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FINA 4330

FINA 4330. Fall, 2010 The Static Tradeoff Theory of Capital Structure Lecture 22. Static Tradeoff Theorem. Costs of Financial Distress Potential Bankruptcy Costs Underinvestment Risk Shifting Agency Costs. General Approach. Assume: No Taxes Single period Cost of Capital = 10%.

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FINA 4330

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  1. FINA 4330 Fall, 2010 The Static Tradeoff Theory of Capital Structure Lecture 22

  2. Static Tradeoff Theorem • Costs of Financial Distress • Potential Bankruptcy Costs • Underinvestment • Risk Shifting • Agency Costs

  3. General Approach • Assume: • No Taxes • Single period • Cost of Capital = 10%

  4. Perfect Capital Market • Widgets International • Good State Bad State • Pure Equity 11 million 2.2 million • Probability of each state is 50% • Stockholders’ Wealth • V = $6 million • E = $6 million

  5. Bond and Stock Valuation • Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million. • What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (rB) is 5% • Then the value is B = E{Cash Flows}/1.05

  6. Debt valuation • What is the Yield to Maturity? (YTM) • What is the Expected Return? • This will require some work

  7. Perfect Capital Markets • Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%) Use proceed to repurchase equity • Widgets International • Good State Bad State Expected • Total 11 million 2.2 million 6.6 • Debt 4.2 million 2.2 million 3.2 • Equity 6.8 million 0 3.4 • Stockholders’ Wealth • V = $6 million • B = 3.2/(1.05) = $3.05 • E = $6 - $3.05 = $2.95 IF The Value of the Firm remains unchanged

  8. Valuation of Equity • If the value of the firm is independent of capital structure, • rE = ro + (ro-rB)B/S Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And: E = 3.4/1.1517 = ??? Finally What is Stockholders’ Wealth?

  9. Valuation of Equity • If the value of the firm is independent of capital structure, • rE = ro + (ro-rB)B/S Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And: E = 3.4/1.1517 = 2.95 Finally What is Stockholders’ Wealth?

  10. Debt Valuation • Yield to Maturity • Coupon rate • Expected (required) return to Bonds

  11. Bankruptcy Costs Widgets International Good State Bad State Pure Equity 11 million 2.2 million Probability of each state is 50% Stockholders’ Wealth V = $6 million E = $6 million

  12. Direct Bankruptcy Costs • Typically amounts to 2% to 5% of the distressed value of the firm • Widgets International • Again assume the same leverage of a bond promising to pay 4.4 million • Good State Bad (Default) • Total 11 million 2.2 million Bankruptcy cost 0.1 million • Net 11 million 2.1 million

  13. Impact of Bankruptcy Costs • Good State Bad (Default) • Total 11 million 2.2 million Bankruptcy cost (0.1 million) • Net 11 million 2.1 million • Value 5.95 million • Debt .5*(4.2+2.1)/1.05 3.00 million • Equity (residual) 2.95 million • Thus stockholders’ wealth declines by $50,000 • (SHW = 2.95 + 3 = 5.95 not 6) • Notice that it is the stockholders that pays the expected bankruptcy costs.

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