Chapter 17 Notes

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10 Oct 2011

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Chapter 17 Capital Structure: Limits to the Use of Debt Notes
17.2 Description of Costs
Agency Costs
agency costs costs of conflicts of interest among shareholders, bondholders, and managers; agency costs are the costs of
resolving these conflicts; they include costs of providing managers with an incentive to maximize shareholder wealth and then
monitoring their behaviour, and the cost of protecting bondholders from shareholders; agency costs are borne by shareholders
17.3 Can Costs of Debt be Reduced?
Protective Covenants
because the shareholders must pay higher interest rates as insurance against their own selfish strategies, they frequently make
arrangements with bondholders in hopes of lowering rates
protective covenants parts of the indenture or loan agreement (between shareholders and bondholders) that limit certain
actions a company takes during the term of the loan to protect the lender’s interest
protective covenants can be classified into two types: negative covenants and positive covenants
negative covenant part of the indenture or loan agreement that limits or prohibits actions that the company may take
positive covenant part of the indenture or loan agreement that specifies an action that the company must abide by
17.4 Integration of Tax Effects and Financial Distress Costs
Pie Again
the pie theory says that all of these claims are paid from only one source, the cash flows (CF) of the firm
CF = payments to shareholders + payments to bondholders + payments to the government + payments to lawyers + payments to
any and all other claimants to the cash flows of the firms
the value of the firm, VT, is unaltered by the capital structure
VT = S + B + G + L where S is the value to shareholders, B is the value to bondholders, G stands for government and taxes,
and L is for lawyers (the cash flows to the claim L rise with the debt-equity ratio
essence of MM intuition and theory: V is V(CF) and depends on total cash flow of the firm; capital structure cuts it into slices
marketed claims claims that can be bought and sold in financial markets, such as those of S and B
nonmarketed claims claims that cannot be easily bought and sold in financial market, such as those of G and L
VT = S + B + G + L = VM + VNwhere VM is the value of the marketed claims and VN is the value of the nonmarketed claims
17.7 The Pecking-Order Theory
Rules of the Pecking Order
rule 1—use internal financing
the pecking-order theory implies that, if outside financing is required, debt should be issued before equity
only when the firm’s debt capacity is reached should the firm consider equity
rule 2—issue the safest securities first
there are a number of implications associated with the pecking-order theory that are at odds with the trade-off theory:
1) There is no target amount of leverage. According to the trade-off model, each firm balances the benefits of debt, such as the
tax shield, with the costs of debt, such as distress costs. The optimal amount of leverage occurs where the marginal benefit
of debt equals the marginal cost of debt.
By contrast, the pecking-order theory does not imply a target amount of leverage. Rather, each firm chooses its leverage
ratio based on financing needs. Firms first fund projects out of retained earnings. This should lower the percentage of debt
in the capital structure, because profitable, internally funded projects raise both the book value and the market value of
equity. Additional cash needs are met with debt, clearly raising the debt level. However, at some point the debt capacity of
the firm may be exhausted, giving way to equity issuance. Thus, the amount of leverage is determined by the happenstance
of available projects. Firms do not pursue a target ratio of debt to equity.
2) Profitable firms use less debt. Profitable firms generate cash internally, implying less need for outside financing. Because
firms desiring outside capital turn to debt first, profitable firms end up relying on less debt. The trade-off model does not
have this implication. The greater cash flow of more profitable firms creates greater debt capacity. These firms will use that
debt capacity to capture the tax shield and the other benefits of leverage.
3) Companies like financial slack. The pecking-order theory is based on the difficulties of obtaining financing at a reasonable
cost. A sceptical investing public thinks a stock is overvalued if the managers try to issue more of it, thereby leading to a
stock price decline. Because this happens with bonds but to a lesser extent, managers rely first on bond financing. However,
firms can issue only so much debt before encountering the potential costs of financial distress.
17.9 Personal Taxes
The Miller Model
VL = VU + [1 – {(1 – TC) × (1 – TS)} / (1 – TB)] × B
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