Chapter 15 - Capital Structure: Limits to the Use of Debt

Why do firms prefer debt over equity as a source of external financing?

- debt is less likely to be mispriced - equity has more risk than debt

Advantages of using internal financing?

- it may be cheaper than debt or equity issues - it prevents the adverse market reaction that tends to accompany a stock issue

What will increase the value of stocks and bonds?

- reduction in government taxes - reduction in the claims of lawyers

Bondholders want to restrict the sale of corporate assets to avoid ______

- the transfer of corporate assets to shareholders - underinvestment by the firm

Consequences of raising debt to fool the market about the firm's value?

- what the market discovers the truth, share prices will drop - probability and expected costs of financial distress will increase if debt rises about the optimal level

From a tax shield perspective, why would a firm with low profits not borrow much?

Because the firm needs only a small interest deduction to offset pretax profits

When a bankruptcy is issued the ownership of assets is transferred from where to where?

From the shareholders to the bondholders

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

MM did not consider bankruptcy costs

Something to note

Management tries to reduce the value of nonmarketed claims

T/F - It is possible for the present value of distress costs to exceed the present value of tax savings

TRUE

Total value of firm is paid out to

Vt = S+B+G+L shareholders bondholders bankruptcy claims (nonmarketed) taxes (government) (nonmarketed)

free class flow hypothesis

We might expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to generate only small flows. The distribution of dividends benefits shareholders because it increases the amount of free cash flow available to managers for making bad acquisitions.

Rules of Pecking Order

What are the practical implications of the theory for financial managers? Rule #1: Use internal financing. Avoid investor skepticism by avoiding going to investors and finance through retained earnings Rule #2: Issue safe securities first. If outside financing is required, debt should be issued before equity (less risk)

Signaling

any announcement or action by the firm that conveys information to the market

Agency costs

are incurred with conflict between stockholders and bondholders

Relationship between a firm's profitability and its level of debt

as profitability increases, a firm will increase the level of debt

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

at high levels of debt

The ways in which a bankruptcy filing might hinder a firm's normal business operations -

banks may place restrictions on the firm's financial activities customers may not buy, fearing future service problems suppliers may not supply inventory, fearing nonpayment

Who pays to gain the privilege of receiving cash flows in the future?

bondholders and shareholders

T/F: It is easy to measure indirect costs of financial distress

false

The payment to lawyers become relevant in the context of capital structure decisions in the event of _________

financial distress

WACC rises at higher levels of debt owing to

financial distress costs

In bankruptcy cases, the claims of lawyers are _______ the claims of senior bondholders.

given priority over

Why do bond covenants restrict high risk investments by shareholders during financial distress?

high risk projects tend to transfer wealth from bondholders to shareholders

As more debt is added, present value of distress costs _____________

increases

What is generally the most important component of direct costs?

legal costs

agency costs include

leisure time, work-related perquisites, and unprofitable investments called agency costs because managers of the firm are agents of the stockholders

marketed vs unmarketed claims

marketed claims can be bought and sold in financial markets

Managers will try to _______ the value of marketed claims

maximize

Agency conflicts generally lead to agency costs, which ______ the value of the firm

reduce

LBO (leveraged buyouts)

significantly reduce the cost of equity In an LBO, a purchaser (usually a team of existing management) buys out the stockholders at a price above the current market. Company goes private. Managers work harder. Managers own most of the firm

value of the firm depends on the value of its

stocks and bonds

One of the most important reasons why firms choose to raise capital by issuing debt is _________ benefits of debt

tax

How does the level of debt affect the WACC?

the WACC initially falls and then rises as debt increases

Pecking order theory

the key - asymmetric information, manager must know more than his firm's prospects than does the typical investor

The effect of bankruptcy costs on the firm

they reduce the value of the firm

T/F -- increase debt level when profits are expected to INCREASE

true "raise firms debt levels when profits are expected to increase

Protective covenant

ways to reduce debt are frequently included with loan agreements and bond indentures Benefit shareholders by 1) lowering interest rates on bonds and 2) increasing firm value

consolidation of debt

ways to reduce debt perhaps one or a new lenders can shoulder the entire debt. different creditors (and their lawyers) contend with each other, this drives up costs