There's no gain without pain
In the previous chapter we saw that the value of a firm is the same whether or not it has taken on debt. True, shareholders will pay less for the shares of a levered company, but they will have to pay back the debt (or buy it back, which amounts to the same thing) before obtaining access to the enterprise value. In the end, they will have paid, directly or indirectly, the same amount (value of equity plus repayment of net debt1); that is, the enterprise value.
Now, what about the financial manager who must issue securities to finance the creation of enterprise value? It does not matter whether he issues only shares or a combination of bonds and shares, since again the proceeds will be the same – the enterprise value.
Enterprise value depends on future flows and how the related, non-diversifiable risks are perceived by the market.
But if that is the case, why diversify sources of financing? The preceding theory is certainly elegant, but it cannot fully explain how things actually work in real life.
In this chapter we look at two basic explanations of real-life happenings. First of all, within the same market logic, biases occur which may explain why companies borrow funds, and why they stop at a certain level. The fundamental factors from which these biases spring are taxes and financial distress costs. Their joint analysis will give birth to the “tradeoff model”.
There are features of debt ...