Costs of Financial Distress

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice.

As we will see, financial distress is costly. Investors know that levered firms may run into financial difficulty, and they worry about the costs of financial distress. That worry is reflected in the current market value of the levered firm's securities. Even if the firm is not now in financial distress, investors factor the potential for future distress into their assessment of current value. This means that the overall value of the firm is

Overall market value value if all-equity + PV tax financed shield

PV costs of financial distress

The present value of the costs of financial distress depends both on the probability of distress and on the magnitude of the costs encountered if distress occurs.

Figure 15.7 shows how the trade-off between the tax benefits of debt and the costs of distress determines optimal capital structure. Think of a firm like River Cruises, which starts with no debt but considers moving to higher and higher debt levels, holding its assets and operations constant.

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate. But at some point the probability of financial distress increases rapidly with additional borrowing and the potential costs of distress begin to take a substantial bite out of firm value. The theoretical optimum is reached when the present value of tax savings due to additional borrowing is just offset by increases in the present value of costs of distress.

6 Recall from Chapter 2 that tax rates on ordinary income can reach 39.6 percent. The maximum tax rate on long-term capital gains is only 20 percent.

Brealey-Myers: I V. Capital Structure and I 15. The Capital Structure I I © The McGraw-Hill

Fundamentals of Corporate Dividend Policy Decision Companies, 2001

Finance, Third Edition chapter 15 The Capital Structure Decision 439


The trade-off theory of capital structure. The curved green line shows how the market value of the firm at first increases as the firm borrows, but finally decreases as the costs of financial distress become more and more important. The optimal capital structure balances the costs of financial distress against the value of the interest tax shields generated by borrowing.

chapter 15 The Capital Structure Decision 439

Trade Off Theory


Debt levels are chosen to balance interest tax shields against the costs of financial distress.

This is called the trade-off theory of optimal capital structure. The theory says that managers will try to increase debt levels to the point where the value of additional interest tax shields is exactly offset by the additional costs of financial distress.

Now let's take a closer look at financial distress.

bankruptcy costs

In principle, bankruptcy is merely a legal mechanism for allowing creditors (that is, lenders) to take over the firm when the decline in the value of its assets triggers a default on outstanding debt. If the company cannot pay its debts, the company is turned over to the creditors, who become the new owners; the old stockholders are left with nothing. Bankruptcy is not the cause of the decline in the value of the firm. It is the result.

In practice, of course, anything involving courts and lawyers cannot be free. The fees involved in a bankruptcy proceeding are paid out of the remaining value of the firm's assets. Creditors end up with only what is left after paying the lawyers and other court expenses. If there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of these potential costs.

It is easy to see how increased leverage affects the costs of financial distress. The more the firm owes, the higher the chance of default and therefore the greater the expected value of the associated costs. This reduces the current market value of the firm.

Creditors foresee the costs and realize that if default occurs, the bankruptcy costs will come out of the value of the firm. For this they demand compensation in advance in the form of a higher promised interest rate. This reduces the possible payoffs to stockholders and reduces the current market value of their shares.

v self-test 15.5 Suppose investors foresee $2 million of legal costs if the firm defaults on its bonds.

How does this affect the value of the firm's bonds if bankruptcy occurs? How does the

440 part five Capital Structure and Dividend Policy possibility of default affect the interest rate demanded by bondholders today? How does this possibility affect today's value of the firm's common stock?

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