FIN 620-session 5 lecture

FIN 620-session 5 lecture - FIN 620 Long-Term Financial...

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FIN 620 Long-Term Financial Management Session 5  1. Lecture Notes/Comments RWJ, Chapter 17 In this session we will study an advanced topic I Capital Structure, the limits to the use of debt. Limits to the Use of Debt MM suggests capital structure is irrelevant. To the MM world if we add taxes, then the tax shield benefit of debt should drive firms to take on 100% debt financing (so that they can shield maximum income from taxes). However that is not what we observe in the real world. What are the costs of debt that prevent 100% debt financed firms? Costs of Financial Distress Direct Costs of Financial Distress : Legal and Administrative Costs of Liquidation or Reorganization. The key disadvantage of the use of debt is bankruptcy costs. Direct bankruptcy costs are the legal and administrative expenses directly associated with bankruptcy. Generally, these costs are quantifiable and measurable. Indirect bankruptcy costs (e.g., difficulties in hiring and retaining good people because the firm is in financial difficulty) are hard to measure and generally take the form of forgone revenues, opportunity costs, etc. Agency Costs - The selfish strategies represent agency costs between bondholders and stockholders. These costs exist because stockholders enjoy limited liability and payoffs to bondholders are limited. When a firm is in financial distress, investment strategies that maximize firm value may no longer maximize the value of stockholders. Firms close to
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FIN 620-session 5 lecture - FIN 620 Long-Term Financial...

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