Bankruptcy Cost - (A) A firm\'s optimal capital structure changes over time. Dur

Question

Bankruptcy Cost -

(A) A firm's optimal capital structure changes over time. During the product development phase, a firm uses little to no debt. Later, when the firm has regular sales and earnings, it will use more debt. Explain why this occurs?

(B) Suppose bankruptcy laws were changed such that anytime a firm misses a requirement payment on its debt, the ownership of the assets of teh firm immediately adn costlessly transfers to its bondholders. Would this increase or decrease most firm's Debt/Equity?

Corporate Control -

(C) Corporate control is a factor that the firm's decision makers use but it doesn't necessarily work out well for firm value. Acme. Inc. was founded by teh Acme family and its members own the majority of its stock. Not wishing to lose control of the company, Acme has done all new borrowing with debt and it now has the highest Debt/Equity in its industry. How might this hurt the value of Acme Inc. eventually?

Explanation / Answer

During the product development phase the firm has no idea about the success of the product and there is no regularity of sales and revenue. Due to this the business uses very little debt to avoid the burden of regular interest payments. Later in the product cycle when a regular pattern is established the firm uses more debt since it is in a better position to service its interest obligations.

If the bankruptcy laws were changed in a way that the ownership of assets would immediately transferred to the bondholders in case of non payment of payments, the business would reduce its debt obligations and decrease its debt equity. This is because the business assets would be in risk of transfer to the bondholders on any kind of default.

A very high debt equity ratio reduces the value of the owners stake in a business in proportion to its assets since it creates a claim on the assets towards the creditors of the business. There is a higher risk of default due to very high debt. The value of a firm increases when the firm is able to maximize the returns to the shareholders. However due to higher debt the company will not be able to increase the returns to the shareholders due to liabilities created towards debt servicing and hence the value of the firm reduces.

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