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)
16.5 Exploiting Debt Holders: The Agency Costs of Leverage (Slides 67-68)
• Excessive Risk-Taking and Asset Substitution (Slides 69–77)
• Table 16.3 Outcomes for Baxter’s Debt and Equity under Each Strategy (in $ thousand)
(Slide 73)
16.6 Motivating Managers: The Agency Benefits of Leverage (Slide 102)
• Concentration of Ownership (Slides 103–107)
16.7 Agency Costs and the Trade-Off Theory (Slide 115)
• Figure 16.2 Optimal Leverage with Taxes, Financial Distress, and Agency Costs (Slide
116)
• The Optimal Debt Level (Slides 117–118)
16.8 Asymmetric Information and Capital Structure (Slide 121)
• Leverage as a Credible Signal (Slides 122–124)
• Example 16.8 Debt Signals Strength (Slides 125–126)
• Issuing Equity and Adverse Selection (Slides 127–133)
16.9 Capital Structure: The Bottom Line (Slide 149)
Berk/DeMarzo • Corporate Finance, Fourth Edition 69
II. Learning Objectives
16-1 Describe the effect of bankruptcy in a world of perfect capital markets.
16-3 Discuss several direct and indirect costs of bankruptcy.
16-5 Calculate the value of a levered firm in the presence of financial distress costs.
16-7 Calculate the value of the firm, including financial distress costs and agency costs.
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
value available to all investors.” In this section, the authors describe the long, complicated process of
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
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
16.9 Capital Structure: The Bottom Line
This section provides a summary of the previous discussion. The authors also point out that most
IV. Spreadsheet Solutions in Excel
The following Problems for Chapter 16 have spreadsheet versions of the problems available: 1, 8, 19,