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CHAPTER15CAPITALSTRUCTURE:LIMITSTOTHEUSEOFDEBTAnswerstoConceptsReviewandCriticalThinkingQuestions1.Directcostsarepotentiallegalandadministrativecosts.Thesearethecostsassociatedwiththelitigationarisingfromaliquidationorbankruptcy.Thesecostsincludelawyer’sfees,courtroomcosts,andexpertwitnessfees.Indirectcostsincludethefollowing:1)Impairedabilitytoconductbusiness.Firmsmaysufferalossofsalesduetoadecreaseinconsumerconfidenceandlossofreliablesuppliesduetoalackofconfidencebysuppliers.2)Incentivetotakelargerisks.Whenfacedwithprojectsofdifferentrisklevels,managersactinginthestockholders’interesthaveanincentivetoundertakehigh-riskprojects.Imagineafirmwithonlyoneproject,whichpays$100inanexpansionand$60inarecession.Ifdebtpaymentsare$60,thestockholdersreceive$40(=$100–60)intheexpansionbutnothingintherecession.Thebondholdersreceive$60forcertain.Now,alternativelyimaginethattheprojectpays$110inanexpansionbut$50inarecession.Here,thestockholdersreceive$50(=$110–60)intheexpansionbutnothingintherecession.Thebondholdersreceiveonly$50intherecessionbecausethereisnomoremoneyinthefirm.Thatis,thefirmsimplydeclaresbankruptcy,leavingthebondholders“holdingthebag.”Thus,anincreaseinriskcanbenefitthestockholders.Thekeyhereisthatthebondholdersarehurtbyrisk,sincethestockholdershavelimitedliability.Ifthefirmdeclaresbankruptcy,thestockholdersarenotresponsibleforthebondholders’shortfall.3)Incentivetounder-invest.Ifacompanyisnearbankruptcy,stockholdersmaywellbehurtiftheycontributeequitytoanewproject,eveniftheprojecthasapositiveNPV.Thereasonisthatsome(orall)ofthecashflowswillgotothebondholders.Supposearealestatedeveloperownsabuildingthatislikelytogobankrupt,withthebondholdersreceivingthepropertyandthedeveloperreceivingnothing.Shouldthedevelopertake$1millionoutofhisownpockettoaddanewwingtoabuilding?Perhapsnot,evenifthenewwingwillgeneratecashflowswithapresentvaluegreaterthan$1million.Sincethebondholdersarelikelytoendupwiththepropertyanyway,thedeveloperwillpaytheadditional$1millionandlikelyendupwithnothingtoshowforit.4)Milkingtheproperty.Intheeventofbankruptcy,bondholdershavethefirstclaimtotheassetsofthefirm.Whenfacedwithapossiblebankruptcy,thestockholdershavestrongincentivestovoteforincreaseddividendsorotherdistributions.Thiswillensurethemofgettingsomeoftheassetsofthefirmbeforethebondholderscanlayclaimtothem.2.Thestatementisincorrect.Ifafirmhasdebt,itmightbeadvantageoustostockholdersforthefirmtoundertakeriskyprojects,eventhosewithnegativenetpresentvalues.Thisincentiveresultsfromthefactthatmostoftheriskoffailureisbornebybondholders.Therefore,valueistransferredfromthebondholderstotheshareholdersbyundertakingriskyprojects,eveniftheprojectshavenegativeNPVs.Thisincentiveisevenstrongerwhentheprobabilityandcostsofbankruptcyarehigh.3.Thefirmshouldissueequityinordertofinancetheproject.Thetax-losscarry-forwardsmakethefirm’seffectivetaxratezero.Therefore,thecompanywillnotbenefitfromthetaxshieldthatdebtprovides.Moreover,sincethefirmalreadyhasamoderateamountofdebtinitscapitalstructure,additionaldebtwilllikelyincreasetheprobabilitythatthefirmwillfacefinancialdistressorbankruptcy.Aslongastherearebankruptcycosts,thefirmshouldissueequityinordertofinancetheproject.B-2SOLUTIONS4.Stockholderscanundertakethefollowingmeasuresinordertominimizethecostsofdebt:1)Useprotectivecovenants.Firmscanenterintoagreementswiththebondholdersthataredesignedtodecreasethecostofdebt.Therearetwotypesofprotectivecovenants.Negativecovenantsprohibitthecompanyfromtakingactionsthatwouldexposethebondholderstopotentiallosses.Anexamplewouldbeprohibitingthepaymentofdividendsinexcessofearnings.Positivecovenantsspecifyanactionthatthecompanyagreestotakeoraconditionthecompanymustabideby.Anexamplewouldbeagreeingtomaintainitsworkingcapitalataminimumlevel.2)Repurchasedebt.Afirmcaneliminatethecostsofbankruptcybyeliminatingdebtfromitscapitalstructure.3)Consolidatedebt.Ifafirmdecreasesthenumberofdebtholders,itmaybeabletodecreasethedirectcostsofbankruptcyshouldthefirmbecomeinsolvent.5.ModiglianiandMiller’stheorywithcorporatetaxesindicatesthat,sincethereisapositivetaxadvantageofdebt,thefirmshouldmaximizetheamountofdebtinitscapitalstructure.Inreality,however,nofirmadoptsanall-debtfinancingstrategy.MM’stheoryignoresboththefinancialdistressandagencycostsofdebt.Themarginalcostsofdebtcontinuetoincreasewiththeamountofdebtinthefirm’scapitalstructuresothat,atsomepoint,themarginalcostsofadditionaldebtwilloutweighitsmarginaltaxbenefits.Therefore,thereisanoptimallevelofdebtforeveryfirmatthepointwherethemarginaltaxbenefitsofthedebtequalthemarginalincreaseinfinancialdistressandagencycosts.6.Therearetwomajorsourcesoftheagencycostsofequity:1)Shirking.Managerswithsmallequityholdingshaveatendencytoreducetheirworkeffort,therebyhurtingboththedebtholdersandoutsideequityholders.2)Perquisites.Sincemanagementreceivesallthebenefitsofincreasedperquisitesbutonlyshoulderafractionofthecost,managershaveanincentivetooverspendonluxuryitemsattheexpenseofdebtholdersandoutsideequityholders.7.Themorecapitalintensiveindustries,suchasairlines,cab