Discussion Issues and Derivations
Estimating Expected Bankruptcy Costs
- Estimating the Tax Benefit from Borrowing
The tax benefit from borrowing has its source in the tax code. Interest on debt is tax deductible while cash flows to equity investors (such as dividends) are not. This tax deduction leads to several implications:
a. The after-tax cost of borrowing will be lower than the pre-tax cost of borrowing. Thus, an 8% interest rate to a firm in the 40% tax bracket will translate into a 4.8% after-tax interest rate.
b. Since interest expenses reduce income at the margin, the tax savings will occur at the marginal tax rate and not the average rate.
c. Since the interest tax deduction reduces taxes only if the firm has sufficient income, firms which have negative operating income (EBIT) or large net operating losses will not get this tax benefit. At some point in time in the future, the firm may be able to claim the tax benefit by carrying forward losses. In such a case, the present value of the tax benefits has to be computed.
The expected bankruptcy cost is determined by two factors - the likelihood that the firm will go bankrupt and the cost of bankruptcy.
The probability of bankruptcy is largely a function of the variability in operating cash flows. Firms with more volatile (and less predictable) operating cash flows will have a greater probability of going bankrupt than firms with more stable cash flows, even though the two may have similar operating cash flows currently.
The cost of going bankrupt has two components as well. The direct cost of bankruptcy refers to the deadweight cost of going bankrupt, which includes the legal and liquidation costs associated with the act of bankruptcy. The indirect cost refers to the lost sales and higher costs associated with the perception that a firm is in trouble.
Neither input is easy to estimate and we have to depend upon empirical observation.
Estimating Agency Costs
The agency costs associated with bankruptcy arise from the fact that stockholders and bondholders have different claims on the cash flows and different perceptions of risk. Equity investors, who share in both the upside and the downside, may be much more willing to take risk than bond investors, who have a limited share of the upside but are exposed significantly to downside risk.
The agency costs show up in one of two ways. The lenders may charge a higher interest rate to reflect their perception of agency cost. Alternatively, they can write covenants that severely restrict the actions of equity investors in running the firm. These covenants may prevent the firm from initiating actions later on - taking projects, borrowing more or buying back stock - which would have increased value.
When making financial decisions, managers consider the effects such decisions will have on their capacity to take new projects or meet unanticipated contingencies in future periods. Practically, this translates into firms maintaining excess debt capacity or larger cash balances than are warranted by current needs, to meet unexpected future requirements. While maintaining this financing flexibility has value to firms, it also has a cost; the large cash balances earn low returns and excess debt capacity implies that the firm is giving up some value and has a higher cost of capital.
The value of flexibility can be analyzed using the option pricing framework; a firm maintains large cash balances and excess debt capacity in order to have the option to take projects that might arise in the future. The value of this option will depend upon two key variables:
1. Quality of the Firms Projects: It is the excess return that the firm earns on its projects that provides the value to flexibility. Other things remaining equal, firms operating in businesses where projects earn substantially higher returns than their hurdle rates should value flexibility more than those that operate in stable businesses where excess returns are small.
2. Uncertainty about Future Projects: If flexibility is viewed as an option, its value will increase when there is greater uncertainty about future projects; thus, firms with predictable capital expenditures should value flexibility less than those with high variability in capital expenditures.
This option framework would imply that firms such as Microsoft and Compaq, which earn large excess returns on their projects and face more uncertainty about future investment needs, can justify holding large cash balances and excess debt capacity, whereas a firm such as Chrysler, with much smaller excess returns and more predictable investment needs, should hold a much smaller cash balance and less excess debt. In fact, the value of flexibility can be calculated as a percentage of firm value, with the following inputs for the option pricing model.
S = Annual Net Capital Expenditures as percent of Firm Value (1 + Excess Return)
K = Annual Net Capital Expenditures as percent of Firm Value
t = 1 year
s2 = Variance in ln(Net Capital Expenditures)
y = Annual Cost of Holding Cash or Maintaining Excess Debt Capacity as % of Firm Value
To illustrate, assume that a firm which earns 18% on its projects has a cost of capital of 13%, and that net capital expenditures are 10% of firm value; the variance in ln(net capital expenditures) is 0.04. Also assume that the firm could have a cost of capital of 12% if it used its excess debt capacity. The value of flexibility as a percentage of firm value can be estimated as follows:
S = 10% (1.05) = 10.50% [Excess Return = 18% - 13% = 5%]
K = 10%
t = 1 year
s2 = 0.04
y = 13% - 12% = 1%
Based on these inputs and a riskless rate of 5%, the value of flexibility is 1.31% of firm value.