COMM 370 Final

Restructuring Legal Tools

=Trustee in Bankruptcy - judge appoints trustee to oversee the state; protect creditors from actions of the firm such as fraudulent transfer. =Suspension of debt payments - relieve financial pressure paralyzing the firm (debt in default must be renegotiated). =Automatic stay - lenders cannot seize the assets or collect from borrower - allows firm to continue operating its assets. =Contract renegotiation - the defaulted borrower can renegotiate contracts, such as debt, leases, or even wages. =Debtor in possession (DIP) - management remains in control, although the firm defaulted on debt and is thus owned by creditors. =DIP financing - can issue debt senior to existing debt (only way to raise money to fund operations) - otherwise precluded by covenants.

Dividend Cut and COVID-19

In February of 2020 the COVID-19 recession, also known as the Great Shutdown, started - In the U.S. shareholders were notified of a net $42.5 billion reduction in dividends in the second quarter of 2020, the largest reduction since the Great Recession -These cuts have been mostly focused in industries directly affected by the pandemic, as travel and tourism 41 companies in the S&P 500 have suspended their dividends this year to preserve cash - American Airlines, Carnival Corp and Marriott - These stocks have loss 40% of their value during 2020 As some analysts consider that the worse is behind, should we expect these firms to go back to their prior payout policy?

Bankruptcy Reorganization

• Firm or creditors file petition for bankruptcy reorganization. • If judge approves, management remains in charge (debtor in possession) • Managers must file a reorganization plan within pre-set time frame. • Plan includes changes to operations and financial restructuring. • Reorganization plan requires creditor approval and ratification by judge. • The firm can emerge from bankruptcy as a solvent firm. • Firm can re-file for bankruptcy again later, but usually much less likely to succeed as this is part of the same distress event (move to liquidation).

Synergies for different types of mergers

• Horizontal mergers can lead to cost savings (economies of scale) and market power in setting prices (higher profits). • Vertical mergers can eliminate bottlenecks in production, increase supply chain reliability, and increase product quality. • What about conglomerate mergers? - Diversification of a firm's activities and the associated reduction of business risk is often mentioned as a benefit to such mergers. - But investors can diversify their portfolios (hold many firms) more cheaply; they don't need the firm to do it, so won't pay more for such firms. - Maybe managers want to reduce their own exposure to risk? This would happen to the personal benefit of mangers, not investors. - Note there is some evidence of a diversification discount, i.e., a conglomerate firm is worth less than a replica based on independent firms.

Assume the project is in the same line of business as the firm (same business risk) but the firm is levered. Can we use the firm's cost of capital (rWACC) to discount the project's free cash flow?

- Correct only if the firm will impose its capital structure on the project and thus have the same financial risk: If the firm's D/V = 50%, the project's financing is 50% debt and 50% equity - this firm maintains a target D/V = 50%. So firm and project have the same financial risk as well. - Incorrect if the firm's D/V and project financing mix differ: e.g., firm's D/V = 50%, but the project's financing is all equity. With different financial risk, the firm's cost of capital might understate or overstate the project's cost of capital.

What is the cost of capital for a startup that will be financed with D/V = 50%?

- Estimate rWACC of a 50% debt firm in the startup's line of business! - Find comparable publicly traded firms; same business risk - But their WACCs cannot be used if their D/Vs are not 50% - Further adjustments to get the right rWACC are needed!

Inefficient Management and Takeovers - Pros and Cons

- There are firms whose value could be increased with a change in management - these firms are poorly run. - Corporate raiders can identify poorly run firms, take them over, replace inefficient management, and create value for the target firm shareholders and society in general. - But takeovers frequently result in layoffs, which may reduce trust between managers and labor, and thus reduce efficiency and increase costs. - There might also be social costs. If takeovers result in plant closures or layoffs, then workers' wellbeing is affected. Taxpayers may be burdened by costs of retraining and relocation programs.

Bankruptcy Liquidation

-Firm or creditors file petition for liquidation; can happen after failed restructuring attempts or directly without such attempts. -A trustee liquidates the assets, pays administration costs, and then pays remaining proceeds to investors based on the absolute priority rule (APR). • APR - seniority of claims in descending order: • Admin expenses of bankruptcy • Owed wages, rent, and taxes • Creditors (first secured creditors, then unsecured creditors) • Preferred shareholders • Common shareholders -Judges have some discretion in their use of the APR.

Mechanics of LBO's

-First, the buyout group creates a "shell company", with no real operations, that holds the investors' equity. -Second, the shell company issues debt equal to the target's purchase price minus the shell company's equity. -Third, the shell company acquires the "target", and the two firms are legally unified in a merger. -The new firm's assets are those of the target, but the new firm now carries the debt inherited from the shell company. -The new entity quickly repays its debt from cash flows, until within a few years it reaches its "target capital structure".

Acquisition Classifications

-Horizontal Acquisition: acquisition of a firm in the same industry as the buyer - an acquisition of a rival firm. Example: Great-West Lifeco acquired Canada Life Financial. -Vertical Acquisition: acquisition of a firm at a different stage of the production process - acquisition of a supplier or customer firm. Example: Imperial Oil acquires gas stations. -Conglomerate / Diversifying Acquisition: acquisition of a firm in an unrelated line of business. Example: Campeau Corporation's acquisition of Federated Department Stores. Note: horizontal acquisitions can raise antitrust concerns; vertical ones too, but much less frequently. The word takeovers refers broadly to a firm gaining control of another firm (various legal forms), in a friendly or hostile deal.

Where does MM1 come from?

-MM1 is the relation between the values of U and L if financial markets are in equilibrium and there are no imperfections -Equilibrium means there is no arbitrage opportunity: you cannot make a profitable risk free trade by buying equity of L and selling equity U, or the reverse. -If a profit opportunity exists, it is because the prices of U and L are "wrong". As investors take advantage of this, prices quickly adjust until they are "right" and the profit disappears -If an investor wants a particular payoff, ex. the dividend L pays, she can get it by buying L's equity or by buying U's equity and borrowing herself. This is "home made leverage" -Investors care about the payoff, not how they get it. Both ways of getting the same payoff should cost the same in equilibrium

Pre-Packaged Bankruptcy

-The firm simultaneously files for bankruptcy and submits a reorganization plan with consensus among creditors. -Combines benefits of formal bankruptcy (use of legal tools) and private workouts (prepackaging reduces legal costs). -Useful when firm has already agreed on a reorganization plan with most creditors, but some are holding out: a majority (instead of unanimous) vote is enough for the reorganization to be approved. -Pre-packaged bankruptcies are used in the USA. -In Canada, neither the Bankruptcy & Insolvency Act nor the Companies' Creditors Arrangement Act contain formal procedures for this. -Still, both statutes can handle pre-packaged reorganizations at an early stage in the restructuring proceedings.

Why would a firm have a zero debt policy?

-debt covenants could restrict the firm's flexibility, especially for a growth firm -maybe managers hoard cash and avoid leverage due to personal preference and weak governance allows this?

Conditions for a perfect capital market

-investors and firms can borrow and lend at the same interest rate -no transaction costs (ex. brokerage fees) -no issuance costs (ex. underwriting fees) -no agency costs -no information asymmetries -financing decisions do not change the firms assets or cashflows -no corporate taxes (no interest tax deductions)

Other Ways to Reduce Agency Costs of Debt

-issuing convertible debt (solution to over investment problem) -issuing senior debt (any benefit of taking the project would go to senior creditors; covenants often restrict issuance of debt that is senior to existing debt, but in a bankruptcy proceeding the debtor-in-possession financing allows for exactly this reason) -board participation (for large lenders) -reputation (for some frequent borrowers)

Some basic empirical observations about leverage

-on average, across all public and private firms, firms have book leverage ratios around 30% and this is quite stable over time -market leverage ratios are affected by stock prices, and thus are more volatile than book ratios -there are large differences in the debt ratios across industries, possibly related to factors such as capital intensity or technology -even within an industry, firms may have very different debt ratios -firms debt ratios tend to fall when they are above their "time series mean" and increase when they are below -most firms choose a target debt ratio and try to stay close to it. this target differs across firms and industries and varies over time

Summary of Topic 6

-with perfect capital markets, changing capital structure does not affect total firm value or the firms WACC -with taxes, firm value is increasing and WACC is decreasing in the amount of debt. Shareholders capture the tax benefits of increases in debt -both with and without taxes, MM2 implies that: =leverage increases expected EPS but also its volatility =leverage increases the required return on equity

How do taxes affect payout policy?

1. Corporate taxes make retaining excess cash more costly, but whether the cash should be retained or paid out depends on whether the firm's tax rate exceeds the tax rate investors pay on personal income (including interest). 2. Personal taxes create a tax disadvantage for dividends over share repurchases, because the effective tax rate on dividends is higher than on capital gains (paid in the repurchase). Capital gains are taxed only when they are realized, and they are taxed at 50% of the marginal tax rate. Investors with a low tax rare (Tc>Ti) prefer cash distributions to retention Even if the tax rates on dividends and capital gains were the same (but the rate on dividends is usually higher), dividends have a tax disadvantage because they trigger taxes sooner. This disadvantage of dividends could differ across investors: - A long-term investor can defer capital gains taxes for a long time, so dislikes a dividend today more than a short-term investor does. - Corporations don't pay taxes on dividends received from stock held in other firms - dividends have an advantage for them! - There are also tax-exempt investors (pension funds, endowment funds, and trust funds). Idea of clienteles: firms could choose payout policies catering to the tax preferences of particular clienteles.

What is a Leveraged Buyout (LBO)?

A group of investors buys a company and finances the buyout partly with their own money and partly with debt. Shareholders service the interest and principal payments with cash flow (ideally buy out a "cash cow") and with asset sales. Shareholders hope to reverse the LBO within 3 to 7 years by way of a public offering or sale of the company to another firm. In a LBO shareholders are expected to pay off outstanding principal according to a specific timetable. The owners know that the debt-to-equity will fall and can forecast the dollar amount of debt needed to finance future operations. In this situation APV is the most practical valuation approach because the capital structure is changing.

Capital Structure and Competitive Strategy

A highly leveraged firm might be vulnerable to predation by low- leverage rivals (e.g. those with "deep pockets"). A competitor might choose to lower its prices (or take other actions) to drive the highly leveraged firm out of business. Leverage may serve as a strategic tool that allows a firm to achieve a competitive advantage. Low debt allows the firm to: - defend from or even deter competitive attacks by rivals - to be opportunistic vs. weaker rivals (attack or prey on them!) Empirically, we see that: - highly leveraged firms lose market share during industry downturns, when high debt leads to financial distress. - firms with low leverage often increase their market share during industry downturns - it pays to maintain low debt.

Who Benefits from Acquisitions?

Acquirers must often pay a premium over the target's current market price to for the target to accept the deal. Target firms earn excess stock returns in a merger (e.g., about 23%) - target shareholders clearly benefit. For acquirers, excess stock returns at announcement are much lower (3%-11% in Canadian mergers and closer to zero for American mergers) - not so clear: - Expected merger gains may not be realized. - Bidding firms are larger, so it takes a larger dollar gain to get the same percentage gain. - Management may not be acting in the best interests of shareholders (e.g., managerial empire building). - Takeover market may be competitive. - Announcement may not contain new information about the bidding firm (e.g., information already contained in prices).

In an MM world without taxes, what should happen after a recapitalization?

After the recap, firm value does not change (MM 1), the cost of equity goes up (MM 2), and WACC stays the same.

In an MM world with taxes, what should happen after a recapitalization?

After the recap, firm value goes up by the present value of the interest tax shields (MM 1), the cost of equity goes up (MM 2), and WACC decreases.

What is Ra?

determined by the risk of an unlevered firm's cash flows; it is the market return for investments with the same risk also Ru (because the firm is unlevered, assets and equity are the same)

How does Asymmetric Information and Signalling work?

Asymmetric information: Managers know more about the firm's fundamentals (future prospects) than outside investors. -If the manager knows that future cash flows are high but outside investors do not then equity will be undervalued. -In this case the manager can use high leverage to credibly signal to investors that the firm has high future cash flows. -Why is this credible? Investors understand that a firm with high future cash flows can repay high debt, but one with low future cash flows cannot. A low cash flow firm would never maintain high debt and it would be driving itself into bankruptcy! -If a firm has high leverage, it must be the case it is expecting high future cash flows. Thus, investors will pay higher prices. This gives rise to a signaling theory of debt. Investors know that managers can exploit their private information and issue equity only when it is overvalued. If a firm issues equity, investors will infer that it is overvalued, even if it is not, and would only pay very low prices. Debt issues suffer less from this problem; their value largely depends on interest rates. Thus, they are less underpriced. Empirically, asymmetric information is important: - Stock prices fall on the announcement of an equity issue - Stock prices tend to rise prior to an equity issue (timing) - Equity issues tend to occur when information asymmetries are minimized (e.g., after earnings announcements)

What is the name of the legislation behind bankruptcy proceedings in Canada and the USA?

Bankruptcy proceedings are governed by the Bankruptcy & Insolvency Act and the Companies' Creditors Arrangement Act in Canada and the Bankruptcy Reform Act with Chapter 7 (liquidation) and Chapter 11 (reorganization) in the USA.

Why is Re>Rd?

Because debt is a guaranteed payment, while equity is residual so equity is riskier than debt Re>Ra>Rd ^Because A=D+E, so Ra is about the average of Rd and Re

Bu vs. Be

Bu reflects business risk only Be reflects business AND financial risk Be>Bu>Bd

Beta

Company's volatility in relation to the market B=1, moves in line with market B>1, more volatile (ex. tech) B<1, less volatile B=0, usually gold Determinants of Beta: -nature of business (necessities have lower B) -operating leverage (if FC are higher, higher B) -financial leverage (high borrowing, higher B)

Debt Schedule- getting PV(ITS)

Debt Schedule Interest Tax Shields Amt Paid back

How are Cash Dividends Paid?

Declaration date: board of Directors authorizes the dividend. Ex-dividend date: two business days before the record date. Record date: shareholders of record are designated to receive the declared dividend (2-3 weeks prior to the payment date). Shareholder of record: bought the stock before ex-dividend date. Payment date: the dividend is paid to all shareholders of record.

Modigliani-Miller Payout Irrelevance

Economists used to believe the (now known as) bird-in-the-hand fallacy: • If a firm retains cash its future dividends might be larger; • But a dividend today is safer than one in the future! • If the second effect dominates, so dividend payers are worth more! MM come in... In a perfect MM world, Pay out vs. retain has no effect on price or firm value:- Paying out is a zero NPV transaction - firm value before payout equals firm value after + the value of the funds paid out. - If funds are retained (paid out), investors who want (do not want) the cash can sell some (buy more) of the firm's shares. - This point relates to "home-made dividends" Dividends vs. repurchases has no effect on price or value: - If investors want the cash, they get it by either selling some of their stocks in case of repurchase or by keeping the dividends. - If they do not want cash, they can either reinvest dividends or not sell shares. As long as payout does not affect investment policy, the only determinant of firm value is a firm's investment policy.

Schedule for Debt Capacity

FCF PV(FCF) Debt Capacity (% of PV) New Debt Issued Equity (% of PV) New Equity Issued

Formal Bankruptcy Proceedings

Firm can file for bankruptcy (often under strong pressure from creditors) and have a judge oversee the proceedings: Bankruptcy liquidation: • Used for firms that are not viable • Firm ceases operations • Sell the assets and distribute proceeds to investors according to the APR Bankruptcy reorganization: • Used for firms that are viable • Firm kept as going concern • Restructuring of operations and financial claims

Practical Use of IRR and Hurdle Rates

Firm has many projects so would need to estimate rp for each one (painful). Instead set a hurdle rate Rh and use it for all projects. Rule: take any project if IRR ≥ Rh (or if NPV > 0 discounting at Rh). To set the hurdle rate Rh, management must have in mind a true cost of capital Rp to use as benchmark (e.g., the firm's WACC). Key advantage: no need to calculate rp for every different project! Works well if: all projects have the same risk and thus same rp and firm sets rh = rp. If this is true, then the rule leads to decisions consistent with the standard DCF / NPV analyses. Note: some firms set rh > rp , so may discard positive NPV projects with low IRR; also some may not revise rh frequently enough.

How do Cash Holding affect beta?

Firms often have both a lot of debt and large cash balances (more than what is needed for normal operations). One practical view is that cash is negative debt, e.g., when you compute enterprise value you use equity plus net debt (debt - cash). Some firms, e.g., Lululemon, have no long-term debt (all-equity financed) and have large cash to assets (50% in Lulu's case). If you estimate Lulu's equity beta from its stock returns (to obtain its cost of capital), does that reflect Lulu's asset (or unlevered) beta? No! It likely understates the firm's true asset (or unlevered) beta. Excess cash reduces Lulu's risk below the true risk of its business! So Be<Bu So, in formulas, replace Debt (D) by Net Debt (D-C)

Bankruptcy Costs as Market Imperfections

Firms with risky cash flows can become distressed or bankrupt if they use too much leverage VL=VU - PV(Bankruptcy Costs) Who bears the cost? Shareholders! With bankruptcy costs, rational lenders require a higher promoted debt payment (or higher YTM) to loan the firm the same amount of money they would lend if there were no bankruptcy costs. Bankruptcy costs are priced into the debt contract, making it more costly for the firm to raise debt. Hence it is the shareholders who bear the expected bankruptcy costs Direct Costs of bankruptcy arise because outside professionals get involved (legal and accounting experts, consultants, appraisers, auctioneers). Costs about 3-4% of firm value Indirect Costs of financial distress (10-20% of firm value): -loss of customers, suppliers, employees -fire sales of assets -agency costs -opportunistic behaviour by rivals *costs of financial distress and bankruptcy vary with asset type. firms with tangible assets lose less value in financial distress than firms with intangible assets

What is FCF?

Free Cash Flow is the cash flow to the firm if it had no leverage (this is also called the unlevered cash flow). This is the total cash flow leading the firm, if we ignore any interest tax shields FCF ignores interest payments the cash flow (dividend) that would accrue to shareholders if the firm had no debt

Why do certain industries have high/low book leverage?

High Book Leverage: -lots of manufacturers with large investment in plant+equipment Low Book Leverage: -lots of intangible assets -more variable cash flows (risky for debt holders)

Agency Benefits of Debt

High leverage constrains managers bad behaviour -leverage increases default risk, which managers want to avoid -leverage commits the firm to disburse free cash flow to lenders -debt, rather than retained earnings, finances new projects -monitoring from debt rating agencies

Selecting Comparable Firms

Ideally, comparable firms should be publicly traded companies that are: -Exclusively in the same line of business as project (same industry classification or peer group). -Generally, affected by the same economic forces as the project, i.e., their business risk should be similar. -Serving the same target market as the project. -Similar in size (assets, revenue, employees) to project. -Located in the same geographic region as the project. -Similar in capital structure to project; not a huge issue: we can correct for differences using our formulas.

In the whole bankruptcy issue it is very important to have conceptual clarity regarding what firms need to be restructured and which ones need to be liquidated. Can you explain this?

If a firm's business is sound and the firm is profitable in the long-run, but facing temporary trouble due to temporary adverse conditions, then it should be restructured and kept alive. If besides facing financial distress, the firm's business model is not viable and hard to change then firm is not profitable in the long run (unsolvable economic distress). Such firm should be liquidated and the proceeds should be distributed to its owners.

MM2, WACC, and Leverage

In perfect capital market/equilibrium Rwacc doesn't change as a result of recapitalization Changes in capital structure do not affect a firms Rwacc or the firm value -Re increases because equity is riskier than it previously was -Rwacc=Ru -Rwacc stays the same because debt is cheap and equity is expensive. The ratio stays the same because you're putting more weight in cheap debt and less weight on expensive equity so it evens out -Where Re=Ru is diskless debt

Dividend Policy in Practice

In practice, once dividend payments are initiated investors expect them to continue unless fundamentals change: - Dividend cuts (eliminations) thought to convey bad news - Dividend increases (initiations) thought to convey good news Changes in dividends may confuse investors due to information asymmetry, e.g., firm cuts dividends to fund positive NPV project but investors interpret bad news about fundamentals. A stable dividend policy (e.g., same dividend per share every period) reflects "business as usual" and reduces uncertainty. Share repurchases are more flexible, i.e., not expected to remain the same, so firms can use them more discretionarily. The firm could follow a residual dividend approach: pay dividends only after meeting investment needs, while keeping a desired debt-to-equity ratio (recall dividends decrease equity value). Makes sense, but dividends can then be very unstable! In practice, many firms appear to follow a compromise dividend policy (that balances stability with investment needs): - Avoid cutting back on positive NPV projects to pay a dividend. - Avoid cutting dividends. - Avoid issuing new equity. - Maintain a target debt-to-equity ratio. - Maintain a target dividend payout ratio (a long-run Div/NI), while smoothing dividends relative to earnings.

Trade-Off Theory of Capital Structure

Issuing debt implies a tradeoff, as it carries: -a benefit investors capture: interest tax shields -a cost investors bear: expected financial distress costs Managers choose D to maximize VL= VU + PV(ITS) - PV(EFDS) -high bankruptcy costs + low tax benefits; D will be low -low bankruptcy costs + high tax benefits; D will be high

If we want to value a project that a firm wants to pursue, can we use the unlevered firm's cost of capital to discount the project's free cash flow?

It depends! Correct to use Ru only is the firm and the project have the same business risk -the project is an expansion of its main line of business -ex. Lululemon wants to open a new store in toronto Incorrect if the firm and project have different risk For a project in a different line of business than the firm, estimate the projects cost of capital using comparables: Find comparable publicly traded companies that focus solely on the same business as the project (pure plays). If the pure play firms are levered but the project is all equity, use the MM2 levering/delevering formulas: - Delever the equity betas of all comparable firms and get their βU - Project's βU = avg of βU across all comparables - Plug project's βU into CAPM to get the project's rU

Microsoft 2004 Payout

July 2004 Microsoft announced it would return $75 billion cash to investors over 4 years - a $30 Bn buyback - $3 a share specia lpayout, - doubles regular dividend; - stock soared: about 5% return on announcement! What happened there? - Firm was all equity, sitting on pile of cash, low payout. - Faced pressure to payout - Excuse was pending litigation (now resolved) - Gates and Ballmer received a lot of money... - Lack of new investment opportunities + agency?

When should you accept a project?

NPV>0 IRR>Rp Rp=true cost of capital of project IRR= the discount rate r that makes a projects NPV=0

GE's Dividend Cut

November 2017 GE cut its dividend by 50% as the company advanced restructuring plans. - Many investors sold the stock - No impact on price (arguably already priced) - Preserve cash to fund investment - Refocusing of the conglomerate - Speculation that GE might be excluded from the DJ Industrials Index - Langenberg & Co. actually upgraded GE's rating to buy. - Note GE had paid a dividend since 1899 and had only cut it twice before: in 1939 and in 2009.

Anheuser-Busch's Dividend Cut

October 2018 A-B cut its dividend by 50% as it tried to steady its balance sheet after an acquisition. - 10% drop in stock price to a 6-year low as a result - Causing a 16 Billion euro loss of market value - CEO claimed currency volatility drove the decision ,e.g., in Argentina (lost half of its value in previous year) - High leverage ($109 Bn in debt) after acquisition of SAB Miller - likely a good idea to delever (repay debt) - Goal: to reduce leverage to about Debt/EBIDTA=2x - But announcement came with a dropin Q3 sales and earnings below on consensus forecasts (fundamentals?) - Was the dividend cut triggering the price drop?

Bankruptcy vs. Private Workouts

Private workouts and bankruptcies are both commonly used; firm choose how they want to restructure, thinking of potential benefits and costs. Often file for bankruptcy after failed private workouts. Advantages of bankruptcy reorganization: • Can use all the legal tools (very useful!) and judge oversight; good especially when reaching agreements is hard (e.g., too many creditors). • Some restructurings cannot be done unless in formal bankruptcy as they are complicated (e.g., United Airlines spent 3 years and 51 days in Ch 11) Disadvantages of bankruptcy reorganization: • Much more costly than private workouts (latter cost • Judge has a little too much power (e.g., may refuse to liquidate a firm) • Tendency for bad firms to survive

Flow vs. Stock Insolvency

Stock Insolvency: the value of the firm's assets < the value of the firms debt (negative net worth) Flow Insolvency: operating cash flows are insufficient to cover obligations Stock & flow insolvency often come together; but could be stock insolvent but not flow insolvent if e.g. obligations are mostly due in future years. Financial distress is often driven by macroeconomic/industry wide factors that affect all firms but also happens to specific firms for various reasons.

Private Workouts

Process starts with default or impending default, leading to private negotiations between creditors and management. If successful, agreement to modify terms of debt: • reduce current amount in return for a (possibly higher) later payment • reduction of required interest or principal • extension of maturity • exchange of debt for equity -Tends to work better when debt is private and concentrated in a few creditors. -Restructuring public debt is more difficult; requires unanimous consent from every (even small) bondholder. -Holdouts: dissenting bondholders can block the restructuring unless they get sweet deals ... this makes the workout very costly.

MM2 (no taxes)

Re = Ru + (D/EL)*(Ru-Rd) meaning: the required return on levered equity is increasing in financial leverage (Ru>Rd) key intuition: leverage amplifies the firm's business risk and this increases the risk of equity (even with no risk of default) *Ru=Rwacc* but Re>Ru because the firm now uses less equity capital and more (safer) debt capital (Re>Ru>Rd)

MM2 with taxes

Re = Ru + (D/EL)*(Ru-Rd) times (I-t) When you lever up: Firm value will increase, Re will increase, Rwacc will decrease, Beta will decrease Meaning: the required return on levered equity is increasing in financial leverage because leverage amplifies the firm's business risk and this increases the risk of equity Note: higher debt increases Re less than without taxes; now shareholders get interest tax shields which are relatively safe

Managing Financial Distress: Restructuring

Restructuring / rationalization of operations: • Liquidate some (e.g., non-core) assets; focus on profitable businesses • Plant closings & layoffs / wage cuts / introduction of cost saving technologies • Use proceeds of asset sales to pay off creditors and keep firm alive • Note: this is often a precondition for any agreement with creditors • If not successful (economic distress unresolved), the firm should be liquidated Restructure financial contracts: • Firm is now viable but debt is in default; lenders now own and control the firm • To formalize this, swap defaulted debt for equity in the firm • Remaining debt must have long maturity - allow firm to breathe • Can do this in private workout, or in court under formal bankruptcy Infusion of new capital (firm still needs funds): • Raise new debt (collateral; seniority) and equity (e.g., preferred shares) • Government support if firm is "of social interest"

Schedule for getting FCF

Sales -COGS -Operating Expenses -Depreciation =EBIT -Taxes =Net Income +Depreciation -Changes in NWC -Capital Expenditures =FCF

Agency Costs of Debt

Shareholders agree to debt covenants because, by restricting the firm's actions, they are able to get better prices on debt. Key covenants include: -restrictions on asset sales -restrictions on new issues or seniority over older issues -dividend or payout equity restrictions -financial ratios: minimum NWC, max Debt/EBITDA Covenants also come with costs: -constrain management and reduce flexibility -monitoring compliance is expensive

Recapitalizing to Capture the Tax Shield

Shareholders capture the benefit of the tax shield! After the recap firm value, share prices, EPS, and the cost of equity increase, but WACC decreases

Cash vs. Share Offer

Synergies are estimated but uncertain. Note that: - if cash is used, the target firm's shareholders do not participate in the potential gains (or losses) of the merger. - if shares are used, then the target firm's shareholders share in the potential gains (or losses) of the merger. - If an acquirer is confident that the synergies will materialize, what form of payment would the acquirer prefer? Tax issues: - payment by cash usually results in a taxable transaction - acquisition by exchanging shares is generally tax free. Control rights of acquirer: - payment by cash does not affect the acquirer's control. - payment with voting shares does affect control (target shareholders are now owners of the acquirer!).

What are Market Imperfections that make it so that payout policy matters?

Taxes Reducing issuance and distress costs - a key benefit. - Retain cash to cover future cash shortfalls, e.g., fund future projects or avert distress. - Avoids asymmetric information problems related to raising capital (e.g., low share prices if investors worry about timing). - Avoids costly issuance fees: 5-15% for IPOs, 3-13% for SEOs, 1-8% for debt (smaller for larger issues). Agency costs of retaining cash - a key cost. - "Cash can burn a hole in your pocket!" - Excess cash retained in the firm can lead managers to fund money- losing projects or acquisitions, shirk, or consume perks. - RJR Nabisco CEO kept 2 maids on payroll, 12 country club memberships, and 10 corporate planes (RJR air force). Asymmetric Information (between managers and investors: Dividend changes signal managers' views of future earnings: - Increases signal ability to pay higher dividends in the future. - Cuts signal inability to pay the current dividend in the future. Transaction costs: If dividend payments minimize transaction costs to equity holders that prefer current income, e.g., brokerage fees are involved in making dividends at home and this requires planning, then paying dividends might be optimal. Institutional constraints: If various institutions avoid investment in non- or low dividend payout stocks because of legal restrictions, management may find it optimal to pay dividends despite the tax burden it imposes on investors. For example, some mutual funds are precluded from holding non- dividend paying stocks.

Outline the "absolute priority rule (APR)" used in bankruptcy proceedings. Any legal caveats to its implementation?

The APR roughly says legal fees associated with the proceeding get paid first, then wages and taxes, senior creditors, junior creditors, preferred shareholders, and finally common shareholders. Judges have some discretion in implementing these rules and thus can affect outcomes.

APV in the RJR Nabisco LBO

The LBO of RJR Nabisco by KKR (Kohlberg, Kravis, & Roberts) in 1988 was the largest LBO in history. RJR had $5 billion in debt (at market values) and 229 million shares trading at around $55 per share. RJR's target capital structure was thought to be a debt-to- value ratio of about 25%. RJR's management offered $75 per share to take the firm private in a management buyout (MBO). Within days of the offer, KKR entered the bidding and finally paid $25 billion for RJR Nabisco's equity or $109 per share and it assumed the $5 billion in debt (at market values). To finance the transaction, KKR issued $24 billion in new debt and contributed equity from its investors for $1 billion.

Market Timing

The Market Timing view states that debt ratios largely result from managers' attempts to "time" equity markets: - sell new equity if it is overpriced - repurchase shares if equity is underpriced Implication: firms with low (high) D/V raised funds when past equity values were high (low) so issued more equity (debt).

Appropriate use of WACC to discount new projects

The WACC is the correct cost of capital to use in evaluating new projects, provided that the following three underlying assumptions are true for those new projects: 1. The projects are in the firm's main line of business, and so have the same business risk as the firm. 2. The new projects are financed with the same capital structure weights as the firm. 3. The firm must maintain the capital structure weights you use to compute WACC over time

How are repurchases done?

The company purchases its own shares from investors in an open market repurchase and pays current market prices. Unlike dividends, repurchases reduce the # of shares outstanding, and thus reduce the book value of the company's common stock. Note 1: 95% of repurchases are open market, but there are also "tender offers" where the company offers to buy a fixed price (usually above market) - this often happens in the context of takeovers. Note 2: the open market repurchases might allow companies to "manipulate" the price of their shares. Hence, there are "antimanipulative" provisions in the securities regulation: -publicly announce the repurchase program - only use one broker or dealer on any single day - avoid trading just before market closing - limit the daily volume of purchases to a specified amount

Stakeholder Theory

The stakeholder theory of capital structure suggests that the way a firm and its non-financial stakeholders (customers, employees, suppliers) interact is an important determinant of the firm's optimal capital structure. Since these other stakeholders may be reluctant to do business with a financially distressed firm, firms that worry about this may choose to be financed in a conservative way. Financial distress is especially costly for firms with: - Employees and suppliers who require specialized (firm- specific) capital or training - Products that require future servicing - Products with quality that is important yet unobservable (customers won't purchase from them) These firms should hold less debt - evidence supports this view.

Pecking Order Theory

The theory says firms prefer the following ordering of financing: - Retained earnings (avoid investor skepticism) - Debt (a little bit of information asymmetry) - Equity (large information asymmetry) This story is consistent with the data: retained earnings account for most financing, followed by debt, and firms issue little equity. However, the theory has no clear implication for the optimal level of debt a firm should carry. There is no target D/E! Prediction: more profitable firms will have lower debt ratios; build "financial slack" to avoid equity issues in the future (issue debt when CFs are low and retire when CFs are high). True in data! • Other reasons for pecking order: a) higher issuance costs for equity than for debt, and b) managers don't like monitoring by lenders.

Why is a formal bankruptcy proceeding needed?

To provide an opportunity for an orderly reorganization or liquidation; ensure viable firms are reorganized and the rest are liquidated -Courts coordinate the process : • multiple creditors have conflicting interests and want to be paid first • interests of other stakeholders (e.g., employees or government) are important -Direct costs of bankruptcy proceedings are large; incurred when involved parties cannot reaching a private agreement on their own. -Bankruptcy system is generally "pro-debtor"; allowing viable firms to restructure, develop their long-term strategy, and exit from bankruptcy.

Timeline of Leveraged Recapitalization

U firm will issue debt to repurchase equity; will become firm L on the date of the transaction Key date is the announcement date; what happens that date depends on the exact assumptions we are using to describe the world

Laws Governing Bankruptcy and Reorganization

USA: Bankruptcy Reform Act of 1978 • Chapter 7 - liquidation • Chapter 11 - reorganization CANADA: • Bankruptcy & Insolvency Act of Canada - liquidation • Companies' Creditors Arrangement Act - reorganization

Broader Tradeoff Theory

VL = VU + PV(ITS) - PV(Financial Distress Cost) - PV(Agency costs of debt) + PV(agency benefits of debt) Low D= high R&D firms (like biotech); low current CF (no agency or tax benefit), intangible assets (high distress costs), high business risk (likely to default), flexibility in choosing investment (high agency costs of debt) High D= ex. oil refineries; high CF (high agency benefits and high tax benefits), fixed assets (low distress costs), low business risk (unlikely to default), and little room to manipulate investment (low agency costs of debt)

MM1 (no taxes)

VL=VU meaning: the choice of capital structure does not affect the firm value; that is, capital structure is irrelevant. key intuition: changing the capital structure does not affect the firms cash flows or cost of capital

MMI with taxes

VL=VU+PV(ITS) Meaning: firm value increases with financial leverage because higher leverage increases PV(ITS) For perpetual debt, we will use VL=VU+(t*D) Key intuition: -increasing leverage generates interest tax shield which increase the firm's after-tax cash flows (pizza gets bigger) -Leverage reduces the after-tax cost of debt and thus the firms cost of capital (Rwacc<Ru)

WACC and MM2 with taxes

WACC decreases in leverage as long as t>0

More Distress Costs: Debt and Incentives

When a firm is in trouble, shareholders may make decisions that reduce firm value but benefit equity at the expense of debt -Cashing out: liquidate assets and pay the cash to shareholders when keeping the asset would have benefitted lenders -Over-investment or risk-shifting: undertaking high risk negative NPV projects that increase equity value but reduce debt value. Such projects should not be done and shift risk onto lenders -Under-investment or debt-overhang: shareholders refuse to provide the additional capital for a positive NPV project because lenders get most of the benefit through higher debt values. Such projects should be done, but pending debt prevents it But rational lenders anticipate this when buying debt, and thus shareholders ultimately bear these agency costs of debt

B and MM2 with taxes

financial leverage amplifies the market risk of a firm's unlevered assets, Bu, increasing the market risk of its equity (assuming perpetual debt)

Economic Distress

firm is unable to generate cash flow (ignoring debt; i.e. firm is all equity) due to: -bad business model, production inefficiency, competition -overall economic downtown economically distressed firms often become financially distressed -bad business model leads to financial distress, so firm should be liquidated -temporary downturn can lead to financial distress of a viable firm; reorganize it

How to get share price

for unlevered firm: EPS/Ru for levered firm: EPS/Re Equity Value/Shares OS

What is Rd?

the (before-tax) cost of debt is the expected return investors require to lend to the firm After-tax cost of debt is Rd*(1-t)

Debt Capacity

the amount of debt required at time t to maintain the firm's target D/V at time t. Debt capacity = target D/V × Vt where Vt is the firm's levered continuation value on date t (PV of FCF in t+1 onwards, discounted at rWACC)

What is Rwacc?

the average cost of all claims in the firms capital structure, weighted by their market values

What is FCFE?

the cash flow (dividend) to the shareholders of a levered firm

What is Re?

the expected return that shareholders require to hold the firm's stock

Financial Distress

the firms liquid assets/operating cash flow are insufficient to cover contractual obligations (creditors, suppliers, labor) -lawsuit or accident could make firm unable to pay interest -can lead to default, leading to debt renegotiation

What are Synergies?

the incremental gain arising from the combination of two firms, A and B, through a merger or acquisition. The merger should be undertaken only if: VAB > VA + VB The synergies (value gain) is: ∆V = VAB - (VA + VB) When ∆V > 0, the merger should be undertaken. If Firm A buys Firm B, it gets a company worth VB plus the incremental gain ∆V . Thus, the value of Firm B to Firm A is: VB* =VB +∆V

Why would the NPV>0 in an acquisition?

this excess value likely results from: - the acquirer's access to superior managerial and labour talents at costs not fully reflective of their marginal value - access to raw material inputs at lower costs - ability to price the product more profitably - synergies in production and/or distribution - access to capital at lower cost - greater efficiency due to lower agency costs

Legal forms of Acquisitions

• Merger: complete absorption of one company by another, where the acquiring firm retains its identity and the acquired firm ceases to exist as a separate entity. Must be approved by the stockholders of both firms. (A+T=A) • Consolidation: acquisition in which a new firm is created and both the acquired and acquiring firms cease to exist. (A+T=New Company) • Acquisition of stock: purchase of a firm's voting stock. No stockholder vote is required; acquirer can deal directly with stockholders, even if management opposes. (more common) • Acquisition of Assets: a firm can effectively acquire another firm by buying most or all of its assets; the target firm does not necessarily cease to exist. (easier than stock)

What covenants (based on financial ratios) is a firm likely to violate when it becomes distressed?

• Minimum Current Ratio • Maximum Debt to Equity Ratio • Maximum Debt to EBITDA Ratio • Minimum Interest Coverage Ratio • Minimum NWC / Assets

Symptoms for Financial Distress

• Plant closings; layoffs; delays in investment • Drop in stock prices; dividend cuts • Management turnover • Reported losses; weakening of financial ratios

List some measures you might take to restructure the operations of a firm in distress.

• Re-focusing on core assets • Selling assets • Closing plants • Labour force reductions

Sources of Synergies

• Revenue enhancement: The combined firm may generate greater revenues than two separate firms due to: - Marketing gains (advertising, distribution network, product mix) - Strategic benefits (more flexibility regarding future operations) - Market power (reduce product market competition) • Cost reductions: The combined firm may operate more efficiently than two separate firms due to: - Economies of scale (ability to produce larger quantities at lower cost; common in industries with high fixed costs) - Economies of vertical integration (control whole production process, reduce search cost for suppliers or customers) - Complementary resources (using skills/resources that complement each other) • Reducing Capital Needs: - Reductions in required investment in working capital and fixed assets relative to the two firms operating separately. - More efficient management of assets under one umbrella. - Some assets can be sold if they are redundant in combined firm. • Tax Gains: - The use of tax losses. A firm that loses money on a pre-tax basis is attractive to a partner with high tax liabilities. - The use of unused debt capacity. Acquirer can use acquired firm to increase debt and gain tax shields. - The use of surplus funds. If, instead, free cash flow were paid to investors as dividends it would be taxed. - The ability to write up the value of depreciable assets (so tax deductions from depreciation are higher). - Changing tax jurisdictions.