Corporate Finance

Questions and Practice problems_Chapter 17

Chapter 17:
Concept questions (page 553 textbook): 2, 3, 4, 5, 6
2. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders
for the firm to undertake risky projects, even those with negative net present values. This
incentive results from the fact that most of the risk of failure is borne by bondholders.
Therefore, value is transferred from the bondholders to the shareholders by undertaking
risky projects, even if the projects have negative NPVs. This incentive is even stronger
when the probability and costs of bankruptcy are high.
4. Stockholders can undertake the following measures in order to minimize the costs of
debt: 1) Use protective covenants. Firms can enter into agreements with the bondholders
that are designed to decrease the cost of debt. There are two types of protective
covenants. Negative covenants prohibit the company from taking actions that would
expose the bondholders to potential losses. An example would be prohibiting the
payment of dividends in excess of earnings. Positive covenants specify an action that the
company agrees to take or a condition the company must abide by. An example would be
agreeing to maintain its working capital at a minimum level. 2) Repurchase debt. A firm
can eliminate the costs of bankruptcy by eliminating debt from its capital structure. 3)
Consolidate debt. If a firm decreases the number of debt holders, it may be able to
decrease the direct costs of bankruptcy should the firm become insolvent.
6. There are two major sources of the agency costs of equity: 1) Shirking. Managers with
small equity holdings have a tendency to reduce their work effort, thereby hurting both
the debt holders and outside equity holders. 2) Perquisites. Since management receives all
the benefits of increased perquisites but only shoulder a fraction of the cost, managers
have an incentive to overspend on luxury items at the expense of debt holders and outside
equity holders.
Questions and Problems (page 554 textbook): 1, 2, 3, 4

Question and problem:

1. Firm Value Janetta Corp. has an EBIT rate of $975,000 per year that is expected to
continue in perpetuity. The unlevered cost of equity for the company is 14 percent, and
the corporate tax rate is 35 percent. The company also has a perpetual bond issue
outstanding with a market value of $1.9 million.
a. What is the value of the company?
$ 975,000×(1−35 %)
Value of the company= =$4,526,786
14 %
b. The CFO of the company informs the company president that the value of the company
is $4.8 million. Is the CFO correct?
=> The value of the company is $4.5 million and so the CFO would be wrong if he
provides such information
a. The value of a levered firm is:
VL = [EBIT(1 – tC)/R0] + tCB
VL = [975,000(1 –0 .35)/0.14] + 0.35x1,900,000
VL = $5,191,785.71
b.It's possible that the CFO is correct. The cost of any nonmarketed claims, such as
bankruptcy or agency costs, is not included in the value computed in component a.
2. Agency Costs Tom Scott is the owner, president, and primary salesperson for Scott
Manufacturing. Because of this, the company’s profits are driven by the amount of work
Tom does. If he works 40 hours each week, the company’s EBIT will be $550,000 per
year; if he works a 50-hour week, the company’s EBIT will be $625,000 per year. The
company is currently worth $3.2 million. The company needs a cash infusion of $1.3
million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume
there are no corporate taxes.
a. What are the cash flows to Tom under each scenario?
b. Under which form of financing is Tom likely to work harder?
c. What specific new costs will occur with each form of financing?
a. (1) Issue debt
- Interest payment = 1,300,000 x 0.08 = 104,000
- CF to Tom if he works 40 hours = 550,000 - 104,000 = 446,000
- CF to Tom if he works 50 hours = 625,000 - 104,000 = 521,000
(2) Issue equity
- The company value will increase by the amount of the equity issued. Therefore, Tom's
equity interest in the company will decrease to
3,200,000/(3,200,000 + 1,300,000) = 0.71
- CF to Tom if he works 40 hours = 550,000 x 0.71 = 390,500
- CF to Tom if he works 50 hours = 625,000 x 0.71 = 443,750
b. If the company issues debt, Tom will work harder because his CF is higher. Since
payments to bondholders are fixed, Tom will gain more benefits. Meanwhile, if the
company issues equity, stockholders will share proportionally in his hard work. This will
reduce his propensity for additional work.
c. There will be direct and indirect cost. The direct cost of both debt issues and equity
issues is the payments to bondholders and stockholders. The indirect cost of issuing debt
is the financial distress and bankruptcy cost. The indirect cost of issuing equity is the
shirking and perquisites.

3. Nonmarketed Claims Dream, Inc., has debt outstanding with a face value of
$6 million. The value of the firm if it were entirely financed by equity would be
$17.85 million. The company also has 350,000 shares of stock outstanding that sell
at a price of $38 per share. The corporate tax rate is 35 percent. What is the decrease
in the value of the company due to expected bankruptcy costs?

According to M & M Proposition I with taxes, the value of the levered firm is
VL = VU + TCB = $17,850,000 + $6,000,000 x 0.35 = $19,950,000
The value of the levered firm with market value of stock
VL = B + S = $6,000,000 + $38 x 350,000 = $19,300,000
The decrease in the value of the company due to expected bankruptcy costs
VT = VM + VN => VN = $19,950,000 - $19,300,000 = $650,000

4. Capital Structure and Nonmarketed Claims Suppose the president of the company
in the previous problem stated that the company should increase the amount of debt
in its capital structure because of the tax-advantaged status of its interest payments.
His argument is that this action would increase the value of the company. How
would you respond?
Taking on more debt increases a company's risk of bankruptcy. While debt in a
company's capital structure may be a good way to finance its operations, it does come
with risks.
As the company adds more debt to its capital structure, the company's WACC increases
beyond the optimal level, further increasing bankruptcy costs. In other words, bankruptcy
costs arise when there is a greater likelihood a company will default on its financial
obligations because it has decided to increase its debt financing rather than use equity.
In order to avoid financial devastation, companies should take into account the cost of
bankruptcy when determining how much debt to take on, or even whether they should
add to their debt levels at all.