According to the managerial entrenchment theory, managerschoose capital structure so as to preserve their control of thefirm. On the one hand, debt is costly for managers becausethey risk losing control in the event of default. On theother hand, if they do not take advantage of the tax shieldprovided by debt, they risk losing control through a hostiletakeover.
Suppose a firm expects to generate free cash flows of $89million per year, and the discount rate for these cash flowsis 9%. The firm pays a tax rate of 25%.
A raider is poised to take over the firm and finance it with$915 million in permanent debt. The raider will generate the samefree cash flows, and the takeover attempt will be successfulif the raider can offer a premium of 21% over the current value ofthe firm. According to the managerialentrenchment hypothesis, what level of permanent debt willthe firm choose?
According to the managerial entrenchment theory, managers choose capital structure so as to preserve their control of t
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