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Outline: Chapter 13 The Dynamics of the Capital Structure Decision. Transactions Costs and Capital Structure Decisions Financial distress costs Agency costs Impact of Capital Investment Decisions Signalling Capital structure impacts on firm value
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Transactions Costs and Capital Structure Decisions
If a firm has the following market-value-based balance sheet:
Cash $130 Debt $150
Other assets 33 Equity 13
The debt matures in one year at $260 and the following two investment projects are available
Low-Risk (LR) High-Risk (HR)
Today Possible Payoffs Today Possible Payoffs
Next Year Next Year
$250 (Pi = 0.30) $400 (Pi = 0.20)
$130 $130
$170 (Pi = 0.70) $0 (Pi = 0.80)
At a discount rate of 10% NPVLR = $46.36 and
NPVHR = -$57.27. Which project will the firm accept?
V’’L = VU + PV(Tax savings)
- PV(Financial distress costs)
- PV(Agency costs)
Agency costs ($)
Total agency costs
Agency
costs of
equity
Agency costs of debt
Financial leverage
B*/S
(B/S)
Optimal amount of debt
b) Financial Distress and Agency Costs
a) Tax Aspects
Total value of
Total value of
the firm, V($)
the firm, V($)
V = V + TB
L
U
Present value of tax shelter
Present value of tax shelter
mimus present value of
provided by interest on
financial distress
debt, TB
and agency costs
{
V’
U
{
V’
{
U
V’’
U
V
V
U
U
Present value of tax
shelter based on interest
and nondebt tax shields
Financial
Financial
leverage (B/S)
leverage (B/S)
B*/S
B*/S
Optimal amount of debt, B*
Optimal amount of debt, B*
Then capital structure does not affect a firm's value