33:390:400 Lecture Notes - Lecture 4: Agency Cost, Indirect Costs, Net Present Value
11 May 2018
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Chapter 17: Limits to the Use of Debt
17.1 Costs of Financial Distress
Debt
(+): Provides tax benefits to the company (1 – TR)
(-): Forces more interest and principal payment obligations (legally obligated)
- If missed Bankruptcy
- Bankruptcy: Ownership of firm’s assets go from stockholders to bondholders
Increase in Debt Increase in bankruptcy costs and financial distress costs
Ex:
- Company A owes $49 in debt.
- Company B owes $60 in debt
Company A Company B
Boom Rec. Boom Rec.
CF 100 50 100 50
Debt
Owed 49 49 60 50
Distribution
To 51 1 40 0
Stockholders
Recession for Company B – Owes $60 but can only pay $50. Bondholders seize all $50 in CF
but lose the other $10 b/c no company doesn’t have anymore money.
Both firms have the same value! Goes to show the effect leverage has on financial distress
Realistically:
- Bondholders will not actually get all $50.
- Company B will default lawyer fees, bankruptcy costs, etc. all diminishing CF
** Look at “Notes” on the “More Realistic Scenario” Example to see who pays for bankruptcy *
find more resources at oneclass.com
find more resources at oneclass.com
17.2 Description of Financial Distress Costs
Direct costs of financial distress:
- Legal and administrative costs of liquidation or reorganization
Indirect costs of financial distress:
- Impaired ability to conduct business
- Looks bad to customers harder to do business
Agency Costs: Conflicting interests between stockholders/bondholders
- Really exposed when there is financial distress
Strategies stockholders use to hurt bondholders and help themselves:
Selfish Investment Strategy #1: Incentive to Take Excessive Risks
- Firms near bankruptcy will take on more risk, as if they’re playing w/ someone else’s
money
Value of Firm if Low-Risk Project is Chosen:
Probability Value of Firm = Stock Bonds
Recession: .5 100 = 0 100
Boom: .5 200 = 100 100
Expected value of firm = (.5 x 100) + (.5 x 200) = 150
Expected value of equity = (.5 x 0) + (.5 x 100) = 50
Expected value of debt = (.5 x 100) + (.5 x 100) = 100
Value of Firm if High-Risk Project is Chosen:
Probability Value of Firm = Stock Bonds
Recession: .5 50 = 0 50
Boom: .5 240 = 140 100
Expected value of firm = (.5 x 50) + (.5 x 240) = 145
Expected value of equity = (.5 x 0) + (.5 x 140) = 70
Expected value of debt = (.5 x 50) + (.5 x 100) = 75
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Bankruptcy: ownership of firm"s assets go from stockholders to bondholders. Chapter 17: limits to the use of debt. Debt (+): provides tax benefits to the company (1 tr) (-): forces more interest and principal payment obligations (legally obligated) Increase in debt increase in bankruptcy costs and financial distress costs. Recession for company b owes but can only pay . Bondholders seize all in cf but lose the other b/c no company doesn"t have anymore money. Goes to show the effect leverage has on financial distress. ** look at notes on the more realistic scenario example to see who pays for bankruptcy * Bondholders will not actually get all . Company b will default lawyer fees, bankruptcy costs, etc. Firms near bankruptcy will take on more risk, as if they"re playing w/ someone else"s money. Really exposed when there is financial distress. Legal and administrative costs of liquidation or reorganization. Looks bad to customers harder to do business.
