Chapter 16 Finance

Low level of debt v high level of debt

- low debt levels, the probability of bankruptcy and financial distress is low, and the benefit from debt outweighs the cost. -high debt levels, the possibility of financial distress is a chronic, ongoing problem for the firm, so the benefits from debt financing may be more than offset by the financial distress costs.

financial risk of equity

- risk that arises from use of debt financing - depends on financial policy

Absolute Priority Rule / priority of payment in bankruptcy

Administrative expenses associated with the bankruptcy. Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee. Wages, salaries, and commissions. Contributions to employee benefit plans. Consumer claims. Government tax claims. Payment to unsecured creditors. Payment to preferred stockholders. Payment to common stockholders. - priority list for liquidation is a reflection of the absolute priority rule (APR)

How does company reduce debt-equity ratio

Alternatively, it could issue stock and use the money to pay off some debt, thereby reducing the debt-equity ratio.

bankruptcy cost

As D/E increases, so does probability that firm cant pay back debt to bondholders ownership of firms assets transferred from stockholders to bondholders

Business failure

Business failure: This term is usually used to refer to a situation in which a business has terminated with a loss to creditors; but even an all-equity firm can fail.

High debt v low debt industries

Cable and airlines = high drugs and computer equiptment = low

Cases

Case I - Assumptions: No corporate or personal taxe, No bankruptcy costs Case II - Assumptions:Corporate taxes, but no personal taxes, No bankruptcy costs Case III - Assumptions: Corporate taxes, but no personal taxes, Bankruptcy costs

Reorganization

Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors

Liquidation

Chapter 7 of Federal Bankruptcy Reform Act of 1978 Trustee takes over assets, sells them, and distributes the proceeds according to the absolute priority rule

M&M Proposition II

Cost of equity depends on 3 things 1)required return on firms assets: Ra 2) firm's cost of debt Rd 3) DE ratio

Legal bankruptcy:

Firms or creditors bring petitions to a federal court for bankruptcy. Bankruptcy is a legal proceeding for liquidating or reorganizing a business.

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.

Financial leverage

How much debt a firm has Magnifies gains or losses to shareholders... increases variability The fraction of the total financing that is represented by debt

How does company increase debt-equity ratio

If management so desired, a firm could issue some bonds and use the proceeds to buy back some stock, thereby increasing the debt-equity ratio.

Corporate Tax results

Leverage DOES affect firm value. Stockholder benefits from tax shield.Stockholder is better off with more debt. Debt policy matters. Optimum is 100% debt - meaningless conclusion

WACC relation to firm value

Minimize WACC to maximize value

Are assets affected by capital restructuring?

No, This means that a firm can consider capital restructuring decisions in isolation from its investment decisions.

M&M Proposition II with corporate taxes

RE = RU + (RU − RD ) × (D/E) × (1 − TC ) some of interest in equity risk and return is offset by tax shield

Interest shield

Tax savings attained by firm from interest expense Tc x Debt assume perpetual debt value of firm increases by PV of interest tax shield

Technical insolvency:

Technical insolvency occurs when a firm is unable to meet its financial obligations.

indirect bankruptcy costs

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

Financial leverage and EBIT relationship

The effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial and the opposite is true if EBIT is low. leverage increases the returns to shareholders, as measured by both ROE and EPS. Shareholders are exposed to more risk bc the EPS and ROE are much more sensitive to changes in EBIT.

Managerial recommendations on capital structure

The tax benefit is only important if the firm has a large tax liability. Risk of financial distress -The greater the risk of financial distress, the less debt will be optimal for the firm. - The cost of financial distress varies across firms and industries, and as a manager you need to understand the cost for your industry.

Homemade leverage

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed debt replicated by investors

M&M Proposition 1

The value of the firm is independent of its capital structure - completely irrelevant how firm chooses to arrange finances

Pecking order theory

Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. ◦Rule 1 - Use internal financing first Rule 2- Issue debt next, new equity last. The pecking-order theory is at odds with the tradeoff theory - There is no target D/E ratio. - qProfitable firms use less debt. - Companies like financial slack.

M&M Proposition I with taxes = leverered firm

VL = VU + TC × D capital structure MATTERS - firm value increases with leverage

WACC And DE ratio relationship

WACC declines as the debt-equity ratio grows. This illustrates again that the more debt the firm uses, the lower is its WACC.

Optimal capital structure

WACC minimized, also called target capital structure. Discount rates for cash flows needs to be low to increase value of CF. Move in opposite directions

default

When a firm fails to make the required interest or principal payments on its debt, or violates a debt covenant After the firm defaults, debt holders are given certain rights to the assets of the firm and may even take legal ownership of the firm's assets through bankruptcy.

Capital structure

capital structure is the mix of financial securities used to finance its activities.The mix will always include common stock (if publically traded) and will often include debt and preferred stock.

Difference between M&M and static theory

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 with no taxes is the gain from leverage, net of distress costs.

marketed claims v unmarketed claims

marketed claims - claims of stockholders and bondholders. unmarketed - the claims of the government and other potential stakeholders. - key difference is that the marketed claims can be bought and sold in financial markets and the nonmarketed claims cannot be sold in financial markets. -the overall value of the firm is unaffected by changes in capital structure. - The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions.

Ra depends on business risk

nature of firm's operating activities - risk inherent in a firm's operations - depends on systematic risk of firm's assets - more business risk, higher Ra, higher COE - unaffected by cap structure

financial distress cost

refer generically to the direct and indirect costs associated with going bankrupt or avoiding a bankruptcy filing. financial distress costs are larger, when the stockholders and the bondholders are different group

What happens as firm raises debt to equity ratio

shows that as the 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

Static theory of capital structure

that firms borrow 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. - We call this the static theory because it assumes that the firm is fixed in terms of its assets and operations and it considers only possible changes in the debt-equity ratio.

Unlevered cost of capital

the cost of capital for a firm that has no debt VU=EBIT×(1−TC)/RU

direct bankruptcy costs

the costs that are directly associated with bankruptcy, such as legal and administrative expenses

Extended pie model

the value of all the claims against the firms cash flows is not affected by capital structure, but the relative value of claims change as the amount of debt financing is increased - Payments to stockholders+ Payments to creditors+ Payments to the government+ Payments to bankruptcy courts and lawyers+ Payments to any and all other claimants to the cash flows of the firm

bankruptcy occurs when

value of its assets equals the value of its debt. When this occurs, the value of equity is zero, and the stockholders turn over control of the firm to the bondholders. When this takes place, the bondholders hold assets whose value is exactly equal to what is owed on the debt

financial distress

when a firm has difficulty meeting its debt obligations