PowerPoint PresentationKey Concepts and SkillsChapter Outline15.1 Costs of Financial DistressExample: Company in DistressSelfish Strategy 1: Take RisksSlide 7Selfish Strategy 2: UnderinvestmentSlide 9Selfish Strategy 3: Milking the Property15.2 Can Costs of Debt Be Reduced?15.3 Tax Effects and Financial DistressTax Effects and Financial DistressThe Pie Model Revisited15.4 Signaling15.5 The Agency Cost of Equity15.6 The Pecking-Order Theory15.7 How Firms Establish Capital StructureFactors in Target D/E Ratio15.8 The Bankruptcy ProcessThe Bankruptcy ProcessQuick Quiz15-1CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBTChapter 15Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.15-2KEY CONCEPTS AND SKILLS•Define the costs associated with bankruptcy•Explain and interpret the theories addressing the level of debt a firm carries•Tradeoff •Signaling•Agency Cost•Pecking Order•Describe real world factors that affect the debt to equity ratio15-3CHAPTER OUTLINE15.1 Costs of Financial Distress15.2 Can Costs of Debt Be Reduced?15.3 Integration of Tax Effects and Financial Distress Costs15.4 Signaling15.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity15.6 The Pecking-Order Theory15.7 How Firms Establish Capital Structure15.8 A Quick Look at the Bankruptcy Process15-415.1 COSTS OF FINANCIAL DISTRESS•Direct Costs•Legal and administrative costs •Indirect Costs•Impaired ability to conduct business (e.g., lost sales, compromised supply chain)•Agency Costs•Selfish Strategy 1: Incentive to take large risks•Selfish Strategy 2: Incentive toward underinvestment•Selfish Strategy 3: Milking the property15-5EXAMPLE: COMPANY IN DISTRESSAssets BV MV Liabilities BV MVCash $200 $200 LT bonds $300Fixed Asset $400 $0 Equity $300Total $600 $200 Total $600 $200What happens if the firm is liquidated today?The bondholders get $200; the shareholders get nothing.$200$015-6SELFISH STRATEGY 1: TAKE RISKSThe Gamble Probability PayoffWin Big 10% $1,000Lose Big 90% $0Cost of investment is $200 (all the firm’s cash)Required return is 50%Expected CF from the Gamble = $1000 × 0.10 + $0 = $100NPV = –$200 + $100 (1.50)NPV = –$13315-7SELFISH STRATEGY 1: TAKE RISKS•Expected CF from the Gamble•To Bondholders = $300 × 0.10 + $0 = $30•To Stockholders = ($1000 – $300) × 0.10 + $0 = $70•PV of Bonds Without the Gamble = $200•PV of Stocks Without the Gamble = $0$20 =$30 (1.50)• PV of Bonds With the Gamble:$47 =$70 (1.50)• PV of Stocks With the Gamble:15-8SELFISH STRATEGY 2: UNDERINVESTMENT•Consider a government-sponsored project that guarantees $350 in one period.•Cost of investment is $300 (the firm only has $200 now), so the stockholders will have to supply an additional $100 to finance the project.•Required return is 10%.-Should we accept or reject?NPV = –$300 + $350 (1.10)NPV = $18.1815-9SELFISH STRATEGY 2: UNDERINVESTMENTExpected CF from the government sponsored project:To Bondholder = $300To Stockholder = ($350 – $300) = $50PV of Bonds Without the Project = $200PV of Stocks Without the Project = $0$272.73 =$300 (1.10) PV of Bonds With the Project:– $10015-10SELFISH STRATEGY 3: MILKING THE PROPERTY•Liquidating dividends•Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.•Such tactics often violate bond indentures.•Increase perquisites to shareholders and/or management15-1115.2 CAN COSTS OF DEBT BE REDUCED?•Protective Covenants•Debt Consolidation:•If we minimize the number of parties, contracting costs fall.15-1215.3 TAX EFFECTS AND FINANCIAL DISTRESS•There is a trade-off between the tax advantage of debt and the costs of financial distress.•It is difficult to express this with a precise and rigorous formula.15-13TAX EFFECTS AND FINANCIAL DISTRESSDebt (B)Value of firm (V)0Present value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + tC BV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debt15-14THE PIE MODEL REVISITED•Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.•Let G and L stand for payments to the government and bankruptcy lawyers, respectively.•VT = S + B + G + L•The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.SGBL15-1515.4 SIGNALING•The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.•Investors view debt as a signal of firm value.•Firms with low anticipated profits will take on a low level of debt.•Firms with high anticipated profits will take on a high level of debt.•A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.15-1615.5 THE AGENCY COST OF EQUITY•An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.”•While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity.•The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.•The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.15-1715.6 THE PECKING-ORDER THEORY•Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. •Rule 1•Use internal financing first.•Rule 2•Issue debt next, new equity last.•The pecking-order theory is at odds with the tradeoff theory:•There is no target D/E ratio.•Profitable firms use less debt.•Companies like financial slack.15-1815.7 HOW FIRMS ESTABLISH CAPITAL STRUCTURE•Most corporations have low Debt-Asset ratios.•Changes in financial leverage affect firm value.•Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.•Another interpretation is that firms signal good news when they lever up.•There are differences in capital structure across industries.•There is