The Role of Limited Liability Limited liability limits owners’ liability for obligations to the amount
The Role of Limited Liability Limited liability limits owners’ liability for obligations to the amount
of their original investment in the shares of stock. Limited liability for owners of some forms of business creates a valuable right and an inter- esting incentive for shareholders. This valuable right is the right to default on obligations to creditors—that is, the right not to pay credi- tors. Because the most shareholders can lose is their investment, there is an incentive for the firm to take on very risky projects: If the projects turn out well, the firm pays creditors only what it owes and keeps the
Capital Structure
rest, and if the projects turn out poorly, it pays creditors what it owes— if there is anything left.
We can see the benefit to owners from limited liability by comparing the Unlimited Company, whose owners have unlimited liability, to the Limited Company, whose owners have limited liability. Suppose that the two firms have the following identical capital structures in Year 1:
Year 1
Unlimited Company Unlimited Company
3,000 Total value of firm’s assets
$4,000 Owners’ equity—their investment—is $3,000 in both cases.
If the value of the assets of both firms in Year 2 are increased to $5,000, the value of both debt and equity is the same for both firms:
Year 2
Unlimited Company Unlimited Company
4,000 Total value of firm’s assets
$5,000 Now suppose the total value of both firm’s assets in Year 2 is $500
instead of $5,000. If there are insufficient assets to pay creditors the $1,000 owed them, the owners with unlimited liability must pay the dif- ference (the $500); if there are insufficient assets to pay creditors the $1,000 owed them, the owners with limited liability do not make up the difference and the most the creditors can recover is the $500.
Year 2
Unlimited Company Unlimited Company
Total value of firm’s assets
$500 In this case, the Unlimited Firm’s owners must pay $500 to their
creditors because the claim of the creditors is greater than the assets available to satisfy their claims. The Limited Company’s creditors do
FINANCING DECISIONS
not receive their full claim and since the owners are shielded by limited liability, the creditors cannot approach the owners to make up the dif- ference.
We can see the role of limited liability for a wider range of asset val- ues by comparing the creditors’ and owners’ claims in Exhibit 18.8 for the Unlimited Company (Panel a) and the Limited Company (Panel b). The creditors make their claims at the expense of owners in the case of the Unlimited Company for asset values of less than $1,000. If the value of assets of the Unlimited Company is $500, the creditors recover the remaining $500 of their claim from the owners’ personal assets (if there are any such assets). In the case of Limited Company, however, if the assets’ value is less than $1,000, the creditors cannot recover the full $1,000 owed them—they cannot touch the personal assets of the owners!
The fact that owners with limited liability can lose only their initial investment—the amount they paid for their shares—creates an incentive for owners to take on riskier projects than if they had unlimited liabil- ity: They have little to lose and much to gain. Owners of the Limited Company have an incentive to take on risky projects since they can only lose their investment in the firm. But they can benefit substantially if the payoff on the investment is high.
For firms whose owners have limited liability, the more the assets are financed with debt, the greater the incentive to take on risky projects, leaving creditors “holding the bag” if the projects turn out to
be unprofitable. This is a problem: There is a conflict of interest between shareholders’ interests and creditors’ interests. The investment decisions are made by managers (who represent the shareholders) and, because of limited liability, there is an incentive for managers to select riskier projects that may harm creditors who have entrusted their funds (by lending them) to the firm. The right to default is a call option: The own- ers have the option to buy back the entire firm by paying off the credi- tors at the face value of their debt. As with other types of options, the option is more valuable, the riskier the cash flows.
However, creditors are aware of this and demand a higher return on debt (and hence a higher cost to the firm). 9 The result is that sharehold- ers ultimately bear a higher cost of debt.
9 Michael Jensen and William H. Meckling analyze the agency problems associated with limited liability in their article “Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure,” Journal of Financial Economics (1976), pp. 305–360. They argue that creditors are aware of the incentives the firm has to take on riskier project. Creditors will demand a higher return and may also require protective provisions in the loan contract.
Capital Structure
EXHIBIT 18.8 Comparison of Claims for the Unlimited Company
Panel a: Claims on Assets: Unlimited Company
Panel b: Claims on Assets: Limited Company
FINANCING DECISIONS
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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