Lecture 16, Ch 16 UGBA 103 2011

Lecture 16, Ch 16 UGBA 103 2011 - Chapter 16 Financial...

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Chapter 16 Financial Distress, Managerial Incentives, and Information
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Debt-to- Value Ratio [ D / ( E + D )] for Select Industries Source: Capital IQ, 2009.
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Do Firms Shield all their Taxes?
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Suppose that you are the sole shareholder in a firm whose only asset is $1,000,000 in cash. The firm has $1,500,000 in debt due tomorrow. Which of these options is in your economic best interest (assuming all are legally feasible)? Issue a cash dividend of $999,999 to shareholders (i.e., yourself). Fly to Las Vegas and bet the firm’s $1,000,000 on red at the roulette wheel. Accept an opportunity to invest the firm’s $1,000,000 plus an additional $100,000 (which you must raise by selling additional equity in the firm to yourself) for a certain payoff of $1,200,000 tomorrow. Negotiate with debt holders to reduce debt payment to $1,050,000 and accept C.
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Why do firms not use more debt thereby reducing corporate taxes? • There must be something counterbalancing taxes.
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6 Bankruptcy (no taxes) • Up to now we have not explicitly considered the possibility of bankruptcy. Might this change the basic MM result of capital structure irrelevance?
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7 Example • Consider two corporations in a world without frictions: Fly by Night and Fly by Day. They are identical in every way, except FbN is all equity, while FbD has $1 million in debt outstanding (due in 1 year). Both will liquidate in one year. The liquidating value of the firms could be either $500,000, $5 mil or $10 million. The risk is purely idiosyncratic and the probability of each state is the same. The risk free rate in the economy is 8%. What is the value of the two companies?
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What is the promised payment on FbD’s debt? What is the interest rate? D FbD = $1,000,000 = *$500000 + * P + * P 1.08 P = $1.370 million Interest rate is 37%. E FbN = *$500000 + *$5 million + *$10 million 1.08 = $4.7839 E FbD + D FbD = $4.78 million E FbD + $1 million = $4.78 million E FbD = $3.78 million
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9 Effect of Bankruptcy • If there are no costs associated with bankruptcy, then MM I and II hold.
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This note was uploaded on 09/11/2011 for the course UGBA 103 taught by Professor Berk during the Spring '07 term at University of California, Berkeley.

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Lecture 16, Ch 16 UGBA 103 2011 - Chapter 16 Financial...

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