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,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,McGraw-Hill/Irwin,Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.,Click here for title,16-,0,Chapter Outline,16.1,Costs of Financial Distress,16.2 Description of Costs,16.3 Can Costs of Debt Be Reduced?,16.4 Integration of Tax Effects and Financial Distress Costs,16.5 Shirking,Perquisites,and Bad Investments:A Note on Agency Cost of Equity,16.6 The Pecking-Order Theory,16.7 Growth and the Debt-Equity Ratio,16.8 Personal Taxes,16.9 How Firms Establish Capital Structure,16.10 Summary and Conclusions,Chapter Outline16.1 Costs of F,16.1,Costs of Financial Distress,Bankruptcy risk versus bankruptcy cost.,The possibility of bankruptcy has a negative effect on the value of the firm.,However,it is not the risk of bankruptcy itself that lowers value.,Rather it is the costs associated with bankruptcy.,It is the stockholders who bear these costs.,16.1 Costs of Financial Distre,16.2,Description of Costs,Direct Costs,Legal and administrative costs(tend to be a small percentage of firm value).,Indirect Costs,Impaired ability to conduct business(e.g.,lost sales),Agency Costs,Selfish strategy 1:Incentive to take large risks,Selfish strategy 2:Incentive toward underinvestment,Selfish Strategy 3:Milking the property,16.2 Description of CostsDirec,Balance Sheet for a Company in Distress,AssetsBVMVLiabilitiesBVMV,Cash$200$200LT bonds$300,Fixed Asset$400$0Equity$300,Total$600$200Total$600$200,What happens if the firm is liquidated today?,The bondholders get$200;the shareholders get nothing.,$200,$0,Balance Sheet for a Company in,Selfish Strategy 1:Take Large Risks,The GambleProbabilityPayoff,Win Big10%$1,000,Lose Big90%$0,Cost of investment is$200(all the firms cash),Required return is 50%,Expected CF from the Gamble=$1000,0.10+$0=$100,Selfish Strategy 1:Take Large,Selfish Stockholders Accept Negative NPV Project with Large Risks,Expected CF from the Gamble,To Bondholders=$300,0.10+$0=$30,To Stockholders=($1000-$300),0.10+$0=$70,PV of Bonds Without the Gamble=$200,PV of Stocks Without the Gamble=$0,PV of Bonds With the Gamble=$30/1.5=$20,PV of Stocks With the Gamble=$70/1.5=$47,Selfish Stockholders Accept Ne,Selfish Strategy 2:Underinvestment,Consider a government-sponsored project that guarantees$350 in one period,Cost of investment is$300(the firm only has$200 now)so the stockholders will have to supply an additional$100 to finance the project,Required return is 10%,Should we accept or reject?,Selfish Strategy 2:Underinves,Selfish Stockholders Forego Positive NPV Project,Expected CF from the government sponsored project:,To Bondholder=$300,To Stockholder=($350-$300)=$50,PV,of Bonds Without the Project=$200,PV,of Stocks Without the Project =$0,PV,of Bonds With the Project=$300/1.1=$272.73,PV,of Stocks with the project=$50/1.1-$100=-$54.55,Selfish Stockholders Forego Po,Selfish Strategy 3:Milking the Property,Liquidating dividends,Suppose our firm paid out a$200 dividend to the shareholders.This leaves the firm insolvent,with nothing for the bondholders,but plenty for the former shareholders.,Such tactics often violate bond indentures.,Increase perquisites to shareholders and/or management,Selfish Strategy 3:Milking th,16.3,Can Costs of Debt Be Reduced?,Protective Covenants,Debt Consolidation:,If we minimize the number of parties,contracting costs fall.,16.3 Can Costs of Debt Be Redu,Protective Covenants,Agreements to protect bondholders,Negative covenant:Thou shalt not:,Pay dividends beyond specified amount.,Sell more senior debt&amount of new debt is limited.,Refund existing bond issue with new bonds paying lower interest rate.,Buy another companys bonds.,Positive covenant:Thou shall:,Use proceeds from sale of assets for other assets.,Allow redemption in event of merger or spinoff.,Maintain good condition of assets.,Provide audited financial information.,Protective CovenantsAgreements,16.4,Integration of Tax Effects and Financial Distress Costs,There is a trade-off between the tax advantage of debt and the costs of financial distress.,It is difficult to express this with a precise and rigorous formula.,16.4 Integration of Tax Effect,Integration of Tax Effects and Financial Distress Costs,Debt(,B,),Value of firm(,V,),0,Present value of taxshield on debt,Present value offinancial distress costs,Value of firm underMM with corporatetaxes and debt,V,L,=,V,U,+,T,C,B,V,=Actual value of firm,V,U,=Value of firm with no debt,B*,Maximumfirm value,Optimal amount of debt,Integration of Tax Effects and,The Pie Model Revisited,Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.,Let,G,and,L,stand for payments to the government and bankruptcy lawyers,respectively.,V,T,=S+B+G+L,The essence of the M&M intuition is that V,T,depends on the cash flow of the firm;capital structure just slices the pie.,S,G,B,L,The Pie Model RevisitedTaxes a,16.5,Shirking,Perquisites,and Bad Investments:The Agency Cost of,
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