CORPORATE FINANCE

18. How Much Should a Firm

Borrow
Trade off Theory; Pecking Order Theory

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 18-3 costs of financial distress

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 Figure 18.2 FIRM value

• Firm value is true if all-equity-financed plus PV tax shield

minus PV costs of financial distress

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 18-3 costs of financial distress

•Capital Structure
r
Bond Yield

D
E
Structure of Bond Yield Rates

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 18-3 costs of financial distress

•Traditional View of WACC Without Taxes

r
rE

Includes
Bankruptcy Risk

rD

D
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V 5
 18-3 costs of financial distress

•Cost of Financial Distress

• Costs arising from bankruptcy or distorted
business decisions before bankruptcy
•Market Value Equals Value If:
• All-equity financed
• + PV tax shield

• − PV costs of financial distress

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 18-3 costs of financial distress

Maximum value of firm

Costs of
financial distress

PV of interest
Market Value of the Firm

tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount Debt

of debt
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Figure 18.3 Comparison of limited and unlimited liability

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Figure 18.4 payout to ace limited security holders

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 18-3 Costs of financial distress

• Circular File company has $50 of one-year debt

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 18-3 Costs of financial distress

• Circular File Company has $50 of one-year debt

• Why does equity have any value?

• Shareholder option to obtain rights to assets
by paying $50 debt
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 18-3 Costs of financial distress

•Circular File Company invests $10

• Assume NPV of project is (-$2)

• What is effect on market values?
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 18-3 Costs of financial distress

•Circular File Company Value, Post-Project

•Firm value falls by $2

•Equityholder gains $3

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 18-3 Costs of financial distress

•Circular File Company Value

• Assumes safe project with NPV = $5

•Firm value rises and lack of potential payoff for

shareholders causes decrease in equity value

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 18-3 Costs of financial distress

•Financial Distress Games

• Cash In and Run
• Playing for Time

• Bait and Switch

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 18-3 Costs of financial distress

•Henrietta Ketchup has two possible investment

projects

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
•Trade-Off Theory
• Theory that capital structure is based on trade-off
between tax savings and distress costs of debt
•Pecking-Order Theory
• Theory stating firms prefer to issue debt over equity if
internal finances are insufficient

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
•Trade-Off Theory and Prices
• Stock-for-debt exchange offers results in stock price
falling
• Inversely, debt-for-stock exchange offers results in stock
price rising
• Issuing common stock drives down stock prices,
whereas repurchases increase stock prices
• Issuing straight debt has small negative impact

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
•Issues and Stock Prices
• Why do security issues affect stock prices when
demand for firm’s securities should be flat?
• Any firm is drop in bucket
• Plenty of close substitutes
• Large debt issues do not significantly depress stock
price

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
•Pecking-Order Theory
• Firms prefer internal finance
• Adapt target dividend payout ratios to investment
opportunities while avoiding changes in dividends

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
• Pecking-Order Theory
• Internally generated cash flows sometimes more than
capital expenditures, other times not
• Due to dividend policies, plus fluctuations in profitability
and investment opportunities
• If more, firm pays off debt or invests in marketable
securities
• If less, firm first draws down cash balance or sells
marketable securities

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
• Pecking-Order Theory
• If external finances are required, firms issue the safest
security first
• They start with debt then possibly hybrid securities, such
as convertible bonds, then equity as a last resort

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 18-4 PECKING ORDER OF FINANCIAL
CHOICES
•Pecking-Order Theory
• Internal equity may be better than external equity
• Financial slack is valuable

• If external capital is required debt is better

• There is less room for difference in opinions about what

debt is worth

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Thank You