Session 7: Capital Structure. C15.0008 Corporate Finance Topics. Outline. Distress costs Agency conflicts Finding the optimal capital structure. Financial Distress Costs. Direct costs Lawyers, accountants, consultants fees Forced asset sales Indirect costs Wasted time and energy
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C15.0008 Corporate Finance Topics
Since the market is smart, bondholders anticipate future actions and demand protection up front
VL = VU + PV(tax shield)
- PV(financial distress costs)
- PV(agency costs)
Financial distress and agency costs (bondholder vs. stockholder) increase as the amount of debt increases.
Optimal capital structure trades off the tax benefits of debt with financial distress and agency costs.
Financial distress and
V = UCFt/(1+rWACC)t
UCF = EBIT(1-T) + depreciation – capex – nwc
Large manufacturing companies
VL = VU + PV(tax shield) - PV(financial distress costs)
Source: Altman, 1971-2002
% of high yield bonds defaulting in a given year
VU = S
Liquidating dividend is only cash flow
Value via DCF
VU = S = 3.27
VL = S + B = 1.45 + 2 =3.45
VL = VU + PV(tax shield) - PV(f.d. costs) ?
The tax shield is risk-less (even though the debt is risky):
PV(tax shield) = [56.65%(2)(0.4)/1.02]