Debt Policy
Changing a firms capital structure should not affect its value to shareholders.
This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm.
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If this holds, can financial managers increase the value of the firm by changing the mix of securities used to finance the company?
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Before Restructuring:
After Restructuring:
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Shareholders can easily replicate a firms borrowing on their own if they choose.
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1.50
1.25
150,000
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MMs Proposition II
Debt increases financial risk and causes shareholders to demand higher rates of return.
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Bankruptcy Costs
If there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of all court expenses.
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Loan Covenant: Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.
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Financial Slack
Financial Slack: Ready access to cash or debt financing.
Financial managers usually place a very high value on having financial slack.
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Drawbacks
Too much financial slack may lead to lazy management. Managers may try to increase their own perks or engage in empire-building.
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