Cybertex’s management currently owns 1 percent of the firm’s outstanding shares. The firm is currently financed with 50 percent debt and 50 percent equity but is planning to increase its leverage ratio to 80 percent debt by borrowing and using the funds to repurchase shares. Management has decided not to participate in the repurchase so their percentage ownership of the firm will increase.

Explain how managers’ investment incentives are likely to change after the recapitalization.

Specifically, discuss their incentives to take:

• Negative NPV projects that benefit them personally.

• Risky projects.

• Long-term projects that take more than 10 years to provide an adequate return to capital.

AppendixLO1