Chapter 17 - Capital Structure: Limits to the Use of Debt
67. The All-Mine Corporation is deciding whether to invest in a new project. The project would have to be financed by equity, the cost is $2,000 and will return $2,500 or 25% in one year. The discount rate for both bonds and stock is 15% and the tax rate is zero. The predicted cash flows are $4,500 in a good economy, $3,000 in an average economy and $1,000 in a poor economy. Each economic outcome is equally likely and the promised debt repayment is $3,000. Should the company take the project? What is the value of firm and its components before and after the project addition?
Determine cash flows before the project.
B = (($3,000 + $3,000 + $1,000)/3)/1.15 = $2,333.33/1.15 = $2,028.99 S = (($1,500 + $0 + $0)/3)/1.15 = $500/1.15 = $434.78
Determine value with project.
B = (($3,000 + $3,000 + $3,000)/3)/1.15 = $3,000/1.15 = $2,608.70 S = (($4,000 + $2,500 + $500)/3)/1.15 = $2,333.33/1.15 = $2,028.99
Do not accept as NPV goes mostly to bondholders not equity. Equity net change in value = ($2,028.99 - $434.78) - $2,000 = $-405.79
Topic: FIRM VALUE Type: ESSAYS
17-49
Chapter 17 - Capital Structure: Limits to the Use of Debt
68. Define and describe the direct and indirect costs of bankruptcy. Give three examples of each.
Direct Costs
- Legal and Administrative Costs - Accounting and other related fees
- These costs are easily measurable and studies have shown the direct costs of bankruptcy to be about 3% of the market value of the firm.
Indirect Costs
- These costs are harder to measure and studies estimate they may range in the vicinity of 20% of firm value. Some of the costs are highlighted below. - Loss of Business and Customers - Loss of Reputation
- Cost of lost supplies and other agents
Topic: DIRECT AND INDIRECT COST OF BANKRUPTCY Type: ESSAYS
69. What is the pecking order theory and what are the implications that arise from this theory? The company will first use internal financing, which includes retained earnings, and then issue safe securities. The company will issue debt before equity.
Implications
1. There is no target amount of leverage 2. Profitable firms use less debt 3. Companies like financial slack
Topic: PECKING ORDER THEORY Type: ESSAYS
17-50