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Chapter 17

BU393 Chapter Notes - Chapter 17: Capital Structure, Agency Cost, Cash Flow

Course Code
S I Li

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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
-Investors view debt as a signal of firm value
-Exchange offers – offers that allow shareholders to exchange debt with stock and vice versa,
either increasing or decreasing firm leverage
Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
-An individual will work harder for a firm if he or she is one of its owners rather than just an
-The individual will work harder as the owner of a larger percentage of the company
-Shareholders reduce bankruptcy costs and agency costs of debt through protective covenants
-For large firms, the monitoring role is played by the board of directors although there is
considerable controversy over boards’ effectiveness in this role
-An increase in dividends should benefit the shareholders by reducing the ability of managers to
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