Question

Consider a situation where a company will earn $100 payable in one year if it completes
a contract. If the company completes the contract the debt holders are promised a
payment of $40 in one year. However, if the firm cannot complete the contract,
expected earnings in one year will be only $50. If this results then the bond holders will
only receive a payment of $15 (because of the costs of bankruptcy). The probability of
the firm completing the contract is 50%. If bondholders are fully aware of all this
information, what will they pay for the debt? Assume the rate of interest on the bonds
is 12%.
b. Explain the difference between direct and indirect bankruptcy costs. Give two examples
of each.
c. List and explain four practical considerations that firms take into account when
determining capital structure.

Answer 1

a.Bondholders being fully aware of all that is said in the situation,

the amount they will pay for the debt

is the present value of future cash flows expected on their debt,

ie. (50%*40)+(50%*15)= 27.5 at end yr. 1 --so discounted to yr.0 at their rate of interest of 12%

27.5/1.12^1=

24.55

$24.55

b.A company in such a financially weak position , knowing that it cannot honor its obligations to its creditors,files for bankruptcy , as a last resort---ie. to get declared by the court that it is insolvent & incapable to meet its debts.So, this filing of bankruptcy is a legal solution available to the company to come free from its obligations to its creditors . All costs incurred towards filing for bankruptcy are called   bankruptcy costs.

Direct bankruptcy costs are cash spent to obtain "bankrupt" status declared by the court ---for example,fees to paid lawyers accountants & investment bankers, court fees , other administrative charges.

Indirect costs associated with bankruptcy do not involve cash expenditure , unlike the above direct costs --but their effects can be felt like, lost opportunities --for example,loss of goodwill for the company, losing the market, the customers and even the possibility of losing favorable terms with banks & vendors.

c.4 practical considerations that firms take into account when determining capital structure:

1.Cash flow position of the company--

One of the main determinent of capital structure ----if there is adequate liquid cash within the company, as perceived by the lenders, they will be willing to lend more to the company, without suspecting the capacity of the company in meeting the regular interest obligations & repayment of their capital.In such companies, debt/bonds will have a larger share in the capital structure.

2.Management's attitude-- towards debt & equity--- more conservative style is to choose equity & keep the profits among themselves as owners whereas, an aggressively managing style , is to include more debt , for the sake of increased Earnings per share

3. Interest rates in the market--- when market interest rates are comparatively high, the company may limit iis acqusition of debts & in that case, go for equity issues, or postpone debt-funding to a more opportune moment.

4. Tax rates---Tax rates of a company , if high creates valuable interest tax-shields for the company,ie. Saving tax expenses, to the extent of interest paid---so the high the tax rate, the more the company will try to take advantage , by considering to issue debts, rather than equity.