Chapter 16 - Chapter 16 Limits to the Use of Debt Theory...

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Chapter 16 Limits to the Use of Debt
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Theory vs. Reality Firms do not use an infinite amount of debt, why not? 1. Bankruptcy/financial distress costs 2. Personal taxes
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1. Costs of Financial Distress Example: Two firms with identical cash flows Knight Corp.- debt repayment of $49 Day Corp.- debt repayment of $60 Booms and recessions both occur with probability ½ Stockholders enjoy limited liability Knight Corp. Day Corp. Boom Recession Boom Recession Cash flow 100 50 100 50 Debt repayment 49 49 60 50 Cash to stockholders 51 1 40 0
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Example (continued) Assume all cash flows can be discounted at 10% Value of claims on Knight Corp : EKnight = (51 x .5 + 1 x .5) / 1.10 = $23.64 DKnight = (49 x .5 + 49 x .5) / 1.10 = $44.54 VKnight= 23.64 + 44.54 = $68.18 Value of claims on Day Corp : EDay = (40 x .5 + 0 x .5) / 1.10 = $18.18 DDay = (60 x .5 + 50 x .5) / 1.10 = $50 VDay = 18.18 + 50 = $68.18
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Problem with above analysis: In a recession Day Corp will default on its debt. The prospect of bankruptcy may further diminish cash flows. Why? -Lawyers’ fees -Loss in consumer confidence -Managers may not take care of equipment
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More realistic scenario Boom Recession Cash flow 100 50 Debt repayment 60 35 Cash to stockholders 40 0 New value of claims on Day Corp : EDay = (40 x .5 + 0 x .5) / 1.10 = $18.18 DDay = (60 x .5 + 35 x .5) / 1.10 = $43.18 VDay = 18.18 + 43.18 = $61.36 Note With no bankruptcy costs, equityholders can sell debt for $50 and maintain an equity claim worth $18.18 With bankruptcy costs, equityholders can sell debt for $43.18 and maintain an equity claim worth $18.18 Equityholders lose 50 – 43.18 = $6.82 due to bankruptcy costs. Bankruptcy costs are borne by equityholders since debtholders pay fair price for debt by anticipating bankruptcy costs.
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2. Description of types of bankruptcy costs A. Direct Costs Legal expenses, expert witnesses Administrative and accounting fees How large are these costs? For large firms on average 3% of market value of firm Direct bankruptcy costs are larger for smaller firms B. Indirect costs or agency costs Managers may have an incentive to make inefficient decisions that raise equity value while lowering total firm value- examples below These costs can amount to 20% of firm value
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Strategy #1- Taking on excessive risks Low Risk Project Prob. Firm Value Stock Value Bond Value Recession .5 $100 $0 $100 Boom .5 $200 $100 $100 Expected value of the firm = .5 x 100 + .5 x 200 = $150 Expected value of equity = .5 x 0 + .5 x 100 = $50 Expected value of debt = .5 x 100 + .5 x 100 = $100 High Risk Project Prob. Firm Value Stock Value Bond Value Recession .5 $50 $0 $50 Boom .5 $240 $140 $100 Expected value of the firm = .5 x 50 + .5 x 240 = $145 Expected value of equity = .5 x 0 + .5 x 140 = $70 Expected value of debt = .5 x 50 + .5 x 100 = $75 Managers will choose project 2
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Strategy #2- Underinvesting in safe projects Firm has $4,000 debt due next year
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Chapter 16 - Chapter 16 Limits to the Use of Debt Theory...

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