Integration of tax effects and financial distress costs

Hi everyone!

Today, I am going to present information about the corporate finance system in the organization. I will discuss how different factor influence the value of a firm in a negative or positive way. How firm value increases and how firms face financial conflicts and problems. Basically, my presentation is divided into two major topics the first one is "integration of tax effects and financial distress costs" and the second is "Agency cost of equity". So, at first, I am going to provide an overview of tax effects. 

Integration of Tax Effects and Financial Distress Costs

In this first slide, I will discuss tax effects and distress cost. Here you may have a question what is "financial distress cost" because most of us are not enough familiar with this term, therefore, I would explain it first. Basically, it is the cost of a financial distress situation in which a company finds it difficult to pay back obligations and liabilities. Indirect costs, conflicts of interest, bankruptcy costs and higher cost of capital are common examples of costs that are associated with financial distress cost.

In the current organizational system debt financing is quite common. Organizations take debt on a short-term or long-term return basis to finance their operations. Modigliani and Miller claim that in the presence of corporate taxes “debt” causes to increase the value of a firm. While on the other financial researcher and experts also commonly considered that bankruptcy cost can cause to decrease the overall value of the firm. According to their point of view and research findings, a firm value increase when the company starts moving towards the debt from equity. Now come to the impact of debt financing. In this situation, the probability of distress is small because of the present value of minimal distress cost. Thus every little increase in debt value will increase the present value of these costs. At some it will come equals the increase in tax shield present value. Here bankruptcy will get increase rapidly from tax shield that will cause to decrease firm value. See the graph presented in the next slide that represents the integration of tax effects and financial distress costs.       

In this graph, we can see that as the present value of financial distress cost increases “present value of tax shield on debt” also increases in response. Thus, we can understand how both are integrated with each other.     

A Note on Agency Cost of Equity

Now in this slide, I will discuss the agency cost of equity. Agency cost of equity represents the cost that a company faces because of issues raised in the management and shareholders of the company. For instance the cost of a problem caused by the difference in the overall interest of shareholders and management. Information asymmetry also includes an agency cost of equity. Shareholder bears such kind of cost when managerial interest doesn't match with their interest. For instance, managers may take decisions that cause to decrease firm value. Then to control this problem shareholder will take measures that increase agency cost of equity. somehow, cost spend on monitoring process to present managers from taking wrong decisions is also included in the agency cost of equity.  

Shirking

Now, in this slide, I am going to explain "shirking". Shirking is basically an example of agency cost of equity that a company face because of the lack of interest of owners and managers in the business. We all know that owners take interest in business because of their investment (in equity). Therefore when companies start taking debt from the market to finance business operation with debt rather than equity interest of owners automatically goes down. Because of such situation replace equity with debt and owners have more incentive to shirk.

Perquisites

After getting understanding about shirking as a type of agency cost of equity now its time to understand perquisites. Perquisites also represent that agency cost of equity. It is basically a direct benefit for a company owner or an entrepreneur. Free cash flow, Use of the company's car, and other assets for personal benefit are fine examples of perquisites.

Bad Investments

Now in this last slide, I will explain “bad investment”. Commonly it is accepted that shirking and perquisites can give more loss to business as compared to the bad investment. But in fact, an unprofitable project can cause more financial problems. Investment in the wrong project can cause bankruptcy for the whole firm. Shareholders ever try to avoid such a situation because of this agency cost of equity increases.