\Chapter 17: Capital Structure:
Limits to the Use of Debt
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 theproject 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, the developer will 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 interest payments each year will be:
Interest payment = .12($80,000) = $9,600
This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario,
the value of equity will be zero since shareholders will never receive a payment. Since the
market value of the company’s debt is $80,000, and there is no probability of default, the total
value of the company is the market value of debt. This implies the debt to value ratio is 1 (one).