1. Trade between tax benefits of debt and the costs of financial distress2. Implications of personal taxesDebt = obligation = potential of bankruptcyPromised payment of principal = 60RECESSION: can only pay 50***But 15 goes to bankruptcy lawyers before bondholders are paid***Stockholders banged…no obligationto pay dividendsPossibility of bankruptcy decreases value of firmIt is not the riskof bankruptcy but rather the costs associated with it.Boom (.50)Recession (.50)Earnings10050 *Can’t pay, so defaultDebt Repayment6035*Default = Costs (15)Dist to Stockholders400S = 40 x .5 + 0 x .5= 18.18D = 60 x .5 + 35 x .5= 22.214.171.124(Price stockholders would pay)(Price one would pay for debt)S + D = V = 67.36 Promise return or yield = 60 / 43.18 – 1 = .39(For debt)UNDERSTAND 434 and 435No bankruptcy costs:Bondholders willing to pay 50 for promised return of 60 (.2 return)In this case stockholders could receive this 50 as a dividendBankruptcy costs:Bondholders now only willing to pay 43.18 for debt (.39 return)Stockholders only receive 43.18 thus Bankruptcy costs hurt stockholdersSame result holds even if legal bankruptcy is prevented (Fncal Distress)A. Direct Costs: Legal and Admin costs of Liquidation or Reorganiztn.Level of debt chosento go bankrupt once every 20 years or (.05 / year)When bankruptcy occurs must pay .03 of current Market ValueCost estimates x probability of bankruptcy = expected cost of Bankrupt.03MV x .05 = .015MVB. Indirect costs of Financial Distress:Sales lost, buyers question – No way to estimate these costsMV = stockprice x # of shares outstandingC. Agency Costs – Conflicts of interest arise between stock/bondholders when debtThus, stockholders pursue selfish strategiesMagnified when financial distress occursSelfish Investment Strategy 1:Incentive to Take large Risks2 potential projects:Stockholders select highrisk project because avg value higher for themLOW RISK:Value=Stock+BondRecession (.50)100=0+100Boom (.50)200=100+100Expected value of firm = 150 (.5 x 100 + .5 x 200)Expected value of stock = 50 ( .5 x 0 + 5 x 100)HIGH RISK:Value=Stock+BondRecession (.50)50=0+50Boom (.50)240=140+100Expected Value of firm = 145 (.5 x 50 + .5 x 240)Expected value of stock = 70 (.5 x 0 + .5 x 140)*No matter what in each circumstance must first pay bondholders 100Stockholders take value from bondholders by selecting riskier projectsNothing to lose because not paid, thus capture increase in value during boom and bondholders take decrease in value during recession in aceSelfish Investment Strategy 2: Incentive toward underinvestmentOne is not going to invest in a building that will be repossessed even if the project has a positive NPV. (page 439)Project would have been accepted in an unlevered firmStockholders get banged however b/c expected increase < cost of proj.Selfish Investment Strategy 3:Milking the propertyPayout excess dividends in times of financial distress: less for bondholdSummary: ONLYif probability of financial distressOverall: Stockholders banged b/c bondholders raise iRates accordingly in order to make up for increased riskFor firms with these distortions, debt will be difficult and costly to obtain thus the firms will have low leverage ratios.