Chap015(WW-FIN357TALT)SPR07

Chap015(WW-FIN357TALT)SPR07 - 15-1Chapter Outline15.1 Costs...

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Unformatted text preview: 15-1Chapter Outline15.1 Costs of Financial Distress15.2 Description of Costs15.3 Can Costs of Debt Be Reduced?15.4 Integration of Tax Effects and Financial Distress Costs15.5 Signaling15.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity15.7 The Pecking-Order Theory15.8 Growth and the Debt-Equity Ratio15.9 Personal Taxes15.10 How Firms Establish Capital Structure15.11 Summary and Conclusions15-215.1 Costs of Financial DistressBankruptcy riskversus bankruptcy cost.The possibility of bankruptcy has a negative effect on the value of the firm.It is not so much the risk of bankruptcy that lowers firm value, but the costs associated with bankruptcy.Stockholders bear these costs.15-315.2 Description of CostsDirect CostsLegal and administrative costs (tend to be a small percentage of firm value).Indirect CostsImpaired ability to conduct business (e.g., lost sales, poor morale, etc.)15-415.2 Description of CostsAgency CostsSelfish strategy 1: Incentive to take large risksSelfish strategy 2: Incentive to under investSelfish Strategy 3: Milking the property15-5Balance Sheet for a Company in DistressAssetsBVMVLiabilitiesBVMVCash$200$200LT bonds $300Fixed Asset$400$0Equity$300Total$600$200Total$600$200If the firm is liquidated today, the bondholders get $200; the shareholders get nothing.$200$015-6Selfish Strategy 1: Take Large RisksThe GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is $200 (all the firms cash)Required return is 50%E(CF) from the Gamble = $1000 0.10 + $0 0.90 = $100NPV = $200 + $100 (1.50)NPV = $13315-7Stockholders Accept Negative NPV Project with Large RisksExpected CF from the GambleTo Bondholders = $300 0.10 + $0 = $30To Stockholders = ($1000 $300) 0.10 + $0 = $70PV of Bonds Without the Gamble = $200PV of Stocks Without the Gamble = $0$20 =$30(1.50)PV of Bonds With the Gamble:$47 =$70(1.50)PV of Stocks With the Gamble:15-8Selfish Strategy 2: UnderinvestmentConsider a government-sponsored project that guarantees $350 in one periodCost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the projectRequired return is 10%Willthe project be accepts or rejected?NPV = $300 + $350 (1.10)NPV = $18.1815-9Selfish Stockholders Forego Positive NPV ProjectExpected CF from the project:To Bondholders = $300To Stockholders = ($350 $300) = $50PVof Bonds Without the Project = $200PVof Stocks Without the Project = $0$272.73 =$300 (1.10)PVof Bonds With the Project:$-54.55 =$50 (1.10)PVof Stocks With the Project: $10015-10Selfish Strategy 3: Milking the Property...
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This note was uploaded on 05/10/2008 for the course FIN 357 taught by Professor Hadaway during the Spring '06 term at University of Texas at Austin.

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Chap015(WW-FIN357TALT)SPR07 - 15-1Chapter Outline15.1 Costs...

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