Cost of debt Flashcards
Cost of financial distress
Direct costs include costs incurred during the bankruptcy process. It also includes costs of avoiding bankruptcy.
What are the costs incurred during bankruptcy process?
Administrative and legal costs: filings, lawyer etc.
What are the costs of avoiding bankruptcy?
Negotiating directly with creditors, developing a reorganisation plan.
Indirect costs of debt
Costs when a firm has difficulty meeting its debt obligations:
- Difficulty to manage firm e.g. loss of sales
- Loss of intangible assets
- Loss of key employees, suppliers, customers
- Fire sale of assets and products
How to decide whether to choose debt vs equity?
1) Trade-off theory
2) Pecking order theory
3) Market timing theory
Trade-off theory
The optimal amount of debt should balance tax benefits of debt with costs of financial distress.
Pecking order theory
Firms should structure their capital according to the following rule to minimise the cost of funding. First use internal funding and use equity as a last resort.
How to calculate the pre-tax cost of debt
Find R when NPV=0
How to find the after-tax cost of debt
R x (1- tax rate)
What is the market timing theory?
The act of choosing debt based on predictive methods and market conditions. This is by issuing equity when stock prices are high and issuing debt when interest rates are low.
What are two agency costs of debt?
1) Over-investment- when a firm faces financial distress shareholders can gain profit by taking excessive risk.
2) Under-investment- when a firm faces financial distress due to too much debt and refuses to take on positive NPV projects.
Selling the family silver can also occur.
Examples of agency cost of equity
1) Empire building: increasing firm size instead of profitability.
2) Wasteful investment: taking negative NPV projects when firms have high levels of free cash flow.
3) Managerial perks: maximising personal benefits.
4) Shirking: putting in less effort.
5) Costs of monitoring managers.
When does financial distress occur?
Dividend reductions, plummeting share prices, layoffs or plant closures.
What is a debt/equity swap?
A debt/ equity swap is a transaction in which a company or individual exchanges debt owed for equity shares.
How to maximise firm value?
By minimising the sum of two claims.
What are the opposite effects of debt?
1) Tax shield- increases firm value
2) Bankruptcy risk- decreases firm value
Impact of leverage on agency costs
Increases the agency cost of debt
- Encourage more over/under investment
- High-interest or debt covenants
Decreases the agency cost of equity
- Committment to interest payments decreasing this cost
Strategies to combat financial distress
- Asset expansion policies- acquisitions, joint ventures
- Financial policies- increase cash liquidity, reduce dividends, restructure
- Change in managerial control
- Declare bankruptcy
What is debt overhang?
When there is substantial existing debt which makes investors less willing to invest even if NPV is positive as they are unlikely to be paid back.
How to find price from P/E ratio
Use forecasted earnings and the equation P= P/E * E(forecasted earnings)
