16

Case II example unlevered vs. levered

- Corporate taxes, but no personal taxes - No bankruptcy costs reduction in taxes increases the cash flows of the firm EBIT is still the same now there is interest, taxable income is lower, total taxes paid are lower cash available to capital providers is higher (normal cash available + interest tax shield) how does this increase the value of the firm?

Case III- taxes and bankruptcy costs

-Proposition 1: the optimal capital structure equates the marginal benefits of debt through the interest tax shield to its marginal cost of expected distress and bankruptcy. This debt-to-equity ratio will maximize the capital providers' share (traded) of the value pie while minimizing the slice lost to taxes and bankruptcy (untraded) -Proposition 2: Once again, the cost of equity increases with leverage to compensate the shareholders for the increasing financial risk. However, the cost of debt is no longer constant and will start to rise when lenders perceive an increased likelihood of default as the firm levers up. At that point, both the cost of equity and debt will rise together, and so too will WACC. It is just before this point that the firm minimizes WACC

distribution of the proceeds of the liquidation occurs according to the following priority list:

1. Administrative expenses associated with the bankruptcy 2. other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee 3. wages, salaries, and commissions 4. contributions to employee benefit plans 5. consumer claims 6. government tax claims 7. payment to unsecured creditors 8. payment to preferred stockholders 9. payment to common stockholders

M&M Proposition II shows that the firms cost of equity can be broken down into two components:

1. Ra, or the WACC, the required return on the firms assets overall, and it depends on the nature of the firms activities 2. (Ra - Rd) * (D/E), is determined by the firms financial structure.(financial risk premium) (unlevered Ra = Ru)

bankruptcy liquidation process

1. a petition is filed in federal court (voluntary or involuntary) 2. trustee-in-bancrptcy is elected by the creditors to take over the assets of the debtor corporation (attempts to liquidate assets) 3. when assets are liquidated, after payment of bankruptcy administration costs, proceeds are distributed among creditors 4. if any proceeds remain, they are distributed to shareholders

Static theory

1. firms lever up to minimize taxes 2. firms lever down to minimize expected distress and bankruptcy costs 3. The value of the firm is maximized when the marginal benefit from another dollar of debt due to the interest tax shield equals that dollar of debt's marginal cost due to expected financial distress

Pecking order theory implications:

1. no target capital structure: debt to equity ratio is determined by the need for external financing 2. profitable firms use less debt: greater internal cashflow, less need for external financing 3. companies will want financial slack: to avoid selling new equity, companies will want to stockpile internally generated cash

two qualifications for the previous list

1. secured creditors, who are entitled to the proceeds from the sale of the security and are outside the ordering 2. who gets what is subject to negotiation

M&M Proposition II tells us that the cost of equity depends on three things:

1. the required rate of return on the firms assets, (compensation for business risk) 2. cost of debt, De, 3. debt to equity ratio, D/E Re = Ru + (Ru-Rd)(D/E) When unlevered and no taxes, Ra = Ru = (E/V)Re + (D/V)Rd

in general, bankruptcy costs range between

1.4 and 3.4 percent of pre-bankruptcy value

for an unlevered firm, with no taxes and no bankruptcy, the cash generated by the assets is

100% available to the shareholders

Case II: Value of an unlevered firm (Vu) =

= [EBIT * (1-t)] / Ru Ru = unlevered cost of capital

Bankruptcy

A legal proceeding involving a business that is unable to fulfill its contractually required debt obligations. The process begins with a petition, either filed by the debtor or creditors. After the petition is filed the debtor's assets are evaluated and a court decides which assets, if any, will be liquidated, which debts will be paid or forgiven, and which parties will control the firm when the proceedings are concluded

Case I, what happens when we issue debt and buy back stocks (lever up)

Assets do not change (only changing right side of balance sheet) debt increases, equity decreases D/E increases Share price stays the same Less shares outstanding interest is introduced

the total systematic risk of a firm has two parts:

Business risk and financial risk cost of equity rises when the firm increases financial leverage because of the financial risk of the equity increases while the business risk remains the same

Oshkosh example (different from book) different assets have different systematic risk, the systemic risk of a levered (also no taxes, no bankruptcy) firm

EBIT's do not change because the assets are not changing, but now we have bondholders in front of the stockholders interest expense is introduced, which you are required to pay in all states of the world The systematic risk, Beta, changes now that we levered up, this is called financial risk Be = Bu * (1+(D/E))

the effect of financial leverage depends on ___________. When __________ is high, leverage is beneficial

EBIT, when EBIT is relatively high, leverage is beneficial

T/F: All else equal, a change in the business risk premium has no effect on the cost of debt in a world with financial distress

False

T/F: Different businesses have different assets resulting in different levered betas

False

T/F: If Alpha Company has more business risk than WSB Inc., then its its financial risk premium will be bigger than WSB's

False

T/F: In M&M Case I, the firm's cost of equity is fixed.

False

T/F: Levering down changes the assets of the company.

False

T/F: The equity beta measures only the business risk.

False

T/F: In a world with taxes and no bankruptcy, changing the company's capital structure changes the size of the slices of the value pie going to stockholders and bondholder, but not the size of the pie available to both

False changes the size available to both because some has to go to government when taxes are introduced

T/F: The cost of equity for a levered firm equals the return on assets for the unlevered company

False unlevered Re = Ra = Ru levered Re = Ru + (Ru-Rd)(D/E)(1-t)

T/F: In part, Case I Proposition II states that a firm's cost of equity is not affected by changes in the capital structure.

False, it goes up as leverage increases, but WACC stays the same

component 2 of cost of equity from M&M II: (Ru - Rd) * (D/E)

Financial Risk is determined by the firms financial structure. for an all equity firm, this component is 0. as the firm begins to rely on debt, the required return on equity rises. this occurs because the debt financing increases the risk borne by the stockholders

CASE III: adding financial distress and bankruptcy

Higher D/E = higher probability of bankruptcy and financial distress this increased probability will increase the expected costs of distress and bankruptcy cost of debt is no longer fixed

Observed Capital Structures

I. Drug companies appear to use less debt than electric utility companies do. (wildly volatile cashflows) II. It appears that many firms choose to pay substantial taxes rather than increase debt to further benefit from the interest tax shield. III. It appears that, for whatever reason, capital structures vary quite a bit across industry groups

homemade leverage

In the absence of taxes and bankruptcy, the ability of investors to lever up or down their personal portfolios to achieve whatever return volatility they desire, regardless of the manager's capital structure choice. Homemade leverage render's the manager's debt-to-equity selection irrelevant

(different from book) different assets have different systematic risk, the systemic risk of an unlevered (also no taxes, no bankruptcy) firm:

Is just the business risk (different risk in different states of the world) whatever systematic risk is in the assets is transferred 1 for 1 to the shareholders If the cashflows have a Beta of 1.5, the stock has a Beta of 1.5 if the firm is unlevered

Pie model of capital structure: Case II, proposition I

Lower financial leverage: high stockholder claim, lower bondholder claim, larger tax claim Higher leverage: all bondholder claims, no stockholder claim, very small tax claim

ROE

Net income/equity

Case I, no tax, no bankruptcy

Proposition 1: The optimal capital structure is any capital structure because the value of the business enterprise is the same regardless of the debt-to-equity ratio the CFO selects Proposition 2: WACC and the cost of debt do not change with leverage

Case II, proposition II

Ra, Wacc, is no longer constant Ra = (E/V)Re + (D/V)Rd(1-t) Re = Ru + (Ru-Rd)(D/E)(1-t) Re = return on unlevered firm + return on unlevered firm beyond the cost of debt * the degree of leverage * deductibility for cost of debt Ru is compensation for business risk (Ru = Rf + business risk premium), this stays the same, but cost of equity goes up because of the higher debt/equity ratio

M&M Proposition II, Re (without taxes) =

Re = Ra + (Ra -Rd) * (D/E) Unlevered, Ra = Ru = (E/V)Re + (D/V)Rd Ra = WACC

M&M Proposition I with taxes: Re =

Re = Ru + (Ru-Rd) * (D/E) * (1-t) Ru = unlevered cost of capital

Graph of M&M Proposition II (with no taxes)

Re = straight line with slope Ra - Rd Y-int = corresponds to a firm with a debt-to-equity ratio = 0, so Ra = Re in that case WACC remains the same due to M&M Proposition I: overall cost of capital is unaffected by capital structure shows that as the firm increases the debt to equity ratio, the increase in leverage raises the cost of equity (Re)

in financial leverage, what happens

Systemic risk rises when you start putting bondholders in front of shareholders, so you are taking whatever risk there is and magnifying it, this is called financial risk financial risk is a choice variable, CFO is choosing to put bondholders in front of shareholders Bu < Be Be = Bu * (1+(D/E))

present value of the interest tax shield

Tax rate x Amount of debt tc x D

Unlevered Beta

The beta of a company's assets, which reflects the systematic risk of the business (just business risk) levered beta/(1+[(1-tax rate)*(debt/equity)])

Levered Beta

The beta of a company's stock, which reflects the systematic risk of the business and any financial risk due to increasing the firm's debt-to-equity ratio Case II: Be = Bu * (1+[(1-tax rate)*(debt/equity)]) Case I: Be = Bu * (1+(D/E))

Optimal Capital Structure

The capital structure that minimizes a firm's weighted cost of capital and, therefore, maximizes the value of the firm.

Bankruptcy costs

The costs a firm incurs when it files for protection from its creditors. There are direct bankruptcy costs that include measurable legal, consulting, and administrative expenditures. Indirect cost soar in bankruptcy: As with distress, there are indirect costs that are difficult to measure such as lost sales, suppliers changing the terms of their contracts, difficulty in retaining and attracting talented employees, managerial distraction

leverage

The extent to which debt is used to finance the assets of the firm. The manager tries to pick the leverage that will maximize the value of the firm more debt = more financial leverage

traded claims

The stock and bond securities that trade in secondary markets and represent the slice of the value pie due the capital providers

nontraded claims

The tax, financial distress, and bankruptcy costs that are not traded in secondary markets and reduce the slice of the value pie available to the traded claims

M&M Proposition I with taxes

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.

Case II - Proposition I

The value of the firm increases by the present value of the annual interest tax shield therefore value of levered firm = value of unlevered firm + PV of interest tax shield to increase firm value, you make the PV of the interest tax shield larger optimal capital structure is all debt (because there is no bankruptcy, so cost of debt is constant)

Case II: cost of debt

There is no bankruptcy so cost of debt is still constant

T/F: According to the Static Theory of Capital Structure, levering up to gain the tax shield is only important if the firm has a large tax liability.

True

T/F: All else equal, the bigger the unlevered beta the bigger the financial risk premium.

True

T/F: An optimal capital structure is all equity when there are no taxes and no bankruptcy

True

T/F: An optimal capital structure is some debt and some equity when there are no taxes and no bankruptcy.

True

T/F: In a world with no taxes and no bankruptcy, changing the company's capital structure changes the size of the slices of the value pie going to stockholders and bondholder.

True

T/F: In a world with taxes and bankruptcy, changing the company's capital structure changes the size of the slices of the value pie going to stockholders and bondholder, as well as the size of the pie available to both

True

T/F: In a world with taxes and bankruptcy, there is a unique capital structure that minimizes WACC.

True

T/F: In a world with taxes and bankruptcy, value does change because of the CFO's leverage choice because both the numerators and denominators in the DCF equation change

True

T/F: M&M Case I and II assumptions are same except when it comes to taxes

True

T/F: The business risk premium decreases as the beta of the unlevered firm decreases

True

Pie model of capital structure, Case 1, proposition I

Value of firm is not changing(size of the pie stays the same). Lever up = Bondholder gets a bigger slice. Lever down = Shareholder gets a bigger slice

any increase in Vm(value of marketed claims) must imply an identical decrease in

Vn (value of nonmarketed claims). the optimal capital structure is the one that maximizes the value of the marketed claims, or equivalently, minimizes the value of the nonmarketed claims such as taxes and bankruptcy costs

Vt, the total value of all the claims against a firms cashflows =

Vt = E + D + G + B + ...... Vt = Vm + Vn Vt = value of marketed claims + value of nonmarketed claims value of marketed claims may be affected by capital structure, but the total value of all of the claims against the firms cash flows is not

The value of the firm is maximized when

WACC is minimized value of the cashflows is maximized when WACC is minimized

If a firm goes bankrupt, a piece of the firm disappears, this amounts to

a bankruptcy "tax" so the firm faces a tradeoff: borrowing saves a firm money on its corporate taxes, but the more the firm borrows, the more likely it is that the firm will become bankrupt and have to pay the bankruptcy "tax" (higher financial distress costs, which = higher Rd)

unlevered

a firm that is financed with 100% equity and thereby no debt

How does leverage affect ROE of a firm

amplifies variation in ROE for the stockholders Do shareholders care? No, homemade leverage (in a world of no taxes and no bankruptcy)

in a world without taxes and bankruptcy, what is the optimal choice for the mix of debt and equity

any mix is optimal because any selection will result in the same company value and WACC. Capital structure is meaningless because it does not change the size of the value pie, though it does determine the size of the slices claimed by the owners and lenders

Case I, propositions I and II

cash flows of the firm (CFFA) do not change, therefore riskiness of the cashflows does not change (WACC) S-C stays the same, Change NWC stays the same, NCS stays the same: nothing is happening in the numerators, so because the risk cannot change, the WACC cannot change, because the WACC cannot change, the value of the firm cannot change Case 1: Proposition I: Value of the firm is NOT affected by change in capital structure Proposition II: WACC of the firm is not affected by capital structure

changing the company's leverage does not

change the firm's assets the leverage choice impacts the liabilities and owners' equity side of the balance sheet, but not the asset side

By relaxing the no-tax assumption, suddenly, the firm's capital structure can

change the value of the business through the deductibility of interest expense

the pecking order:

companies will use internal financing first, then issue debt if necessary, then equity will be sold pretty much as a last resort

in addition to WACC being fixed, the cost of debt is

constant as well because there is no bankruptcy, meaning all debt is riskless. With levering up or down, the cost of equity does indeed change because of financial risk, but the shareholder does not care because they can achieve their desired risk-return level through homemade leverage

All else equal, the financial leverage of a firm will __________ as the firms retained earnings account grows

decrease

levering down

decreasing the use of debt relative to equity to finance a firm's assets. This is achieved by issuing stock in the primary markets and using the proceeds to repurchase bonds in the secondary market. Though no assets change in the transaction, the firm's debt-to-equity ratio is reduced.

different business risk means

different Beta's if your assets (or EBIT) are more sensitive to different states of the economy, your Beta will be higher

the no bankruptcy assumption can be seen when

even in the worst state of the world, a company can pay their interest expense (their EBIT is bigger than their interest payment, so net income is positive)

as illustrated in the graph of M&M Proposition II, the fact that the cost of debt is lower than the cost of equity is

exactly offset by the increase in the cost of equity from borrowing (We goes down, Wd goes up, so the increase in Re is offset) in other words, the change in capital structure weights is exactly offset by the change in cost of equity, Re, so WACC stays the same

Because the assets of a firm are not directly affected by capital restructuring, we can

examine the firms capital structure decision separately from its other activities

reorganization

financial restructuring of a failing firm to attempt to continue operations as a going concern

Homemade leverage and ROE: firm unlevered, investor prefers levered

firm unlevered, investor prefers levered investor borrows $2000 and uses the $2000 to buy 200 shares of stock Payoffs: #shares * EPS of unlevered firm - r*debt (pay interest) ROE = payoffs/personal equity stake exact same ROE as if the company had levered up

Pecking Order Theory

firms prefer to issue debt rather than equity if internal finance is insufficient

Pecking Order Theory is an alternative to the static theory. one key element is that

firms prefer to use internal financing whenever possible selling securities to raise cash is expensive, and so it is avoided if possible also because most insiders (executives) have information that leads them to believe that their stock is undervalued(so you issue debt instead) also, if equity is issued, you signal to investors that the price is too high

Case II: taxes, no bankruptcy costs

firms value critically depends on its debt policy. -Proposition 1: the more the firm borrows, the more it is worth because interest is tax deductible, gain in firm value is equal to the present value of its interest tax shield -Proposition 2: all-debt company achieves a minimum WACC, which is equal to the after-tax cost of debt. All debt is riskless (Rd is constant). weighted average cost of capital decreases as the amount of debt goes up. as the firm increases its financial leverage, cost of equity does go up, but this is more than offset by the tax break associated with debt financing, so overall cost of capital declines

In this chapter, we think of a highly stylized firm

generate the same cashflows every period forever, perpetuities PV of perpetuity: cashflow/R same debt every year, same interest expense every year, both forever

Case III: financial distress

getting close to not being able to pay your obligations but you are still paying your bills creditors start charging higher rates (higher Rd) suppliers change terms indirect costs: lost sales, managerial distractions, interrupted operations distress costs higher in bad states of the world for levered firms

right side of balance sheet

how you finance the assets total value of liabilities and shareholders equity left side = asset side, PPE, assets

In a world with taxes and no bankruptcy(Case II), taxes make the CFO want to

increase the debt-to-equity ratio to the point where the optimal capital structure is an all-debt firm. CFO can maximize the value of the business by minimizing the present value of the government's tax claims

If capital structure is to influence the value of the business, it must do so by either

increasing the cash flows in the numerators, reducing WACC in the denominators, or both. Remember, WACC is a function of the riskiness of the assets' cash flows, so the manager could influence the discount rate by changing the risk of the numerators

levering up

increasing the use of debt relative to equity to finance a firm's assets. This is achieved by issuing debt, typically bonds, in the primary markets and using the proceeds to repurchase shares of stock in the secondary market. Though no assets change in the transaction, the firm's debt-to-equity ratio increases.

The Static Theory also indicates that the manager can minimize WACC. To do so, the manager

initially substitutes artificially cheap debt for equity, reducing the cost of capital. At some point, the lenders start to charge a default risk premium, and the cost of debt begins to rise. Because the cost of equity always rises with leverage, WACC will start to increase again with higher debt-to-equity ratios(because now Rd is rising too). The manager will minimize WACC just before this occurs

Without taxes and bankruptcy, the cash flows from assets in the numerators are

invariant to changes in leverage; their size and risk are the same regardless of the mix of financing the company uses. WACC, the value equation's discount rate, is a function of the riskiness of the numerators. Since the leverage choice does not change the volatility of the numerators, WACC remains constant no matter what debt-to-equity ratio the CFO selects changes in financing do not affect the value of the business

Homemade leverage and ROE: management levers up but investor prefers unlevered payoffs

investor buys $1000 worth of stock (50 shares) and $1000 worth of company bonds paying 10% the company offered bonds, the investor can go out and hold those bonds (lower volatility) to collect interest and effectively cancel out the same debt that the firm has to pay payoffs: #share * EPS of levered firm + r*debt(get interest) ROE = payoffs/personal equity stake exact same ROE as if the company was unlevered

with taxes, the value of a levered firm

is that of an unlevered firm plus the present value of all tax savings due to the deductibility of interest. The Interest expense reduces the government's tax claim on the company's value pie and increases the value available to the capital providers

The greater the volatility in EBIT, the

less a firm should borrow (greater possibility of financial distress)

All else equal, the value-destroying expected indirect and direct costs resulting from financial distress and bankruptcy give the manager the incentive to

lever down

financial risk is the additional risk that ___________, thus, ____________

leverage induces; thus, the levered beta will be greater than the unlevered beta of the assets Be = Bu * (1+(D/E)) shareholders do not care because they can use homemade leverage, in a world without taxes and bankruptcy, the manager's choice of how to finance the company's assets is irrelevant

Bankruptcy Reorganization

look at book

financial leverage acts to

magnify gains and losses to shareholders increases variability (risk) in both EPS and ROE (to changes in EBIT)

Shortcomings of the static theory

many large, financially sophisticated, highly profitable firms use little debt, which is the opposite of what we would think

Marketed vs non-marketed claims

marketed claims can be bought and sold in financial markets and nonmarketed claims cannot be sold in financial markets

Case II: levered up = more

more financial risk = higher reward you can no longer undo the financial risk, cannot use homemade leverage WACC decreases as D/E ratio increases because of the government subsidy on interest payments (Re still goes up, but is canceled out)

Earnings Per Share (EPS)

net income/shares outstanding

with the static theory, there is no

one-size-fits-all perfect debt-to-equity ratio. The manager must think carefully about the firm, its industry, its tax liabilities, and the likelihood of entering states of the world where the company's assets may have difficulty paying or fail to pay its debts

in the extended pie model, cash flows =

payments to stockholders + payments to creditors + payments to the government + payments to bankruptcy courts and lawyers + payments to any and all other claimants of cash flows of the firm in this model, the value of the claims against the firms cash flows is unaffected by capital structure, but the relative values change as the amount of debt financing is increased the goal is to maximize the traded portion (bondholders and stockholders), and minimize the untraded portion (taxes and distress costs)

For each case (I, II, III), there are two propositions

proposition I: impact of leverage on the firm value Proposition II: impact of leverage on returns (what does it do to WACC, or cost of debt or equity that influences WACC)

particularly in the US, companies seem to have

relatively low debt-equity ratios. ranges widely across industries

when a company uses leverage, shareholders are exposed to more

risk because EPS and ROE are much more sensitive to changes in EBIT

Without bondholders (unlevered) and taxes, the systematic risk of the assets(business risk) translates directly into the

risk borne by the shareholders. In other words, the nature of the business will generate various returns on equity (ROE) and earnings per share(EPS) in different systematic states of the world

With no taxes and no bankruptcy, the claim that capital structure is important because it impacts expected returns to shareholders and the riskiness of the stock is incorrect, why?

shareholders can adjust the amount of financial leverage by borrowing and lending on their own. this is called homemade leverage

static vs. pecking order theory

static theory speaks more to long run financial goals or strategies(tax shields and financial distress), pecking order is more short run (tactical issue of raising external funds to finance investments)

with taxes and no bankruptcy, the deductibility of interest gives the manager incentive to

substitute subsidized, and therefore artificially cheap, debt in the place of equity. in an all debt firm, the after-tax cost of debt is the minimum WACC. The cost of debt remains constant for all debt-to-equity levels because of the no bankruptcy assumption the cost of equity increases with leverage to compensate the shareholders for additional financial risk. In this case, the shareholders cannot use homemade leverage to negate the manager's actions

What is impacted by a firms capital structure

systematic risk, financial risk NOT business risk systematic risk = financial risk + business risk. because financial risk is affected, total systematic risk is affected

interest tax shield

tax savings resulting from deductibility of interest payments interest*t The interest tax shield allows the manager to reduce the cash flow from the firm that goes to pay government taxes and use the savings to increase payments to the capital providers, the bondholders and stockholders

liquidation

termination of a business operation by using its assets to discharge its liabilities

to change the value of the firm, either change

the cash flows(CFFA) or the riskiness of the cash flows (WACC) -maximize cash available for the capital providers -minimize WACC

unlevered cost of capital (Ru)

the cost of capital for a firm that has no debt Ru = Rf + business risk premium Business risk premium = Bu * market risk premium

indirect bankruptcy costs (financial distress costs)

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm Foregone sales, managerial distraction, the loss of good employees, altered terms from suppliers, and other costs firms bear that become financially distressed. These are very difficult to measure but can destroy a lot of value

direct bankruptcy costs

the costs that are directly associated with bankruptcy, such as legal and administrative expenses Expenses the bankrupt company pays for lawyers, consultants, clerical staff, and other legal fees. These can be readily totaled up by looking at the company's checkbook these costs are a disincentive to debt financing

financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress When the firm gets close to bankruptcy without entering it, it will suffer from lost sales, suppliers changing the terms of their contracts, difficulty in retaining and attracting talented employees, and managerial distraction. These costs are very difficult to measure

financial risk

the equity risk that comes from the financial policy (the capital structure) of the firm The additional volatility imposed upon the shareholders by levering up. Increasing the D/E ratio takes the existing business risk and magnifies it from the perspective of the shareholders. This is because increasing leverage puts payments to the bondholders ahead of those to the residual claimants, the shareholders, thus making their position riskier completely determined by financial policy

Business Risk

the equity risk that depends on the nature of the firm's operating activities and is completely unaffected by capital structure Business risk premium = Bu * market risk premium The volatility of cash flows generated by a firm's assets. the inherent systemic risk of a business.

financial distress is more costly for some firms than others, the costs of financial distress depend primarily on

the firms assets, these costs will be determined by how easily the ownership of those assets can be transferred EX: tangible assets that can be sold without great loss in value will have an incentive to borrow more -for firms that rely heavily on intangibles, such as employee talent or growth opportunities, debt will be less attractive because these debts effectively cannot be sold

the difference between the value of the firm in the static theory and the M&M value of the firm without taxes is (difference in proposition 1 between Case 1 and Case 3)

the gain from leverage(PV interest tax shield), net of distress costs

the difference between the value of the firm in the static theory and the M&M value of the firm with taxes is (difference in proposition 1 between case 2 and case 3)

the loss in value from the possibility of financial distress (financial distress costs)

The change in the value of the firm is the same as

the net effect on the stockholders AKA: the NPV rule applies to capital structure decisions, and the change in value of the overall firm is the NPV of a restructuring

M&M Proposition II

the proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure (more leverage = higher Re)

M&M Proposition I

the proposition that the value of the firm is independent of the firm's capital structure the size of the pie does not depend on how it is sliced, total firm value does not change

component 1 of cost of equity from M&M II: Ru, or the unlevered WACC

the risk inherent in a firms operations is called business risk of the firms equity(depends on systemic risk). Greater the risk, the greater Ra will be, and all else equal, the greater the firms cost of equity

Absolute Priority Rule (APR)

the rule establishing priority of claims in liquidation

financial distress costs are larger when

the stockholders and bondholders are different groups until the firm is legally bankrupt, the stockholders are in control of the firm. because stockholders can be wiped out in legal bankruptcy, they have a strong incentive to avoid bankruptcy filing the bondholders, on the other hand, are concerned with protecting the value of the firms assets and will try to take control away from the stockholders. they have a strong incentive to seek for bankruptcy filing. this results in a long, drawn out, and potentially expensive legal battle

Case III: optimal capital structure is at D*, which is when

the tax savings from an additional dollar of debt financing is exactly balanced by the increased bankruptcy costs associated with the additional borrowing corresponding to D*, the optimal debt level, is the optimal debt to equity ratio, this is when the lowest possible WACC occurs

Static Theory of Capital Structure

the theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress The value of the firm is maximized when the marginal benefit from another dollar of debt due to the interest tax shield equals that dollar of debt's marginal cost due to expected financial distress

In principle, a firm becomes bankrupt when

the value of its assets equals the value of its debt its equity value falls to zero, and the stockholders turn over control of the firm to the bondholders

based on the static theory's optimal debt-to-equity ratio, the manager maximizes _____________ and minimizes ___________

the value of the capital providers' claims and minimizes the joint value of taxes and bankruptcy. From another perspective, the best leverage choice the manager can pick is the one that makes the traded claims as big as possible and makes the nontraded claims as small as possible

extended pie model, essence of the M&M issue and theory

the value of the firm depends on the total cashflows of the firm the firms capital structure just cuts that cash flow up into slices without altering the total

Case II: Value of levered firm (Vl)

value of unlevered firm + PV of interest tax savings Vl = Vu + (t * D) This means that capital structure definitely matters once we include taxes

based on the static theory, levering up makes sense for

very profitable companies with significant tax obligations and have assets that can generate strong cash flows across many states of the world Low or no debt may be the best choice for firms that don't have tax bills or have wildly volatile cash flows