Topic 9 – Tutorial Questions + Answers

Discussion Questions

Briefly discuss bankruptcy costs.

There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative costs of
liquidation or reorganization. Indirect costs of potential bankruptcy (financial distress) include impaired
ability to conduct business and increased agency costs. Agency costs associated with managerial actions
under the threat of bankruptcy include: risk shifting, underinvestment or refusal to invest more equity,
cash in and run, bait, and switch, and playing for time.

Explain the pecking order theory of capital structure.

This theory is based on the observation that, in general, managers know more about the firm's
prospects, risks, and values than do outsiders. Their asymmetric information affects managers' choices
between internal and external financing and between new issues of debt and equity. The key problem is
the difficulty of selling securities to investors at a fair value. Investors infer—by the mere act of selling
stock—that the stock must be overvalued. The implication is that firms prefer internal financing to
external financing. When firms are propelled to go for external financing, they prefer debt to equity.
Question 1

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)
and equity for debt exchanges were bad news.

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?

c. How could Masulis’s results be explained?

a. Masulis’ results are consistent with the view that debt is always preferable because of its tax
advantage, but are not consistent with the “tradeoff” theory, which holds that management strikes a
balance between the tax advantage of debt and the costs of possible financial distress. In the tradeoff
theory, exchange offers would be undertaken to move the firm’s debt level toward the optimum.
That ought to be good news, if anything, regardless of whether leverage is increased or decreased.

b. The results are consistent with the evidence regarding the announcement effects on security issues
and repurchases.

c. One explanation is that the exchange offers signal management’s assessment of the firm’s prospects.
Management would only be willing to take on more debt if they were quite confident about future
cash flow, for example, and would want to decrease debt if they were concerned about the firm’s
ability to meet debt payments in the future.
Question 2

Agency costs The Salad Oil Storage (SOS) Company has financed a large 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:

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

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

c) Why SOS stockholders could gain from paying out a large cash dividend.

a. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt.
Under these conditions, the benefits of the project accrue to the bondholders.

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

c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend.
Stockholders get all of the assets, and the bondholders are left with nothing. (Note: fraudulent
conveyance laws may prevent this outcome.)
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, the announcement of a new stock issue to fund an investment project with an
NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past
evidence, management expects equity value to fall by $30 million. There may be several reasons for
the discrepancy:

(i) Investors may have already discounted the proposed investment. (However, this alone
would not explain a fall in equity value.)
(ii) Investors may not be aware of the project at all, but they may believe instead that cash is
required because of, say, low levels of operating cash flow.
(iii) Investors may believe that the firm’s decision to issue equity rather than debt signals
management’s belief that the stock is overvalued.
b. The fall in value is not an issue cost in the same sense as the underwriter’s spread. If the stock is
indeed overvalued, the stock issue merely brings forward a stock price decline that will occur
eventually anyway. If the 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 the project by an issue of debt.