Corp Finance Midterm Chapter 16
Debt and its impact on the firm
1) interest paid on debt is tax deductible, an added benefit of debt financing 2) failure to meet debt obligations can result in bankruptcy, a detriment of debt financing.
Implications of pecking order theory
1) no target capital structure: there is no target or optimal debt-equity ratio. Instead the firm's capital structure is determined by its need for external financing, which dictates the amount of debt the firm will have 2) profitable firms use less debt: because profitable firms have greater internal cash flow, they will need less external financing, therefore less debt. 3) companies will want financial slack: to avoid selling new equity, companies will want to stockpile internally generated cash. Cash reserve is known as financial slack. gives management the ability ti finance project as they appear to move quickly.
Priority list for liquidation (absolute priority rule)
1. administrative expenses associated with the bankruptcy 2. other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee 3. wages, salaries, commision 4. contribution to employee benefit plans 5. consumer claims 6. government tax claims 7. payment to unsecured creditors 8. payment to preferred stockholders 9. payment to common stockholders
Financial Leverage and and its implications
1. the effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial 2. Under the expect scenario, leverage increases the returns to shareholders, as measured by ROE and EPS 3. Shareholders are exposed to more risk under the proposed capital structure (0:1 vs 1:1 debt to equity ratio) 4. because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important consideration.
Total systematic risk of the firm's equity is what two parts?
Business risk: depends on the firm's assets and operations and is unaffected by capital structure. Given the firm's business risk (and its cost od debt), the second part (financial risk) is completely determined by capital structure.
Firms cost of equity and financial leverage relationship
Firms cost of equity 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.
direct bankruptcy costs
Legal and administrative costs from declaring bankruptcy ultimately cause sbondholders to incur additional losses. Disincentive to debt financing
Present value of the interest tax shield formula
PV of the interest tax shield = (Tc x D x Rd) / Rd or Tc x D
WACC formula for the required return of the firm's overall assets
Ra= (E/V) x Re + (D/V) x Rd
Cost of Equity Capital Forumla
Re = Ra + (Ra - Rd) x (D/E)
M&M Proposition 2 with corp. taxes state that the cost of equity formula is
Re = Ru + (Ru - Rd) x (D/E) x (1 - Tc)
Formula notation for M&M Propisition
Re = required return on cost of equity Ra = required return on the firm's assets Rd = the firm's cost of debt D/E = debt to equity ratio
Restructurings
Takes place whenever the firm substitutes one capital structure for another while leaving the firm's assets unchanged. Because the assets of a firm are not directly affected by a capital restructuring, we can examine the firm's capital structure decision separately from its other activities.
WACC and its relationship to the value of the firm
The value of the firm is maximized when the WACC is minimized. WACC is the appropriate discount rate for the firm's overall cash flows. Because values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firm's cash flows.
M&M Proposition 1 with taxes formula
Vl = Vu + Tc x D the value of the levered firm, Vl; equals the Value of the unlevered firm plus the present value of a tax shield
WACC formula
WACC = (E/V) x Re + (D/V) x Rd x (1 -Tc)
Firms and bankruptcy
a firm becomes bankrupt when the value of its assets equals the value of its debt. When this happens, the value of equity is zero, and the stockholders turn over control of the firm to the bondholders.
pecking-order theory
an alternative to the static theory, states that firms prefer to use internal financing whenever possible. Selling securities to raise cash can be expensive, so it makes sense to avoid doing so if possible. if a firm is very profitable, it might never need external financing, thus it would end up with little or no debt, eg google parent company Alphabet. Also, if you know that your stock is gonna be worth more than outside investors realize, why would you issue equity to finance the new venture? If your stock is undervalued then you don't want to sell it cheaply. Issue debt instead. If your companies stock was overvalued, then you still don't want to issue equity, because investors will realize that the shares are overvalued.
How should a firm go about choosing its debt-equity ratio?
assume that the guiding principle is to choose the course of action that maximizes the value of a share of stock.
different industries and their relationship to debt or equity financing
because different industries have different operatinf characteristics in terms of EBIT volatility and asset types, there does seem to be a connection between these characterisitc and capital structure. In certain industries, companies may have much higher usage of debt, like in airline and cable vision
Critics of M&M theory
critics say that the theory fails to hold as we add in real world issues
Capital structure decisions
decisions about a firm's debt-equity ratio
Changing capital structure and its impact
does not change the firm's total value, but it does cause important changes in the firm's debt and equity.
Legal bankruptcy
firm or creditors bring petitions to a federal court for bankruptcy, 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
marketed claims vs. non marketed claims
marketed claims can be bought and sold in financial markets and the non-marketed claims cannot be sold in financial markets.
Technical insolvency
occurs when a firm is unable to meet its financial obligations
reorganization
option of keeping the firm a going concern: it often involved issuing new securities to replace old ones.
financial distress costs
refer generically to the direct and indirect costs associated with going bankrupt or avoiding a bankruptcy filing
Business failure
refers to a situation in which a business has terminated with a loss to creditors; but even an all equity firm can fail
Financial leverage
refers to the 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
Optimal capital structure
results in the lowest possible WACC
the change in the value of the firm is the ...
same as the net effect on the stockholders. to put it another way, the NPV rule applies to capital structure decisions.
WACC
tells us that the firm's overall cost of capital is a weighted average of the costs of the various components of the firm's capital structure. The value of the firm is maximized when the WACC is minimized.
liquidation
termination of the firm, selling off the assets of the firm. the proceeds, net of selling costs, are distributed to creditors in order of established priority.
unlevered cost of capital
the cost of capital for a firm that has no debt, represented by Ru
M&M Proposition 2
the cost of equity depends on three things: the required rate of return on the firm's assets, Ra; the firm's cost of debt, Rd; and the firm's debt to equity ratio, D/E. Firm's cost of equity can be broken down into two components 1) Ra, the required return on the firm's assets overall, and it depends on the nature of the firm's operating activities 2) cost of equity, (Ra- Rd) x (D/E), is determined by the firm's financial structure. For an all equity firm, this component is zero. As the firm begins to rely on debt financing, the required return on equity rises. This occurs because the debt financing increases the risks borne by the stockholders.
indirect bankruptcy costs
the costs of avoiding a bankruptcy filing incurred by a financially distressed firms.
financial risk
the equity risk that comes from the capital structure of the firm.
M&M Proposition 1
the firm's overall cost of capital is unaffected by its capital structure. The cost odf debt can be lower than the cost of equity which is exactly offset by the increase in the cost of equity from borrowing. In other words, the change in 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
Chapter 16 summary
the ideal capital structure is one that maximizes the value of the firm and minimizes the overall cost of capital if we consider the effect of corporate taxes, we find that capital structure is very impactful. This is based on the fact that interest is tax deductible and generate a valuable tax shield. the costs of bankruptcy and financial distress make debt financing less appealing. optimal capital structure exists when the net tax savings from an additional dollar in interest equals the increase in expected financial distress costs. this is the essence of static theory of capital structure. Pecking order theory suggests that firms will use internal financing as much as possible, followed by debt financing if needed. Equity will not be issued if possible. As a result, a firm's capital structure reflects its historical needs for external financing, so there is no optimal capital structure Actual capital structures 1) firms in the US typically do not use great amounts of debt, but they pay substantial taxes. This tells us that there is a limit to the use of debt financing to generate tax shields. 2) firms in similar industries tend to have similar capital structures, suggesting that the nature of their assets and operations is an important factor to determining capital strucutre
Business risk
the risk inherent in a firm's operations. the greater the firm's business risk, the greater Ra will be, and the greater will be the firm's cost of equity.
Interest tax shield
the tax savings attained by a firm from interest expense
Extended pie model implications
the total value of all the claims to the firm's cash flows is unaltered by capital structure. However, the value of the marketed claims, Vm, may be affected by changes in the capital structure. Based on the model, any increase in the value of the marketed claims must imply an identical decrease in the value of all non-marketed claims. The optimal capital structure is the one that maximizes the value of the marketed claims, or equivalently, minimizes the value of non-marketed claims such as taxes and bankruptcy costs.
Homemade leverage
the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed
Extended pie model
the value of all claims against the firm's cash flows is unaffected by capital structure, but the relative values of claims change as the amount of debt financing is increased
Essence of the M&M intuition and theory
the value of the firm depends on the total cash dlow of the firm. The firm's capital structure just cuts that cash flow up into slices without altering the total. Stockholder and bondholders are not the only entities entitled to a firm's cash flows.
