FNCE 100 Ch. 16

FNCE 100 Ch. 16 - 1 Trade between tax benefits of debt and...

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1. Trade between tax benefits of debt and the costs of financial distress 2. Implications of personal taxes Debt = obligation = potential of bankruptcy Promised payment of principal = 60 RECESSION: can only pay 50 ***But 15 goes to bankruptcy lawyers before bondholders are paid*** Stockholders banged…no obligation to pay dividends Possibility of bankruptcy decreases value of firm It is not the risk of bankruptcy but rather the costs associated with it . Boom (.50) Recession (.50) Earnings 100 50 *Can’t pay, so default Debt Repayment 60 35 *Default = Costs (15) Dist to Stockholders 40 0 S = 40 x .5 + 0 x .5 = 18.18 D = 60 x .5 + 35 x .5 = 43.18 1.10 1.10 (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 435 No bankruptcy costs: Bondholders willing to pay 50 for promised return of 60 (.2 return) In this case stockholders could receive this 50 as a dividend Bankruptcy costs: Bondholders now only willing to pay 43.18 for debt (.39 return) Stockholders only receive 43.18 thus Bankruptcy costs hurt stockholders Same result holds even if legal bankruptcy is prevented (Fncal Distress) A. Direct Costs : Legal and Admin costs of Liquidation or Reorganiztn. Level of debt chosen to go bankrupt once every 20 years or (.05 / year) When bankruptcy occurs must pay .03 of current Market Value Cost estimates x probability of bankruptcy = expected cost of Bankrupt .03MV x .05 = .015MV B. Indirect costs of Financial Distress: Sales lost, buyers question – No way to estimate these costs MV = stockprice x # of shares outstanding C. Agency Costs – Conflicts of interest arise between stock/bondholders when debt Thus, stockholders pursue selfish strategies Magnified when financial distress occurs Selfish Investment Strategy 1: Incentive to Take large Risks 2 potential projects: Stockholders select highrisk project because avg value higher for them LOW RISK: Value = Stock + Bond Recession (.50) 100 = 0 + 100 Boom (.50) 200 = 100 + 100 Expected 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 + Bond Recession (.50) 50 = 0 + 50 Boom (.50) 240 = 140 + 100 Expected 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 100 Stockholders take value from bondholders by selecting riskier projects Nothing to lose because not paid, thus capture increase in value during boom and bondholders take decrease in value during recession in ace Selfish Investment Strategy 2: Incentive toward underinvestment One 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 firm Stockholders get banged however b/c expected increase < cost of proj. Selfish Investment Strategy 3:
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