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CHAPTER 17
CAPITAL STRUCTURE: LIMITS TO THE
USE OF DEBT
Answers to Concepts Review and Critical Thinking Questions
1. Direct costs are potential legal and administrative costs. These are the costs associated with the
litigation arising from a liquidation or bankruptcy. These costs include lawyers’ fees, courtroom costs,
and expert witness fees. Indirect costs include the following: 1) Impaired ability to conduct business.
– 60) in the expansion but nothing in the recession. The bondholders receive only $50 in the recession
because there is no more money in the firm. That is, the firm declares bankruptcy, leaving the
bondholders “holding the bag.” Thus, an increase in risk can benefit the stockholders. The key here is
that the bondholders are hurt by risk, since the stockholders have limited liability. If the firm declares
bankruptcy, the stockholders are not responsible for the bondholders’ shortfall. 3) Incentive to under-
invest. If a company is near bankruptcy, stockholders may well be hurt if they contribute equity to a
new project, even if the project has a positive NPV. The reason is that some (or all) of the cash flows
will go to the bondholders. Suppose a real estate developer owns a building that is likely to go
bankrupt, with the bondholders receiving the property and the developer receiving nothing. Should the
developer take $1 million out of his own pocket to add a new wing to a building? Perhaps not, even if
the new wing will generate cash flows with a present value greater than $1 million. Since the
bondholders are likely to end up with the property anyway, why would the developer pay the additional
$1 million and likely end up with nothing to show for it? 4) Milking the property. In the event of
2. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for the firm to
undertake risky projects, even those with negative net present values. This incentive results from the
3. The firm should issue equity in order to finance the project. The tax loss carryforwards make the firm’s
effective tax rate zero. Therefore, the company will not benefit from the tax shield that debt provides.
4. Stockholders can undertake the following measures in order to minimize the costs of debt: 1) Use
protective covenants. Firms can enter into agreements with the bondholders that are designed to
decrease the cost of debt. There are two types of protective covenants. Negative covenants prohibit
5. Modigliani and Miller’s theory with corporate taxes indicates that, since there is a positive tax
advantage of debt, the firm should maximize the amount of debt in its capital structure. In reality,
6. There are two major sources of the agency costs of equity: 1) Shirking. Managers with small equity
holdings have a tendency to reduce their work effort, thereby hurting both the debt holders and outside
7. The more capital intensive industries, such as air transport, television broadcasting stations, and hotels,
tend to use greater financial leverage. Also, industries with less predictable future earnings, such as
8. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
9. As in the previous question, it could be argued that using bankruptcy laws as a sword may be the best
10. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
bankruptcy filing enabled Continental to restructure and keep flying. The other side is that Continental
abused the bankruptcy code. Rather than renegotiate labor agreements, Continental abrogated them to
the detriment of its employees. In this, and the last several questions, an important thing to keep in
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
1. a. Using M&M Proposition I with taxes, the value of a levered firm is:
VL = [EBIT(1 – TC)/R0] + TCB
2. a. Debt issue:
The company needs a cash infusion of $1.2 million. If the company issues debt, the annual
interest payments will be:
Interest = $1,200,000(.08)
Interest = $96,000
3. According to M&M Proposition I with taxes, the value of the levered firm is:
VL = VU + TCB
VL = $18,300,000 + .21($4,500,000)
VL = $19,245,000
4. The president may be correct, but he may also be incorrect. It is true the interest tax shield is valuable,
and adding debt can possibly increase the value of the company. However, if the company’s debt is
5. a. The interest payments each year will be:
Interest payment = .09($95,000)
b. At a growth rate of 3 percent, the earnings next year will be:
Earnings next year = $8,550(1.03)
Earnings next year = $8,806.50
Using M&M Proposition I with no taxes, we can calculate the value of the firm as:
c. At a growth rate of 7 percent, the earnings next year will be:
Earnings next year = $8,550(1.07)
Earnings next year = $9,148.50
6. a. The total value of a firm’s equity is the discounted expected cash flow to the firm’s stockholders.
If the expansion continues, each firm will generate earnings before interest and taxes of
$2,700,000. If there is a recession, each firm will generate earnings before interest and taxes of
only $1,100,000. Since Steinberg owes its bondholders $900,000 at the end of the year, its
stockholders will receive $1,800,000 (= $2,700,000 – 900,000) if the expansion continues. If
its stockholders will receive nothing since the firm’s bondholders have a more senior claim on
all $1,100,000 of the firm’s earnings. So, the market value of Dietrich’s equity is:
b. The value of the company is the sum of the value of the firm’s debt and equity. So, the value of
Steinberg is:
VSteinberg = B + S
VSteinberg = $796,460 + 1,309,735
VSteinberg = $2,106,195
7. a. The expected value of each project is the sum of the probability of each state of the economy
times the value in that state of the economy. Since this is the only project for the company, the
company value will be the same as the project value, so:
b. The value of the equity is the residual value of the company after the bondholders are paid off. If
the low-volatility project is undertaken, the firm’s equity will be worth $0 if the economy is bad
and $200 if the economy is good. Since each of these two scenarios is equally probable, the
expected value of the firm’s equity is:
c. Risk-neutral investors prefer the strategy with the highest expected value. Thus, the company’s
stockholders prefer the high-volatility project since it maximizes the expected value of the
company’s equity.
d. In order to make stockholders indifferent between the low-volatility project and the high-
volatility project, the bondholders will need to raise their required debt payment so that the
expected value of equity if the high-volatility project is undertaken is equal to the expected value
of equity if the low-volatility project is undertaken. As shown in part b, the expected value of
equity if the low-volatility project is undertaken is $100. If the high-volatility project is
8. a. The expected payoff to bondholders is the face value of debt or the value of the company,
b. The promised return on debt is:
Promised return = (Face value of debt/Market value of debt) – 1
c. In part a, we determined bondholders will receive $51,000,000 in a recession. In a boom, the
bondholders will receive the entire $75,000,000 promised payment since the market value of the
company is greater than the payment. So, the expected value of debt is:
9. a. In their no tax model, M&M assume that TC, TB, and C(B) are all zero. Under these assumptions,
VL = VU, signifying that the capital structure of a firm has no effect on its value. There is no
optimal debt-equity ratio.
b. In their model with corporate taxes, M&M assume that TC > 0 and both TB and C(B) are equal to
zero. Under these assumptions, VL = VU + TCB, implying that raising the amount of debt in a
d. If the costs of financial distress are zero, the value of a levered firm equals:
VL = VU + {1 – [(1 – TC)/(1 – TB)]} × B
Therefore, the change in the value of an all-equity firm that issues $1 of perpetual debt instead
of $1 of perpetual equity is:
10. a. If the company decides to retire all of its debt, it will become an unlevered firm. The value of an
all-equity firm is the present value of the aftertax cash flow to equity holders, which will be:
VU = (EBIT)(1 – TC)/R0
VU = ($1,300,000)(1 – .21)/.20
