C09.+Chap+17.+Capital+Structure+-+Limits+to+the+use+of+Debt

C09.+Chap+17.+Capital+Structure+-+Limits+to+the+use+of+Debt...

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Unformatted text preview: Chapter 17: Capital Structure Limits to the Use of Debt Costs of Financial Distress Description of Costs Can Costs of Debt Be Reduced? Integration of Tax Effects and Financial Distress Costs Personal Taxes How Firms Establish Capital Structure Summary and Conclusions 17.1 Costs of Financial Distress Bankruptcy risk versus bankruptcy cost. 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. It is the stockholders who bear these costs. 17.2 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) Agency Costs Selfish Strategy 1: Incentive to take large risks Selfish Strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property 17.3 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 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. $200 $0 17.4 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 firms cash) Required return is 50% Expected CF from the Gamble = $1000 0.10 + $0 = $100 NPV = $200 + $100 (1.10) NPV = $133 17.5 Selfish 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 PV of Bonds With the Gamble = $30 / 1.5 = $20 PV of Stocks With the Gamble = $70 / 1.5 = $47 Should we accept the project? 17.6 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% 18 . 18 $ 10 . 1 350 $ 300 $ = +- = NPV NPV 17.7 Selfish Stockholders Forego Positive NPV Project Expected CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 - $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project = $300 / 1.1 = $272.73 PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55 17.8 Selfish Strategy 3: Milking the Property Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders....
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C09.+Chap+17.+Capital+Structure+-+Limits+to+the+use+of+Debt...

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