Chapter 16
Financial Distress, Managerial Incentives, and Information
I. Chapter Outline
The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides
are referenced in bold. Alternative Examples to selected textbook examples are also available in the
PowerPoint Lecture Slides and are also referenced in bold.
16.1 Default and Bankruptcy in a Perfect Market (Slides 7–8)
• Armin Industries: Leverage and the Risk of Default (Slides 9–10)
– Scenario 1: New Product Succeeds (Slides 11–13)
16.2 The Costs of Bankruptcy and Financial Distress (Slide 25)
• The Bankruptcy Code (Slides 26–29)
16.3 Financial Distress Costs and Firm Value (Slide 37)
• Armin Industries: The Impact of Financial Distress Costs (Slides 37–40)
• Example 16.2 Firm Value When Financial Distress Is Costly (Slides 41–42)
• PowerPoint Alternative Example 16.2 (Slides 43–46)
• Who Pays for Financial Distress Costs? (Slides 47–49)
16.4 Optimal Capital Structure: The Trade-Off Theory (Slides 52–53)
• The Present Value of Financial Distress Costs (Slides 54–56)
Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 69
II. Learning Objectives
16-2 List and define two types of bankruptcy protection offered in the 1978 Bankruptcy Reform
Act.
16-4 Illustrate why, when securities are fairly priced, the original shareholders of a firm pay the
present value of bankruptcy and financial distress costs.
16-6 Define agency costs, and describe agency costs of financial distress and agency benefits of
leverage.
16-8 Explain the impact of asymmetric information on the optimal level of leverage.
16-9 Describe the implications of adverse selection and the lemons principle for equity issuance;
describe the empirical implications.
III. Chapter Overview
Chapter 15 concluded that U.S. firms use less leverage than theory justifies. Chapter 16 describes
imperfections that explain at least part of this result.
16.1 Default and Bankruptcy in a Perfect Market
The authors begin the chapter by considering a hypothetical company (Armin Industries) that has a
new project available that can save its falling revenues. If the product is a hit, the company will be
16.2 The Costs of Bankruptcy and Financial Distress
“With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt—bankruptcy
simply shifts the ownership of the firm from equity holders to debt holders without changing the total
16.3 Financial Distress Costs and Firm Value
This section begins the discussion of firm value when financial distress is costly. In the case of Armin
©2017 Pearson Education, Ltd.
16.4 Optimal Capital Structure: The Trade-Off Theory
Equation 16.1 shows the total value of the levered firm with financial distress costs. These costs are
16.5 Exploiting Debt Holders: The Agency Costs of Leverage
In this section, the agency costs of debt are addressed. The text uses the example of a firm that will
default on its debt if it does not change its strategy. Given the opportunity to invest in a risky asset
that has a chance of retaining some value for shareholders, management, acting in the interest of
16.6 Motivating Managers: The Agency Benefits of Leverage
This section discusses the agency benefits of debt. In particular, debt will allow original shareholders
16.7 Agency Costs and the Trade-Off Theory
Equation 16.2 shows the value of the levered firm in the presence of financial distress costs and
16.8 Asymmetric Information and Capital Structure
The previous discussion assumed that all parties have the same information and that securities are
fairly priced. In this section, those assumptions are relaxed. The authors use a hypothetical company
with good prospects that cannot be revealed to explain the signaling theory of debt. In order to
credibly signal the positive prospects, the manager must commit enough cash flow to debt that it
©2017 Pearson Education, Ltd.
16.9 Capital Structure: The Bottom Line
This section provides a summary of the previous discussion. The authors also point out that most
changes in capital structure occur passively, as the market value of equity fluctuates with changes in
the firm’s stock price.
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 16 have spreadsheet versions of the problems available: 1, 8, 19,
21, 22, 23, and 25.
These spreadsheets can be downloaded from the Instructor’s Resource Center at: