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Chap015(WW-FIN357TALT)SPR07

Chap015(WW-FIN357TALT)SPR07 - 15-0 Chapter Outline 15.1...

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15-1 Chapter Outline 15.1 Costs of Financial Distress 15.2 Description of Costs 15.3 Can Costs of Debt Be Reduced? 15.4 Integration of Tax Effects and Financial Distress Costs 15.5 Signaling 15.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 15.7 The Pecking-Order Theory 15.8 Growth and the Debt-Equity Ratio 15.9 Personal Taxes 15.10 How Firms Establish Capital Structure 15.11 Summary and Conclusions
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15-2 15.1 Costs of Financial Distress Bankruptcy risk versus 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.
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15-3 15.2 Description of Costs Direct Costs Legal and administrative costs (tend to be a small percentage of firm value). Indirect Costs Impaired ability to conduct business (e.g., lost sales, poor morale, etc.)
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15-4 15.2 Description of Costs Agency Costs Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive to under invest Selfish Strategy 3: Milking the property
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15-5 Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 If the firm is liquidated today , the bondholders get $200; the shareholders get nothing. $200 $0
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15-6 Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% E(CF) from the Gamble = $1000 × 0.10 + $0 × 0.90 = $100 NPV = –$200 + $100 (1.50) NPV = –$133
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15-7 Stockholders Accept Negative NPV Project with Large Risks Expected CF from the Gamble To Bondholders = $300 × 0.10 + $0 = $30 To Stockholders = ($1000 – $300) × 0.10 + $0 = $70 PV of Bonds Without the Gamble = $200 PV 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:
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15-8 Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10% Will the project be accepts or rejected? NPV = –$300 + $350 (1.10) NPV = $18.18
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15-9 Selfish Stockholders Forego Positive NPV Project Expected CF from the project: To Bondholders = $300 To Stockholders = ($350 – $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 $272.73 = $300 (1.10) PV of Bonds With the Project: $-54.55 = $50 (1.10) PV of Stocks With the Project: – $100
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15-10 Selfish Strategy 3: Milking the Property Liquidating dividends
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