Chapter 16

Present value of the interest tax shield

(Tc X D X Rd)/Rd =Tc X D

EPS and EBIT graph

-EPS is steeper and more sensitive to change in EBIT because of the financial leverage employed -When the lines intersect, that point EPS is exactly the same for both capital structures

Basic of financial leverage

-Increasing debt increases the variability of return to stockholders -leverage has a beneficial impact on stockholders when earnings are rising and a detrimental impact when earnings are falling

Optimal capital structure

-Position I: No optimal structure -Position II: maximize debt -Position III: debt = cost of financial distress

to avoid bankruptcy

-lenders find it worthwhile to work with distressed creditors rather than force them into bankruptcy -Extension: Postponement of the date of payment -composition: reducing the required payment of debt

Value of going bankrupt

1. freezes the actions of creditors and gives management time to evaluate various courses of action 2. Used to forestall lawsuits and restructure the firm

Outcomes of legal bankruptcy

1. liquidation 2. reorganization

Bankruptcy

A legal process to get out of debt when you can no longer make all your required payments -liquidating or reorganizing a business

bankruptcy cost

A limiting factor affecting the amount of debt a firm might use -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 -Firms become bankrupt when the value of equity is zero, when the firms assets equals the value of its debt -bankruptcy results in giving ownership to bondholders

legal bankruptcy

Firms or creditors bring petitions to a federal court for bankruptcy

Optimal Capital Structure

The lowest possible WACC or the lowest weighted average cost of capital to maximize the value of the firm

M&M Proposition I with taxes

Vl= Vu + Tc X D

Business Failure

a business that has stopped operating with a loss to creditors, but even an all equity firm can fail

reorganization

financial restructuring of a failing firm to attempt to continue operations as a going concern -involves issuing new securities to replace old securities

financial slack

gives management the ability to finance projects as they appear and to move quickly if necessary

liquidation

termination of the firm as a going concern -involves selling off the assets of the firm

Unlevered cost of capital

the cost of capital for a firm that has no debt - Represented by Ru

indirect bankruptcy costs

the costs of avoiding a bankruptcy filing incurred by a financially distressed firm

Direct bankruptcy costs

the costs that are directly associated with bankruptcy, such as legal and administrative expenses -Its expensive to go bankrupt and bondholders do not get all that they are owed -firm faces problem as the more they borrow the more they owe increasing chance of bankruptcy

M&M Proposition I

the proposition that the value of the firm is independent of the firm's capital structure -states that it is completely irrelevant how a firm chooses to arrange its finances

interest tax shield

the tax saving attained by a firm from interest expense

homemade leverage

the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed

Two parts of a systematic risk

1. Business risk (unaffected by capital structure and depends on the firms assets and operations 2. Financial risk (determined by financial policy

Debt has two distinguishing features

1. Interest paid on debt is tax deductible 2. failure to meet debt obligations can result in bankruptcy

Pecking order

1. Internal financing 2. Issue debt 3. Equity

Implications of the pecking order

1. No target capital structure. Under the pecking-order theory there is no target or optimal debt equity ratio 2. Profitable firms use less debt. Because profitable firms have greater internal cash flow, they will need less external financing and will therefore have less debt 3. Companies will want financial slack. to avoid selling new equity, companies will want to stockpile internally generated cash known as financial slack

Corporate Borrowing and Homemade Leverage

1. The effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial 2. Under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS 3. Shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case

Why internal financing is first in pecking order

1. selling securities is expensive 2. may require the disclosure of information management would rather not allow competitors to see 3. may signal to market that firms shares of overvalued

Capital structure decisions

A firms dept- equity ratio

Capital structure is irrelevant in the change of stock price

Corporate borrowing is not special as investors can borrow or lend on their own -no matter how one chooses to borrow the stock price will stay the same

Value of firm

Depends on the total firm cash flow. the capital structure cuts that cash flow up into slices without altering the total but stockholders and bondholders may not be the only ones who claim a slice

Financial Leverage

Extent to which a firm relies on debt -the more debt financing a firm uses in its capital structure, the more financial leverage it employs -magnifies gains or losses

accounting insolvency

Firms with negative net worth are insolvent on the books. This happens when the total book liabilities exceed the book value of the total assets

Observations about capital structure

Most US companies have low debt-equity ratios -use much less debt financing the equity financing

Which is correct theory, static or pecking order

No one knows but -Static theory speaks more to long-run financial goals or strategies -issue of tax shields and financial distress costs are plainly important -Pecking order theory is more concerned with the shorter-run, tactical issue of raising external funds to finance investments

proposition II with taxes

Re= Ru + (Ru- Rd) X (D/V) X (1-Tc)

As a firm raises its debt-equity ratio

The increase in leverage raises the risk of the equity and therefore the required return or cost of equity (Re)

M&M Proposition I: The Pie model

The size of the pie doesn't depend on how it is sliced

Extended pie theory

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

technical insolvency

firm is unable to meet debt obligations -results from a firm's default on a legal obligation to pay a debt

Capital Restructuring

involves changing the debt-equity mix, adding debt or equity

The change in the capital structure weights (E/V and D/V)

is exactly offset by the change in the cost of equity (Re) so the WACC stays the same

marketed claims vs. non marketed claims

key difference is that the marketed claims can be bought and sold in financial markets and the non marketed claims cannot be sold in financial markets -Optimal structure max value of market claims and min value of non marketed claims

financial distress costs

the direct and indirect costs associated with going bankrupt or experiencing financial distress -EX: customers question ability of the firm to provide service and do not buy -difficult to estimate

Financial risk

the equity risk that comes from the financial policy (the capital structure) of the firm (Ra- Rd)* (D/E) -risk that arises from the firms financial decisions -As debt financing increase so does the risk of the equity

Business Risk

the equity risk that comes from the nature of the firm's operating activities -results of previous investment decisions -The greater the risk, the greater Ra, the greater the firm's cost of equity -related to the firms systematic risk

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 -Re= Ra(WACC) + (Ra-Rd) X (D/E) -Cost of equity depends on three things 1. The required return Ra 2. The firms cost of debt Rd 3. The firms debt-equity ration D/E

Absolute priority rule

the rule establishing priority of claims in liquidation -Qualifications 1. secured creditors 2. Subject to much negotiation

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 -assumes that the firm is fixed in terms of assets and operations -firm value is maximized 1. Firms with higher tax rates should borrow more 2. Firms with higher risk of distress should borrow less 3. Firms with higher financial distress should borrow less