Financial Distress & Agency Cost

Point to ponder??

Given the fact, that Debt is the cheapest source of finance (which is possible due to
the deductibility of Interest as per the provisions of relevant tax laws.) why don’t
firms go for 100% debt for their capital requirements?

The Answer to this question is: the disadvantages emanating from the debt which is
popularly grouped as ‘Financial Distress’.

Meaning of Financial Distress: Financial distress arises when a firm is not able to make
payment of interest/principal to debt holders.

Consequences of Financial Distress:

1. Firm’s Continuous failure to make payments to debt holders may result into the
insolvency of the firm.
2. For a given level of operating risk, financial distress exacerbates with the increase in
debt. (With the higher level of operating risk and higher debt, the probability of
financial distress becomes much greater.)
3. Insolvency of firms involves direct as well indirect costs.
4. The expected costs of insolvency raises the lender’s required rate of return which in
turn affects the market value of equity negatively.

Direct costs of Insolvency:

1. Cost of Insolvency as the proceedings of insolvency involve cumbersome process.

2. The conflicting interest of Creditors and other stakeholders can delay the liquidation
of assets and further the physical conditions of assets, which become in-operative
due to commencement of liquidation process, may deteriorate over time and reduce
their NRV ( Net Realizable Value).
3. Eventually the assets are sold out at distressed prices which cause loss to the
company.
4. Insolvency also causes high legal and administrative costs.

Indirect costs of Insolvency: These costs relates to the actions of employees, Managers,
Customers, suppliers and shareholders.

In a financially distressed firm:

❖ The morale of employees is adversely affected and their productivity declines.

❖ Customers get concerned about the quality and after-sale services
❖ Suppliers curtail supplies
❖ Shareholders start withdrawing their investments by selling –off their shares
❖ And Managers expropriate the resources of firms.

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Since financial distress reduces the value of the firms, the value of a levered firm
is calculated as follows :

Value of Levered Firm = Value of Unlevered firm + PV of Interest Tax Shield(

PVINTS) – PV of Financial Distress

Or V L = Vu + Dt – PVFD

Optimum Capital Structure under Financial Distress:

The Capital structure of the firm is determined as a result of the tax benefits and the costs
of financial distress. The Present value of Interest Tax Shield (ITS) increases with every
increase in borrowings and so does the cost of financial distress. Since the Cost of Financial
Distress are very nominal at moderate level of debt, the value of firm increases with debt.

With more and more debt the costs of financial distress increases and therefore, the tax
benefit shrinks.

The Optimum point is reached when the marginal present value of ITS is equal to marginal
cost of financial distress. The Value of firm is maximum at this point.

Asymmetric Information Theory or Pecking Order Theory:

This theory is based on the assertion that Managers have more information about their
firms than their investors. This disparity is referred to as asymmetric information. Other
things being equal, because of asymmetric information, managers will issue debt when they
are positive about firm’s future prospects and will issue equity shares when they are
unsure. A commitment to pay fixed amount of interest and the principal to debt holders
implies that the company expects stable cash inflows. On the other hand, an equity issue
would indicate that the current share price is overvalued.

In this background, it is said that the manner in which managers raise capital gives a
signal of their belief in their firm’s prospects to investors. It also indicates that firms always
use internal finance when available, and chooses debt over new issue of equity when
external financing is required. Myers called this ‘pecking order theory’ because of two
reasons :

1. There is no well-defined debt-equity target.

2. There are two types of equity, internal and external ; one at the top of pecking order and
the other at the bottom.

Broadly the Pecking order theory implies that managers raise finance in following order :

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 1. They always prefer to use internal finance first to avoid any signaling from their
side to the investors.
2. In absence of availability of internal finance their second preference is debt. Within
debt they first issue secured debt followed by unsecured debt and hybrid securities
such as convertible debentures.
3. As a last step, Managers resort to issue of shares to raise funds.

Reasons for this pecking order:

A) Debt is preferred because it is cheaper than internal and external equity due to
deductibility of interest.
B) Internal equity is cheaper and easier than external because
(i) Personal taxes might have to be paid by shareholders on distributed
earnings while no tax is to be paid on retained earnings and
(ii) No floatation cost/transaction costs are incurred when the earnings are
retained.

This theory explains the inverse relationship between profitability and Debt ratio within an
industry.

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Capital Structure Policy :

Some companies do not plan their capital structure and they develop their capital
structure as a result of their financial decisions taken by the financial managers without
any formal policy and planning. These companies may prosper in the short run but
ultimately they face considerable difficulties in raising fund to finance their activities.
With unplanned capital structure they fail to economize the use of their funds. Hence, it is
realized that the company should have a planned capital structure to maximize the use of
funds and to be able to adapt to the changing conditions easily.

Optimum Capital Structure :

Theoretically, a finance manager should plan an optimum capital structure for the company
which should maximize the value of the firm. Since a number of factors influence the
capital structure decision of a company, the judgment of the person making the capital
structure decision plays a crucial role. Two similar companies may have different capital
structure if decision makers differ in their judgment of the significance of various factors.

Since the capital markets are not perfect and the decision has to be taken under imperfect
knowledge and risk, a totally theoretical model perhaps can not adequately handle all these
factors and come up with an optimum capital structure.

Target Capital Structure :

The board of directors or the CFO of a company should develop an appropriate or target
capital structure which is able to maximize the value of the firm.

The target (optimal) capital structure is simply defined as the mix of debt, preferred stock
and common equity that will optimize the company's stock price. As a company raises new
capital it will focus on maintaining this target (optimal) capital structure.

Framework for Capital Structure: FRICT ( Flexibility, Risk, Income, Control &
Timing) ANALYSIS

Financial Structure of a company may be evaluated from different perspectives. From the
owners’ point of view return, risk and value are important considerations. From the
strategic point of view flexibility is very important. A sound capital structure can be
achieved by following considerations:

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Flexibility: The capital structure of a firm should be flexible so as to enable the firm to
adapt the changes in capital structure with minimum cost and delay. It should also be
possible for the company to provide funds whenever needed to finance profitable activities.

Risk: The capital structure of a company must not have greater risk. The excessive use of
debt magnifies the variability of shareholder’s earnings and threatens the solvency of the
company.

Income: The Capital structure of a firm must generate substantial income to ensure the
maximum wealth for the shareholders with minimum cost of capital.

Control: There should be least dilution of control in an optimum capital structure.

Timing: The capital structure of a company should be feasible to implement in the light of
current and future conditions of the capital market. The present decision of Capital
structure influences the future options of raising capital.

Factors Determining Capital Structure :

Following factors determine the capital structure of a company:

1. Type of assets held by the company; i.e. Tangible or Intangible.

2. Growth opportunities ;i.e. Market-to-book value ratios
3. Debt and non-debt tax shields
4. Financial Flexibility and Operational Strategy
5. Loan covenants
6. Financial Slack (including unused debt capacity, excess liquid assets etc.)

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