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11 11 18 Review Session 7 _Concept Review_

11 11 18 Review Session 7 _Concept Review_ - so they might...

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Managerial Finance: Review Session 7 TA: Pablo Villanueva November 18, 2011
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Agenda for Today 1. New Reasons why MM does not Hold Bankruptcy Costs (Financial Distress). Questions 16.8 and 16.12 Agency Costs of Leverage Excessive Risk Taking (Asset Substitution). Question 16.16 and 16.19 Debt Over Hang. Question 16.25. Agency Benefits of Leverage Assymetric Information Question 16.30
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Bankruptcy Costs 1. When firms go bankrupt, debtholders take over all the assets. However, this process has a cost that does not go to either equity or bond holders. This cost leaves the firm! 2. V L = V U + PV (Tax Shield) - PV (Financial Distress)
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Agency Cost of Leverage 1. Excessive Risk . Managers take excessive risk because they have limited liability in the downside! For them, it is the same that the value of the firm is equal to the value of debt or zero,
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Unformatted text preview: so they might as well take on projects with high upside. 2. Debt Overhang . If the firm faces financial distress, each extra dollar of return goes to debt holders so managers will not carry on some positive present value projects since the benefit goes to them. 3. Equity holders benefit from new investment only if: NPV I > β D D β E E Agency Benefits of Leverage 1. Leverage ties manager’s hands and it commits him/her to avoid wasteful investment. Assymetric Information 1. Only overvalued firms will raise equity. Manager’s who perceive the firm’s equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity....
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