Chapter 16 Limits to the Use of Debt.ppt

Chapter 16: Limits to the Use of Debt 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 MM Assumptions Homogeneous expectations. Homogeneous business risk classes. Perpetual cash flows: V = CF/r. Perfect capital markets No market frictions: corporate or personal taxes, issue costs, transactions costs, costs of financial distress. The Modigliani-Miller Capital Structure Propositions NO TAX CASE: Proposition I: VL = VU Proposition II: rS = r0 +(B/S)(r0-rB) WITH CORPORATE TAXES: Proposition I: VL = VU + TCB Proposition II: rS = r0 +(B/SL)(1- TC) (r0-rB) MM Theory with Taxes VL = VU + TCB implies firms should issue nearly all debt financing. Extensions personal taxes financial distress costs 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. Costs of Financial Distress Direct costs Indirect costs Financial distress costs result in an interior solution in the determination of optimal capital structure. VL = VU + PV(tax savings)-PV(costs of financial distress) Costs of Financial Distress Direct Costs Legal and administrative costs Indirect Costs Impaired ability to conduct business (e.g., lost sales) Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed