Financial Leverage and Capital Structure
What happens when you increase the D/E, what happens to the WACC?
* rD increases, because more risk to debt * D/(D+E) increases, automatically * rE increases, because more risk to equity * E/(D+E) decreases, automatically
What is the M&M theory? (Modigliani-Miller Theorem)
A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends.
What is an advantage to having more debt, and what is a disadvantage?
An advantage is that your earnings per share can increase with more debt, but a disadvantage is that
Capital Asset Pricing Model Formula For Beta of the Asset
B_A = (D/(D+E)) x B_D + ((E/(D+E)) x B_E
Bankruptcy process includes
Business failures, legal bankruptcy, technical insolvency, and accounting insolvency.
How can a value of a firm increase?
By increases its debt due to the interest tax shield.
Capital Asset Pricing Model Formula For Return on Assets
CAPM: R_A = R_f + B_A(R_M - R_f) * f stand for free rate
Present value of an annual tax shield
PV of tax shield = annual tax shield / interest rate
The WACC decreases as D/E increases because of the government subsidy on interest payments
R_A = (E/V)R_E + (D/V)(R_D)(1-T_C) R_E = R_U + (R_U - R_D)(D/E)(1-T_C)
Capital Asset Pricing Model Formula For Return on Equity
R_E = R_f + B_A(1+D/E)(R_M - R_f)
Bankruptcy type: Chapter 11 of the Federal Bankruptcy Reform Act of 1978
Restructure the corporation with a provision to repay creditors
Capital Asset Pricing Model Formula For Beta of the Equity
Set B_D = 0 and solve for B_E B_E = B_A(1+D/E)
Cost of Capital and Firm Value
The Value of a firm is the present value of future cash flows. If you view the firm as a perpetuity its value is Value = Cash Flow / Weighted Average Cost of Capital
Weighted Average Cost of Capital
The required rate of return on a firm's assets is the weighted average return on the securities the issued. WACC = R_A = R_D x (D/(D+E)) + R_E x (E/(D+E))
What is the pie theory?
The value of a firm is defined to be the sum of the value of the firm's debt and the firm's equity. Value = Debt + Equity
Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
What are R_A, R_D, R_E in the WACC formula
They are the return on the firms assets, debt, and equity
What happens with firms who have more debt?
They pay less in taxes. This is also known as being a levered firm.
What are a few examples of direct costs?
They would be legal fees, accounting fees, and court fees.
What are a few example of indirect cost?
They would be loss of supplier credit, loss of bank credit, loss of customers, loss of human capital, inefficient management, and agency costs.
Bankruptcy type: Chapter 7 of the Federal Bankruptcy Reform Act of 1978
Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule
Assuming never ending cash flows; V_L =
VL = VU + DTC
Assuming never ending cash flows; V_U =
V_U = EBIT(1-T) / R_U
What is the value of a levered firm
Value of a levered firm = value of an unlevered firm + PV of interest tax shield
What is the value of equity
Value of equity = Value of the firm - Value of debt
Does the value of the company increase with more or less debt?
With more debt.
Annual tax shield
annual tax shield = tax rate X interest payment
Accounting insolvency
book value of equity is negative
Business failure
business has terminated with a loss to creditors
How can a firm increase financial leverage?
by issuing debt and repurchasing outstanding shares.
How can you decrease financial leverage?
by issuing new shares and retiring outstanding debt
Capital restructuring involves...
changing the amount of leverage a firm has without changing the firm's assets
Technical insolvency
firm is unable to meet debt obligations
Legal bankruptcy
petition federal court for bankruptcy
The value you of your firm increases by...
the present value of the annual interest tax shield
What are the D & E in the WACC formula
they are the market value of the debt and the equitty
