chapter17 - Chapter 17 Capital Structure: Limits to the Use...

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Chapter 17 Capital Structure: Limits to the Use of Debt Lecture Notes for Actsc 372 - Fall 2008 Ken Seng Tan Department of Statistics and Actuarial Science University of Waterloo K.S. Tan/Actsc 372 F08 Ch. 17Capital Structure: Limits to the Use of Debt – p. 1/35 Chapter Outline Cost of Financial Distress Trade-off theory of capital structure Signalling Free Cash Flow Hypothesis The Pecking-Order Theory Personal Taxes and its impact on capital structures How Firms Establish Capital Structure Some Empirical Evidences K.S. Tan/Actsc 372 F08 Ch. 17Capital Structure: Limits to the Use of Debt – p. 2/35 Financial Distress and Bankruptcy By borrowing through issuing bonds, the firm is the debtor ; while the bondholders, the creditors , legally entitled to interest and principal payments. The shareholders, the owners of the firm, have limited liabilities and only entitle to the portion (if any) in excess of the debt obligations. Financial distress arises when a corporation is not able to meet these financial obligations (i.e. interest and principal payments). Ultimately, if financial distress persists, the firm will declare bankruptcy Bankruptcy is a legal mechanism allowing creditors to take over when a firm defaults. K.S. Tan/Actsc 372 F08 Ch. 17Capital Structure: Limits to the Use of Debt – p. 3/35
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Example on Bankruptcy Risk and Bankruptcy Cost Corp. A, with $49 annual debt obligations, forecasts a cash flow of either $100 or $50 in the coming year, each occurring with 50% prob. Corp. B has identical cash flows prospects but has $60 annual debt obligations Corp. A Corp. A Boom Recession Boom Recession Cash flow 100 50 100 50 Distribution to bondholders 49 49 60 50 Distribution to shareholders 51 1 40 0 assume both bondholders and shareholders are risk-neutral and risk free rate 10%: Corp. S B V A 23.64 44.54 68.18 B 18.18 50 68.18 K.S. Tan/Actsc 372 F08 Ch. 17Capital Structure: Limits to the Use of Debt – p. 4/35 Example (cont’d) Corp. B’s bondholders’ promised return = 60 50 - 1 = 20% . In the event of financial distress, Corp. B’s bondholders are likely to receive the entire $50. A more realistic scenario for Corp. B would be: Boom Recession Cash flow 100 50 S = 18 . 18 Distribution to bondholders 50 35 B = 43 . 18 Distribution to shareholders 40 0 V = 61 . 36 Implications: The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the costs associated with bankruptcy. Bankruptcy cost also has a claim on the value of the company It is the stockholders who bear these costs. K.S. Tan/Actsc 372 F08 Ch. 17Capital Structure: Limits to the Use of Debt – p. 5/35 Cost of Financial Distress 3 types of cost associated with financial distress 1. Direct costs 2. Indirect costs 3. Agency costs 1. Direct Costs: Legal and administrative costs of Liquidation (e.g. lawyers, accountants, expert witness)
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chapter17 - Chapter 17 Capital Structure: Limits to the Use...

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