MGMT_130_Lecture_16

MGMT_130_Lecture_16 - 16-1MGMT 130 Lecture 16Chapter 16:...

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Unformatted text preview: 16-1MGMT 130 Lecture 16Chapter 16: Capital Structure, Limits to the Use of DebtChapter 17:Valuation and Capital Budgeting for the Levered Firm16-2Costs of Financial DistressBankruptcy risk versus bankruptcy cost.The possibility of bankruptcy has a negative effecton the value of the firm.However, it is not the risk of bankruptcy itself thatlowers value.Rather it is the costs associated with bankruptcy.It is the stockholders who bear these costs.16-3Description of CostsDirect CostsLegal and administrative costs (tend to be a small percentage of firm value).Indirect CostsImpaired ability to conduct business (e.g., lost sales)Agency CostsSelfish strategy 1: Incentive to take large risksSelfish strategy 2: Incentive toward underinvestmentSelfish Strategy 3: Milking the property16-4Balance Sheet for a Company in DistressAssetsBVMVLiabilitiesBVMVCash$200$200LT bonds$300Fixed Asset$400$0Equity$300Total$600$200Total$600$200What happens if the firm is liquidated today?The bondholders get $200; the shareholders get nothing.$200$016-5Selfish Strategy 1: Take Large RisksThe GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is $200 (all the firms cash)Required return is 50%Expected CF from the Gamble = $1000 0.10 + $0 = $100133$50.1100$200$-=+-=NPVNPV16-6Selfish Stockholders Accept Negative NPV Project with Large RisksExpected CF from the GambleTo Bondholders = $300 0.10 + $0 = $30To Stockholders = ($1000 - $300) 0.10 + $0 = $70PV of Bonds Without the Gamble = $200PV of Stocks Without the Gamble = $0PV of Bonds With the Gamble = $30 / 1.5 = $20PV of Stocks With the Gamble = $70 / 1.5 = $4716-7Selfish Strategy 2: UnderinvestmentConsider a government-sponsored project that guarantees $350 in one periodCost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the projectRequired return is 10%18.18$10.1350$300$=+-=NPVNPVShould we accept or reject?16-8Selfish Stockholders Forego Positive NPV ProjectExpected CF from the government sponsored project:To Bondholder = $300To Stockholder = ($350 - $300) = $50PVof Bonds Without the Project = $200PVof Stocks Without the Project = $0PVof Bonds With the Project = $300 / 1.1 = $272.73PVof Stocks with the project = $50 / 1.1 - $100 = -$54.5516-9Selfish Strategy 3: Milking the PropertyLiquidating dividendsSuppose our firm paid out a $200 dividend to the shareholders....
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This note was uploaded on 04/25/2010 for the course MGMT 130A taught by Professor Stuff during the Winter '10 term at UCLA.

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MGMT_130_Lecture_16 - 16-1MGMT 130 Lecture 16Chapter 16:...

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