chapter16_a - Chapter 16 Limits to the Use of Debt Theory...

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Chapter 16 Limits to the Use of Debt
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Theory vs. Reality Firms do not use an infinite amount of debt, why not? Debt puts pressure on the firm since interest and principal payments are obligations. If these obligations are not met, bondholders can force bankruptcy. What happens in bankruptcy?
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1. Costs of Financial Distress Example: Two firms with identical cash flows and both have no other assets. Knight Corp.- $49 of interest and principal obligations Day Corp.- $60 of interest and principal obligations Booms and recessions both occur with probability ½ Stockholders of Day Corporation enjoy limited liability in recession. Knight Corp. Day Corp. Boom (Prob. 50%) Recession (Prob. 50%) Boom (Prob. 50%) Recession (Prob. 50%) Cash flow 100 50 100 50 Payment of interest and principal on debt 49 49 Cash to stockholders 51 1
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Example (continued) Assume all cash flows can be discounted at 10% Value of claims on Knight Corp : E Knight = D Knight = V Knight = Value of claims on Day Corp : E Day = D Day = V Day = Note that the two firms have the same value, even though Day runs the risk of bankruptcy.
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Problem with above analysis: Day’s example is not realistic.
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