Ch 13 - Capital/Leverage Structure

M&M Prop I

**The value of the firm is independent of its cap structure** -The WACC will be the same for any cap structure of a firm. -Choosing cap structure is irrelevant. -Assuming no tax

M&M Prop II

-Assuming no tax. WACC = ROA -Stockholders return = Business Risk + Financial Risk Re = Ra + [(Ra-Rd) x (D/E)] -Cost of equity depends on: ROA, the firms cost of debt Rd, and the firm's debt-to-equity ratio (D/E). -When a co. raises its D/E ratio, the increase in leverage raises the risk of equity -> raises the cost of Equity -WACC does not depend on D/E ratio.

Unleveraged

-No debt. All capital. -WACC= ROE, assuming no tax

Homemade Leverage

-Stockholders borrow money and invests that money into the company, so the company can use it. -Investors can always increase financial leverage themselves to create a different pattern of payoffs. -Advantage depends on whose in higher tax bracket, want larger interest deduction

Leverage

-The more debt financing, the more leverage a firm has. -The level of debt a co. has will directly influence the cost of debt (interest rates). 1)Effect of leverage depends on the co. EBIT. When EBIT is relatively high, leverage is beneficial. 2)Under the "expected" scenario, leverage increases the returns to shareholders (EPS and ROE) 3)Shareholders are exposed to more risk under the capital structure since EPS and ROE are much more sensitive to changes in EBIT in this case

Target Capital Structure

-When the WACC is at its absolute lowest. -Optimal Cap Structure -We only consider permanent capital, not working capital.

Value of firm is maximized....

...when the WACC is minimized. -Will maximize the firm's cash flows -So, we want to choose the firm's structure so that the WACC is minimized. So, one cap structure is better than another if it results in a lower WACC.

Static Theory of Cap Structure

A firm borrows up to the point where the tax benefit from an extra dollar in debt is equal to the cost that comes from the increased probability of financial distress. -With taxes, debt has advantage. However, debt also brings more risk and possibility of financial distress costs. -When tax deductible interest = amount of risk -> Quit Borrowing.

Recapitalization

Borrow money to buy back stock. -Effects: 1)Accretive to earnings (opposite of dilutive, increases earnings) 2) increases ROE 3) increases EPS 4)Financial flexibility decreases - ability to use capital to take on debt 5)The higher the EBIT, the less sensitive your earnings are to a Recap.

Total Systematic Risk of Firm's Equity

Business Risk: not affected by cap structure Financial Risk: completely determined by cap structure = Business Risk + Financial Risk -The firm's cost of equity rises when it increases its use of financial leverage b/c the financial risk of the equity increases while the business risk remains the same.

Once we include taxes,

Capital Structure definitely matters

Indirect Bankruptcy Costs

Costs of avoiding bankruptcy. 1)Lose sales if on brink of bankruptcy 2)Deposits to suppliers 3)Employee Defection - employees leave for other companies

Direct Bankruptcy Costs

Costs that are directly associated with bankruptcy, such as legal and admin costs.

Prepackage

Creditors arrange for bankruptcy b4 it actually happens.

DIP Financing

Debtor in possession. -Once bankrupt, a bank will lend the company $. Whoever does this first gets repaid first. -Mostly banks, charge high rates.

Financial Risk

Equity risk that comes from the financial policy (cap structure) of the firm. -All-equity firm, this component is zero. -As debt financing increases, required return on equity rises, b/c the debt financing increases the risks borne to the s/h. -The extra risk that arises from debt financing

Business Risk

Equity risk that comes from the nature of the firm's op activities. -Depends on systematic risk of firm's assets. The higher the business risk, the greater Ra will be and the greater the firm's cost of equity.

Reorganization

Financial restructuring of a failing firm to attempt to continue ops as a going concern.

Absolute Priority Rule

Rule establishing priority of claims in liquidation. 1)Admin Costs - lawyers 2)Wages/Salaries (any backlog) 3)Pensions/401K's 4)Consumer claims 5)Govt Claims 6)Debt - secured and unsecured. 7)P/S 8)C/S

Liquidation

Termination of the firm as a going concern. -Selling off assets of the firm, proceeds distributed to creditors in order of priority.

Financial Distress Costs

The direct and indirect costs associated with going bankrupt or not being able to meet debt obligations. -Greater risk of financial distress will borrow less than firms with lower risk of distress. -The greater the volatility of EBIT, the less a firm should borrow.

Interest Tax Shield

The tax savings attained by a firm from the tax deductibility of interest expense. =Interest per period x Tax Rate -Firm with debt financing will have an interest tax shield and will have a higher cash flows from assets. =EBIT-Taxes (not factoring in interest) -NI will go to s/h, while interest goes to creditors. -Firm with higher aftertax cash flows is worth more.

Leveraging Up

When a cap structure goes from 50/50 to 90(D)/10, the interest rates and cost of equity will rise, since your co. is more risky now (s/h want higher rate of return since riskier investment).

Bankruptcy

When co has all debt, and no equity. -Ownership of the firm is in the hands of the creditors, not the s/h. -Very expensive to go bankrupt: Have indirect and direct costs -Debt may be greater than assets, if a co has negative equity (accumulated losses) -During bankruptcy, judge eliminates debt. Turns debt-holders into stockholders.