Wednesday, April 18, 2012

Costs of Financial Distress and Financial Strategy

Continuing on in our series about perfect capital market assumptions and what occurs when we confront reality, with this post we turn towards the concept of “Financial Distress”, #3 on our list.
The previous topics we have looked at – Perfect Information and Taxes – have had relatively straightforward implications when we have examined reality’s divergence from the perfect capital market assumptions. This is not the case when it comes to Financial Distress.

What is “Financial Distress”?
Financial Distress is not very easily defined - ask five people what it means and you will likely get five different answers. We can take a point of view that varies along a wide continuum, from limited scope to broad.
At one end (the “strict view”), it is the costs of going into bankruptcy – legal fees, court fees, etc. It is not the loss of stock value, etc., but literally just the cost associated with the event. At the other (the “expanded view”), if one can only afford a Fiat rather than a Ferrari this can be construed as “distress” by some.
Fundamentally, what these extremes have in common is the fact that there are not sufficient funds available to make necessary expenditures (the key word being “necessary”, and this is subjectively defined).

Bankruptcy events are the most obvious financial distress situations. In some cases bankruptcy results the reorganization of the firm, after which time it “emerges” in a transformed state. Often this occurs with losses to former debt and equity holders. In other situations bankruptcy results the cessation of the entity as a going concern and ultimately results in that entity’s liquidation.
Figure A
Theoretically, the cost of financial distress in the bankruptcy situation can be calculated. Simply add up the additional costs of filing for bankruptcy (legal fees, court fees, etc.), along with the losses to debt and equity holders, and multiply this times the probability of the firm going bankrupt (Figure A).

While Great in Theory…
Practically speaking, this is not so simple. How does one determine the probability of bankruptcy?
The major ratings agencies, Moodys and Standard and Poor’s, have a wealth of historical data on default frequency and losses given default for securities that they provide ratings for (I have not linked this as they require a subscription). This data can be useful for some purposes, such as pricing rated debt.
However, this is not the full universe of companies. The local corner coffee shop or your Uncle John’s farm are probably not rated by either ratings agency. In statistical speak, the ratings agency data are not a representative sample, and therefore we cannot confidently draw conclusions from this data for every type of firm.

Financial Distress Can Be So Much More
Even if we had representative data, using an “expanded view” of financial distress leads us to other costs that are not captured in that calculation.
Let us say that we are shareholders in Farmco. Last year, Farmco generated ²10 in cash (the symbol ² representing Treasury Café Monetary Units, or TCMU’s). Let’s further say that Farmco has a dividend of ²8 per year. This indicates that Farmco retains ²2 per year. As discussed in our initial Financial Strategy post, we expect that Farmco invests these funds at our cost of capital, which for the sake of this example we say is 10%.
In the farming business, one can increase crop yields by installing drainage tile in areas that have higher than normal wetness. This wetness may come about due to the slope of the field, the elevation of the field relative to its neighbors, waterways, etc.
If we could install drainage tile on Farmco’s eligible sites, we could generate an additional ²1 per year due to the incrementally higher yield. If we have a 10% cost of capital, we would be willing to make this investment so long as it did not require more than ²10 (using the Dividend Discount Model and assuming the investment lasts forever).

Figure B
However, due to the fact that Perfect Capital Market Assumption #1 (perfect information by all participants) does not hold, we are able to make this investment for ²5 instead, which means this investment will yield 20%, a significant premium to our 10% requirement.
Figure B shows the result of this on the value of Farmco (an increase of slightly more than ²3 from the base value calculated in our last post) under the fully retained cash condition.  
However, due to Farmco’s dividend policy, it only has ²2 available to make this investment. If it chooses to cut its dividend, as we discussed in Apple’s Dividend – A Good Financial Strategy?, this will provide a negative signal to the market, offsetting part or all of the additional return this investment opportunity presents.
Figure C
By funding internally but delaying part of the investment until year 1 and year 2 when it has the funds, Farmco executes the investment opportunity and realizes the value, but on a delayed basis. This impacts its ultimate return, due to the time value of money, by about ²0.35. The delay in activity and subsequent valuation are shown in Figure C.
Income and investment opportunities that are delayed or forgone are also, in the broad view, costs of financial distress.

Yet the Costs of Financial Distress Remain a Mystery
The big problem, however, is that fact that these factors are never objectively known or able to be quantified precisely ahead of time. In fact, shareholder’s likely will never know. After year 1 Farmco will probably not say “we had ²5 in investment opportunity at 20% and only did ²2”, rather it will state “we made great investments this year, and remain expectant that, through our business development efforts, we are confident that other similar opportunities may present themselves in the future”. This is a very difficult statement to infer costs of financial distress from.
The fact that the true costs of financial distress cannot be measured, let alone determined, makes this cost a very “theoretical” exercise, which does not lend itself well to organizational decision-making processes. These are usually attuned to “hard” numbers rather than theoretical ones, yet the fact remains that opportunities were not taken and shareholder value suffered as a result.

Key Takeaways
Costs of Financial Distress are great in theory, and can be used to explain events that occur in financial management of organizations and in the markets. Costs of Financial Distress are real, even if they cannot be measured. Because of this, they may not always be taken sufficiently into account.
·         What examples do you have of the Costs of Financial Distress?

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Thursday, April 5, 2012

Taxes and Dividend Strategy

Our last post covered Apple Computer’s dividend and share buyback announcement from a “those folks know more than we do about the company” perspective, a state of affairs some like to call “asymmetrical information”.
We did this because we wanted to explore how information differences “change the game” when compared to the theoretical perfect capital market world.
Today we examine another common perfect-capital-market-assumption “violation” and explore what this means in the context of distributing funds to investors.

Only Two Things are Certain in Life
Assumption #2 from our list of Perfect Capital Market Assumptions is “Absence of Taxes”. If ever there was an assumption in theory that does not hold true in reality this is it - taxes are everywhere!
The company’s choice to either distribute funds to shareholders or retain funds to make further investments has implications for shareholders from a tax perspective. Dividends are usually considered “Income” to an investor, while funds received for selling shares is considered “Capital Gains or Losses”. [Note that these are terms I am using in a very general sense and am not providing tax advice of any kind]

Do Taxes Change our Conclusion?
Figure A
So let’s add the new wrinkle of taxes to our example from the last post, where we established that investors are indifferent to fund distribution or retention by the firm under the perfect capital market assumptions.
Figure B
Figure A shows the original results from our last post, where we are considering the value of a firm that earns ²10 per year in cash, is expected to earn that in perpetuity, with a cost of capital of 10% under a full payout scenario and a full retention scenario. Each scenario is worth ²110 to the investor, as shown in the Results box (sum of the Discount Factor at 10% line and the Total Proceeds to Investor line).
Figure B shows the same pattern with a tax rate of 25% for both dividends and capital gains. Note that the investment values, while now somewhat lower, are still the same for each scenario.
This leads us to conclude that even with the addition of taxes, so long as the tax rate is the same between the different categories the original thesis still holds true: investors will be indifferent to the full payout or full retention scenarios.
Figure C
What about when tax rates are different? As you may have already suspected, this does change our conclusion. Figure C shows the results if Capital Gains taxes (30%) are higher than taxes on Income (20%), and Figure D shows the results if taxes on Income (30%) are higher than on Capital Gains (20%). Investors subject to varying tax rates will value the dividend or re-investment strategies differently, with the policy that coincides with their lower tax alternative more highly valued.
Figure D

Research is Mixed
Prior to 2003, US taxpayers faced different rates for dividends compared to capital gains. In 2003, the US enacted tax legislation that cut the tax rate on dividends to be equivalent to capital gains.
Based on our calculations above, this should have made the dividend payout strategy more attractive than before and therefore we should have seen a general increase in dividends. The research on this is mixed, however. A review of many of the studies was performed as part of an analysis conducted by the Federal Reserve.
Some studies suggested there was an impact from the tax rate change, and others did not.  Things in life are not so simple as in theory. The biggest problem is the fact that there is not a way to conduct these studies in a pure experimental fashion.
A normal scientific experiment is set up so that any difference between the “control” group and the “experimental” group can only be attributed to the factor under study, because all other factors are kept constant between the two groups.
In the case of the dividend studies, this cannot be accomplished. For example, the tax cuts occurred during a time when the economy was growing. So were dividend increases due to the tax cut or because companies were doing better and had more excess cash to distribute? There is no easy way to tell.

Taxes have Valuation Implications
From the perspective of our organizations, taxes do have an impact on the valuation, as our example earlier illustrates. If we go from different treatment of income and capital gains to the same treatment (compare Figure C or D to Figure B), one strategy would be valued higher by ²2.40 and the other group would be valued lower by ²2.40.
Given that Apple enacted a dividend, it is in essence taking a view on whether the 2003 tax rate for dividends will be extended. If this tax rate is not extended, then the stock’s valuation should evidence some “adjustment” for the higher tax rates. This would not have occurred if they implemented a one-time special dividend instead.
Taxes and valuation are intertwined at a more primitive level as well. Many firms use the Capital Asset Pricing Model (in one of its many permutations) to assess what their cost of capital is. A major component of this calculation is determining how the price of a security changes given a change in the market (the relationship of the changes is called “beta”).
However, as we have seen, the level of taxation affects the valuation of a security. So if the market moves 10% and our stock under consideration moves 12% (a beta of 1.2), is the tax rate on the market investors the same tax rate as those of our security? Maybe…maybe not.
Say that investors in the market are 70% in the highest tax bracket and 30% in the lowest. If our stock has an investor mix that is 50%-50% in each, then the tax rate differential is part of the difference in returns, and not due to “beta”. We should thus adjust accordingly to arrive at our “true” cost of capital.
However, in the real world we do not know our investors tax brackets and cannot make such an analytical assessment. Perhaps we could if we conducted a really intensive survey, but this would likely be very costly and the results might still be somewhat tentative. So suffice it to say that tax code impacts our cost of capital in ways we can only approximate.

Key Takeaways
Taxes impact our financial strategy in a number of ways. First, tax rate differences between capital gains and income can determine whether it is more optimal for us to retain funds for reinvestment or distribute them to shareholders. Taxes can also impact the valuation of our company, independently and in relation to the market. Finally, it is unclear as to whether establishing an earnings distribution policy or an earnings re-investment policy is optimal from a tax standpoint, based on research performed to date. Due to this uncertainty, taxes do not appear to be a driving force behind dividend policy.
·         What is your firm’s earnings distribution and earnings re-investment priorities? Are taxes taken into consideration when these are being established?
·         How can investor’s tax preferences be discovered?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!