Chapter III

• Loss of Customers, Suppliers, Employees, Receivables

• Fire Sale of Assets

• Delayed Liquidation

• Costs to Creditors

Average costs of bankruptcy are approx. 3-4% of the pre-bankruptcy market value

• Costly outside experts (RX bankers, Lawyers)

• Delayed payments

If securities are fairly priced, the orignal shareholders pay the PV of financial distress costs

The firm picks its capital structure by trading off the benefits of tax shield against the cost of financial distress and agency costs

Firms increase leverage until they maximize firm value

A situation arsing as the result of the separation of ownership and control in which managers may make decisions that benefit themselves at investors expenses

Managers may make large unprofitable investments reffered to as empire building

• Managers of large firms earn higher salaries and gain greater prestige

• Thus they may expand unprofitable divisions

Wasteful spending is more likely when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders

Leverage can reduce the degree of managerial entrenchement because managers are more likely to be fired if a firm faces financial distress

• In addition, highly levered firms are closely monitored by creditors and have thus an addditional layer of management oversight

1. Open Market Repurchase

2. Tender Offer

3. Targeted Repurchase

Option holders do not receive dividends and only experience losses due to falling prices (ex-dividend) - therefore they prefer share repurchases