MGMT310_lecture23

# MGMT310_lecture23 - Simple Simpleexample...

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Simple example Assume that capital markets are competitive and that the appropriate discount rate for all cash flows is zero percent. There are no taxes or transactions costs. Two period economy (everything will be liquidated/disbursed at t=2) Dividends can be paid in a period as long as that period's promised payment to the bondholders is made first. Project t=0 t=1 t=2 NPV t=0 t=1 A -50 100 50 100 B -75 100 25 D bt 1 ? 20 100 0 Wh ld h if fi i D b 1? H b D b 2? Debt 1 ? -20 -100 Debt 2 ? -10 -50 0 1. What would happen if firm issues Debt 1? How about Debt 2? 2. Who do you think would bear the costs of increased leverage here? How much debt should the firm issue?

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Recap: under debt 1 Initially, suppose bondholders willing to pay \$120 upfront (remember, under debt 1 , they are promised \$20 at t=1, and another \$100 at t=2) If invest in both A and B: t=0 t=1 t=2 CF from assets 50 25 150 CF to BH 120 20 100 CF to SH 70 5 50 Recall CF identity: CF from assets = CF to BH + CF to SH If invest in A only: t=0 t=1 t=2 CF from assets 50 100 50 THUS, shareholders will choose to only invest in A. CF to BH 120 20 50 CF to SH 70 80 0 THUS, bondholders will only be willing to pay \$70 upfront!! Final outcome under debt 1: BH’s will only pay \$70 for bond, and PV(CF to SH) = 100 So… what happens under debt 2 (where BH’s are promised \$10 at t=1, and \$50 at t=2)?
Firm’s capital structure choice Firm s capital structure choice Tradeoff theory

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