Lecture9 - capital structure theory

All bonds mature tomorrow the firm has can undertake

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Unformatted text preview: firm, and thus likes risk a lot. option and risk 33 34 35 Incentive to Under-invest Debt Overhang A firm has assets with market value of $200, and $300 in firm debt outstanding. All bonds mature tomorrow. The firm has can undertake a riskless project with zero required return (the payoff is immediate) that costs $300 and has a payout of $350. The firm can only make this investment with additional equity capital. (No more debt may be issued) capital. What should the owner/manager do to maximize the value of What the firm? NPV=$350/1 – 300 = $50 NPV=$350/1 Equity holders should provide the additional $100 required. Equity 36 Incentive to Under-invest Debt Overhang What will a self-interested owner/manager do? No project With project Expected CF to bondholders $200 $300 Expected CF to Expected owner/manager owner/manager $0 $50 PV bonds $200 $300 PV stock $0 $50 Firm Value $200 $350 Since the equity holders have to pay $100 for their stake to Since start with, they would lose $50, and will not undertake the project even though it has positive NPV. The equity holdings will not invest the funds because bondholders would capture most of the gain. most 37 Milking the Property Shareholders may attempt to capture some of the firm’s Shareholders value by paying out extra dividends or higher salaries to management at times of financial distress. In this instance the protective covenants on bonds (e.g., the limitation of dividends) are important to bondholders. Such tactics often violate bond indentures. Such In our previous example, today the market value of the In firm is $200, but tomorrow debt matures, the firm will go bankrupt, bondholders will seize the company’s assets, and shareholders will get nothing. and So management can sell all of the firm’s assets, and pay So out the cash to existing shareholders through a large dividend before the firms goes bankrupt. dividend 38 How can firms reduce / manage costs How of financial distress? of Debt consolidation – Reduce number of parties to bargain with in Reduce bankruptcy / pre-bankruptcy negotiations bankruptcy Having stockholders hold debt – They act more like owners of the total firm cash flow. They Seek to maximize total firm value rather than fighting for more risky strategy (equity) or less risky strategy (debt). (debt). 39 How can firms reduce / manage costs of How financial distress? financial...
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This document was uploaded on 03/09/2014 for the course COMM 371 at UBC.

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