Chap017 capital structure-limits to the use of debts.pptVIP

17-* Capital Structure: Limits to the Use of Debt Chapter 17 Copyright ? 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Key Concepts and Skills Define the costs associated with bankruptcy Understand the theories that address the level of debt a firm carries Tradeoff Signaling Agency Cost Pecking Order Know real world factors that affect the debt to equity ratio Chapter Outline 17.1 Costs of Financial Distress 17.2 Description of Financial Distress Costs 17.3 Can Costs of Debt Be Reduced? 17.4 Integration of Tax Effects and Financial Distress Costs 17.5 Signaling 17.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 17.7 The Pecking-Order Theory 17.8 Growth and the Debt-Equity Ratio 17.9 Personal Taxes 17.10 How Firms Establish Capital Structure 17.1 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. 17.2 Description of Financial Distress Costs Direct Costs Legal and administrative costs 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 Example: Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. $200 $0 Selfish Strategy 1: Take Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 NPV = –$200 + $100 (1.50) NPV = –$133 Self