Financial Leverage Essentials
Prepackaged Bankruptcy
A bankruptcy plan approved by a majority of creditors before the actual filing for bankruptcy
Market Claim
A claim that can be bought or sold in a market, providing liquidity
Nonmarketed Claim
A claim that cannot be easily bought or sold in a market
Chapter 7 Bankruptcy
A form of bankruptcy that involves the liquidation of assets to pay off creditors
Bankruptcy
A legal process for individuals or businesses that cannot repay their outstanding debts
Financial slack
Accumulated internal cash for flexibility
Stay
An immediate halt on creditor payments when a firm files for bankruptcy
Weighted Average Cost of Capital (WACC)
Average rate of return a company expects to compensate all its investors
Weighted Average Cost of Equity
Average rate of return expected by equity investors
Key Employee Retention Plans (KERPs)
Bonuses paid to valuable employees to prevent them from leaving for other companies
Financial Restructuring Impact
Change in firm value equals net effect on shareholders
RA - RD
Component determined by financial structure
Extended pie model
Concept of claims on firm's cash flows
Unlevered Cost of Capital
Cost of capital for a debt-free firm
Financial distress costs
Costs due to risk of financial distress
Present Value of Interest Tax Shield
Current worth of future tax savings on interest payments
Optimal Capital Structure
Debt-equity ratio minimizing weighted average cost of capital
Capital Structure Choice
Decision on debt-equity ratio to maximize firm value
Market claims vs. nonmarket claims
Distinction between tradable and non-tradable claims
Financial Risk
Equity risk from capital structure
Business Risk
Equity risk from operating activities
Bankruptcy Process
Essentials of legal process for insolvent firms
Absolute Priority Rule
Establishes the priority of claims in liquidation, determining the order in which creditors are paid
Financial Distress Costs
Expenses associated with going bankrupt or facing financial distress
Direct Bankruptcy Costs
Expenses directly linked to a firm's bankruptcy process
Bankruptcy Costs
Expenses incurred during insolvency proceedings
Indirect Bankruptcy Costs
Expenses incurred to avoid a bankruptcy filing
Financial Leverage
Extent of firm's reliance on debt in capital structure
Default
Failure to meet financial obligations, leading to potential bankruptcy
Reorganization
Financial restructuring of a failing firm to continue operations under Chapter 11 bankruptcy
Static Theory of Capital Structure
Firm borrows until tax benefits equal financial distress costs
Pecking-order theory
Firms prefer internal financing over external
Tax benefit from leverage
Important for tax-paying firms
Homemade Leverage
Individuals adjusting leverage through personal borrowing
Break-even EBIT
Level where EBIT covers fixed costs and interest
Optimal capital structure
Maximizes firm value and minimizes cost of capital
Capital Structure
Mix of debt and equity financing
NPV per Dollar of Debt
Net present value increase for each dollar of debt issued
Target capital structure
No specific optimal debt-equity ratio
Pecking-Order Theory
Preference for internal financing over external debt
Earnings per Share (EPS)
Profit allocated to each outstanding share
Earnings Before Interest and Taxes (EBIT)
Profit before deducting interest and taxes
Debt-Equity Ratio
Proportion of a company's assets financed by debt versus equity
Debt-equity ratio
Ratio of debt to equity in capital structure
Static theory
Relates WACC to costs of debt and equity
M&M Proposition I with Taxes
Relationship between firm value, debt, and tax shield
Unlevering the Stock
Removing financial leverage effects from stock valuation
RA
Required return on firm's assets
Voluntary Arrangement
Restructuring or rescheduling a company's debt without filing for bankruptcy
Cost of Equity
Return a company requires on its equity
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
Significant overhaul of U.S. bankruptcy laws, focusing on individual debtors
Financial Distress
State of a company struggling to meet debt obligations
M&M Proposition II with Corporate Taxes
States the cost of equity considering corporate taxes
Interest Tax Shield
Tax savings from deductible interest payments
Liquidation
The process of selling off a company's assets to pay creditors when the company cannot pay its debts
Tax Shield
Value of tax savings from deductible expenses
WACC
Weighted average cost of capital for firm's financing
Technical Insolvency
When a firm is unable to meet its financial obligations
Accounting Insolvency
When a firm's total book liabilities exceed the book value of total assets
Value of Levered Firm (VL)
Worth of a firm with debt factored in
Value of Unlevered Firm (VU)
Worth of a firm with no debt
