Session 17: the effect of financial disstress, agency problems and asymmetric information

Question 0

Optimal capital structure in the presence of taxe and costs of financial distress: the trade-off theory

Answer 0

Vl=Vu+PV(interest TS)-PV(financial distress costs)

-> firms should use more debt as long as the incremental TS is higher than the additional costs for financial distress

Question 1

Factors that limit the advantage of debt

Answer 1

1. Financial distress and bankrupcy (increasing probability with increasing debts)
2. Agency problems (conflicts of interest between shareholders and debt-holders/management)
3. Asymmetric information

Question 2

Agency costs of debt

Answer 2

• the conflicts are more likely to occur when the risk of financial distress is high
• two types of investment strategies that represent this problem
  
  1. excessive risk-taking and asset substitution
  2. debt-overhang and under-investment

Question 3

The optimal capital structure: the trade- off theory with taxes, financial distress costs and agency problems

Answer 3

Vl=Vu+PV(interest TS)-PV(financial distress costs)-PV(agency costs of debt)+PV(agency benefits of debt)