468 Part Five Payout Policy and Capital Structure
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stockholders simply to walk away from it, leaving all its troubles to its creditors. The former
creditors become the new stockholders, and the old stockholders are left with nothing.
Stockholders in corporations automatically get limited liability. But suppose that this were
not so. Suppose that there are two firms with identical assets and operations. Each firm has
debt outstanding, and each has promised to repay $1,000 (principal and interest) next year.
But only one of the firms, Ace Limited, enjoys limited liability. The other firm, Ace Unlim-
ited, does not; its stockholders are personally liable for its debt.^10
Figure 18.3 compares next year’s possible payoffs to the creditors and stockholders of these
two firms. The only differences occur when next year’s asset value turns out to be less than
$1,000. Suppose that next year the assets of each company are worth only $500. In this case Ace(^10) Ace Unlimited could be a partnership or sole proprietorship, which does not provide limited liability.
◗ FIGURE 18.3 Comparison of limited and unlimited liability for two otherwise identical
firms. If the two firms’ asset values are less than $1,000, Ace Limited stockholders default and
its bondholders take over the assets. Ace Unlimited stockholders keep the assets, but they must
reach into their own pockets to pay off its bondholders. The total payoff to both stockholders and
bondholders is the same for the two firms.
Payoff to bondholders
Ace Limited
(limited liability)
1,000
500
500 1,000
Payoff
Asset value
Payoff to stockholders
1,000
–1,000
0
500 1,000
Payoff
Asset value
Payoff to bondholders
Ace Unlimited
(unlimited liability)
1,000
500 1,000
Payoff
Asset value
Payoff to stockholders
1,000
–1,000
–500
0
500 1,000
Payoff
Asset value