Corporate Finance Exam 2
WACC
(E/E+D)*Re + (D/E+D)*Rd*(1-T)
beta of market portfolio
= 1
levered vs unlevered assets equation
Al = Dl + El Au = Eu so for MMI -> Au = Al = Dl + El
Benefits of Debt
ITS after tax cost of debt, WACC
tradeoff theory
ITS vs financial distress Vl = Vu + PV(ITS) - PV (financial distress cost) Explains 2 puzzles: 1. why firms choose to exploit debt levels that are too low to fully exploit ITS 2. differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries
Bankruptcy direct costs
Legal and accounting experts, consultants, appraisers, actioneers, IBs, and court costs (lehman fees hit 2.2b) reduce total asset value available to creditors (about 3-4% of pre bankruptcy market value of assets)
how to estimate Re for all equity financed
Re = Ra so Ra' = Ra and Re' = Re
Equity cost of capital equation
Re = rfr + equity beta*(ERm-rfr)
risk premium
The return in excess of the risk-free rate of return that an investment is expected to yield. - for of compensation for investors who tolerate the extra risk, compared to that of risk free asset return - risk free rate
trade off theory with agency costs
Vl = Vu + PV(ITS) - PV fin distress - PV agency cost of debt + PV agency benefit of debt
leveraged recap
a firm issues a large amount of debt and uses the proceeds to pay a special dividend or to repurchase shares (to reduce tax payments)
adverse selection problem
a problem that occurs when buyers and sellers have different amounts of information, the average quality of assets in the market will differ from the average quality overall - the offer conveys negative information about what is being offered Lemons principle - when a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection
asymmetric information
a situation in which parties have different info - when managers have superior info to investors
signaling effect
actions taken by insiders to reveal info to outsiders credibility principle = claim's of ones' self interest are credible only if they are supported by actions that would be too costly to take if claims were untrue (actions speak louder than words) For example: if a manager chooses to take on debt, you should take on enough to be higher than something you could easily pay off because you want to signal that you are VERY confident best outcome will occur
market portfolio
all stocks and securities trade in capital markets
bankruptcy
an orderly process for settling firm's debt chapter 7 and 11
debt risks
borrowing money can amplify the outcome of a deal so it can amplify gains as well as losses even though leverage doesn't affect the asset volume (return), it increases the risk of equity even when there is no default risk
how does leverage change managers' incentives?
concentration of ownership - leverage can allows original owners of the firm to maintain equity stake - so owners will be incentivized to do what is best for the firm reduce wasteful investment - FCF hypothesis = wasteful spending is more likely to occur when firms have high levels of cash flow in excess to what is needed after all +NPV projects are taken -leverage is a way to be monitored by creditors and also the threat of financial distress makes CEOs want to succeed
Agency Problem
costs that arise when there are conflicts of interest between stakeholders - can arise between equity and debt holders only when there is leverage - managers represent shareholders - so they can make decisions to benefit equity holders but harm debt holders and lower total value of firm - most likely to occur when financial distress is high
cost of debt
debt has the benefit of ITS which lowers the cost of debt after tax borrowing rate = Rd*(1-T)
how does leverage affect firm's total value?
debt lowers the income available to equity holders but increases the total amount available to all investors by how much? interest expense * tax rate
problems with agency problems
debt vs equity holders reduce firm value another cost of high leverage
downfalls of debt
default (financial distress)
do firms fully exploit the tax advantages of debt?
depreciation tax shield low leverage puzzle - int/EBIT around 30%, higher during market downturn, around 10% of all firms with negative pre-tax income who will not benefit from higher debt
T/F issuing equity will dilute existing shareholders' ownership, so debt financing should be used instead
dilution = if a firm issues new shares the cash flows generates by firm must be divided among a larger number of shares, thereby reducing the value of each individual share BUT pie gets larger so when new shares are issues, SHO increases but new capital is raises because assets grow as long as firm sells new shares of equity at a fair price, there will be no gain or loss to shareholders associated with the equity issue itself
how to estimate equity cost of capital using comps
equity cost of capital varies with capital structure so you can NOT compare Re across firms with different capital structures (can only compare Ra directly)
unlevered equity
equity in a firm with no debt
levered equity
equity in a firm with outstanding debt
How much do taxes take from investors?
every time equity holders get a slice, US gets a slice from taxes but when debt holders get a slice, US gets nothing so higher leverage means higher interest payments, higher ITS, lower taxes higher firm value
debt cost of capital
expected return of other investments available in the market with equivalent risk to the firm's debt
equity cost of capital
expected return of other investments available in the market with equivalent risk to the firm's shares
T/F - leverage can increase a firm's expected eps, so leverage should also increase the firm's stock price
false - in perfect capital markets the stock price will be the same. Leverage increases' firms EPS (necessary to compensate shareholders for added risk) but not stock price SO as EPS increases, Re increases and price doesn't change P/E ratio comparison across firms with different capital structures is not reliable while Ev multiples are more useful
what types of risk are compensated?
financial markets only reward investors for taking systematic risk - risk premium is determined by systematic risk and does not depend on diversifiable risk
bankruptcy chapter 11
firm continue operations rationale: creditors will get more if the firm is worth more as a whole
how to value ITS with permanent debt
firm issues debt and plans to keep dollar amount debt constant forever PV(ITS) = t*debt
ITS and firm value
firm's assets generate the same future cash flows, regardless of who financed them (debt vs equity) when T=0, all cash flows go to investors
optimal capital structure with taxes
firms prefer to use debt as a source of external financing and firms issue debt to repurchase shares
how to value ITS
forecast interest payments to get ITS each year and then discount ITS at a rate that corresponds to its risk
who does ITS benefit?
goes to all existing shareholders share price will rise at announcement of recap when securities are fairly priced, the original shareholders of a firm capture the full benefit of the ITS from an increase in leverage even though leverage reduces the total market cap of equity, shareholders capture the benefits of ITS upfront
unlevered cost of capital/asset cost of capital from MMI
holding unlevered equity and holding a portfolio of levered equity and debt should give investors the same return Ra = (D/D+E)*Rd + (E/E+D)*Re = Ru OR Re = Ru + (D/E)*(Ru-Rd) Ra or Ru serves as lower bounds of Re
market risk premium
how much premium investors demand to hold the market portfolio = expected market return - risk free rate
who bears cost of agency problem?
if firm is unlevered and now chooses to increase leverage, original shareholders bear the cost if debt is already in place, existing debt holders bear some of the costs
debt cost of capital equation
if there is no default risk Rd = YTM Re = rfr + debt beta*(ERm-rfr)
Modigliani-Miller Theorem I
in perfect capital markets, the total value of a firm's securities is equal to the market value of the total cash flows generated by its assets and is NOT affected by its choice of capital structure perfect cap markets assumptions: no misplacing, no taxes, no transaction costs, financing decisions do not change the cash flows generated by its investments, fin decisions do NOT reveal new info about investment intuition = asset is how large a pizza is and MMI says that how you slice the pizza doesn't change how big the entire pie is MMI: Al = Au
having higher debt/leverage...
increases the risk of equity so high leverage means higher Re
leverage ratchet effect
leverage begets more leverage if debt is already in place: equity holders have incentive to further increase leverage even though it might reduce firm value equity holders do NOT have incentive to reduce leverage even if it will increase total firm value
Bankruptcy indirect costs
loss of customers, suppliers, employees, receivable first sale of assets costs to creditors often larger than direct costs in general, bankruptcy is very expensive and firms want to avoid it!!!
managers vs shareholders
management entrenchment - managers have incentive to make himself or herself less likely to be fired and replaced (take projects they specialize in) personal perks - private cars, planes, sports tickets empire building - prefer to run large firms due to higher salaries, more prestige and more publicity
Pecking Order Theory
managers will prefer to fund investments by first using retained earnings, then debt and equity only as a last resort retained earnings (almost no asymmetrical info)> debt >equity higher order funding sources are less sensitive to asymmetrical info
beta
measures sensitivity to systematic risk/to return of market portfolio it is the expected % change in its return given 1% change in return of market portfolio lower beta = essential goods and non cyclical (close to 0) and higher betas = luxury goods and cyclical (over 1)
default
miss interest or principle payment, when senior creditors can't even get paid debt is an obligation so higher leverage, higher chance of being in fin distress - renegotiate with creditors: workout - raise new capital - sell assets
how to estimate Re for a levered company and levered comp
need to unlever Re comp to get Ra comp then we can lever Ra to get Re
bankruptcy chapter 7
operations are stopped, firms go out of business assets are sold, proceeds distributed to creditors equity and low seniority creditors get nothing unless high seniority creditors are paid in full
tax and jobs act 2017
reduce corporate income tax from 35% to 21% there is a limit to tax benefit from debt corporation cannot deduct interest exceeding 30% of their EBITDA
Capital Structure
relative proportions of debt and equity that a firm has
discount rate
return required by investors to compensate the relevant risk they take = risk free rate + risk adjustment
CAPM
rfr + beta*(expected return market - risk free rate)
market indexes as an approximation
s&p 500
leverage reduces the income available to ____
shareholders
PV of financial distress costs depend on...
some firms are more costly to dissolve: probability of financial distress (utility firm/stable cash flows vs semiconductor) - stability can have more debt magnitude of financial distress costs tech (harder to recover value of assets) vs real estate firms
consequences of ITS
subsidizing debt financing encourages firms to borrow and take excessive risk unstable firms/economy
two types of risk
systematic risk (market risk) - undiversifiable, fluctuation of return that are due to market wide factors, will be compensated idiosyncratic (firm specific risk) - diversifiable, fluctuation of return that are due to company specific factors (unrelated across stocks)
interest tax shield
tax deductibility of interest payments ITS = T*interest payments
how do corporations pay taxes?
tax is on earnings before tax, but after interest so interest is tax deductible. higher debt -> higher interest -> lower taxes
MMII
the cost of capital of levered equity increases with the firm's market value debt-equity ratio - leverage does not change asset cost of capital but it does increase risk of equity Re = Ra + (D/E)*(Ra-Rd) in perfect cap market, a firm's WACC is independent of its capital structure and is equal to Re if unlettered, which matches cost of capital for assets
bankruptcy and shareholders
the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress
MM Proposition I (with taxes)
the total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt Vu + PV(ITS) = Vl
efficient portfolio
theoretically, we can build a portfolio that all unsystematic risk is diversified away and contains only systematic risk
limits of tax benefit of debt
to receive full benefit of leverage, a firm need not use 100% debt financing but the firm does need to have taxable income - the optimal level of leverage from a tax savings perspective is that interest equals the income limit debt should be proportional to earnings
debt hangover/underinvestment problem
when a firm faces financial distress it may choose not to finance new, positive NPV projects because debt holders harvest the gain first, making the project and negative npc project for equity holders
Risk Shifting Problem
when a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently even if they are negative NPV also called: asset substitution (replace low risk assets with riskier ones) and over investment (take negative NPV but risky projects) equity holders are gambling with debt holders money
adverse selection problem of equity issuance
when are the managers willing to sell shares? - when they are overpriced stock price actually goes down when equity issuance is announced but stock price increases prior announcement of equity issue you should issue equity when info asymmetries are minimized, like right after an earnings announcement
Recapitalization
when firms make significant changes to their capital structure
MM summary
with perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk and return capital structure affects a firms value ONLY because of its impact on some type of market imperfection leverage increases equity cost of capital but not asset cost of capital
how to estimate Re for a levered comp firm
you have to unloved Re' so Ra comp = (D/D+E)*Rd + (E/E+D)*Re
how to estimate Re for a levered company and unlevered comp
you need to lever Ra with Re = Ra + (D/E)*(Ra-Rd)
