公司理财（英文版·第5版）课件 第16章　财务困境、管理者激励与信息

CorporateFinanceFifthEditionChapter16FinancialDistress,ManagerialIncentives,andInformationCopyright©2020,2017,2014PearsonEducation,Inc.

AllRightsReservedChapterOutline(1of2)16.1

DefaultandBankruptcyinaPerfectMarket16.2

TheCostsofBankruptcyandFinancialDistress16.3

FinancialDistressCostsandFirmValue16.4

OptimalCapitalStructure:TheTradeoffTheoryChapterOutline(2of2)16.5ExploitingDebtHolders:TheAgencyCostsofLeverage16.6

MotivatingManagers:TheAgencyBenefitsofLeverage16.7AgencyCostsandtheTradeoffTheory16.8AsymmetricInformationandCapitalStructure16.9CapitalStructure:TheBottomLineLearningObjectives(1of3)Describetheeffectofbankruptcyinaworldofperfectcapitalmarkets.Listanddefinetwotypesofbankruptcyprotectionofferedinthe1978BankruptcyReformAct.Discussseveraldirectandindirectcostsofbankruptcy.LearningObjectives(2of3)Illustratewhy,whensecuritiesarefairlypriced,theoriginalshareholdersofafirmpaythepresentvalueofbankruptcyandfinancialdistresscosts.Calculatethevalueofaleveredfirminthepresenceoffinancialdistresscosts.Defineagencycosts,anddescribeagencycostsoffinancialdistressandagencybenefitsofleverage.LearningObjectives(3of3)Calculatethevalueofthefirm,includingfinancialdistresscostsandagencycosts.Explaintheimpactofasymmetricinformationontheoptimallevelofleverage.Describetheimplicationsofadverseselectionandthelemonsprincipleforequityissuance;describetheempiricalimplications.16.1DefaultandBankruptcyinaPerfectMarket(1of2)FinancialDistressWhenafirmhasdifficultymeetingitsdebtobligationsDefaultWhenafirmfailstomaketherequiredinterestorprincipalpaymentsonitsdebtorviolatesadebtcovenantAfterthefirmdefaults,debtholdersaregivencertainrightstotheassetsofthefirmandmayeventakelegalownershipofthefirm’sassetsthroughbankruptcy.16.1DefaultandBankruptcyinaPerfectMarket(2of2)AnimportantconsequenceofleverageistheriskofbankruptcyEquityfinancingdoesnotcarrythisrisk.Althoughequityholdershopetoreceivedividends,thefirmisnotlegallyobligatedtopaythem.ArminIndustries:LeverageandtheRiskofDefault(1of2)ArminisconsideringanewprojectAlthoughthenewproductrepresentsasignificantadvanceoverArmin’scompetitors’products,theproduct’ssuccessisuncertain.Ifitisahit,revenuesandprofitswillgrow,andArminwillbeworth$150millionattheendoftheyear.Ifitfails,Arminwillbeworthonly$80million.ArminIndustries:LeverageandtheRiskofDefault(2of2)Arminmayemployoneoftwoalternativecapitalstructures:Itcanuseall-equityfinancing.Itcanusedebtthatmaturesattheendoftheyearwithatotalof$100milliondue.Scenario1:NewProductSucceeds

(1of3)Ifthenewproductissuccessful,Arminisworth$150million.Withoutleverage,equityholdersownthefullamount.Withleverage,Arminmustmakethe$100milliondebtpayment,andArmin’sequityholderswillowntheremaining$50million.EvenifArmindoesnothave$100millionincashavailableattheendoftheyear,itwillnotbeforcedtodefaultonitsdebt.Scenario1:NewProductSucceeds

(2of3)Withperfectcapitalmarkets,aslongasthevalueofthefirm’sassetsexceedsitsliabilities,Arminwillbeabletorepaytheloan.Ifitdoesnothavethecashimmediatelyavailable,itcanraisethecashbyobtaininganewloanorbyissuingnewshares.Scenario1:NewProductSucceeds

(3of3)Ifafirmhasaccesstocapitalmarketsandcanissuenewsecuritiesatafairprice,thenitneednotdefaultaslongasthemarketvalueofitsassetsexceedsitsliabilities.Manyfirmsexperienceyearsofnegativecashflowsyetremainsolvent.Scenario2:NewProductFailsIfthenewproductfails,Arminisworthonly$80million.Withoutleverage,equityholderswilllose$20million.Withleverage,Arminwillexperiencefinancialdistressandthefirmwilldefault.Inbankruptcy,debtholderswillreceivelegalownershipofthefirm’sassets,leavingArmin’sshareholderswithnothing.Becausetheassetsthedebtholdersreceivehaveavalueof$80million,theywillsufferalossof$20million.ComparingtheTwoScenarios(1of3)Bothdebtandequityholdersareworseoffiftheproductfailsratherthansucceeds.Withoutleverage,iftheproductfailsequityholderslose$70million.

Withleverage,equityholderslose$50million,anddebtholderslose$20million,butthetotallossisthesame,$70million.Table16.1ValueofDebtandEquitywithandwithoutLeverage($Million)ComparingtheTwoScenarios(2of3)Ifthenewproductfails,Armin’sinvestorsareequallyunhappywhetherthefirmisleveredanddeclaresbankruptcyorwhetheritisunleveredandthesharepricedeclines.ComparingtheTwoScenarios(3of3)Note,thedeclineinvalueisnotcausedbybankruptcy:Thedeclineisthesamewhetherornotthefirmhasleverage.Ifthenewproductfails,Arminwillexperienceeconomicdistress,whichisasignificantdeclineinthevalueofafirm’sassets,whetherornotitexperiencesfinancialdistressduetoleverage.BankruptcyandCapitalStructureWithperfectcapitalmarkets,Modigliani-Miller(MM)PropositionIapplies:Thetotalvaluetoallinvestorsdoesnotdependonthefirm’scapitalstructure.Thereisnodisadvantagetodebtfinancing,andafirmwillhavethesametotalvalueandwillbeabletoraisethesameamountinitiallyfrominvestorswitheitherchoiceofcapitalstructure.TextbookExample16.1(1of3)BankruptcyRiskandFirmValueProblemSupposetherisk-freerateis5%,andArmin’snewproductisequallylikelytosucceedortofail.Forsimplicity,supposethatArmin’scashflowsareunrelatedtothestateoftheeconomy(i.e.,theriskisdiversifiable),sothattheprojecthasabetaof0andthecostofcapitalistherisk-freerate.ComputethevalueofArmin’ssecuritiesatthebeginningoftheyearwithandwithoutleverage,andshowthatM

MPropositionIholds.TextbookExample16.1(2of3)Solution

Withoutleverage,theequityiswortheither$150millionor$80millionatyear-end.Becausetheriskisdiversifiable,noriskpremiumisnecessaryandwecandiscounttheexpectedvalueofthefirmattherisk-freeratetodetermineitsvaluewithoutleverageatthestartoftheyear:Withleverage,equityholdersreceive$50millionornothing,anddebtholdersreceive$100millionor$80million.Thus,TextbookExample16.1(3of3)Therefore,thevalueoftheleveredfirmisWithorwithoutleverage,thetotalvalueofthesecuritiesisthesame,verifyingMMpropositionI.Thefirmisabletoraisethesameamountfrominvestorsusingeithercapitalstructure.AlternativeExample16.1(1of3)ProblemConsiderthefollowingoutcomesforthefollowingscenariosbothwithandwithoutleverageforMoonIndustries’newventure:ValueofDebtandEquitywithandwithoutLeverage($million)BlankWithoutLeverageBlankWithLeverageBlankBlankSuccessFailureSuccessFailureDebtvalueBlankBlank$150$90Equityvalue$250$90$100$0Totaltoallinvestors$250$90$250$90AlternativeExample16.1(2of3)ProblemAssumeMoon’snewventureisequallylikelytosucceedortofail.Therisk-freerateis4%.Theventurehasabetaof0,andthecostofcapitalisequaltotherisk-freerate.ComputethevalueofMoon’ssecuritiesatthebeginningoftheyearwithandwithoutleverage.AlternativeExample16.1(3of3)Solution

AsstatedbyM

MPropositionI,thetotalvalueofthefirmisunaffectedbyleverage.16.2TheCostsofBankruptcyandFinancialDistressWithperfectcapitalmarkets,theriskofbankruptcyisnotadisadvantageofdebt;rather,bankruptcyshiftstheownershipofthefirmfromequityholderstodebtholderswithoutchangingthetotalvalueavailabletoallinvestors.Inreality,bankruptcyisrarelysimpleandstraightforward.Itisoftenalongandcomplicatedprocessthatimposesbothdirectandindirectcostsonthefirmanditsinvestors.TheBankruptcyCode(1of4)TheU.S.bankruptcycodewascreatedsothatcreditorsaretreatedfairlyandthevalueoftheassetsisnotneedlesslydestroyed.U.S.firmscanfilefortwoformsofbankruptcyprotection:Chapter7orChapter11.TheBankruptcyCode(2of4)Chapter7LiquidationAtrusteeisappointedtooverseetheliquidationofthefirm’sassetsthroughanauction.Theproceedsfromtheliquidationareusedtopaythefirm’screditors,andthefirmceasestoexist.TheBankruptcyCode(3of4)Chapter11ReorganizationChapter11isthemorecommonformofbankruptcyforlargecorporations.WithChapter11,allpendingcollectionattemptsareautomaticallysuspended,andthefirm’sexistingmanagementisgiventheopportunitytoproposeareorganizationplan.Whiledevelopingtheplan,managementcontinuestooperatethebusiness.Thereorganizationplanspecifiesthetreatmentofeachcreditorofthefirm.TheBankruptcyCode(4of4)Chapter11ReorganizationCreditorsmayreceivecashpaymentsand/ornewdebtorequitysecuritiesofthefirm.Thevalueofthecashandsecuritiesistypicallylessthantheamounteachcreditorisowedbutmorethanthecreditorswouldreceiveifthefirmwereshutdownimmediatelyandliquidated.Thecreditorsmustvotetoaccepttheplan,anditmustbeapprovedbythebankruptcycourt.Ifanacceptableplanisnotputforth,thecourtmayultimatelyforceaChapter7liquidation.DirectCostsofBankruptcy(1of4)Thebankruptcyprocessiscomplex,time-consuming,andcostly.Costlyoutsideexpertsareoftenhiredbythefirmtoassistwiththebankruptcyprocess.Creditorsalsoincurcostsduringthebankruptcyprocess.Theymaywaitseveralyearstoreceivepayment.Theymayhiretheirownexpertsforlegal

andprofessionaladvice.DirectCostsofBankruptcy(2of4)Thedirectcostsofbankruptcyreducethevalueoftheassetsthatthefirm’sinvestorswillultimatelyreceive.Theaveragedirectcostsofbankruptcyareapproximately3%to4%ofthepre-bankruptcymarketvalueoftotalassets.AstudyofChapter7liquidationsofsmallbusinessesfoundthattheaveragedirectcostsofbankruptcywere12%ofthevalueofthefirm’sassets.DirectCostsofBankruptcy(3of4)Giventhedirectcostsofbankruptcy,firmsmayavoidfilingforbankruptcybyfirstnegotiatingdirectlywithcreditors.WorkoutAmethodforavoidingbankruptcyinwhichafirminfinancialdistressnegotiatesdirectlywithitscreditorstoreorganizeThedirectcostsofbankruptcyshouldnotsubstantiallyexceedthecostofaworkout.DirectCostsofBankruptcy(4of4)PrepackagedBankruptcy(Prepack)AmethodforavoidingmanyofthelegalandotherdirectcostsofbankruptcyinwhichafirmfirstdevelopsareorganizationplanwiththeagreementofitsmaincreditorsandthenfilesChapter11toimplementtheplan.Withaprepackagedbankruptcy,thefirmemergesfrombankruptcyquicklyandwithminimaldirectcosts.IndirectCostsofFinancialDistressAlthoughtheindirectcostsaredifficulttomeasureaccurately,theyareoftenmuchlargerthanthedirectcostsofbankruptcy.LossofCustomersLossofSuppliersLossofEmployeesLossofReceivablesFireSaleofAssetsDelayedLiquidationCoststoCreditorsOverallImpactofIndirectCosts(1of2)TheindirectcostsoffinancialdistressmaybesubstantialItisestimatedthatthepotentiallossduetofinancialdistressis10%to20%offirmvalue.OverallImpactofIndirectCosts(2of2)Whenestimatingindirectcosts,twoimportantpointsmustbeconsideredLossestototalfirmvalue(andnotsolelylossestoequityholdersordebtholdersortransfersbetweenthem)mustbeidentified.Theincrementallossesthatareassociatedwithfinancialdistress,aboveandbeyondanylossesthatwouldoccurduetothefirm’seconomicdistress,mustbeidentified.16.3FinancialDistressCostsandFirmValue(1of3)ArminIndustries:TheImpactofFinancialDistressCostsWithall-equityfinancing,Armin’sassetswillbeworth$150millionifitsnewproductsucceedsand$80millionifthenewproductfails.16.3FinancialDistressCostsandFirmValue(2of3)ArminIndustries:TheImpactofFinancialDistressCostsWithdebtof$100million,Arminwillbeforcedintobankruptcyifthenewproductfails.Inthiscase,someofthevalueofArmin’sassetswillbelosttobankruptcyandfinancialdistresscosts.Asaresult,debtholderswillreceivelessthan$80million.Assumedebtholdersreceiveonly$60millionafteraccountingforthecostsoffinancialdistress.Table16.2ValueofDebtandEquitywithandWithoutLeverage($Million)16.3FinancialDistressCostsandFirmValue(3of3)ArminIndustries:TheImpactofFinancialDistressCostsAsshownonthepreviousslide,thetotalvaluetoallinvestorsisnowlesswithleveragethanitiswithoutleveragewhenthenewproductfails.Thedifferenceof$20millionisduetofinancialdistresscosts.Thesecostswilllowerthetotalvalueofthefirmwithleverage,andM

M’sPropositionIwillnolongerhold.TextbookExample16.2(1of3)FirmValueWhenFinancialDistressIsCostlyProblemComparethecurrentvalueofArminIndustrieswithandwithoutleverage,giventhedatainTable16.2.Assumethattherisk-freerateis5%,thenewproductisequallylikelytosucceedorfail,andtheriskisdiversifiable.TextbookExample16.2(2of3)SolutionWithandwithoutleverage,thepaymentstoequityholdersarethesameasinExample16.1.Therewecomputedthevalueofunleveredequityas$106.52millionandthevalueofleveredequityas$23.81million.Butduetobankruptcycosts,thevalueofthedebtisnowTextbookExample16.2(3of3)Thevalueoftheleveredfirmiswhichislessthanthevalueoftheunleveredfirm,Thus,duetobankruptcycosts,thevalueoftheleveredfirmis$9.52millionlessthanitsvaluewithoutleverage.Thislossequalsthepresentvalueofthe$20millioninfinancialdistresscoststhefirmwillpayiftheproductfails:AlternativeExample16.2(1of4)ProblemExtendingthepreviousexample,assumenowthatthecostsoffinancialdistressare$15million:ValueofDebtandEquitywithandwithoutLeverage($million)BlankWithoutLeverageBlankWithLeverageBlankBlankSuccessFailureSuccessFailureDebtvalueBlankBlank$150$75Equityvalue$250$90$100$0Totaltoallinvestors$250$90$250$75AlternativeExample16.2(2of4)ProblemComputethevalueofMoon’ssecuritiesatthebeginningoftheyearwithandwithoutleveragegiventhatfinancialdistressiscostly.AlternativeExample16.2(3of4)SolutionAlternativeExample16.2(4of4)Solution

inthepresenceoffinancialdistresscosts.Thedifference,isthepresentvalueofthe$15millioninfinancialdistresscosts:WhoPaysforFinancialDistressCosts?

(1of3)ForArmin,ifthenewproductfails,equityholderslosetheirinvestmentinthefirmandwillnotcareaboutbankruptcycosts.However,debtholdersrecognizethatifthenewproductfailsandthefirmdefaults,theywillnotbeabletogetthefullvalueoftheassets.Asaresult,theywillpaylessforthedebtinitially(thepresentvalueofthebankruptcycostsless).WhoPaysforFinancialDistressCosts?

(2of3)Ifthedebtholdersinitiallypaylessforthedebt,lessmoneyisavailableforthefirmtopaydividends,repurchaseshares,andmakeinvestments.Thisdifferencecomesoutoftheequityholders’pockets.WhoPaysforFinancialDistressCosts?

(3of3)Whensecuritiesarefairlypriced,theoriginalshareholdersofafirmpaythepresentvalueofthecostsassociatedwithbankruptcyandfinancialdistress.TextbookExample16.3(1of3)FinancialDistressCostsandtheStockPriceProblemSupposethatatthebeginningoftheyear,ArminIndustrieshas10millionsharesoutstandingandnodebt.Arminthenannouncesplanstoissueone-yeardebtwithafacevalueof$100millionandtousetheproceedstorepurchaseshares.GiventhedatainTable16.2,whatwillthenewsharepricebe?Asinthepreviousexamples,assumetherisk-freerateis5%,thenewproductisequallylikelytosucceedorfail,andthisriskisdiversifiable.TextbookExample16.3

(2of3)SolutionFromExample16.1,thevalueofthefirmwithoutleverageis$109.52million.With10millionsharesoutstanding,thisvaluecorrespondstoaninitialsharepriceof$10.952pershare.InExample16.2,wesawthatwithleverage,thetotalvalueofthefirmisonly$100million.Inanticipationofthisdeclineinvalue,thepriceofthestockshouldfalltopershareonannouncementoftherecapitalization.Let’scheckthisresult.FromExample16.2,duetobankruptcycosts,thenewdebtisworth$76.19million.Thus,atapriceof$10pershare,Arminwillrepurchase7.619millionshares,leaving2.381millionsharesoutstanding.InExample16.1,wecomputedthevalueofleveredequityas$23.81million.DividingbythenumberofsharesgivesasharepriceafterthetransactionofTextbookExample16.3

(3of3)Thus,therecapitalizationwillcostshareholders$0.952pershareor$9.52millionintotal.ThiscostmatchesthepresentvalueoffinancialdistresscostscomputedinExample16.2.Thus,althoughdebtholdersbearthesecostsintheend,shareholderspaythepresentvalueofthecostsoffinancialdistressupfront.16.4OptimalCapitalStructure:TheTradeoffTheory(1of2)TradeoffTheoryThefirmpicksitscapitalstructurebytradingoffthebenefitsofthetaxshieldfromdebtagainstthecostsoffinancialdistressandagencycosts.16.4OptimalCapitalStructure:TheTradeoffTheory(2of2)AccordingtotheTradeofftheory,thetotalvalueofaleveredfirmequalsthevalueofthefirmwithoutleverageplusthepresentvalueofthetaxsavingsfromdebt,lessthepresentvalueoffinancialdistresscosts:ThePresentValueofFinancialDistressCosts(1of3)Threekeyfactorsdeterminethepresentvalueoffinancialdistresscosts:TheprobabilityoffinancialdistressTheprobabilityoffinancialdistressincreaseswiththeamountofafirm’sliabilities(relativetoitsassets).Theprobabilityoffinancialdistressincreaseswiththevolatilityofafirm’scashflowsandassetvalues.ThePresentValueofFinancialDistressCosts(2of3)Threekeyfactorsdeterminethepresentvalueoffinancialdistresscosts:ThemagnitudeofthecostsafterafirmisindistressFinancialdistresscostswillvarybyindustry.Technologyfirmswilllikelyincurhighfinancialdistresscostsduetothepotentialforlossofcustomersandkeypersonnel,aswellasalackoftangibleassetsthatcanbeeasilyliquidated.Realestatefirmsarelikelytohavelowcostsoffinancialdistressbecausethemajorityoftheirassetscanbesoldrelativelyeasily.ThePresentValueofFinancialDistressCosts(3of3)Threekeyfactorsdeterminethepresentvalueoffinancialdistresscosts:TheappropriatediscountrateforthedistresscostsDependsonthefirm’smarketriskNotethatbecausedistresscostsarehighwhenthefirmdoespoorly,thebetaofdistresscostshastheoppositesigntothatofthefirm.Thehigherthefirm’sbeta,themorenegativethebetaofitsdistresscostswillbe.Thepresentvalueofdistresscostswillbehigherforhighbetafirms.OptimalLeverage

(1of4)Forlowlevelsofdebt,theriskofdefaultremainslow,andthemaineffectofanincreaseinleverageisanincreaseintheinteresttaxshield.OptimalLeverage(2of4)Asthelevelofdebtincreases,theprobabilityofdefaultincreases.Asthelevelofdebtincreases,thecostsoffinancialdistressincrease,reducingthevalueoftheleveredfirm.OptimalLeverage(3of4)TheTradeofftheorystatesthatfirmsshouldincreasetheirleverageuntilitreachesthelevelforwhichthefirmvalueismaximized.Atthispoint,thetaxsavingsthatresultfromincreasingleverageareperfectlyoffsetbytheincreasedprobabilityofincurringthecostsoffinancialdistress.OptimalLeverage(4of4)TheTradeofftheorycanhelpexplainWhyfirmschoosedebtlevelsthataretoolowtofullyexploittheinteresttaxshield(duetothepresenceoffinancialdistresscosts).Differencesintheuseofleverageacrossindustries(duetodifferencesinthemagnitudeoffinancialdistresscostsandthevolatilityofcashflows).Figure16.1OptimalLeveragewithTaxesandFinancialDistressCostsTextbookExample16.4(1of2)ChoosinganOptimalDebtLevelProblemsGreenleafIndustriesisconsideringaddingleveragetoitscapitalstructure.Greenleaf’smanagersbelievetheycanaddasmuchas$35millionindebtandexploitthebenefitsofthetaxshield(forwhichtheyestimateHowever,theyalsorecognizethathigherdebtincreasestheriskoffinancialdistress.Basedonsimulationsofthefirm’sfuturecashflows,theC

F

Ohasmadethefollowingestimates(inmillionsofdollars):Debt01020253035PV(Interesttaxshield)0.001.503.003.754.505.25PV(Financialdistresscosts)0.000.000.381.624.006.38WhatistheoptimaldebtchoiceforGreenleaf?TextbookExample16.4(2of2)SolutionFromEquation16.1,thenetbenefitofdebtisdeterminedbysubtractingPV(Financialdistresscosts)fromPV(Interesttaxshield).ThenetbenefitforeachlevelofdebtisDebt01020253035NetBenefit0.001.502.622.130.50−1.13Thelevelofdebtthatleadstothehighestnetbenefitis$20million.Greenleafwillgain$3millionduetotaxshields,andlose$0.38millionduetothepresentvalueofdistresscosts,foranetgainof$2.62million.AlternativeExample16.4(1of3)

ProblemHolland,Inc.isconsideringaddingleveragetoitscapitalstructure.Holland’smanagersbelievetheycanaddasmuchas$50millionindebtandexploitthebenefitsofthetaxshield.TheyestimateτC=39%.However,theyalsorecognizethathigherdebtincreasestheriskoffinancialdistress.Basedonsimulationsofthefirm’sfuturecashflows,theC

F

Ohasmadetheestimatesonthenextslide(inmillionsofdollars):AlternativeExample16.4(2of3)ProblemDebt01020304050PV(Interesttaxshield)03.97.811.715.619.5PV(Financialdistresscosts)0003.3819.2323.47

WhatistheoptimaldebtchoiceforHolland?AlternativeExample16.4(3of3)SolutionDebt01020304050NetBenefit03.97.88.32−3.63−3.97Thelevelofdebtthatleadstothehighestnetbenefitis$30million.Hollandwillgain$11.7millionduetotaxshieldsandlose$3.38millionduetothepresentvalueoffinancialdistresscosts,foranetgainof$8.32million.16.5ExploitingDebtHolders:TheAgencyCostsofLeverage(1of2)AgencyCostsCoststhatarisewhenthereareconflictsofinterestbetweenthefirm’sstakeholdersManagementwillgenerallymakedecisionsthatincreasethevalueofthefirm’sequity.However,whenafirmhasleverage,managersmaymakedecisionsthatbenefitshareholdersbutharmthefirm’screditorsandlowerthetotalvalueofthefirm.16.5ExploitingDebtHolders:TheAgencyCostsofLeverage(2of2)ConsiderBaxter,Inc.,whichisfacingfinancialdistressBaxterhasaloanof$1milliondueattheendoftheyear.Withoutachangeinitsstrategy,themarketvalueofitsassetswillbeonly$900,000atthattime,andBaxterwilldefaultonitsdebt.ExcessiveRisk-TakingandAssetSubstitution(1of8)BaxterisconsideringanewstrategyThenewstrategyrequiresnoupfrontinvestment,butithasonlya50%chanceofsuccess.ExcessiveRisk-TakingandAssetSubstitution(2of8)Ifthenewstrategysucceeds,itwillincreasethevalueofthefirm’sassetto$1.3million.Ifthenewstrategyfails,thevalueofthefirm’sassetswillfallto$300,000.ExcessiveRisk-TakingandAssetSubstitution(3of8)Theexpectedvalueofthefirm’sassetsunderthenewstrategyis$800,000,adeclineof$100,000fromtheoldstrategy

Despitethenegativeexpectedpayoff,somewithinthefirmhavesuggestedthatBaxtershouldgoaheadwiththenewstrategyCanshareholdersbenefitfromthisdecision?ExcessiveRisk-TakingandAssetSubstitution(4of8)IfBaxterdoesnothing,itwillultimatelydefaultandequityholderswillgetnothingwithcertainty.EquityholdershavenothingtoloseifBaxtertriestheriskystrategy.Ifthestrategysucceeds,equityholderswillreceive$300,000afterpayingoffthedebt.Givena50%chanceofsuccess,theequityholders’expectedpayoffis$150,000.Table16.3OutcomesforBaxter’sDebtandEquityUnderEachStrategy($Thousand)ExcessiveRisk-TakingandAssetSubstitution(5of8)Equityholdersgainfromthisstrategy,eventhoughithasanegativeexpectedpayoff,whiledebtholdersloseIftheprojectsucceeds,debtholdersarefullyrepaidandreceive$1million.Iftheprojectfails,debtholdersreceiveonly$300,000.Thedebtholders’expectedpayoffis$650,000,alossof$250,000comparedtotheoldstrategy.

ExcessiveRisk-TakingandAssetSubstitution(6of8)Thedebtholders$250,000losscorrespondstothe$100,000expecteddeclineinfirmvalueduetotheriskystrategyandtheequityholder’s$150,000gain.Effectively,theequityholdersaregamblingwiththedebtholders’money.ExcessiveRisk-TakingandAssetSubstitution(7of8)AssetSubstitutionProblemWhenafirmfacesfinancialdistress,shareholderscangainattheexpenseofdebtholdersbytakinganegative-N

P

Vproject,ifitissufficientlyrisky.ExcessiveRisk-TakingandAssetSubstitution(8of8)Shareholdershaveanincentivetoinvestinnegative-N

P

V

projectsthatarerisky,eventhoughanegative-N

P

Vprojectdestroysvalueforthefirmoverall.Anticipatingthisbadbehavior,securityholderswillpaylessforthefirminitially.DebtOverhangandUnder-Investment

(1of5)NowassumeBaxterdoesnotpursuetheriskystrategy,butinsteadthefirmisconsideringaninvestmentopportunitythatrequiresaninitialinvestmentof$100,000andwillgeneratearisk-freereturnof50%.DebtOverhangandUnder-Investment

(2of5)Ifthecurrentrisk-freerateis5%,thisinvestmentclearlyhasapositiveN

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V.WhatifBaxterdoesnothavethecashonhandtomaketheinvestment?CouldBaxterraise$100,000in