Borrower - Lender Conflicts - 1 1.1 Borrower - Lender...

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1 Borrower - Lender Con°icts 1.1 Asset Substitution Theory \Asset substitution theory" is a popular theory in capital structure. It describes thata heavily indebted corporation may want to increase risk to take advantage of the existing debt. Asset substitution theory" assumes that (1) managers maximize existing equity holders' value and we further assume that (2) ¯rms have at most two types of securities: debt and common stock. Asset substitution theory implies that the amount of leverage has an impact on the incentives of someone who maximizes the value of residual equity claim. \ Here we also provide you with some background information. First, debt with face value of F is the amount that a ¯rm promises to payback on maturity date. Second, debt is paid ¯rst and the rest goes to equity holders. Now let V be the value of the ¯rm. Based on the above assumptions and information, we have the following schedule. In general, debt holders own the lower tail of the distribution of the value of the ¯rm and equity holders own the upper tail. Debt Holders Get Equity Holders Get V ¸ F F V ¡ F V < F V 0 1.1.1 Setting Suppose there are two projects. Each project has two possible outcomes: de- pression (D) and prosperity (P). The probability of each outcome is 0.5. Each project requires an initial outlay of $800. Details are shown in the following table. Project's Payo® Project Value in D Value in P Expected Value Expected Return of Project 1 500 1500 1000 25% 2 0 1551 775.5 - 3.06% 1
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1.1.2 Illustration The following examples illustrate how divided ownership of di®erent parts of the cash °ow distribution distorts capital budgeting decisions. Example 1 [ No Debt ] Let's consider a ¯rm with no debt. As shown in the following table, an owner-managed ¯rm with no debt would choose project 1 because it has a higher expected return.
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Borrower - Lender Conflicts - 1 1.1 Borrower - Lender...

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