Lecture17 - TOPIC 17 CAPITAL STRUCTURE 2: Reading: Chapter...

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168 T OPIC 17 C APITAL S TRUCTURE 2: Reading: Chapter 15 Homework: My qualitative questions posted on the course website, due June 1 Objectives: After this lecture, you should be able to: Understand debt overhang and explain why a firm near (but not in) bankruptcy might forego a positive NPV project Understand the nature of the Bondholder-Shareholder Conflict Asset Substitution, Collateral Stripping, & Covenants Understand the Tradeoff Theory of Capital Structure Understand how Information Asymmetry Leads to Transaction Costs Understand the Pecking Order Theory Understand how the Pecking Order and Tradeoff Theory go together
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169 TAXES VS. BANKRUPTCY COSTS Last time we noted that debt has benefits and drawbacks: Benefit: Tax shield Drawback: Bankruptcy costs -Value destroyed because of bankruptcy - Bankruptcy itself is only bad if it interferes with the operations of the firm Debt has other effects on firm value -Another benefit: bebt forces managers to pay out cash so they don’t waste it (the Free Cash Flow argument) -Other drawbacks: The possibility of bankruptcy can distort incentives and destroy value, even if the firm is not bankrupt --Debt overhang --Bondholder-shareholder conflicts
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170 DEBT OVERHANG & UNDERINVESTMENT (MYERS, 1977) Even if the firm is not yet bankrupt, a strong possibility of financial distress may prevent it from taking on good investments. A simple stylized example: Frim has Assets in Place that next year will generate $100 with probability 0.5 and $20 with probability 0.5. The has borrowed in the past, and has to repay $50 in debt next year. Notice, the firm may still be able to meet its financial obligations; it is not bankrupt What are the current market values of Debt & Equity, assuming no further investment? For simplicity, assume a discount rate of zero. Now suppose there is a new project with an NPV of $5 that requires an investment of $10. For simplicity, assume the riskeless rate is 0 and the project is riskless, so it pays off $15 next year no matter what. Will it be possible for the firm to issue equity to finance the project? Do you think old debt will allow issuing new debt senior to them to finance it? I leave it as an excersice to the student to show that the same result holds even if you add risk and discounting to the project.
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171 D EBT O VERHANG IN A NUTSHELL The bottom line is that a firm with a significant probability of default not make an positive NPV investment if: --Prior to the investment, there is a significant probability of default and --The new investment either decreases the probability of default, or increases old debt’s recovery rate in the event of default. When the two conditions above hold, Old Debt reaps most of the benefit
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture17 - TOPIC 17 CAPITAL STRUCTURE 2: Reading: Chapter...

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