Chapter 16: Financial Distress, Managerial Incentives and Information
MM demonstrated that capital structure does not matter in
perfect capital market. (Ch. 14)
Yet, in chapter 15, we found a tax beneft of leverage, at least
up to the point that a frmms EBIT exceeds the interest
payments on the debt
Financial distress: when a frr has trouble reeting its
debt obligation.
o FD starts a process of resolving the broken contract with
creditors:
Private negotiation/workout
Reach an agreement with the B/H that will
make B/H and the company better.
Bankruptcy supervised by court
o If there is no bonds issuance and no trade credits
cant have fnancial distress.
We want to maximize the MV of the frm by maximizing equity
and debt size in pie and minimizing the taxes and destroyed
CF sizes.
o When debt rises, taxes size falls but destroyed CF size
rises.
In here, we consider how a frmms choice of capital structure
can afect its cost of fnancial distress, alter managersm
incentives and signal information to investors.
DEFAULT AND BANKRUPTCY IN A PERFECT MARKET
Debt fnancing puts an obligation on a frm.
A frm that fails to make the required interest or principal
payments on the debt is in default.
o A company goes bust only if the rarket value of its
assets is lower than its liabilities.
So for example: an investment in a new product. If it is a hit,
the company will be worth 150. If fail, the company will be
worth 80. The company considers both all–equity fnancing
and debt equity fnancing (100 debt).
Success Fail (U) Success Fail (L)
(U) (L)
Debt value - - 100 80
Equity 150 80 50 0
value
Total to all 150 80 150 80
investors
o In this scenario, without leverage, equity holders lose
$70M if the product fails. With leverage equity holders
lose $50M and debt holders lose $20M, but the total
loss is the sare (70M). So, the total loss that is
experienced by all investors are the sare
whether it’s levered or not.
o So, if the new product fails, the investors are
equally unhappy whether the frr is levered and
MM demonstrated that capital structure does not matter in
perfect capital market. (Ch. 14)
Yet, in chapter 15, we found a tax beneft of leverage, at least
up to the point that a frmms EBIT exceeds the interest
payments on the debt
Financial distress: when a frr has trouble reeting its
debt obligation.
o FD starts a process of resolving the broken contract with
creditors:
Private negotiation/workout
Reach an agreement with the B/H that will
make B/H and the company better.
Bankruptcy supervised by court
o If there is no bonds issuance and no trade credits
cant have fnancial distress.
We want to maximize the MV of the frm by maximizing equity
and debt size in pie and minimizing the taxes and destroyed
CF sizes.
o When debt rises, taxes size falls but destroyed CF size
rises.
In here, we consider how a frmms choice of capital structure
can afect its cost of fnancial distress, alter managersm
incentives and signal information to investors.
DEFAULT AND BANKRUPTCY IN A PERFECT MARKET
Debt fnancing puts an obligation on a frm.
A frm that fails to make the required interest or principal
payments on the debt is in default.
o A company goes bust only if the rarket value of its
assets is lower than its liabilities.
So for example: an investment in a new product. If it is a hit,
the company will be worth 150. If fail, the company will be
worth 80. The company considers both all–equity fnancing
and debt equity fnancing (100 debt).
Success Fail (U) Success Fail (L)
(U) (L)
Debt value - - 100 80
Equity 150 80 50 0
value
Total to all 150 80 150 80
investors
o In this scenario, without leverage, equity holders lose
$70M if the product fails. With leverage equity holders
lose $50M and debt holders lose $20M, but the total
loss is the sare (70M). So, the total loss that is
experienced by all investors are the sare
whether it’s levered or not.
o So, if the new product fails, the investors are
equally unhappy whether the frr is levered and
