and Armin’s equity holders will own the remain- ing $50 million. But what if Armin does not have $100 million in cash available at the end of the year? Although its assets will be worth $150 million, much of that value may come from an- ticipated future profits from the new product, rather than cash in the bank. In that case, if Armin has debt, will it be forced to default? With perfect capital markets, the answer is no. As long as the value of the firm’s assets exceeds its liabilities, Armin will be able to repay the loan. Even if it does not have the cash immediately available, it can raise the cash by obtaining a new loan or by issuing new shares. For example, suppose Armin currently has 10 million shares outstanding. Because the value of its equity is $50 million, these shares are worth $5 per share. At this price, Armin can raise $100 million by issuing 20 million new shares and use the proceeds to pay off the debt. After the debt is repaid, the firm’s equity is worth $150 million. Because there is now a total of 30 million shares, the share price remains $5 per share. This scenario shows that if a firm has access to capital markets and can issue new s­ ecurities at a fair price, then it need not default as long as the market value of its assets exceeds its liabilities. M16_BERK6318_06_GE_C16.indd 590 26/04/23 8:31 PM  16.1 Default and Bankruptcy in a Perfect Market 591 That is, whether default occurs depends on the relative values of the firm’s assets and liabilities, not on its cash flows. Many firms experience years of negative cash flows yet remain solvent. Scenario 2: New Product Fails. If the new product fails, Armin is worth only $80 mil- lion. If the company has all-equity financing, equity holders will be unhappy but there is no immediate legal consequence for the firm. In contrast, if Armin has $100 million in debt due, it will experience financial distress. The firm will be unable to make its $100 million debt payment and will have no choice except to default. In bankruptcy, debt holders will receive legal ownership of the firm’s assets, leaving Armin’s shareholders with nothing. Because the assets the debt holders receive have a value of $80 million, they will suffer a loss of $20 million relative to the $100 million they were owed. Equity holders in a corpo- ration have limited liability, so the debt holders cannot sue Armin’s shareholders for this $20 million—they must accept the loss. Comparing the Two Scenarios. Table 16.1 compares the outcome of each scenario without leverage and with leverage. Both debt and equity holders are worse off if the prod- uct fails rather than succeeds. Without leverage, if the product fails equity holders lose $150 million − $80 million = $70 million. With leverage, equity holders lose $50 m ­ illion, and debt holders lose $20 million, but the total loss is the same—$70 million. Overall, if the new product fails, Armin’s investors are equally unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and the share price declines.1 TABLE 16.1   Value of Debt and Equity with and without Leverage (in $ million) Without Leverage With Leverage Success Failure Success Failure Debt value — — 100 80 Equity value 150 80 50 0 Total to all investors 150 80 150 80 This point is important. When a firm declares bankruptcy, the news often makes head- lines. Much attention is paid to the firm’s poor results and the loss to investors. But the decline in value is not caused by bankruptcy: The decline is the same whether or not the firm has leverage. That is, if the new product fails, Armin will experience economic distress, which is a significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage. Bankruptcy and Capital Structure With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all investors does not depend on the firm’s capital structure. Investors as a group are not worse off because a firm has leverage. While it is true that bankruptcy results from a firm having leverage, bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure. 1 There is a temptation to look only at shareholders and to say they are worse off when Armin has lever- age because their shares are worthless. In fact, shareholders lose $50 million relative to success when the firm is levered, versus $70 million without leverage. What really matters is the total value to all investors, which will determine the total amount of capital the firm can raise initially. M16_BERK6318_06_GE_C16.indd 591 26/04/23 8:31 PM  592 Chapter 16 Financial Distress, Managerial Incentives, and Information EXAMPLE 16.1 Bankruptcy Risk and Firm Value Problem Suppose the risk-free rate is 5%, and Armin’s new product is equally likely to succeed or to fail. For simplicity, suppose that Armin’s cash flows are unrelated to the state of the economy (i.e., the risk is diversifiable), so that the project has a beta of 0 and the cost of capital is the risk-free rate. Compute the value of Armin’s securities at the beginning of the year with and without leverage, and show that MM Proposition I holds. Solution Without leverage, the equity is worth either $150 million or $80 million at year-end. Because the risk is diversifiable, no risk premium is necessary and we can discount the expected value of the firm at the risk-free rate to determine its value without leverage at the start of the year:2 1 ( 150 ) + 1 ( 80 ) Equity ( unlevered ) = V U = 2 2 = $109.52 million 1.05 With leverage, equity holders receive $50 million or nothing, and debt holders receive $100 million or $80 million. Thus, 1 ( 50 ) + 1 (0) Equity ( levered ) = 2 2 = $23.81 million 1.05 1 ( 100 ) + 1 ( 80 ) Debt = 2 2 = $85.71 million 1.05 Therefore, the value of the levered firm is V L = E + D = 23.81 + 85.71 = $109.52 million. With or without leverage, the total value of the securities is the same, verifying MM Proposition I. The firm is able to raise the same amount from investors using either capital structure. CONCEPT CHECK 1. With perfect capital markets, does the possibility of bankruptcy put debt financing at a disadvantage? 2. Does the risk of default reduce the value of the firm? 16.2 The Costs of Bankruptcy and Financial Distress With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt— bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. Is this description of bankruptcy realistic? No. Bankruptcy is rarely simple and ­straightforward—equity holders don’t just “hand the keys” to debt holders the moment the firm defaults on a debt payment. Rather, bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors, costs that the assump- tion of perfect capital markets ignores. 2 If the risk were not diversifiable and a risk premium were needed, the calculations here would become more complicated but the conclusion would not change. M16_BERK6318_06_GE_C16.indd 592 26/04/23 8:31 PM  16.2 The Costs of Bankruptcy and Financial Distress 593 The Bankruptcy Code When a firm fails to make a required payment to debt holders, it is in default. Debt holders can then take legal action against the firm to collect payment by seizing the firm’s assets. Because most firms have multiple creditors, without coordination it is difficult to guarantee that each creditor will be treated fairly. Moreover, because the assets of the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm. The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed. According to the pro- visions of the 1978 Bankruptcy Reform Act, U.S. firms can file for two forms of bank- ruptcy protection: Chapter 7 or Chapter 11. In Chapter 7 liquidation, a trustee is appointed to oversee the liquidation of the firm’s assets through an auction. The proceeds from the liquidation are used to pay the firm’s creditors, and the firm ceases to exist. In the more common form of bankruptcy for large corporations, Chapter 11 ­reorganization, all pending collection attempts are automatically suspended, and the firm’s existing management is given the opportunity to propose a reorganization plan. While de- veloping the plan, management continues to operate the business. The reorganization plan specifies the treatment of each creditor of the firm. In addition to cash payment, creditors may receive new debt or equity securities of the firm. The value of cash and securities is generally less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated. The creditors must vote to accept the plan, and it must be approved by the bankruptcy court.3 If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation of the firm. Direct Costs of Bankruptcy The bankruptcy code is designed to provide an orderly process for settling a firm’s debts. However, the process is still complex, time-consuming, and costly. When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are generally hired. Investment bankers may also assist with a potential financial restructuring. These outside experts are costly. Between 2003 and 2005, United Airlines paid a team of over 30 advisory firms an average of $8.6 million per month for legal and professional services related to its Chapter 11 reorganization. Enron spent a then-record $30 million per month on legal and accounting fees in bankruptcy, with the total cost exceeding $750 million. WorldCom paid its advisors $620 million as part of its reorganization to become MCI, and the Lehman Brothers bankruptcy, the largest in history, has reportedly entailed fees of $2.2 billion.4 In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. In the case of Chapter 11 reorganization, creditors must often wait 3 Specifically, management holds the exclusive right to propose a reorganization plan for the first 120 days, and this period may be extended indefinitely by the bankruptcy court. Thereafter, any interested party may propose a plan. Creditors who will receive full payment or have their claims fully reinstated under the plan are deemed unimpaired, and do not vote on the reorganization plan. All impaired creditors are grouped according to the nature of their claims. If the plan is approved by creditors holding two-thirds of the claim amount in each group and a majority in the number of the claims in each group, the court will confirm the plan. Even if all groups do not approve the plan, the court may still impose the plan (in a process commonly known as a “cram down”) if it deems the plan fair and equitable with respect to each group that objected. 4 J. O’Toole, “Five years later, Lehman bankruptcy fees hit $2.2 billion,” CNNMoney, September 13, 2013. M16_BERK6318_06_GE_C16.indd 593 26/04/23 8:31 PM  594 Chapter 16 Financial Distress, Managerial Incentives, and Information several years for a reorganization plan to be approved and to receive payment. To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice. Whether paid by the firm or its creditors, these direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive. In some cases, such as Enron, reorganization costs may approach 10% of the value of the assets. Studies typi- cally report that the average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.5 The costs are likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors, because it may be more difficult to reach agreement among many creditors regarding the final disposition of the firm’s assets. Because many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. A study of Chapter 7 liquidations of small businesses found that the average direct costs of bankruptcy were 12% of the value of the firm’s assets.6 Given the substantial legal and other direct costs of bankruptcy, firms in financial distress can avoid filing for bankruptcy by first negotiating directly with creditors. When a financially distressed firm is successful at reorganizing outside of bankruptcy, it is called a workout. Consequently, the direct costs of bankruptcy should not substantially exceed the cost of a work- out. Another approach is a prepackaged bankruptcy (or “prepack”), in which a firm will first develop a reorganization plan with the agreement of its main creditors, and then file Chapter 11 to implement the plan (and pressure any creditors who attempt to hold out for better terms). With a prepack, the firm emerges from bankruptcy quickly and with minimal direct costs.7 Indirect Costs of Financial Distress Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bank- ruptcy). While these costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy. Loss of Customers. Because bankruptcy may enable or encourage firms to walk away from commitments to their customers, customers may be unwilling to purchase prod- ucts whose value depends on future support or service from the firm. For example, customers will be reluctant to buy plane tickets in advance from a distressed airline that may cease operations, or to purchase autos from a distressed manufacturer that may fail to honor its warranties or provide replacement parts. Similarly, many technology 5 See J. Warner, “Bankruptcy Costs: Some Evidence,” Journal of Finance 32 (1977): 337–347; L. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (1990): 285–314; E. Altman, “A Further Empirical Investigation of the Bankruptcy Cost Question,” Journal of Finance 39 (1984): 1067–1089; and B. Betker, “The Administrative Costs of Debt Restructurings: Some Recent Evidence,” Financial Management 26 (1997): 56–68. L. LoPucki and J. Doherty estimate that due to speedier resolution, the direct costs of bankruptcy fell by more than 50% during the 1990s to approximately 1.5% of firm value (“The Determinants of Professional Fees in Large Bankruptcy Reorganization Cases,” Journal of Empirical Legal Studies 1 (2004): 111–141). 6 R. Lawless and S. Ferris, “Professional Fees and Other Direct Costs in Chapter 7 Business Liquidations,” Washington University Law Quarterly (1997): 1207–1236. For comparative international data, see K. Thorburn, “Bankruptcy Auctions: Costs, Debt Recovery and Firm Survival,” Journal of Financial Economics 58 (2000): 337–368; and A. Raviv and S. Sundgren, “The Comparative Efficiency of Small-firm Bankruptcies: A Study of the U.S. and the Finnish Bankruptcy Codes,” Financial Management 27 (1998): 28–40. 7 See E. Tashjian, R. Lease, and J. McConnell, “An Empirical Analysis of Prepackaged Bankruptcies,” Journal of Financial Economics 40 (1996): 135–162. M16_BERK6318_06_GE_C16.indd 594 26/04/23 8:31 PM  16.2 The Costs of Bankruptcy and Financial Distress 595 firms’ customers may hesitate to commit to a hardware or software platform that may not be supported or upgraded in the future. In contrast, the loss of customers is likely to be small for producers of raw materials (such as sugar or aluminum), as the value of these goods, once delivered, does not depend on the seller’s continued success.8 Loss of Suppliers. Customers are not the only ones who retreat from a firm in finan- cial distress. Suppliers may also be unwilling to provide a firm with inventory if they fear they will not be paid. For example, Toys ’R Us filed for bankruptcy protection in September 2017 in part because reports of low liquidity scared suppliers, which then refused to ship goods without receiving cash on delivery. Similarly, Swiss Air was forced to shut down because its suppliers refused to fuel its planes. This type of disruption is an important financial distress cost for firms that rely heavily on trade credit. In many cases, the bankruptcy filing itself can alleviate these problems through debtor-in-possession (DIP) financing. DIP financing is new debt issued by a bank- rupt firm. Because this kind of debt is senior to all existing creditors, it allows a firm that has filed for bankruptcy renewed access to financing to keep operating. Loss of Employees. Because firms in distress cannot offer job security with long-term employment contracts, they may have difficulty hiring new employees, and existing em- ployees may quit or be hired away. Because employees anticipate the possibility of bank- ruptcy, these costs can be particularly large for financially distressed firms even if they do not ultimately file for bankruptcy. Retaining key employees may be costly: Pacific Gas and Electric Corporation implemented a retention program costing over $80 mil- lion to retain 17 key employees while in bankruptcy.9 This type of financial distress cost is likely to be high for firms whose value is derived largely from their human resources. Loss of Receivables. Firms in financial distress tend to have difficulty collecting money that is owed to them. According to one of Enron’s bankruptcy lawyers, “Many custom- ers who owe smaller amounts are trying to hide from us. They must believe that Enron will never bother with them because the amounts are not particularly large in any indi- vidual case.”10 Knowing that the firm might go out of business or at least experience significant management turnover reduces the incentive of customers to maintain a repu- tation for timely payment. Fire Sales of Assets. In an effort to avoid bankruptcy and its associated costs, companies in distress may attempt to sell assets quickly to raise cash. To do so, the firm may accept a lower price than would be optimal if it were financially healthy. Indeed, a study of airlines by Todd Pulvino shows that companies in bankruptcy or financial distress sell their aircraft at prices that are 15% to 40% below the prices received by healthier rivals.11 Discounts are 8 See S. Titman, “The Effect of Capital Structure on a Firm’s Liquidation Decision,” Journal of Financial Economics 13 (1984): 137–151. T. Opler and S. Titman report 17.7% lower sales growth for highly lever- aged firms compared to their less leveraged competitors in R&D-intensive industries during downturns (“Financial Distress and Corporate Performance,” Journal of Finance 49 (1994): 1015–1040). A. Hortacsu, G. Matvos, C. Syverson, and S. Venkataraman find these customer costs for car makers may exceed the tax savings from debt (“Indirect Costs of Financial Distress in Durable Goods Industries: The Case of Auto Manufacturers,” Review of Financial Studies 26 (2013) 1248–1290). 9 R. Jurgens, “PG&E to Review Bonus Program,” Contra Costa Times, December 13, 2003. 10 K. Hays, “Enron Asks Judge to Get Tough on Deadbeat Customers,” Associated Press, August 19, 2003. 11 “Do Asset Fire-Sales Exist? An Empirical Investigation of Commercial Aircraft Transactions,” Journal of Finance 53 (1998): 939–978; and “Effects of Bankruptcy Court Protection on Asset Sales,” Journal of Financial Economics 52 (1999): 151–186. For examples from other industries, see T. Kruse, “Asset Liquidity and the Determinants of Asset Sales by Poorly Performing Firms,” Financial Management 31 (2002): 107–129. M16_BERK6318_06_GE_C16.indd 595 26/04/23 8:31 PM  596 Chapter 16 Financial Distress, Managerial Incentives, and Information also observed when distressed firms attempt to sell subsidiaries. The costs of selling assets below their value are greatest for firms with assets that lack competitive, liquid markets. Inefficient Liquidation. Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down. A study by Lawrence Weiss and Karen Wruck estimates that Eastern Airlines lost more than 50% of its value while in bank- ruptcy because management was allowed to continue making negative-NPV invest- ments.12 On the other hand, companies in bankruptcy may be forced to liquidate assets that would be more valuable if held. For example, as a result of its default, Lehman Brothers was forced to terminate 80% of its derivatives contracts with counterparties, in many cases at purportedly unattractive terms.13 Costs to Creditors. Aside from the direct legal costs that creditors may incur when a firm defaults, there may be other indirect costs to creditors. If the loan to the firm was a significant asset for the creditor, default of the firm may lead to costly financial distress for the creditor. For example, in the 2008 financial crisis, the Lehman Brothers’s bankruptcy in turn helped push many of Lehman’s creditors into financial distress as well.14 While these costs are borne by the creditor and not by the firm, the creditor will consider these potential costs when initially setting the rate of the loan. Because bankruptcy is a choice the firm’s investors and creditors make, there is a limit to the direct and indirect costs on them that result from the firm’s decision to go through the bankruptcy process. If these costs were too large, they could be largely avoided by nego- tiating a workout or doing a prepackaged bankruptcy. Thus, these costs should not exceed the cost of renegotiating with the firm’s creditors.15 On the other hand, there is no such limit on the indirect costs of financial distress that arise from the firm’s customers, suppliers, or employees because these costs are not borne by the firm’s investors (and so they have no incentive to avoid them). In addition, many of these costs are incurred prior to bankruptcy, in anticipation of the fact that the firm may use bankruptcy as an opportunity to renegotiate its contracts and commitments. For example, the firm may use bankruptcy as a way to renege on promises of future employment or retirement benefits for employees, to stop honoring warranties on its products, or to back out of unfa- vorable delivery contracts with its suppliers. Because of this fear that the firm will not honor its long-term commitments in bankruptcy, highly levered firms may need to pay higher wages to their employees, charge less for their products, and pay more to their suppliers than similar firms with less leverage. Because these costs are not limited by the cost of renegotiating to avoid bankruptcy, they may be substantially greater than other kinds of bankruptcy costs.16 12 “Information Problems, Conflicts of Interest, and Asset Stripping: Ch. 11’s Failure in the Case of Eastern Airlines,” Journal of Financial Economics 48 (1998): 55–97. 13 See C. Loomis, “Derivatives: The Risk that Still Won’t Go Away,” Fortune, June 24, 2009. 14   See P. Jorion and G. Zhang, “Credit Contagion from Counterparty Risk,” Journal of Finance 64 (2009): 2053–2087. 15 For an insightful discussion of this point, see R. Haugen and L. Senbet, “Bankruptcy and Agency Costs: Their Significance to the Theory of Optimal Capital Structure,” Journal of Financial and Quantitative Analysis 23 (1988): 27–38. 16 There is evidence that firms can use bankruptcy to improve efficiency (A. Kalay, R. Singhal, and E. Tashjian, “Is Chapter 11 Costly?” Journal of Financial Economics 84 (2007): 772–796) but that these gains may come at the expense of workers (L. Jacobson, R. LaLonde, and D. Sullivan, “Earnings Losses of Displaced Workers,” American Economic Review 83 (1993): 685–709). J. Berk, R. Stanton, and J. Zechner, “Human Capital, Bankruptcy and Capital Structure,” Journal of Finance 65 (2009): 891–925, argue that firms may choose not to issue debt in order to increase their ability to commit to long-term labor contracts. M16_BERK6318_06_GE_C16.indd 596 26/04/23 8:31 PM  16.2 The Costs of Bankruptcy and Financial Distress 597 FINANCE IN TIMES OF DISRUPTION The Chrysler Prepack In November 2008, Chrysler CEO Robert Nardelli flew by process following the prepack agreement. Yet, getting the private jet to Washington with a simple message: Without a debt holders to agree required additional government capi- government bailout, a Chrysler bankruptcy was inevitable. tal commitments and unprecedented political pressure. In Congress was not convinced—it felt that bankruptcy was many cases, the senior debt holders were banks that were inevitable with or without a bailout and that the automaker already receiving TARP aid. Perhaps as a cost of receiv- needed to provide a more convincing plan to justify gov- ing this aid, they accepted a deal that put the claims of ernment funding. A return trip in December (this time by unsecured creditors such as the United Auto Workers ­ automobile) yielded a similar result. Bypassing Congress, ahead of their more senior claims.† So, while some cred- outgoing President Bush decided to bail out Chrysler with itors may have been harmed, there is no doubt that the funds from the Troubled Asset Relief Program ( TARP). In unprecedented cooperation among investors, and more the end the government provided Chrysler with $8 billion in importantly, government intervention, avoided a long and debt financing. costly bankruptcy. As a durable goods manufacturer, a lengthy bankruptcy would have entailed significant bankruptcy costs. Indeed, sales were already suffering in part due to customer con- * The Chrysler employee pension plan owned 55% of Chrysler, Fiat cerns about Chrysler’s future. In response, President Obama 20%, the U.S. Treasury 8%, and the Canadian government 2%. The rest took the unprecedented step of guaranteeing warranties on of the equity was split amongst the remaining debt claimants. all new Chrysler cars in March 2009. † Not all creditors bowed willingly to the government pressure. A group Despite all this assistance, on April 30, 2009, Chrysler de- of pension funds opposed the prepack. In the end the Supreme Court clared bankruptcy as part of a government-orchestrated pre- sided with the company and refused to hear their appeal. Perhaps not surprisingly, as a result of this intervention, other unionized firms with pack. Just 41 days later, Chrysler emerged from bankruptcy large pensions saw their borrowing costs increase as creditors anticipated as a Fiat-run, employee-owned,* and government-financed the possibility of similar resolutions. (See B. Blaylock, A. Edwards, and J. corporation. Stanfield, “The Role of Government in the Labor-Creditor Relationship: Many potential bankruptcy costs were avoided because Evidence from the Chrysler Bankruptcy,” J­ournal of Financial and of the speed with which Chrysler transited the bankruptcy ­Quantitative Analysis 50 (2015): 325–348. Overall Impact of Indirect Costs. In total, the indirect costs of financial distress can be substantial. When estimating them, however, we must remember two important points. First, we need to identify losses to total firm value (and not solely losses to equity hold- ers or debt holders, or transfers between them). Second, we need to identify the incre- mental losses that are associated with financial distress, above and beyond any losses that would occur due to the firm’s economic distress. A study of highly levered firms by Gregor Andrade and Steven Kaplan estimated a potential loss due to financial distress of 10% to 20% of firm value.17 Next, we consider the consequences of these potential costs of ­leverage for firm value. CONCEPT CHECK 1. If a firm files for bankruptcy under Chapter 11 of the bankruptcy code, which party gets the first opportunity to propose a plan for the firm’s reorganization? 2. Why are the losses of debt holders whose claims are not fully repaid not a cost of ­financial distress, whereas the loss of customers who fear the firm will stop honoring warranties is? 17 “How Costly Is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions That Became Distressed,” Journal of Finance 53 (1998): 1443–1493. M16_BERK6318_06_GE_C16.indd 597 26/04/23 8:31 PM  598 Chapter 16 Financial Distress, Managerial Incentives, and Information 16.3 Financial Distress Costs and Firm Value The costs of financial distress described in the previous section represent an important de- parture from Modigliani and Miller’s assumption of perfect capital markets. MM assumed that the cash flows of a firm’s assets do not depend on its choice of capital structure. As we have discussed, however, levered firms risk incurring financial distress costs that reduce the cash flows available to investors. Armin Industries: The Impact of Financial Distress Costs To illustrate how these financial distress costs affect firm value, consider again the example of Armin Industries. With all-equity financing, Armin’s assets will be worth $150 million if its new product succeeds and $80 million if the new product fails. In contrast, with debt of $100 million, Armin will be forced into bankruptcy if the new product fails. In this case, some of the value of Armin’s assets will be lost to bankruptcy and financial distress costs. As a result, debt holders will receive less than $80 million. We show the impact of these costs in Table 16.2, where we assume debt holders receive only $60 million after account- ing for the costs of financial distress. As Table 16.2 shows, the total value to all investors is now less with leverage than it is with- out leverage when the new product fails. The difference of $80 million − $60 million = $20 million is due to financial distress costs. These costs will lower the total value of the firm with leverage, and MM’s Proposition I will no longer hold, as i­llustrated in Example 16.2. EXAMPLE 16.2 Firm Value When Financial Distress Is Costly Problem Compare the current value of Armin Industries with and without leverage, given the data in Table 16.2. Assume that the risk-free rate is 5%, the new product is equally likely to succeed or fail, and the risk is diversifiable. Solution With and without leverage, the payments to equity holders are the same as in Example 16.1. There we computed the value of unlevered equity as $109.52 million and the value of levered equity as $23.81 million. But due to bankruptcy costs, the value of the debt is now 2 ( 100 )+ 21 ( 60 ) 1 Debt = = $76.19 million 1.05 The value of the levered firm is V L = E + D = 23.81 + 76.19 = $100 million, which is less than the value of the unlevered firm, V U = $109.52 million. Thus, due to bankruptcy costs, the value of the levered firm is $9.52 million less than its value without leverage. This loss equals the pres- ent value of the $20 million in financial distress costs the firm will pay if the product fails: 2(0) + 21 ( 20 ) 1 PV (Financial Distress Costs) = = $9.52 million 1.05 Who Pays for Financial Distress Costs? The financial distress costs in Table 16.2 reduce the payments to the debt holders when the new product has failed. In that case, the equity holders have already lost their investment and have no further interest in the firm. It might seem as though these costs are irrelevant M16_BERK6318_06_GE_C16.indd 598 26/04/23 8:31 PM  16.3 Financial Distress Costs and Firm Value 599 TABLE 16.2   Value of Debt and Equity with and without Leverage (in $ million) Without Leverage With Leverage Success Failure Success Failure Debt value — — 100 60 Equity value 150 80 50 0 Total to all investors 150 80 150 60 from the shareholders’ perspective. Why should equity holders care about costs borne by debt holders? It is true that after a firm is in bankruptcy, equity holders care little about bankruptcy costs. But debt holders are not foolish—they recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially. How much less? Precisely the amount they will ultimately give up—the present value of the bankruptcy costs. But if the debt holders pay less for the debt, there is less money available for the firm to pay dividends, repurchase shares, and make investments. That is, this difference is money out of the equity holders’ pockets. This logic leads to the following general result: When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress. EXAMPLE 16.3 Financial Distress Costs and the Stock Price Problem Suppose that at the beginning of the year, Armin Industries has 10 million shares outstanding and no debt. Armin then announces plans to issue one-year debt with a face value of $100 mil- lion and to use the proceeds to repurchase shares. Given the data in Table 16.2, what will the new share price be? As in the previous examples, assume the risk-free rate is 5%, the new product is equally likely to succeed or fail, and this risk is diversifiable. Solution From Example 16.1, the value of the firm without leverage is $109.52 million. With 10 million shares outstanding, this value corresponds to an initial share price of $10.952 per share. In Example 16.2, we saw that with leverage, the total value of the firm is only $100 million. In anticipation of this decline in value, the price of the stock should fall to $100 million ÷ 10 million shares = $10.00 per share on announcement of the recapitalization. Let’s check this result. From Example 16.2, due to bankruptcy costs, the new debt is worth $76.19 million. Thus, at a price of $10 per share, Armin will repurchase 7.619 million shares, leav- ing 2.381 million shares outstanding. In Example 16.1, we computed the value of levered equity as $23.81 million. Dividing by the number of shares gives a share price after the transaction of $23.81 million ÷ 2.381 million shares = $10.00 per share Thus, the recapitalization will cost shareholders $0.952 per share or $9.52 million in total. This cost matches the present value of financial distress costs computed in Example 16.2. Thus, although debt holders bear these costs in the end, shareholders pay the present value of the costs of financial distress up front. M16_BERK6318_06_GE_C16.indd 599 26/04/23 8:31 PM  600 Chapter 16 Financial Distress, Managerial Incentives, and Information CONCEPT CHECK 1. Armin incurred financial distress costs only in the event that the new product failed. Why might Armin incur financial distress costs even before the success or failure of the new product is known? 2. True or False: If bankruptcy costs are only incurred once the firm is in bankruptcy and its equity is worthless, then these costs will not affect the initial value of the firm. 16.4 O  ptimal Capital Structure: The Tradeoff Theory We can now combine our knowledge of the benefits of leverage from the interest tax shield (discussed in Chapter 15) with the costs of financial distress to determine the amount of debt that a firm should issue to maximize its value. The analysis presented in this section is called the tradeoff theory because it weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage. According to this theory, the total value of a levered firm equals the value of the firm with- out leverage plus the present value of the tax savings from debt, less the present value of financial distress costs: V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs) (16.1) Equation 16.1 shows that leverage has costs as well as benefits. Firms have an incentive to increase leverage to exploit the tax benefits of debt. But with too much debt, they are more likely to risk default and incur financial distress costs. The Present Value of Financial Distress Costs Aside from simple examples, calculating the precise present value of financial distress costs is quite complicated. Three key factors determine the present value of financial distress costs: (1) the probability of financial distress, (2) the magnitude of the costs if the firm is in distress, and (3) the appropriate discount rate for the distress costs. In Example 16.2, when Armin is levered, the present value of its financial distress costs depends on the probability that the new product will fail (50%), the magnitude of the costs if it does fail ($20 million), and the discount rate (5%). What determines each of these factors? The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default. This probability increases with the amount of a firm’s liabilities (relative to its as- sets). It also increases with the volatility of a firm’s cash flows and asset values. Thus, firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default. Firms whose value and cash flows are very volatile (for example, semiconductor firms) must have much lower levels of debt to avoid a significant risk of default. The magnitude of the financial distress costs will depend on the relative importance of the costs discussed in Section 16.2, and is also likely to vary by industry. For example, firms, such as technology firms, whose value comes largely from human capital, are likely to incur high costs when they risk financial distress, due to the potential for loss of customers and the need to hire and retain key personnel, as well as a lack of tangible assets that can be eas- ily liquidated. In contrast, firms whose main assets are physical capital, such as real estate firms, are likely to have lower costs of financial distress, because a greater portion of their value derives from assets that can be sold relatively easily. M16_BERK6318_06_GE_C16.indd 600 26/04/23 8:31 PM  16.4 Optimal Capital Structure: The Tradeoff Theory 601 Finally, the discount rate for the distress costs will depend on the firm’s market risk. Note that because distress costs are high when the firm does poorly, the beta of distress costs will have an opposite sign to that of the firm.18 Also, the higher the firm’s beta, the more likely it will be in distress in an economic downturn, and thus the more negative the beta of its distress costs will be. Because a more negative beta leads to a lower cost of capi- tal (below the risk-free rate), other things equal the present value of distress costs will be higher for high beta firms. Optimal Leverage Figure 16.1 shows how the value of a levered firm, V L , varies with the level of permanent debt, D, according to Eq. 16.1. With no debt, the value of the firm is V U. For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield, which has present value τ * D , where τ * is the effective tax advantage of debt calculated in Chapter 15. If there were no costs of financial distress, the value would continue to increase at this rate until the interest on the debt exceeds the firm’s earnings before interest and taxes and the tax shield is exhausted. The costs of financial distress reduce the value of the levered firm, V L. The amount of the reduction increases with the probability of default, which in turn increases with the level of the debt D. The tradeoff theory states that firms should increase their leverage until it reaches the level D * for which V L is maximized. At this point, the tax savings that FIGURE 16.1 Loss of Tax Shield Due to Excess Interest Optimal Leverage with Taxes and Financial Distress Costs Loss of PV (Financial Distress Costs) V L with No Value of Levered Firm, V L Distress Costs As the level of debt, D, in- creases, the tax benefits of debt increase by τ *D until the interest expense exceeds the τ *D firm’s EBIT (see Figure 15.8). V L with Low The probability of default, and Distress Costs hence the present value of financial distress costs, also V L with High increase with D. The optimal Distress Costs level of debt, D *, occurs when VU these effects balance out and V L is maximized. D * will be lower for firms with higher costs of financial distress. 0 D* high D* low Value of Debt, D 18 For intuition, consider a law firm specializing in bankruptcy. Because profits will be higher in d­ ownturns, the law firm will have negative beta. Formally, the beta of distress costs is similar to the beta of a put o ­ ption on the firm, which we calculate in Chapter 21 (see Figure 21.8). See also H. Almeida and T. Philippon, “The Risk-Adjusted Cost of Financial Distress,” Journal of Finance 62 (2007): 2557–2586. M16_BERK6318_06_GE_C16.indd 601 26/04/23 8:31 PM  602 Chapter 16 Financial Distress, Managerial Incentives, and Information result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. Figure 16.1 also illustrates the optimal debt choices for two types of firms. The opti- mal debt choice for a firm with low costs of financial distress is indicated by D low* , and the optimal debt choice for a firm with high costs of financial distress is indicated by Dhigh *. Not surprisingly, with higher costs of financial distress, it is optimal for the firm to choose lower leverage. The tradeoff theory helps to resolve two puzzles regarding leverage that arose in Chapter 15. First, the presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield. Second, differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries. That said, bankruptcy costs alone are not sufficient to explain all of the variation observed. As we will explore in subsequent sec- tions, an even more significant cost of leverage may arise well before financial distress, in the form of conflicts between the firm’s investors. EXAMPLE 16.4 Choosing an Optimal Debt Level Problem Greenleaf Industries is considering adding leverage to its capital structure. Greenleaf ’s managers believe they can add as much as $35 million in debt and exploit the benefits of the tax shield (for which they estimate τ * = 15% ). However, they also recognize that higher debt increases the risk of financial distress. Based on simulations of the firm’s future cash flows, the CFO has made the following estimates (in millions of dollars):19 Debt 0 10 20 25 30 35 PV ( Interest tax shield) 0.00 1.50 3.00 3.75 4.50 5.25 PV ( Financial distress costs) 0.00 0.00 0.38 1.62 4.00 6.38 What is the optimal debt choice for Greenleaf ? Solution From Eq. 16.1, the net benefit of debt is determined by subtracting PV ( Financial distress costs) from PV  ( Interest tax shield). The net benefit for each level of debt is Debt 0 10 20 25 30 35 Net benefit 0.00 1.50 2.62 2.13 0.50 −1.13 The level of debt that leads to the highest net benefit is $20 million. Greenleaf will gain $3 million due to tax shields, and lose $0.38 million due to the present value of distress costs, for a net gain of $2.62 million. CONCEPT CHECK 1. What is the “tradeoff” in the tradeoff theory? 2. According to the tradeoff theory, all else being equal, which type of firm has a higher opti- mal level of debt: a firm with very volatile cash flows or a firm with very safe, predictable cash flows? 19 The PV of the interest tax shield is computed as τ * D. The PV of financial distress costs is generally difficult to estimate and requires option valuation techniques we introduce in Part 7. M16_BERK6318_06_GE_C16.indd 602 26/04/23 8:31 PM  16.5 Exploiting Debt Holders: The Agency Costs of Leverage 603 16.5 E xploiting Debt Holders: The Agency Costs of Leverage In this section, we consider another way that capital structure can affect a firm’s cash flows: It can alter managers’ incentives and change their investment decisions. If these changes have a negative NPV, they will be costly for the firm. The type of costs we describe in this section are examples of agency costs—costs that arise when there are conflicts of interest between stakeholders. Because top managers often hold shares in the firm and are hired and retained with the approval of the board of directors, which itself is elected by shareholders, managers will generally make decisions that increase the value of the firm’s equity. When a firm has leverage, a conflict of inter- est exists if investment decisions have different consequences for the value of equity and the value of debt. Such a conflict is most likely to occur when the risk of financial distress is high. In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. We illustrate this possibility by considering Baxter Inc., a firm that is facing financial dis- tress. Baxter has a loan of $1 million due at the end of the year. Without a change in its strat- egy, the market value of its assets will be only $900,000 at that time, and Baxter will default on its debt. In this situation, let’s consider several types of agency costs that might arise. Excessive Risk-Taking and Asset Substitution Baxter executives are considering a new strategy that seemed promising initially but appears risky after closer analysis. The new strategy requires no up-front invest- ment, but it has only a 50% chance of success. If it succeeds, it will increase the value of the firm’s assets to $1.3 million. If it fails, the value of the firm’s assets will fall to $300,000. Therefore, the expected value of the firm’s assets under the new strategy is 50% × $1.3 million + 50% × $300,000 = $800,000, a decline of $100,000 from their value of $900,000 under the old strategy. Despite the negative expected payoff, some within the firm have suggested that Baxter should go ahead with the new strategy, in the interest of bet- ter serving its shareholders. How can shareholders benefit from this decision? As Table 16.3 shows, if Baxter does nothing, it will ultimately default and equity holders will get nothing with certainty. Thus, equity holders have nothing to lose if Baxter tries the risky strategy. If the strategy succeeds, equity holders will receive $300,000 after paying off the debt. Given a 50% chance of success, the equity holders’ expected payoff is $150,000. Clearly, equity holders gain from this strategy, even though it has a negative expected pay- off. Who loses? The debt holders: If the strategy fails, they bear the loss. As shown in Table 16.3, if the project succeeds, debt holders are fully repaid and receive $1 million. If the project fails, they receive only $300,000. Overall, the debt holders’ expected payoff is $650,000, a loss TABLE 16.3     Outcomes for Baxter’s Debt and Equity under Each Strategy (in $ thousand) New Risky Strategy Old Strategy Success Failure Expected Value of assets 900 1300 300 800 Debt 900 1000 300 650 Equity   0 300   0 150 M16_BERK6318_06_GE_C16.indd 603 26/04/23 8:31 PM  604 Chapter 16 Financial Distress, Managerial Incentives, and Information of $250,000 relative to the $900,000 they would have received under the old strategy. This loss corresponds to the $100,000 expected loss of the risky strategy and the $150,000 gain of the equity holders. Effectively, the equity holders are gambling with the debt holders’ money. This example illustrates a general point: When a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently, even if they have a negative NPV. Because leverage gives shareholders an incentive to replace low-risk assets with riskier ones, this result is often referred to as the asset substitution problem.20 It can also lead to over-investment, as shareholders may gain if the firm undertakes negative-NPV, but suf- ficiently risky, projects. In either case, if the firm increases risk through a negative-NPV decision or investment, the total value of the firm will be reduced. Anticipating this bad behavior, security holders will pay less for the firm initially. This cost is likely to be highest for firms that can easily increase the risk of their investments. Debt Overhang and Under-Investment Suppose Baxter does not pursue the risky strategy. Instead, the firm’s managers consider an at- tractive investment opportunity that requires an initial investment of $100,000 and will gener- ate a risk-free return of 50%. That is, it has the following cash flows (in thousands of dollars): 0 1 2100 150 If the current risk-free rate is 5%, this investment clearly has a positive NPV. The only problem is that Baxter does not have the cash on hand to make the investment. Could Baxter raise the $100,000 by issuing new equity? Unfortunately, it cannot. Suppose equity holders were to contribute the $100,000 in new capital required. Their payoff at the end of the year is shown in Table 16.4. Thus, if equity holders contribute $100,000 to fund the project, they get back only $50,000. The other $100,000 from the project goes to the debt holders, whose payoff increases from $900,000 to $1 million. Because the debt holders receive most of the benefit, this project is a negative-NPV investment opportunity for equity holders, even though it offers a positive NPV for the firm. TABLE 16.4    Outcomes for Baxter’s Debt and Equity with and without the New Project (in $ thousand) Without New Project With New Project Existing assets 900 900 New project 150 Total firm value 900 1050 Debt 900 1000 Equity   0   50 20 See M. Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3 (1976): 305–360. M16_BERK6318_06_GE_C16.indd 604 26/04/23 8:31 PM  16.5 Exploiting Debt Holders: The Agency Costs of Leverage 605 FINANCE IN TIMES OF DISRUPTION Bailouts, Distress Costs, and Debt Overhang Firms and financial institutions in or near financial distress and so lending to them was a negative NPV investment. But in the midst of the 2008 financial crisis experienced many of many, including the banks themselves, pointed to another cul- the costs associated with financial distress that we have de- prit: banks were subject to debt overhang that made it extremely scribed, creating further negative consequences for the real difficult to raise the capital needed to make positive-NPV loans. economy. Thus, a primary rationale for governmental bailouts during the Of particular concern was the seeming unwillingness of crisis was to provide banks with capital directly, alleviating their banks to make loans to borrowers at reasonable terms. One pos- debt overhang and increasing the availability of credit to the rest sible explanation was that the borrowers were not creditworthy of the economy. This example illustrates another general point: When a firm faces financial distress, it may choose not to finance new, positive-NPV projects. In this case, when shareholders prefer not to invest in a positive-NPV project, we say there is a debt overhang or ­under-investment problem.21 This failure to invest is costly for debt holders and for the overall value of the firm, because it is giving up the NPV of the missed oppor- tunities. The cost is highest for firms that are likely to have profitable future growth ­opportunities requiring large investments. Cashing Out. When a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm if possible. As an example, suppose Baxter has equipment it can sell for $25,000 at the beginning of the year. It will need this equipment to continue normal operations during the year; without it, Baxter will have to shut down some opera- tions and the firm will be worth only $800,000 at year-end. Although selling the equipment reduces the value of the firm by $100,000, if it is likely that Baxter will default at year-end, this cost would be borne by the debt holders. So, equity holders gain if Baxter sells the equipment and uses the $25,000 to pay an immediate cash dividend. This incentive to liquidate assets at prices below their actual value to the firm is an extreme form of under- investment resulting from the debt overhang. Estimating the Debt Overhang. How much leverage must a firm have for there to be a significant debt overhang problem? While difficult to estimate precisely, we can use a use- ful approximation. Suppose equity holders invest an amount I in a new investment project with similar risk to the rest of the firm. Let D and E be the market value of the firm’s debt and equity, and let β D and β E be their respective betas. Then the following approximate rule applies: equity holders will benefit from the new investment only if 22 NPV β D > D (16.2) I βE E 21 This agency cost of debt was formalized by S. Myers, “Determinants of Corporate Borrowing,” Journal of Financial Economics 5 (1977): 147–175. For recent evidence see M. Wittry, “(Debt) Overhang: Evidence from Resource Extraction,” The Review of Financial Studies 34(4) (2021): 1699–1746. 22 To understand this result, let dE and dD be the change in the value of equity and debt resulting from an investment with total value dE + dD = I + NPV. Equity holders benefit if they gain more than they in- vest, I < dE , which is equivalent to debt holders capturing less than the investment’s NPV, NPV > dD. Dividing the second inequality by the first, we have NPV I > dD dE. Equation 16.2 follows from the approximation dD dE ≈ β D D β E E ; that is, the relative sensitivity of debt and equity to changes in asset values are similar whether those changes arise from investment decisions or market conditions. We derive this approximation in Chapter 21. M16_BERK6318_06_GE_C16.indd 605 26/04/23 8:32 PM  606 Chapter 16 Financial Distress, Managerial Incentives, and Information That is, the project’s profitability index ( NPV I ) must exceed a cutoff equal to the rel- ative riskiness of the firm’s debt ( β D β E ) times its debt-equity ratio ( D E ). Note that if the firm has no debt ( D = 0) or its debt is risk free ( β D = 0), then Eq. 16.2 is equivalent to NPV > 0. But if the firm’s debt is risky, the required cutoff is positive and increases with the firm’s leverage. Equity holders will reject positive-NPV projects with profitability indices below the cutoff, leading to under-investment and reduction in firm value. EXAMPLE 16.5 Estimating the Debt Overhang Problem In Example 12.7, we estimated that Sears had an equity beta of 1.36, a debt beta of 0.17, and a debt-equity ratio of 0.30, while Saks had an equity beta of 1.85, a debt beta of 0.31, and a ­debt-equity ratio of 1.0. For both firms, estimate the minimum NPV such that a new $100,000 investment (which does not change the volatility of the firm) will benefit shareholders. Which firm has the more severe debt overhang? Solution We can use Eq. 16.2 to estimate the cutoff level of the profitability index for Sears as ( 0.17 1.36 ) × 0.30 = 0.0375. Thus, the NPV would need to equal at least $3750 for the invest- ment to benefit shareholders. For Saks, the cutoff is ( 0.31 1.85 ) × 1.0 = 0.1675. Thus, the mini- mum NPV for Saks is $16,750. Saks has the more severe debt overhang, as its shareholders will reject projects with positive NPVs up to this higher cutoff. Similarly, Saks shareholders would benefit if the firm “cashed out” by liquidating up to $116,750 worth of assets to pay out an addi- tional $100,000 in dividends. Agency Costs and the Value of Leverage These examples illustrate how leverage can encourage managers and shareholders to act in ways that reduce firm value. In each case, the equity holders benefit at the expense of the debt holders. But, as with financial distress costs, it is the shareholders of the firm who ultimately bear these agency costs. Although equity holders may benefit at debt holders’ expense from these negative-NPV decisions in times of distress, debt holders recognize this possibility and pay less for the debt when it is first issued, reducing the amount the firm can distribute to shareholders. The net effect is a reduction in the initial share price of the firm corresponding to the negative NPV of the decisions. These agency costs of debt can arise only if there is some chance the firm will default and impose losses on its debt holders. The magnitude of the agenc