- Direct and indirect cost to bankruptcy

Topic 9 – Tutorial Questions - Direct costs include legal and administrative costs of liquidation or reorganisation
- Indirect costs include impaired ability to conduct business and increased agency costs
Discussion Questions - Agency costs associated with managerial actions under threat of bankruptcy (e.g. risk shifting,
underinevstment or refusal to invest more equity)
Briefly discuss bankruptcy costs. - Observation that managers know more about firm's prospects, risks, and
values than outsiders
Explain the pecking order theory of capital structure.- Their asymmetric information affects managers' choices between internal
and external financing ; between new issues of debt and equity
- Key problem: difficulty of selling securities to investors at fair value
Question 1 - Firms prefer internal financing to external financing
- WHen firms go for external financing -> prefer debt to equity
Ronald Masulis analyzed the stock price impact of exchange offers of debt for equity or vice versa.35 In
an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands
of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for
outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to
trade new shares for outstanding debt securities.

Masulis found that debt for equity exchanges were good news (stock price increased on announcement)
- Results are consistent with view that debt is always preferable because of its tax advantage; not
and equity for debt exchanges were bad news. consistent with "tradeoff" theory: management strikes balance between tax advantage of debt and costs
of possible financial distress
- In tradeoff theory: exchange offers would be undertaken to move firm's debt level toward optimum
a. Are these results consistent with the trade-off theory of capital structure?

b. Are the results consistent with the evidence that investors regard announcements of (1) stock issues
as bad news, (2) stock repurchases as good news, and (3) debt issues as no news, or at most trifling
disappointments? Results are consistent with evidence regarding announcement effects on security issues and repurchases
Exchange offers signal management's assessment of firm's prospects
c. How could Masulis’s results be explained?Management would only be willing to take on more debt if they were confident about
future CF
Decrease debt if they were concerned about firm's ability to meet debt payments in
future
Question 2

Agency costs The Salad Oil Storage (SOS) Company has financed a large bo part of its facilities with long-

term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain:

Why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.

Why SOS stockholders could gain by investing in a negative-NPV project financed by cash.

Why SOS stockholders could gain from paying out a large cash dividend.
a) SOS stockholders could lose if they invest in positive NPV project, then project becomes bankrupt -> under these conditions:
benefits of project accrue to bondholders (người cho nhà phát hành vay tiền thông qua việc mua trái phiếu)

b) If new project is sufficiently risky, even though it has positive NPV -> might increase stockholder wealth by more than money
invested -> result of the fact that, for very risky investment, undertaken by firm with significant risk of default, stockholders benefit if
more favorable outcome is actually realized, while cost of unfavorable outcomes is borne by bondholders

c) suppose project pays out all of assets as one lump-sum dividend -> stockholders get all assets, bondholders are left with nothing
Question 3

Pecking-order theory “I was amazed to find that the announcement of a stock issue drives down the
value of the issuing firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the
underwriter’s spread and the administrative costs of the issue. It makes common stock issues
prohibitively expensive.”

a. You are contemplating a $100 million stock issue. On past evidence, you anticipate that
announcement of this issue will drive down stock price by 3% and that the market value of your
firm will fall by 30% of the amount to be raised. On the other hand, additional equity financing is
required to fund an investment project that you believe has a positive NPV of $40 million.
Should you proceed with the issue?
b. Is the fall in market value on announcement of a stock issue an issue cost in the same sense as
an underwriter’s spread? Respond to the quote that begins this question.

Use your answer to part (a) as a numerical example to explain your response to part (b).
a)
Other things equal -> announcement of new stock issue to fund investment project with NPV of $40 mil increase equity value by $40
million (less issue costs)
Based on past evidence, management expects equity value to fall by $30 million -> several reasons:
- investors have already discounted proposed investment
- investors not be aware of project at all, but believe instead that cash is required because of low levels of operating CF
- investors believe that firm's decision to issue equity rather than debt signals management's belief that stock is overvalued

b)
Fall in value is not issue cost in same sense as underwriter's spread
If stock is indeed overvalued -> stock issue merely brings forward stock price decline that will occur eventually anyway
If stock is not overvalued -> management needs to consider whether it could release some information to convince investors that its
stock is correctly valued, or whether it could finance project by issue of debt