Chapter 13
(T/F) Holding equity in an unlevered firm has no risk.
False
Static Theory of Capital Structure
-According to the static theory, the gain from the tax shield on debt is offset by financial distress costs. -An optimal structure exists that just balances the additional gain from leverage against the added financial distress cost.
Which of the following are direct costs of financial distress?
-Administrative expenses -Legal fees
An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.
A Higher Expected Return
Which of the following is correct?
A firm can be forced into bankruptcy by its creditors or can voluntarily file bankruptcy itself
EPS Example (Ignoring taxes)
EBIT/400,000= (EBIT-400,000)/200,000 EBIT= (400,000/200,000) (EBIT -400,000) EBIT=2EBIT - 800,000 Break-even EBIT=800,000 EPS=(800k/400k)= $2.00
The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of:
Debt
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) included all the following changes to or effects on the bankruptcy process EXCEPT:
Debtor-In-Possession financing is no longer permitted Included: -Firms operating under Chapter 11 are no longer the only firms permitted to file reorganization plans -After 18 months, creditors may file a reorganization plan of their own -BAPCPA permits large payments to retain key employees -More prepackaged bankruptcies are expected
The cost of debt will begin to increase as the:
Degree of leverage increases
Which costs of financial distress are easier to measure?
Direct Costs
According to M&M Proposition 1, a firm's capital structure choices:
Do not affect the value of the firm (It is independent of the firm's capital structure)
An individual can duplicate a levered firm though a strategy called ___ leverage where the investor uses his own funds plus borrowed funds to buy stocks.
Homemade
Financial distress can arise in the form of possible:
-Business failure -Legal bankruptcy
Which of the following industries tend to have a high leverage?
-Cable television -Airlines
Which two of the following are broad types of costs of Financial distress?
-Direct costs -Indirect costs
Which of the following industries tend to have a low leverage?
-Drugs -Computers
Absolute Priority Rule (determines seniority risk)
1. Secured Creditors -people will mortgages/leans, who have the right to take it back and sell it to pay off what they are owed before it goes to the unsecured creditors 2. Administrative Claims -Lawyers/accountants 3. Post-Filing Expenses 4. Employee wages, salaries, and commissions 5. Employee benefit plans 6. Consumer Claims 7. Tax Claims (from government) 8. Unsecured Creditors 9. Preferred Stockholders 10. Common Stockholder
Based on MM Proposition 1 with corporate taxes, the optimal capital structure is ___.
100% Debt
Alpha Co. has a debt-equity ratio of .6, a pretax cost of debt of 7.5%, and an unlevered cost of equity of 12%. What is Alpha's cost of equity if you ignore taxes?
14.7% 12%+.6(12%-7.5)
The costs of financial distress depend mostly on how easily the ownership of the firm's ___ can be transferred.
Assets
The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs ___ the present value of the tax shield benefits.
Equal
(T/F) There is a precise mathematical equation for determining the optimal level of debt for any firm.
False (determined in a subjective manner)
If the degree of leverage increases, the cost of debt will ___.
Increase
Capital structure decisions are made ___ investment decisions.
Independent of
Which of the following is true of the impact of financial leverage?
It magnifies gains and losses
What is generally the most important component of direct bankruptcy costs?
Legal costs
The approval of a bankruptcy plan by the major creditors of a firm in advance of a legal filing is called a:
Prepackaged Bankruptcy
(T/F) It is possible for the present value of distress costs to exceed the present value of tax savings.
True
Example (Interest Tax shield)
Unlevered Firm (does not have debt) / Levered Firm (does have debt) EBIT: 1000 / 1000 Interest: 0 /100 Taxable Income: 1000 / 1000 Taxes (40%): 400 / 360 Net Income: 600 / 640 CFFA: 600 / 640 Levered Firm has paid interest which means it has lower taxable income and pay lower taxes (Cash flow from assets (CFFA) will be higher as well)
A firm is considered bankrupt when the value of its equity is ___.
Zero
Conclusion / Summary
-Case I - no taxes or bankruptcy costs ~No optimal capital structure -Case II - corporate taxes but no bankruptcy costs ~Optimal capital structure is 100% debt (use as much debt as possible) ~Each additional dollar of debt increases the cash flow of the firm -Case III - corporate taxes and bankruptcy costs ~Optimal capital structure is part debt and part equity ~Occurs where the benefit from an additional dollar of debt is just offset by/equal to the increase in expected bankruptcy costs
Case 2 (Firm Value)
-Every additional dollar of debt accumulated, it will generate additional tax shield --> value of the firm (including the present value of the tax shield) will go up -The value of the firm increases as total debt increases because of the interest tax shield. This is the basis of M&M Proposition 1 with
The tax shield afforded by debt will be of the least use to firms with ___.
-Negative EBT -Losses carried forward
How should we pay for our assets?
-Our choice of how we finance our investment has some important effects on the company ~Leverage will affect cash flow, especially EPS, and therefore affects the cost of equity ~Leverage changes how much we pay in taxes but also increases the probability of bankruptcy, substantially increasing the risk of all securities
Bankruptcy is very valuable because:
-Payments to creditors cease pending the outcome of the bankruptcy process -It can be used strategically to improve a firm's competitive position.
Case 1 (Propositions 1 and 2)
-Proposition 1 ~The value of the firm is NOT affected by changes in the capital structure ~The cash flows of the firm do not change, therefore value does not change ~either going to creditors or shareholders -Proposition 2 ~The cost of equity is a linear function of the D/E ratio
Implications of Case 2
-Since the value of the firm increases as we use more debt, 100% debt may be an optimal capital structure -As we use more debt, the WACC decreases (more weight on a less costly source of financing)
A corporation gains no value from an interest tax shield if which of the following are true?
-The corporation is an all-equity firm -Corporate tax rates are zero -The corporation has no debt
Options in Bankruptcy
1. Liquidation -A trustee takes possession of all firm assets, sells them, and distributes them in accordance with absolute priority -If anything is left over after the creditors have been paid, shareholders would receive the remainder -Under Chapter 7 of bankruptcy code 2. Reorganization -Court distinguishes the debts before filing and the debts after filing -Business continues to operate (debtor-in-possession) -Firm submits a reorganization plan of how the creditors will be repaid or what they will own of the firm after emerging from bankruptcy --> which must be approved by the creditors and confirmed by the court -Payments are made in accordance with the reorganization plan after firm emerges -Under Chapter 11 of bankruptcy code
With ___, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.
Homemade Leverage
Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of ___ costs of financial distress.
Indirect
Which of the two types of costs of bankruptcy are more difficult to quantify?
Indirect costs
Which of the following assumptions is necessary for MM Proposition 1 to hold?
Individuals can borrow on their own at an interest rate equal to that of the firm.
MM Proposition 1 does not work with corporate taxes because:
Levered firms pay lower taxes than unlevered firms
Direct bankruptcy costs can include all of the following EXCEPT:
Loss of important customers Includes: -Consultant expenses -General administrative expenses -Accounting fees -Legal fees
The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ___.
Lower
The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the ___ theory of capital structure.
Static
Which of the following is NOT true regarding the application of the Absolute Priority Rule in the distribution of liquidation distributions?
The APR order is strictly followed in all bankruptcies to the extent that claimants not on the APR list are not entitled to any distribution from the liquidation. Are True: -Negotiation can alter the order in the APR -If an asset is sold and the proceeds are more than required to pay the secured creditors, the remainder of the funds go to pay unsecured creditors -Secured creditors are not on the APR list as they are entitled to the proceeds from the sale of the secured assets. -If an asset is sold and the proceeds are insufficient to pay the secured creditors, the remainder of the claim becomes an unsecured claim.
The tax savings attained by a firm from the tax deductibility of interest expense is called ___.
The Interest Tax Shield
It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because:
The bankruptcy process can be long and expensive
MM Proposition 2 shows that ___.
The cost of equity rises with leverage
A firm's capital structure refers to ___.
The firm's mix of debt and equity
A beneficial rule to follow is to set the firm's capital structure so that ___.
The firm's value is maximized
Volatility or ___ increases for equity holders when leverage increases.
Risk
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases
What are some examples of indirect financial distress costs?
-Lost reputation -Lost sales
Rank each of the following in order of priority of payment.
1) Bankruptcy administrative expenses 2) Wages, salaries, and commissions 3) Consumer claims 4) Payment to common shareholders
Observed Capital Structures
-Capital structure does differ by industries -Differences according to Cost of Capital 2010 Yearbook by Ibbotson Associates, Inc. -Table 13.5 (p. 437) ~Low levels of debt (pharmaceuticals and computer equipment manufacturers) =Drugs with 7.80% debt (use little debt b/c a lot of business risks) =Computer equipment with 9.09% debt (risk their products will be obsolete when someone makes something new) ~High levels of debt =Electric utilities with 48.54% debt (regulated therefore very little operating risks) =Airlines with 63.92% debt (high operating risks but has high level of debt b/c equity values were so low when stocks crashed, that debt had to makeup the difference)
An optimal capital structure will ___.
-Maximize the value of the firm -Minimize the cost of capital
Case 1 Equations
-WACC = RA = (E/V)RE + (D/V)RD -RE = RA + (RA - RD)(D/E) ~RA is the "cost" of the firm's business risk, i.e., the risk of the firm's assets ~(RA - RD)(D/E) is the "cost" of the firm's financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage -Cost of Equity is both a business and financial risk -As D/E increases = equity holders demand higher return to compensate them for higher risk
Leverage and Firm Value
-We want to consider how leverage affects the value of the company assuming everything else is unchanged ~Capital restructuring involves changing the capital structure without changing the firm's assets =Increase leverage by issuing/selling debt and using the proceeds to buy back stock =Decrease leverage by issuing new shares/stock and retiring existing debt or buy back bonds -We want to choose leverage that will maximize the value of the firm ~This happens when we minimize the WACC -Interest rates go up = present value goes down -Interest rates go down = present values go up
List the following items from the Absolute Priority Rule
1) Administrative Expenses 2) Expenses incurred after filing but before a trustee is appointed 3) Wages, salaries, and commissions 4) Contributions to employee benefit plans 5) Consumer claims 6) Government tax claims 7) Payments to unsecured creditors 8) Payments to preferred stockholders 9) Payments to common stockholders
Case 3 (Bankruptcy Costs)
-As the D/E ratio increases (the probability that the firm would not generate enough income to pay off its interest increases) , the probability of bankruptcy increases -This increased probability will increase the expected bankruptcy costs -At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost -At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added -Static theory of capital structure says that the optimal capital structure is where the benefit of additional interest tax shields is balanced/equal by the additional bankruptcy costs associated with the increase in debt. -The tax benefit is only important if the firm has a large tax liability -Not for profit --> no benefit from using debt
An optimal capital structure will:
-Maximize the value of the firm -Minimize the cost of capital
Case 2 (Corporate Taxes)
-Cash flows from assets can either go to stockholders, creditors, or government -Interest on debt is tax deductible (if firm has debt and pays interest, it will reduce the taxes) -Therefore, when a firm adds debt, it reduces taxes, all else equal -The reduction in taxes increases the cash flow of the firm -How should an increase in cash flows affect the value of the firm?
Break-Even EBIT
-Find EBIT where EPS is the same under both the current and proposed capital structures -If we expect EBIT to be GREATER than the break-even point, then leverage is beneficial to our stockholders (because you are dividing by a smaller number of shares) -If we expect EBIT to be LESS than the break-even point, then leverage is detrimental to our stockholders
Homemade Leverage: Current Capital Structure (firm does borrowing)
-Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock -Payoffs: ~Recession: 200(1.25) - .1(2000) = $50 ~Expected: 200(2.50) - .1(2000) = $300 ~Expansion: 200(3.75) - .1(2000) = $550 -Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure
Which of the following will apply when a firm's debt levels are extremely high?
-The benefits of debt financing may be more than offset by the costs of financial distress -The possibility of financial distress will become a chronic problem
M&M Proposition 1 States if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___.
-The value of the two firms is equal -How the firms are financed is irrelevant
Bankruptcy Costs (Direct Costs)
-Legal and administrative Costs (fees by lawyer/accountants, additional costs bondholders would occur) -Ultimately cause bondholders to incur additional losses -Disincentive to debt financing
Bankruptcy Costs (Financial Distress)
-ant problems in meeting debt obligations -Most firms that experience financial distress do not ultimately file for bankruptcy 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 -Includes both the financial and operating risks -Operating income fluctuates a lot = wouldn't want to use a lot of debt
What happens when we issue debt and buy back stock?
-Variability in ROE ~Current: ROE ranges from 6.25% to 18.75% ~Proposed: ROE ranges from 2.50% to 27.50% (standard deviation will be bigger) -Variability in EPS ~Current: EPS ranges from $1.25 to $3.75 ~Proposed: EPS ranges from $0.50 to $5.50 (standard deviation bigger) -The variability in both ROE and EPS increases when financial leverage is increased
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?
The rate of return on assets is unaffected by leverage.
Three Special Cases
-Case 1 ~No Corporate or Personal taxes ~No bankruptcy costs -Case 2 ~Corporate taxes, but no personal taxes ~No bankruptcy costs -Case 3 ~Corporate taxes, but no personal taxes ~Bankruptcy costs
4 Definitions of Financial Distress (Can be one or multiple)
1. Business Failure -Termination that results in a loss to creditors (creditors will not be paid all that they are owed) 2. Legal Bankruptcy -Legal filing for relief from creditors 3. Technical Insolvency -When a firm is unable to meet its financial obligations (does not have the means to pay all that it owes this period) 4. Accounting Insolvency -When liabilities exceed value of assets (i.e. negative net worth) -book values of liabilities exceed the value of assets --> book value equity would be negative
___ is the term that describes the capital structure when debt is used to finance assets.
Financial Leverage
The equity risk that comes from the financial policy or capital structure decisions of the firm is known as:
Financial Risk
Tax Shield (Difference in Cash flows)
-Annual interest tax shield ~Tax rate times interest payment (I*TC) ~1000 in 10% debt = 100 in interest expense ~Annual tax shield = 40%*(100) = 40 -Present value of annual interest tax shield ~Assume perpetual debt for simplicity ~PV = 40 / .10 = 400 ~PV = D(RD)(TC) / RD = DTC = 1000(.40) = 400 Interest expense: the amount of debt times the cost of debt
A section 363 bankruptcy has all of the following characteristics EXCEPT:
Plan must be approved by a vote of interested parties Characteristics: -A stalking-horse initial bidder -Simplicity -Auction-like Quality -Speed
Homemade Leverage: Proposed Capital Structure (investor does the borrowing)
-Investor buys $1000 worth of stock (50 shares) and $1000 worth of the company's bonds paying 10%. -Payoffs: ~Recession: 50(.50) + .1(1000) = $125 ~Expected: 50(3.00) + .1(1000) = $250 ~Expansion: 50(5.50) + .1(1000) = $375 -Mirrors the payoffs from purchasing 100 shares under the current capital structure
Bankruptcy Costs (Indirect Bankruptcy Costs)
-Larger than direct costs, but more difficult to measure and estimate -Stockholders/shareholders wish to avoid a formal bankruptcy filing (do not invest into new things) -Bondholders want to keep existing assets intact so they can at least receive that money -Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business (performance of the business decreases) -Also have lost sales, interrupted operations and loss of valuable employees
Case 2 (WACC)
-M&M Proposition 1 with taxes implies that a firm's WACC decreases as the firm relies more heavily on debt financing -M&M Proposition 2 with taxes implies that a firm's cost of equity rises as the firm relies more heavily on debt financing
According to MM Proposition 1, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?
-MM demonstrated that debt financing is neither better nor worse than equity financing -The asset to be financed is the same
The value of a levered firm in MM Proposition 1 with corporate taxes equals the value of an all equity firm:
Plus the tax rate times the value of debt
Under MM Proposition 2, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases ___.
The increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt.
Under MM Proposition 2 with no taxes, the weighted average cost of capital is invariant to the debt level because:
The return on assets is unchanged
Homemade Leverage
-Modigliani and Miller (M&M) Theory of Capital Structure (argued Capital Structure is irrelevant) ~Proposition I - firm value directly ~Proposition II - firm's WACC -The value of the firm is determined by the cash flows to the firm and the risk of the assets -Changing firm value ~Change the cash flows from assets ~Change the risk of the cash flows from assets
Which of the following are generally true about the cost of equity and the cost of debt?
-The cost of debt is generally lower than the cost of equity -The cost of debt increases with leverage -The cost of equity may increase with leverage
Case 2 (Proposition 1)
-The value of the firm increases by the present value of the annual interest tax shield ~Value of a levered firm = value of an unlevered firm + PV of interest tax shield -Assuming perpetual cash flows ~VU = EBIT(1-T) / RU ~VL = VU + DTC
Leverage and Cash Flows
-When we use more debt financing (more leverage), we increase the fixed interest payment ~If we have a great year, we pay the fixed cost and have more left over for the shareholders ~But if we have a terrible year, we still have to pay the fixed costs and have less remaining to pay to the shareholders -Leverage amplifies the variability (i.e., risk) in both Earnings per Share (EPS) and Return on Equity (ROE) ~EPS= Net Income / Shares Outstanding ~ROE=Net Income / Total Equity