Lectures Notes Finance first semester, Study notes of Economics

Download Lectures Notes Finance first semester and more Study notes Economics in PDF only on Docsity! Financial Distress Costs and Firm Value MM assumed that the cash flows of a firm’s assets do not depend on its choice of capital structure. As we have discussed, however, levered firms risk incurring financial distress costs that reduce the cash flows available to investors. Who Pays for Financial Distress Costs? The financial distress costs reduce the payments to the debt holders when the new product has failed. In that case, the equity holders have already lost their investment and have no further interest in the firm. It is true that after a firm is in bankruptcy, equity holders care little about bankruptcy costs. But debt holders are not foolish—they recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially. How much less? Precisely the amount they will ultimately give up—the present value of the bankruptcy costs. When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress. 16.4: Optimal Capital Structure: The Trade-Off Theory The analysis presented in this section is called the trade-off theory because it weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage. According to this theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs: The Present Value of Financial Distress Costs Three key factors determine the present value of financial distress costs: (1) the probability of financial distress, (2) the magnitude of the costs if the firm is in distress, and (3) the appropriate discount rate for the distress costs. The probability of financial distress depends on the likelihood that a firm will be unable to meet its debt commitments and therefore default. This probability increases with the amount of a firm’s liabilities. The magnitude of the financial distress costs will depend on the relative importance of the costs, and is also likely to vary by industry. Finally, the discount rate for the distress costs will depend on the firm’s market risk. The present value of distress costs will be higher for high beta firms. Optimal Leverage Figure 16.1 shows how the value of a levered firm, VL, varies with the level of permanent debt. With no debt, the value of the firm is VU. For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield. The costs of financial distress reduce the value of the levered firm, VL. The amount of the reduction increases with the probability of default, which in turn increases with the level of the debt D. The trade-off theory states that firms should increase their leverage until it reaches the level D* for which VL is maximized. At this point, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. The optimal debt choice for a firm with low costs of financial distress is indicated by D* low, and the optimal debt choice for a firm with high costs of financial distress is indicated by D* high. Not surprisingly, with higher costs of financial distress, it is optimal for the firm to choose lower leverage. The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield. Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.