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Unformatted text preview: firm, and thus likes risk a lot.
risk 33 34 35 Incentive to Under-invest
A firm has assets with market value of $200, and $300 in
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)
What should the owner/manager do to maximize the value of
NPV=$350/1 – 300 = $50
Equity holders should provide the additional $100 required.
36 Incentive to Under-invest
What will a self-interested owner/manager do?
No project With project Expected CF to bondholders $200 $300 Expected CF to
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
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.
37 Milking the Property
Shareholders may attempt to capture some of the firm’s
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.
In our previous example, today the market value of the
firm is $200, but tomorrow debt matures, the firm will go
bankrupt, bondholders will seize the company’s assets,
and shareholders will get nothing.
So management can sell all of the firm’s assets, and pay
out the cash to existing shareholders through a large
dividend before the firms goes bankrupt.
38 How can firms reduce / manage costs
of financial distress?
Debt consolidation – Reduce number of parties to bargain with in
bankruptcy / pre-bankruptcy negotiations
bankruptcy Having stockholders hold debt – They act more like owners of the total firm cash flow.
Seek to maximize total firm value rather than fighting
for more risky strategy (equity) or less risky strategy
(debt). 39 How can firms reduce / manage costs of
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This document was uploaded on 03/09/2014 for the course COMM 371 at UBC.
- Spring '13