Chapter 16 - Chapter 16 Relationship between MM theory with...

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Chapter 16 (excluding 16.8 and 16.9) Relationship between MM theory with taxes and real world behavior The search for costs of debt: Bankruptcy Direct costs of financial distress Indirect costs of financial distress Who bears costs of financial distress Taxes vs. bankruptcy costs: The tradeoff The three determinants of debt level Decision-Making in the real world Agency costs of equity Application to LBOs Bonding the managers How LBOs reduce agency costs The future of LBOs MM theory doesn’t work for the typical firm. L U C V V T B = + suggests that one can maximize a firms value by increasing leverage, but that’s unrealistic. MM doesn’t account for bankruptcy and its attendant costs, which explains why most firms are moderately levered. MM also ignores personal taxes. The personal tax rate on interest is higher than that for equity distributions, so bondholders offset the tax benefits to debt. 16.1 – Costs of Financial Distress Bankruptcy is a risk because of interest and principal payments are obligatory, but dividends aren’t. Ex on page 434 - CF of 50% chance 100 and 50 for two firms in following year, co 1 owes 49, co 2 owes 60. In situation where co 2 earns 50, only pays 50 b/c doesn’t have any more money, so stockholders don’t get anything. In other three cases, stockholders get the residual. -
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This note was uploaded on 10/06/2010 for the course FNCE 100 taught by Professor Jaffe during the Spring '10 term at UNC Asheville.

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Chapter 16 - Chapter 16 Relationship between MM theory with...

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