QDai for FEUNL Finane I November 23. QDai for FEUNL Topics covered  Cost of financial distress Direct cost Indirect cost  Reducing cost of debt  Integration.

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Presentation transcript:

QDai for FEUNL Finane I November 23

QDai for FEUNL Topics covered  Cost of financial distress Direct cost Indirect cost  Reducing cost of debt  Integration of tax benefit and financial distress cost of debt

QDai for FEUNL Last class  MM with corporate tax  Theoretical suggestion:  Practice in the real world:  Cost of debt:

QDai for FEUNL Costs of financial distress  Direct costs:  Indirect costs: Impaired ability to conduct business Agency costs

QDai for FEUNL Balance Sheet for a Company in Distress AssetsBVMVLiabilitiesBVMV CashLT bonds Fixed AssetEquityTotal What happens if the firm is liquidated today?

QDai for FEUNL Selfish Strategy 1: Take Large Risks The GambleProbabilityPayoff Win Big10%$1,000 Lose Big90%$0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble =

QDai for FEUNL Selfish Stockholders Accept Negative NPV Project with Large Risks  Expected CF from the Gamble To Bondholders = To Stockholders =  PV of Bonds Without the Gamble  PV of Stocks Without the Gamble  PV of Bonds With the Gamble:  PV of Stocks With the Gamble:

QDai for FEUNL Selfish 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  the stockholders will have to supply an additional $100 to finance the project  Required return is 10% Should we accept or reject?

QDai for FEUNL Selfish Strategy 2: Underinvestment FirmDebtEquity Without project PV With project CF at t=1 PV

QDai for FEUNL Selfish 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.  Increase perquisites to shareholders and/or management

QDai for FEUNL Protective Covenants  Negative covenant:  Positive covenant:

QDai for FEUNL Reducing Costs of Debt  Debt Consolidation:

QDai for FEUNL Integration of Tax Effects and Financial Distress Costs  Trade-off between the tax advantage of debt and the costs of financial distress.

QDai for FEUNL Integration of Tax Effects and Financial Distress Costs Debt (B) Value of firm (V) 0 B*B* Maximum firm value Optimal amount of debt

QDai for FEUNL The Pie Model  V T =  Marketed claims:  Nonmarketed claims:

QDai for FEUNL Signaling  The firm’s capital structure is optimized where  Investors view debt as

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