472 Part Five Payout Policy and Capital Structure
bre44380_ch18_460-490.indd 472 10/05/15 12:53 PM
If the debt matured today, Circular’s owner would default, leaving the firm bankrupt. But
suppose that the bond actually matures one year hence, that there is enough cash for Circular
to limp along for one year, and that the bondholder cannot “call the question” and force bank-
ruptcy before then.
The one-year grace period explains why the Circular share still has value. Its owner is bet-
ting on a stroke of luck that will rescue the firm, allowing it to pay off the debt with something
left over. The bet is a long shot—the owner wins only if firm value increases from $30 to more
than $50.^15 But the owner has a secret weapon: He controls investment and operating strategy.Risk Shifting: The First Game
Suppose that Circular has $10 cash. The following investment opportunity comes up:(^15) We are not concerned here with how to work out whether $5 is a fair price for stockholders to pay for the bet. We will come to that
in Chapter 23 when we discuss risky debt.
Here is the Circular File Company’s book balance sheet:
Circular File Company (Book Values)
Net working capital $ 20 $ 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets $100 $100 Total value
Circular File Company (Market Values)
Net working capital $20 $25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets $30 $30 Total value
Circular File Company (Market Values)
Net working capital $10 $20 Bonds outstanding
Fixed assets 18 8 Common stock
Total assets $28 $28 Total value
We will assume there is only one share and one bond outstanding. The stockholder is also the
manager. The bondholder is somebody else.
Here is its balance sheet in market values—a clear case of financial distress, since the face
value of Circular’s debt ($50) exceeds the firm’s total market value ($30):
Now Possible Payoffs Next Year
Invest $10
$120 (10% probability)
$0 (90% probability)
This is a wild gamble and probably a lousy project. But you can see why the owner would be
tempted to take it anyway. Why not go for broke? Circular will probably go under anyway, so
the owner is essentially betting with the bondholder’s money. But the owner gets most of the
loot if the project pays off.
Suppose that the project’s NPV is – $2 but that it is undertaken anyway, thus depressing
firm value by $2. Circular’s new balance sheet might look like this: