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Chapter 17

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BU393 Chapter 17 – Capital Structure: Limits to the Use of Debt Week 8 Costs of Financial Distress Bankruptcy Risk or Bankruptcy Cost? -An ultimate distress is bankruptcy, in which ownership of the firm’s assets is legally transferred from the shareholders to the bondholders -Bankruptcy costs tend to offset the advantages of debt Description of Costs -Agency Costs – costs of conflicts of interest among shareholders, bondholders, and managers. Agency costs are the costs of resolving these conflicts. They include the 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 Can Costs of Debt be Reduced? Protective Covenants -Protective covenants – parts of the indenture or loan agreement that limit certain actions a company takes during the term of the loan to protect the lender’s interest -Negative covenant – part of the indenture or loan agreement that limits or prohibits actions that the company may take -Ex. The firm may not merge with another firm -Positive covenant – part of the indenture or loan agreement that specifies n action that the company must abide by -Ex. The company agrees to maintain its working capital at a minimum level -Three choices by shareholders to reduce bankruptcy costs: 1. Issue no debt 2. Issue debt with no restrictive and protective covenants 3. Write protective and restrictive covenants into the loan contracts Integration of Tax Effects and Financial Distress Costs -The firm’s value rises with leverage in the presence of corporate taxes -A firm’s capital structure decisions involve a trade-off between the tax benefits of debt and the costs of financial distress -MM fails when we add such real-world issues as taxes and bankruptcy costs -Marketed claims – claims that can be bought and sold in financial markets, such as those of shareholders and bondholders -Nonmarketed claims – claims that cannot be easily bought and sold in the financial markets, such as those of the government and litigants in lawsuits Signalling -Investors view debt as a signal
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