Pecking Order Theory Essay

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NOTE: How to unlever? If too much debt and company is sensitive to economic shocks, risk of bankruptcy increases. This cost of financial distress offsets the benefit of a tax shield. Default: a firm that fails to make the required interest or principal payments on debt Modigliani and Miller: Bankruptcy results from a firm having leverage, but it does not lead to a greater reduction in the total value to all investors (d+e investors). Bankruptcy is costly. Therefore, instead of a liquidation (a trustee is appointed to oversee this), firm can go trough a reorganization by existing management. Creditors may receive new debt or equity of the firm. Creditors must vote to accept the plan, else firm will be liquidated. If a financially distressed firm can reorganize outside of bankruptcy, this is called a workout. Indirect costs of financial distress: Loss of customers (future support / service), Loss of suppliers, loss of employees, loss of receivables (debtors think they have opportunity to avoid their obligations), fire sales of assets (quick selling for lower price), delayed liquidation (management could continue to make negative NPV investments), cost to creditors (financial distress to creditor). Conclusion: costs of financial distress are an important departure from M&M assumption of perfect capital markets. → levered firms risk incurring financial distress costs. If a firm announces a debt issue, firm value will decrease. The cost of financial distress is paid by equity holders. Agency cost of leverage (in case of financial distress) Over-investment (risky): Equity holders like to increase risk if they are sure they will not gain without additional risk. This is at the expense of debt holders Under-investment: if return of a project first goes to debt holders, firm might not invest in positive NPV projects anymore, as shareholders are not willing to

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