{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Lecture9 - capital structure theory

# 28 other financial distress costs agency costs of

This preview shows page 1. Sign up to view the full content.

This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: f firm value conditional upon bankruptcy) (about – Indirect Costs: Loss of Sales, destruction of supplier / Indirect employee relationships, uncertainty restricts investment, etc. 28 Other Financial Distress Costs Agency Costs of Debt (Think of an owner/manager trying to take advantage of bondholders) advantage – Excessive Risk Taking – Under-investment / Debt Overhang – Overpay Dividends / Milking Property Who bears the costs? Who – At first it looks like bondholders, but if bondholders are forwardllooking, they will anticipate these costs and demand a higher ooking, return in compensation. Ultimately, the owner/manager pays these costs these – Since the firm bears the cost, it will take it into consideration Since when choosing capital structure when 29 Incentive to Take Large Risks A firm has assets with market value of \$200, and \$300 in debt firm outstanding. All bonds mature tomorrow. outstanding. What would shareholders get if firm is liquidated today? What What would bondholders get? would For a cost of \$200, the owner/manager can make one last For investment with an immediate stochastic payoff. The discount rate for the project is 50%. Payoffs & probabilities are: rate Win Lose Prob. 10% 90% Payoff \$1000 \$ 0 30 Incentive to Take Large Risks What should the owner/manager do to maximize the What value of the firm? NPV={.9*0+.1*1000}/1.5-200=-133.33 < 0 NPV={.9*0+.1*1000}/1.5-200=-133.33 PV [Firm | Accept Project] = 200-133.33 = \$66.67 After the investment, the market value of the firm will After fall to \$66.7. fall 31 Incentive to Take Large Risks What will a self-interested owner/manager do? In the current situation the owner/manager will receive In nothing when the bonds mature tomorrow. Thus, he will prefer to undertake the project, as there is 10% chance of obtaining \$700 = \$1000-\$300. 10% The manager will take an negative NPV project!! The Bondholders will anticipate manager’s incentive to take negative NPV projects that hurt bond values and will demand higher returns to hold these bonds. 32 Incentive to Take Large Risks No project Expected CF to bondholders Expected CF to Expected owner/manager owner/manager With project \$200 .9x0+.1x300=\$30 \$0 .9x0+.1x700 = \$70 PV bonds \$200 \$30/1.5=\$20 PV stock \$0 \$70/1.5=\$47 \$200 \$20+\$47=\$67 Firm Value The owner/manager effectively has an out of the money call The option on the value of the...
View Full Document

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern