Finance- Chapter 16

Present Value of the Interest Tax Shield =

(Tc x D x Rd) / Rd

different ways of defining financial distress:

1. business failure 2. legal bankruptcy 3. technical insolvency .4. accounting insolvency

2 Distinguishing Features of Debt

1. interest paid on debt is tax deductible (added benefit of debt financing) 2. failure to meet debt obligations can result in bankruptcy (may be an added cost of debt financing)

static theory is better for the

long run

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. (Ra - Rd) x (D/E), firm's financial structure (for an all equity firm, this component is zero)

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, leverages 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. 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.

list of liquidation order:

1. administrative expenses associated with bankruptcy 2. other expenses 3. wages, salaries, and commissions 4. contributions 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.

total systematic risk of the firm's equity has two parts:

1. business risk 2. financial risk

Firms that cannot or choose not to make contractually required payments to creditors have two basic options:

1. liquidation 2. reorganization

implications of the pecking-order theory:

1. no target capital structure: under the pecking-order theory, there is no target or optimal debt-equity ratio. Instead, a 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 and will therefore have less debt. 3. Companies will want financial slack: To avoid selling new equity, companies will ant to stockpile internally generates cash. Such a cash reserve is known as financial slack. It gives management the ability to finance projects as they appear and to move quickly if necessary.

static model is not capable of identifying a precise optimal capital structure, but it points out 2 relevant factors:

1. taxes 2. financial distress

M&M Proposition II tells us the cost of equity depends on 3 things:

1. the required rate of return on the firm's assets, Ra. 2. The firm's cost of debt, Rd. 3. The firm's debt-equity ratio, D/E.

We can conclude the best capital structure is:

100% debt by examining the WACC.

Bankruptcy

A legal proceeding for liquidating or reorganizing a business.

Pecking-order theory

An alternative to static theory. -key element is the firms prefer to use internal financing whenever possible -equity will be sold as a last resort

Nonmarketed claims

Claims such as this of government and potential litigants in lawsuits. -can not be bought and sold in financial markets

Marketed claims

Claims such as those of bondholders and stockholders. -can be bought and sold in financial markets.

Reorganization

Financial restructuring of a failing firm to attempt to continue operations as a going concern. -the option of keeping the firm a going concern. -often involves issuing new securities to replace old securities.

Legal bankruptcy

Firms or creditors bring petitions to a federal court for bankruptcy.

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

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. -can dramatically alter the payoffs to shareholders in the firm. -impact of leverage in terms of its effects on earning per share, EPS, and Return on Equity, ROE.

Technical insolvency

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

Liquidation

Termination of the firm as a going concern. -involves selling off the assets of the firm. -the proceeds, net of selling costs, are distributed to creditors in order of established priority.

Indirect Bankruptcy Costs

The cost of avoiding a bankruptcy filing incurred by a financially distressed firm.

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. -the firm's overall cost of capital is unaffected by its capital structure. -cost of equity: Re = Ra + (Ra - Rd) x (D/E)

M&M Proposition I: The pie model

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

Absolute Priority rule (APR)

The rule establishing priority of claims in liquidation. -the higher a claim is on the list of liquidation, the more likely it is to be paid.

Interest tax shield

The tax savings attained by a firm from interest expense.

M&M intuition and theory

The value of the firm depends on the total cash flow of the firm.

Business failure

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.

Value of levered firm:

Vl = Vu + (Tc x D) -Vl = value of levered firm -Vu = value of unlettered firm

Extended pie model:

Vt = E + D + G + B + ... = Vm + Vn -G= value of government claims -B= value of bankruptcy claims -Vm = value of marketed claims -Vn = value of non-marketed claims -Optimal capital structure is one that maximizes the value of the marketed claims, or minimizes the value of the non marketed claims.

value of the unlettered firm, Vu:

Vu = (EBIT x (1 - Tc)) / Ru

WACC

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 he firm's cash flows.

One limiting factor affecting the amount of debt a firm might use comes in the form of...

bankruptcy costs -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.

Liquidation or reorganization is the result of a ....

bankruptcy proceeding.

bankruptcies to lawyers are what

blood is to sharks

WACC declines as...

debt-equity ratio rises

To create leverage:

investors borrow on their own

To undo leverage:

investors must lend money

A firm's optimal capital structure (according to static theory):

is at the maximum value of the firm, Vl*, at D*. -composed of D*/Lv* in debt -composed of (1 - D*) / Vl* in equity

the capital structure that managers should choose:

is the one that maximizes the value of the firm

The change in the value of the firm:

is the same as the net effect on the stockholders.

the firm's 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.

If EBIT is above break even point...

leverage is beneficial. -if EBIT is below the break even point, the leverage is not beneficial.

highest firm value =

lowest cost of capital

net interest

means interest paid less interest earned (if any)

ROE =

net income / total equity

Pie Model: CF (cash flows of firm) =

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

Essence of the extended pie model:

that the total value, Vt, of al the claims to the firm's cash flows is unaltered by capital structure.

The value of the firm is maximized when:

the WACC is minimized

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.

The greater the volatility in EBIT...

the less a firm should borrow

The 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.

When the value of a firm's assets equals the value of its debts,

then the firm is economically bankrupt in the sense that the equity has no value. -the formal turning over of the assets is a legal process, not an economic one.

In principle, a firm becomes bankrupt...

when the 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.

M&M

Franco Modigliani and Merton Miller

Unlevered cost of capital

The cost of capital for a firm that has no debt. -Ru is the unlevered cost of capital -cost of capital a firm would have if it had no debt

Direct Bankruptcy Costs

The costs that are directly associated with bankruptcy, such as legal and administrative expenses. -they are a disincentive to debt financing

Financial distress costs

The direct and indirect costs associated with going bankrupt or experiencing financial distress.

Financial Risk

The equity risk that comes from the financial policy (the capital structure) of the firm. -the extra risk that arises from the use of debt financing. -completely determined by financial policy

Business Risk

The equity risk that comes from the nature of a firm's operating activities. -the risk inherent is a firm's operations. -the business risk depends on the systematic risk of the firm's assets. -the greater a firm's business risk, the greater Ra will be, and, all other things being the same, the greater will be the firm's cost of equity. -depends on the firm's assets and operations and is unaffected by capital structure.

Static theory of capital structure

The theory that a firm borrows up to the point of 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. -the value of a firm rises to a maximum and then declines beyond that point.

Homemade Leverage

The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed. -the use of personal borrowing to alter the degree of financial leverage.

A particular debt-equity ratio represents the optimal capital structure:

if it results in the lowest possible WACC. -This optimal capital structure is sometimes called the firm's target capital structure as well.

pecking-order theory is better for the

short run