AEM2241 Prelim 3

Bankruptcy Liquidation: sequence of events

1. a petition is filed under a federal court. corporations amy file voluntarily or involuntary position may be filed against the corporation by several of the creditors. 2. trustee in bankruptcy elected by creditors to take over the assets of the debtor corporation. the trustee will attempt to liquidate the assets. 3. when the assets are liquidated, after payment of the bankruptcy administration costs, proceeds are distributed among creditors. 4. If any proceeds remain, after expenses and payments to creditors, they are distributed to shareholders. Distribution of the proceeds of the liquidation occurs according to the following priority list: Administrative expenses associated with bankruptcy, other expenses arising after the filing of involuntary bankruptcy petition but before the appointment of a trustee, wages, salaries, commissions, contributions to employee benefit plans, consumer claims, government tax claims, payment to unsecured creditors, payment to preferred stockholders, payment to common stockholders.

EBIT, EBIT increases risk homemade leverage

1. the effect of financial leverage depends on the company's ______. when _____ is relatively high, leverage is beneficial. 2. under the expected scenario, leverage ____ returns to shareholders, as measured by both ROE and EPS 3. shareholders are exposed to more ___ under the proposed capital structure because the EPS and the ROE are much more sensitive to changes in EBIT in this case. 4. Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of stock, capital structure is an important consideration. The last conclusion does not always follow- shareholders can adjust the amount of financial leverage by borrowing and lending on their own. this use of personal borrowing to alter the degree of financial leverage is called _______ ______

assets, debt, D/E ratio

Although changing the capital structure of the firm does not change the firm's total value, it does cause important changes in the firm's debt and equity. examine whether returns to a firm financed with debt and equity when the debt-equity ratio is changed (ignore taxes) WACC= (E/V)*Re + (D/V)*Rd where V= E+D We also saw the true way of interpreting the WACC is as the required return on the firm's overall assets. to remind us of this, we will use the symbol Ra to stand for the WACC and write: Ra= (E/V)*Re + (D/V)*Rd If we re-arrange this to solve for the cost of equity capital, we see that: Re= Ra+ (Ra-Rd)(D/E) This is the famous M&M Proposition II, which tells us the cost of equity depends on 3 things: the required rate of return on the firm's ______, the firm's cost of _____ and the firm's ___/____ ratio. the cost of equity is given by a straight line with a slope of (Ra-Rd). The y-intercept corresponds to a firm with debt/equity ratio of zero, so Ra= Re in that case.

assets bankrupt

As the debt/equity ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised to them. When this happens, ownership of the firm's ____ are ultimately transferred from stockholders to bondholders. A firm becomes _____ when the value of its assets equals the value of its debt. This makes the value of equity zero and stockholders turn over control to bondholders. When this takes place, the bondholders hold assets whose value is exactly equal to what is owed on the debt. in a perfect world, there are no costs associated with this transfer of ownership, and the bondholders don't lose anything. it is expensive to go bankrupt, costs associated with bankruptcy may eventually offset the tax related gains from leverage.

equity equity WACC

As the firm raises its debt/equity ratio, the increase in leverage raises the risk of the _____ and therefore the required cost of ____. the ______ doesn't depend on the debt/equity ratio, it's the same no matter what the debt/equity ratio is.

interest tax shield

Because the debt is perpetual, the same $x will be generated every year forever. Levered firms worth more than the unlevered firm, the difference being this $x perpetuity that is the interest tax shield. because the tax shield is generated by paying interest, it has the same risk as the debt and that gives the appropriate discount rate. present value of the interest tax shield= (Tc)*(D) we have seen that the value of a firm, L, VL exceeds the value of Firm U, VU, by the present value of the _____ _____ _____ (Tc x D). M&M Proposition ____ states that: VL= VU + (Tc*d) M&M Proposition 1 with corporate taxes implies that the relationships is generally a straight line with a slope of Tc and y-intercept of Vu.

tax paying greater less

Capital structure: some managerial recommendations: static model is not capable of identifying a precise optimal capital structure Taxes: tax benefits from leverage are important only to firms in a ____-____ position. firms with substantial accumulated losses will get little value from the interest tax shield. furthermore, firms that have substantial tax shields from other sources, such as depreciation, will get less benefit from leverage. Also, not all firms have the same tax rate, a bigger tax rate is a ____ incentive to borrow. Financial distress- firms with greater risk of experiencing financial distress will borrow ____ than firms with a lower risk of financial distress. financial distress is more costly for some firms than others. the costs depend on primarily the firm's assets. determined by how easily the ownership of these assets can be transferred.

business failure legal bankrupcty technical insolvency accounting insolvency

Financial distress can be defined in several ways: 1. _____ _______- businesses has terminated with a loss to creditors, but even an all equity firm can fail 2. _____ ______- firms or creditors bring petitions to a federal court for bankruptcy. this is a legal proceeding for liquidating or reorganizing a business. 3. ______ _____- when a firm in unable to meet its financial obligations 4. ______ ______- firms with negative net worth are insolvent on the books, this happens when the total book liabilities exceed the book value of the assets.

value

How should a firm go about choosing its debt/equity ratio. we assume that the guiding principle is to choose the course of action that maximizes the _____ of a share of stock. this is essentially the same thing as maximizing the value of the whole firm.

target capital structure less slack

Implications of the pecking order: 1. no ____ ____ _______- no optimal debt equity ratios or CS determined by its need for external financing, which dictates the amount of debt the firm will have 2. profitable firms use ____ debt- because profitable firms have more internal CF, they will need less external financing and will therefore have less debt. 3. Companies will want financial _____- to avoid selling new equity, companies will want to stockpile internally generated cash. such a cash reserve is known as financial slack. gives management the ability to finance projects as they appear and to move quickly is necessary. the trade off theory speaks to more LR financial stocks or strategies, the issues of tax shields and financial distress are important in that context. pecking order theory is more concerned with he short run, tactical issue of raising external funds to finance investments.

tax deductive

Interest paid on debt is _____ _________. this is good for the firm and it may be an added benefit of debt financing. second, failure to meet debt obligations can result in bankruptcy. this is not good for the firm and it may be an added cost of debt financing.

business equity rises financial risk

M&M Proposition 2 says that the firm's cost of equity can be broken down into two components- the first component- Ra is the required return on the firm's assets, overall, and it depends on the nature of the firm's operating activities. The risk inherent in a firm's operations is called ______ risk of the firm's equity. This depends on the systemic risk of the firm's assets. the greater a firm's business risk, the greater Ra will be, and all other things being the same, the greater will be the firm's cost of _____. The second component is the cost of equity (Ra-Rd)x(D/E) and is determined by the firm's capital structure. for an all equity firm, this component is 0. as the firm begins to rely on debt financing, the required return on equity ______. this occurs because the debt financing increases the risk borne by stockholders. This extra risk that arises from the use of debt financing is called _____ ______ of the firm's equity. the total systemic risk of the firm's equity thus has two parts: business risk and financial risk

assets loss net present value x 2

The capital structure that maximizes the value of a firm is one that financial managers should choose for the shareholders. restructuring will change the capital structure of the firm with no direct effect on the firm's _____. immediate effect will be to increase debt and decrease equity. if the value of the firm stays the same, the shareholders will experience capital ____ exactly offsetting the extra dividend The change in the value of the firm is the same as the net effect on stockholders. Financial managers can therefore try to find the capital structure that maximizes the value of the firm. ____ ____ ____ applies to capital structure decisions and the change in the value of the overall firm is the ___ ___ ___of a restructuring.

100

Unlevered cost of capital, Symbol Ru, used to represent it. We can think of Ru as the cost of capital a firm would have when it has no debt. The value of the unlettered firm is: VU= (EBIT x (1-Tc))/Ru Value of the levered firm, VL, is: VL= VU + (Tc x D) Once we include taxes, the capital structure definitely matters. however we immediacy reach the illogical conclusion that the optimal capital structure is _____%.

increases

WACC declines as the debt/equity ratio _____. The more debt the firm uses, the lower its WACC.

LESS

We can also conclude that the best capital structure is 100 percent debt by examining the WACC. WACC= (E/V)*Re + (D/V)*Rd*(1-Tc) To calculate this WACC, we need to know the cost of equity. M&M Proposition 2 w/ corporate taxes states that the cost of equity is: Re= Ru + (Ru-Rd)x(D/E)x(1-Tc) WITH DEBT, THE WACC IS ____ SO THE FIRM IS BETTER OFF WITH DEBT.

M&M Proposition 1 equity x 2

Which proposition is this? The firm's overall cost of capital is unaffected by its capital structure. 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. In other words, the change in the capital structure weights (E/V) and (D/V) is exactly offset by the change in cost of the _____ (Re) so the WACC stays the same.

business equity

____ risk depends not he firm's assets and operations and is not affected by the capital structure. given the firm's business risk and cost of debt, the financial risk is completely determined by financial policy. firm's cost of ____ rises when the firm increases its use of financial leverage because the financial risk of the equity increases while the business risk remains the same.

low high

a firm will borrow because the interest tax shield is valuable. at relatively ____ debt levels, the probability of bankruptcy and financial distress is low and the benefit from debt outweighs the cost. at very __ debt levels, the possibility of financial distress is a chronic, ongoing problem for the firm, so the benefit from debt financing may be more than offset by the financial distress costs. optimal capital structure exists somewhere between these two extremes.

capital structure decision

a firm's choice of how much debt it should have relative to equity, decision's about a firm's debt/equity ratio. a firm can choose any capital structure it wants

taxes

assume depreciation is zero. we will also assume that capital spending is zero and there are no changes in NWC. in this case, cash flow from assets is simply EBIT-TAXES. cash flows from levered and un-levered firms are not the same even though the two firms have identical assets. total cash flow to the levered is $x more with $x being the number of dollars saved in ______

real

critics of the M&M theory often say that it fails to hold as soon as we add in real world issues and that the M&M theory is really just that: a theory that doesn't have much to say about the _____ world we live in.

capital restructuring

decisions that alter the firm's existing capital structure, take place whenever the firm substitutes one capital structure for another while leaving the firm's assets unchanged. a firm can consider doing this in isolation from its other activities, in isolation from investment decisions

magnify leverage

describe the impact of leverage in terms of its effects on earnings per share and ROE. these are accounting numbers and are not our primary concern. ROE= net income/ total equity the impact of leverage is evident when the effect of restructuring on EPS and ROE is examined. The variability in both EPS and ROE is much larger under the proposed capital structure. this illustrates how financial leverage acts to ______ gains and losses to shareholders. in this example, EPS is twice as sensitive to changes in EBIT because of the financial leverage employed. graph- lines intersect, at this point, EPS is exactly the same for both capital structures, set the lines equal to find the EBIT where the EPS of the two capital structures is the same. this is called the breakeven point or the indifference point. if EBIT is above this level, _______ is beneficial. if it below it, it is not. the firm earns a return that is just sufficient to pay the interest.

financial distress indirect bankruptcy costs financial distress costs value

firm will spend resources to not go bankrupt. when a firm is having significant problems meeting its debt obligations, we say that it is experiencing _____ ________. Some financially distressed firms ultimately file for bankruptcy, but most do not because they are able to recover or otherwise service. the costs of avoiding a bankruptcy filing are called _____ _______ costs _____ ________ costs- the direct and indirect costs associated with going bankrupt or avoiding bankruptcy filing. These costs are larger when the stockholders and the bondholders are different groups. Until the firm is legally bankrupt, the stockholders control is. they will take actions in their own economic interest. because the stockholders can be wiped out with a legal bankruptcy, they have a very strong interest in avoiding a bankruptcy filing. bondholders are primarily concerned with protecting the value of the firm's assets, and will try to take control away from stockholders. they have a strong incentive to seek bankruptcy to protect their interests and keep stockholders from further dissipating their assets to the firm. long and expensive legal battle. assets of the firm lose value because management is busy trying to avoid bankruptcy instead of running the business. normal operations are disrupted and sales are lost. valuable employees leave, potentially fruitful programs were dropped to preserve cash, and otherwise profitable investments are not taken. whether or not the firm goes bankrupt, the net effect is a loss of ______ because the firm chose to use debt in its capital structure. it is this possibility of loss that limits the amount of debt that a firm will choose to use.

liquidation re-organization

firms that cannot or choose not to make contractually required payments to creditors have two basic options: __________- termination of the firm is a going concern and it involves selling off the assets of the firms. the proceeds, net of selling costs, are distributed to creditors in order of established priority. ____-______- keeping the firm is a going concern, involves selling more securities to replace the old securities. Liquidation or re-organization is the result of a bankruptcy proceeding. which occurs is depending on whether the firm is worth more dead or alive.

size

imagine two firms that are identical on the left side of the balance sheet. their assets and operations are exactly the same. the right sides are different because the two firms finance their operations differently. in this case, we can view the capital structure question in terms of a pie model. the size of the pie is the same for both firms because the value of the assets is the same. this is precisely wha the M&M proposition 1 states: the ______ of the pie does not depend on how it is sliced.

decrease rise cash flows value

in the extended pie model, taxes just represent another claim on the cash flows of the firm. because taxes are reduced, as leverage is increased, the value of the governments claim on cash flows ______ with leverage. bankruptcy costs are also a claim on the cash flows. they come into play as the firm closes to bankruptcy and has to alter assets to attempt to stave off the event itself, they become larger when bankruptcy actually takes place. thus, the value of the claim (B) not he cash flows _____ with the debt equity ratio. the extended pie simply holds that all of the claims can be paid from only one source: the _____ _____(CF) of the firm. algebraically, we must have: CF= Payments ot stockholders + payments to creditors +payments to government + payments to bankruptcy costs and lawyers + payments to any and all other claimants to the CF of the firm there is a change in the relative sizes of the slices as the firm's use of debt financing is increased. the ______ of the firm depends on the total cash flow of the firm the firm's capital structure just cuts the cash flow up into slices without altering the total. stockholders and bondholders may not be the only ones who can claim a slice.

M&M Proposition 1

it is completely irrelevant how a firm chooses to arrange its finances.

pecking order theory

many large financially sophisticated and highly profitable firms use little debt. under the status theory, these are the firms that should use the most debt because there is little risk of ______ and the value of the _____ _____ is substantial. _______ _____ theory is an alternative to the static theory: it says that firm's prefer to use internal financing whenever possible. a reason is selling securities to raise cash can be expensive, so it endeavors to avoid doing so if possible. if a firm is very profitable, it might never need external financing, so it would end up with little or no debt. if you try to raise money by selling equity, you run the risk of signaling to investors that the price is too high. companies rarely sell more equity and the market reacts negatively to such sales when they occur. So, we have a pecking order. Companies will use internal financing first. Then, will use debt. Equity will be sold pretty much as a last resort.

low

most corporations seem to have relatively _____ debt/equity ratios. in fact, most corporations use much less debt financing than equity financing. Most industries rely more on equity than debt, this is true even though many of these corporations pay substantial taxes. Corporations have not in general issued debt up to the point that the tax shield is completely used up. there must be limits to the amount of debt corporations can use. EBIT, volatility, asset types, some connections between these characteristics and capital structure.

static theory of capital structure

says that firms borrow up to the point where the tax benefit from an extra dollar in debt is equal to the cost that comes from the increased probability of financial distress. this assumes that the firm is fixed in terms of operations and considers only possible changes in the debt/equity ratio. the value of a firm rises to a maximum and then declines beyond that point. this is the picture we get from the static theory. the firm's optimal capital structure is composed of D*/VL in debt and (1-D*/VL*) in equity. the difference between the value of the firm in our static theory and the M&M value of the firm with taxes is the loss in value from the possibility of financial distress. also, the difference between the static theory value of the firm and the M&M value of the firm is given from leverage, net of distress costs.

capital declines

the capital structure that maximizes that value of the firm is also the one that minimizes the cost of ______. WACC falls initially because after tax cost of debt is cheaper than equity. so initially, the overall cost of capital ____ At some point, the cost of debt begins to rise and the fact that debt is cheaper than equity is more than offset by financial distress costs. from this point, further increases in debt actually increase the WACC.

financial leverage

the extent to which a firm relies on debt. the more debt financially a firm uses in its capital structure, the more ____ _____ it employs this can dramatically alter the payoffs to the shareholder in the firm but it may not affect the overall cost of capital. if this is true, then the firm's capital structure is irrelevant because changes in the capital structure won't affect the value of the firm.

interest tax shield.

the fact that interest is deductible for tax purposes has generated a tax saving equal to the interest payment multiplied by the corporate tax rate. this tax saving is called the _____ _____ ____

absolute priority rule

the higher a claim is on the list, the more likely it is to be paid.

borrow

the stockholder who prefers the proposed capital structure will simply create it with homemade leverage. to replicate this structure at the proposed level, the stockholder must _____ enough to create the same debt/equity ratio. investors can always increase financial leverage in order to create a different pattern of payoffs.

weighted average cost of capital

this figure tells us the firm's overall cost of capital is a weighted average of the costs of the various components of the firm's capital structure. When we describe this figure, we take the firm's capital structure as given. the value of the firm is __________ when WACC is minimized.

WACC WACC target capital structure

this is the appropriate discount rate for the firm's overall cash flows. Because values and discount rates move in opposite directions, minimizing the ______ will maximize the value of the firm's cash flows. one capital structure is better than another if it results in a lower weighted average cost of capital. a particular debt-equity ratio represents the optimal capital structure if it results in the lowest possible ____ _____ _____ ______. this optimal capital structure is called the firm's ______ ______ ______

direct bankruptcy costs

when the value of the firm's assets equals the value of its debts, then the firm is economically bankrupt in the sense that equity has no value. However, the formal turning over of the assets to the bondholders is a legal process, not an economic one. there are legal and administrative costs to bankruptcy. because of the expenses associated with bankruptcy, bondholders won't get all that they are owed. some fraction of the firm's assets will disappear in the legal and administrative expenses associated with bankruptcy. These direct bankruptcy costs are a disincentive to debt financing. if a firm goes bankrupt, then suddenly a piece of the firm disappears. this amounts to a ______ ________. trade off: borrowing saves a firm money on its corporate taxes, but the more a firm borrows, the more likely it is that a firm will become bankrupt and pay a bankruptcy tax.