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