Lect 15 221 web

Lect 15 221 web - 1 Managerial Finance Lecture 15 Asymmetry...

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Unformatted text preview: 1 Managerial Finance Lecture 15 Asymmetry of Information and the Costs of Raising Equity Capital Debt financing Benefits : Interest tax shield : reduce Costs : Costs of financial distress Interest tax shield : reduce tax bill Incentives : reduce waste and overinvestment Costs of financial distress Risk-shifting : invest in high risk NPV<0 projects Debt over-hang : unable to invest in NPV>0 projects 2 2 Controlling Overinvestment: Benefit When cash is abundant , managers may tend to overinvest Managers may be empire builders and like to invest/dislike to disinvest Even if there are no good investment opportunities available, managers may: Initiate negative NPV projects, or continue pet projects or failed investments Over-hire, pay excessive compensation , and consume lavish perks Make non-strategic acquisitions , or overpay for acquisitions Overinvestment is wasteful and decreases the value of the firm Debt is a disciplinary device Debt is a disciplinary device High leverage can force managers to payout cash rather than overinvest Takeaway . Debt as disciplinary device Low growth, high cash flow firms should have high leverage to maintain incentives for efficiency and reduce overinvestment Leverage and Risk-Taking: Agency Cost Highly leveraged firms have an incentive to make very risky investments Shareholders get the benefit if investment succeeds Bondholders bear the loss if investment fails (limited liability) Example: Suppose firm has future FCF worth $1,000 (current strategy) New strategy worth $1,300 (success) or $300 (failure), equally likely (50,50) Would you take it? (a) If the firm has no debt? (b) If firm has outstanding debt = $900? New Strategy Current Implication : firms that can easily and unexpectedly increase the risk profile of their investments should limit their leverage 200 600 300 400 900 100 900 800 300 1300 1000 Firm Value Expected Failure Success Strategy Equity Debt 3 Highly levered firms may under-invest due to a debt overhang When leverage is risky (not always paid) , debt will be worth less than comparable risk-free debt (the higher its risk, the lower its price) Debt Overhang and Underinvestment New positive NPV investments may decrease the risk of default, and increase the value of the debt Because some of the gains will accrue to debt holders , equity holders have less of an incentive to fund such new investments Example Suppose the market value of firm assets falls below the face value of debt Will equity holders contribute $100 to fund new investments worth $ 200 ? Book Value w/ New Investment Market Value Conclusion: Firms whose value depends on future growth should limit their leverage Low growth, mature firms can sustain more debt 5 Equity holders dont recoup their investment Debt holders gain $150 Book Value Assets 1,000 Debt 900 Equity 100 w/ New Investment...
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Lect 15 221 web - 1 Managerial Finance Lecture 15 Asymmetry...

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