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30 Jan 2019

What are agency costs, and how are agency costs of financial distress different from agency benefits of leverage? Explain their impact on calculating the value of a firm with financial distress.

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Nelly Stracke
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2 Feb 2019

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In the MM world there is only benefit to borrowing. In reality, a firm’s debt capacity is limited by factors such as growth, asset structure, earning volatility, macro conditions, etc. According to financial theories these impediments result in financial distress and agency costs associated with debt usage. The tradeoff theory combines these factors together and suggests that managers should select an optimal capital structure that balances the tax benefit of debt against the financial distress and agency costs of debt.

The following problem is a quantitative, albeit simplistic, example of the tradeoff theory. Jon Jane, CFO of the Silly Pool Corp., is evaluating the firm’s current capital structure. Currently, the firm has $2.0 million debt in market value. The corporate tax rate is 40 percent. The following table provides pertinent information concerning the combined financial distress and agency costs associated with different levels of borrowing. Amount of debt Costs as a percent of debt 1.0 million 5% 2.0 million 7% 3.0 million 10% 4.0 million 14% 5.0 million 20% Given the firm’s current capital structure the combined financial distress and agency costs amount to 7% of the current borrowing which is 2.0 million. According to Jon’s estimate the firm’s β0 is 1.5 and Vu should be about $9.0 million. Expected return on the market portfolio, E(rm), is 14%. Expected return on a risk free portfolio, rf, is 2%.

1) Find Silly Pool’s current firm value. (10 points)

2) Is the firm’s current capital structure optimal? Define your answer and provide quantitative evidence to support your answer. {Requirement: You must define what you mean by an “optimal” capital structure and then use that definition to determine whether firms’ current capital structure is optimal.} (40 points)

The WACC, APV and FTE methods (described in Chapter 18) determine the value of an investment incorporating the tax shields associated with leverage. However, some other potential imperfections are associated with leverage: 1) 1) Issuance and other financing costs (underwriting fees for example) 2) 2) Security mispricing 3) 3) Financial distress and agency costs How do the previous three imperfections affect the valuation and your decision to invest? Where is going to be reflected the imperfections in the three methods (APV, WACC and FTE)? Hint: APV and WACC are two methods that organize the data (cash flows) in different order but reach the same value. So, try to contrast these two methods.

1. Your company pays interest on its 3 year, 6% coupon rate debt as follows: Year 1: $50 million Year 2: $40 million Year 3: $30 million The tax rate is 40%. What is the present value of the interest tax shield if the discount rate is 8%? 48 mil 41.76 mil 52.23 mil 32.18 mil

2. How does the interest deduction from taxes affect the conclusions of the MM Propositions? Firm value increases with leverage but WACC remains constant. Firm value decreases with leverage, and WACC is unaffected. Firm value decreases with leverage, and WACC inreases with leverage. Firm value increases with leverage and WACC decreases with leverage..

3.Which of the following is true about agency considerations in finding the optimal capital structure for a firm? No answer text provided. Outside equity costs more than debt, and debt costs more than retained earnings due to information asymmetry. Therefore, finance project with retained earnings first, debt second, and outside equity last. Through their control of management, stockholders will take more risk than what is in bondholders' interets. The optimal level of debt is determined by trading off the benefits of deducting interest from taxes and the costs of financial distress.

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