6 million 2400000 800000 if the expansion continues

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Unformatted text preview: structure. In reality, however, no firm adopts an all-debt financing strategy. MM’s theory ignores both the financial distress and agency costs of debt. The marginal costs of debt continue to increase with the amount of debt in the firm’s capital structure so that, at some point, the marginal costs of additional debt will outweigh its marginal tax benefits. Therefore, there is an optimal level of debt for every firm at the point where the marginal tax benefits of the debt equal the marginal increase in financial distress and agency costs. There are two major sources of the agency costs of equity: 1) Shirking. Managers with small equity holdings have a tendency to reduce their work effort, thereby hurting both the debt holders and outside equity holders. 2) Perquisites. Since management receives all the benefits of increased perquisites but only shoulder a fraction of the cost, managers have an incentive to overspend on luxury items at the expense of debt holders and outside equity holders. The more capital intensive industries, such as air transport, television broadcasting stations, and hotels, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the process. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it. 5. 6. 7. 8. 9. 368 10. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The bankruptcy filing enabled Continental to restructure and keep flying. The other side is that Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental simply abrogated them to the detriment of its employees. In this, and the last several questions, an important thing to keep in mind is that the bankruptcy code is a creation of law, not economics. A strong argument can always be made that making the best use of the bankruptcy code is no different from, for example, minimizing taxes by making best use of the tax code. Indeed, a strong case can be made that it is the financial manager’s duty to do so. As the case of Continental illustrates, the code can be changed if socially undesirable outcomes are a problem. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. Using M&M Proposition I with taxes, the value of a levered firm is: VL = [EBIT(1 – tC)/R0] + tCB VL = [$850,000(1 – .35)/.14] + .35($1,900,000) VL = $4,611,428.57 b. 2. a. The CFO may be correct. The value calculated in part a does not include the costs of any nonmarketed claims, such as bankruptcy or agency costs. Debt issue: The company needs a cash infusion of $1.2 million. If the company issues debt, the annual interest payments will be: Interest = $1,200,000(.08) = $96,000 The cash flow to the owner will be the EBIT minus the interest payments, or: 40 hour week cash flow = $400,000 – 96,000 = $304,000 50 hour week cash flow = $500,000 – 96,000 = $404,000 Equity issue: If the company issues equity, the company value will increase by the amount of the issue. So, the current owner’s equity interest in the company will decrease to: Tom’s ownership percentage = $2,500,000 / ($2,500,000 + 1,200,000) = .68 369 So, Tom’s cash flow under an equity issue will be 68 percent of EBIT, or: 40 hour week cash flow = .68($400,000) = $270,270 50 hour week cash flow = .68($500,000) = $337,838 b. Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more under this form of financing since the payments to bondholders are fixed. Under an equity issue, new investors share proportionally in his hard work, which will reduce his propensity for this additional work. The direct cost of both issues is the payments made to new investors. The indirect...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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