Chapter 16 - Capital structure Limits to the use of debt

Chapter 16 - Capital structure Limits to the use of debt -...

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Chapter 16 Capital structure: Limits to the use of debt The MM theory states that V L = V U + T C B, which states that one can always increase firm value by increasing leverage , implying that firms should issue maximum debt However, this is inconsistent with the real world, where firms generally employ only moderate amounts of debt A firm’s capital structure can be thought of as a trade-off between the tax benefits of debt and the costs of financial distress and bankruptcy → leads to an optimum amount of debt In addition, the MM theory ignores personal taxes → In the real world, the personal tax rate on interest is higher than the effective personal tax rate on equity distributions →the personal tax penalties to bondholders tend to offset the tax benefits to debt at the corporate level 16.1 Costs of Financial Distress Despite the tax benefits →Debt puts pressure on a firm, because interest and principal repayments are obligations → If these obligations are not met , the firm may risk some sort of financial distress , ultimately leading to bankruptcy (ownership transferred to bondholders) Bankruptcy costs, or more generally financial distress costs, tend to offset the advantages of debt Day Corporation Corporations have limited liability →bondholders cannot sue the rest of the money still due Suppose that the fees of lawyers have to be paid by the fir in case of a law dispute with the firm The possibility of bankruptcy has a negative effect on the value of the firm However, it is not the risk of bankruptcy itself that lowers value→ Rather it is the costs associated with bankruptcy that lower value These bankruptcy costs are immediately (Market Efficiency Hypothesis) reflected in the price of the bonds if they are realistic about the probability and the costs of bankruptcy It is thus the stockholders who bear these future bankruptcy costs , because dividends will be smaller when bankruptcy costs exist 16.2 Description of Costs financial distress costs may be a better phrase than bankruptcy costs Direct Costs of Financial Distress: Legal and Administrative Costs of Liquidation or Reorganisation Lawyers are involved throughout all the stages before and during bankruptcy + administrative and accounting fees Indirect Costs of Financial Distress Impaired Ability to Conduct Business Bankruptcy hampers conduct with customers and suppliers → Sales are frequently lost because of both fear of impaired services and loss of trust Agency Costs When a firm has debt , conflicts of interest arise between stockholders and bondholders 1
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Chapter 16 Capital structure: Limits to the use of debt Because of this, stockholders are tempted to pursue selfish strategies → These conflicts of interest, which are magnified when financial distress is incurred, impose agency costs on the firm (lower the market value of the whole firm) Selfish Investment Strategy 1: Incentive to Take Large Risks
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This note was uploaded on 11/16/2009 for the course F 3033 taught by Professor Hh during the Spring '09 term at Maastricht.

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Chapter 16 - Capital structure Limits to the use of debt -...

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