BFF5520 Chap.9 Financing and Capital Structure II
Financing and Capital Structure II
Real-world leverage trades tax benefits against expected distress, agency and contracting costs. Distress costs include direct bankruptcy expenses and indirect losses that arise before default through customer, supplier, employee and investment responses. Agency conflicts can encourage risk shifting, underinvestment, cash distributions or senior claim issuance that transfers value from existing debt.
Trade-off theory emphasises a target where marginal benefits and costs balance. Pecking-order theory emphasises asymmetric information and a financing sequence from internal funds to debt and then external equity.
What this chapter covers
- 01
Direct bankruptcy costs
- 02
Indirect distress costs
- 03
Risk shifting
- 04
Underinvestment
- 05
Debt covenants
- 06
Agency costs of equity
- 07
Pecking-order theory
- 08
Trade-off theory
Worked example · free
Separate a transfer from a value change
- +1Initial firm value is $12 million + $48 million = $60 million.
- +1Final claim value is $17 million + $42 million = $59 million.
- +1Equity gains $5 million while existing debt loses $6 million.
- +2Of the debt loss, $5 million is transferred to equity; the remaining net $1 million reduces total value.
- +1The stated $2 million project effect cannot be reconciled with the final totals without another negative $3 million effect, which must be identified rather than ignored.
Key terms
- Financial distress
- Financial distress is difficulty meeting obligations and can impose costs before formal bankruptcy occurs.
- Risk shifting
- Risk shifting is the incentive for shareholders of a levered firm to prefer risky projects whose downside falls heavily on debt.
- Underinvestment
- Underinvestment occurs when shareholders reject a positive-NPV project because much of its value would accrue to existing creditors.
- Debt covenant
- A debt covenant is a contractual restriction designed to limit actions that weaken creditor value.
- Pecking order
- The pecking order ranks internal funds first, debt second and external equity last under information asymmetry.
- Trade-off theory
- Trade-off theory balances marginal financing benefits against expected distress and agency costs around a target.
Financing and Capital Structure II FAQ
Can distress costs arise without bankruptcy?
Yes. Customers may avoid a firm, suppliers may tighten terms, employees may leave, managers may become distracted and valuable investment may be delayed. Those indirect costs can reduce operating value before a legal filing.
What is the risk-shifting problem?
Shareholders can favour a risky project because they retain much of the upside while limited liability and debt priority place more downside on creditors. The project can transfer value even when it does not increase total firm value.
How do covenants respond to agency conflict?
Covenants restrict payouts, additional borrowing, collateral disposal or other actions that could weaken creditors. They can reduce agency costs but require monitoring and may block useful operating flexibility, so they are not free.
How do pecking order and trade-off differ?
Pecking order predicts a funding sequence driven by internal cash and information sensitivity. Trade-off theory predicts a target based on tax benefits and expected costs. A firm can have meaningful debt capacity yet borrow little when retained cash is abundant.
Why are market values important in distress?
Book amounts reflect historical accounting records, while market values reflect expected cash flow, risk and priority today. An apparently balanced book structure can leave debt bearing most economic exposure when equity market value has collapsed.
Exam move
Use stakeholder ledgers. For each proposed action, calculate the effect on existing debt, new debt, equity and total firm value. Name whether the result is value creation, value destruction or a transfer. Learn distress costs in direct and indirect groups, and connect risk shifting and underinvestment to the option-like residual equity payoff.
Compare the theories with the same firm: trade-off speaks to capacity and target, while pecking order speaks to funding sequence and current financing need. End predictions with the variable that makes them conditional, such as taxable income, tangibility, volatility, growth options or retained cash.
Separate direct legal and administrative distress costs from indirect losses involving customers, employees, suppliers, investment delay and asset fire sales. For agency cases, write payoffs to debt and equity across a low and high state before judging the project.
Risk shifting can benefit residual claimants while lowering total value; debt overhang can cause equity to reject a positive-NPV investment because much of the gain accrues to existing lenders. Identify the covenant, maturity choice, collateral or financing redesign that changes the incentive.
Compare trade-off and pecking-order predictions using identical firm facts, then note where they address different questions: a long-run leverage target versus the next financing source. Keep market leverage distinct from book leverage and explain why price movements can change the former without an issuance. In empirical answers, avoid a single universal prediction.
Profitability, tax capacity, tangibility and growth opportunities can affect several mechanisms at once, so name the theory, causal channel and relevant horizon for each stated relation.
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