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Unformatted text preview: S S We can rewrite the right-hand side as: B B RB + RS = R0 + R0 S S Moving (B/S)RB to the right-hand side and rearranging gives us: RS = R0 + B (R0 – RB) S 366 CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT Answers to Concepts Review and Critical Thinking Questions 1. Direct costs are potential legal and administrative costs. These are the costs associated with the litigation arising from a liquidation or bankruptcy. These costs include lawyer’s fees, courtroom costs, and expert witness fees. Indirect costs include the following: 1) Impaired ability to conduct business. Firms may suffer a loss of sales due to a decrease in consumer confidence and loss of reliable supplies due to a lack of confidence by suppliers. 2) Incentive to take large risks. When faced with projects of different risk levels, managers acting in the stockholders’ interest have an incentive to undertake high-risk projects. Imagine a firm with only one project, which pays $100 in an expansion and $60 in a recession. If debt payments are $60, the stockholders receive $40 (= $100 – 60) in the expansion but nothing in the recession. The bondholders receive $60 for certain. Now, alternatively imagine that the project pays $110 in an expansion but $50 in a recession. Here, the stockholders receive $50 (= $110 – 60) in the expansion but nothing in the recession. The bondholders receive only $50 in the recession because there is no more money in the firm. That is, the firm simply declares bankruptcy, leaving the bondholders “holding the bag.” Thus, an increase in risk can benefit the stockholders. The key here is that the bondholders are hurt by risk, since the stockholders have limited liability. If the firm declares bankruptcy, the stockholders are not responsible for the bondholders’ shortfall. 3) Incentive to under-invest. If a company is near bankruptcy, stockholders may well be hurt if they contribute equity to a new project, even if the project has a positive NPV. The reason is that some (or all) of the cash flows will go to the bondholders. Suppose a real estate developer owns a building that is likely to go bankrupt, with the bondholders receiving the property and the developer receiving nothing. Should the developer take $1 million out of his own pocket to add a new wing to a building? Perhaps not, even if the new wing will generate cash flows with a present value greater than $1 million. Since the bondholders are likely to end up with the property anyway, why would the developer pay the additional $1 million and likely end up with nothing to show for it? 4) Milking the property. In the event of bankruptcy, bondholders have the first claim to the assets of the firm. When faced with a possible bankruptcy, the stockholders have strong incentives to vote for increased dividends or other distributions. This will ensure them of getting some of the assets of the firm before the bondholders can lay claim to them. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for the firm to undertake risky projects, even those with negative net present values. This incentive results from the fact that most of the risk of failure is borne by bondholders. Therefore, value is transferred from the bondholders to the shareholders by undertaking risky projects, even if the projects have negative NPVs. This incentive is even stronger when the probability and costs of bankruptcy are high. The firm should issue equity in order to finance the project. The tax-loss carry-forwards make the firm’s effective tax rate zero. Therefore, the company will not benefit from the tax shield that debt provides. Moreover, since the firm already has a moderate amount of debt in its capital structure, additional debt will likely increase the probability that the firm will face financial distress or bankruptcy. As long as there are bankruptcy costs, the firm should issue equity in order to finance the project. 2. 3. 4. Stockholders can undertake the following measures in order to minimize the costs of debt: 1) Use protective covenants. Firms can enter into agreements with the bondholders that are designed to decrease the cost of debt. There are two types of protective covenants. Negative covenants prohibit the company from taking actions that would expose the bondholders to potential losses. An example would be prohibiting the payment of dividends in excess of earnings. Positive covenants specify an action that the company agrees to take or a condition the company must abide by. An example would be agreeing to maintain its working capital at a minimum level. 2) Repurchase debt. A firm can eliminate the costs of bankruptcy by eliminating debt from its capital structure. 3) Consolidate debt. If a firm decreases the number of debt holders, it may be able to decrease the direct costs of bankruptcy should the firm become insolvent. Modigliani and Miller’s theory with corporate taxes indicates that, since there is a positive tax advantage of debt, the firm should maximize the amount of debt in its capital...
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