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Limits to the Use of Debt (Financial Distress Costs (Agency costs (Costs…
Limits to the Use of Debt
Financial Distress Costs
Direct costs
Costs of lawyers/accountants for the company and bondholders
Indirect costs
Loss of revenue due to lack of trust from suppliers and customers
Agency costs
Costs as a result of divergance in shareholder and bondholder goals
Loss of value due to incentive to take larger risks
Loss of value due to underinvestment by shareholders
Loss of value due to excessive dividend payments
Protective Covenants
Positive
Maintaining a level of working capital
Negative
Limitations on amount of dividend payments, issuing more long-term debt, merging with other firms, pledging assets to other lenders
Reduce rate required by bondholders
Optimal Level of Debt
Marginal income from tax shield = Marginal cost of financial distress
When the WACC is at its lowest
Alternative Theories
Signalling
Low profits = Low debt
High profit = high debt
Announced becoming more leveraged suggest higher profitability
Pecking Order
Rule 1 - Use internal financing
Avoids investor sceptisism
Rule 2 - Issue safe securities
Fixed return so less likely for value to be volatile
Rule 3 - Only issue more volatile financing methods when necessary (e.g. equity)
Suggestions
No optimal level of debt
Firms like financial slack
Profitable firms use less debt
Reality
Most firms have a target debt-equity ratio close to the industry average
Target ratios vary due to industry, asset type and uncertainty of incomes