FIN CHP 13
Which one of the following statements is correct?
Bankruptcy courts have "cram-down" powers.
the effect of leverage depends on
EBIT *when EBIT is higher, leverage is more beneficial
with a BREAK EVEN EBIT
EPS IS THE SAME FOR BOTH CAPITAL STRUCTURES
REORGANIZATION BANKRUPTCY (CHP 11)
Federal bankruptcy reform act of 1978 - petition filed by firm or creditors - usually, firm continues operations as "debtor in possession" - firm submits reorganization plan - if accepted by classes of creditors, then confirmed by court - firm makes payments to creditors and operates under plan for some fixed time
LIQUIDATION BANKRUPTCY (CHP 7)
Federal bankruptcy reform act of 1978 - petition filed in federal court - trustee elected by creditors to take over firms assets - trustee attempts to sell assets - proceeds distributed according to the absolute priority rule
Which one of the following terms is inclusive of both direct and indirect bankruptcy costs?
Financial distress costs
Which one of the following statements concerning financial leverage is correct?
Financial leverage magnifies both profits and losses.
Which of the following statements correctly relate to M&M Proposition I, with taxes? I. Debt decreases the value of a firm. II. The levered value of a firm exceeds the firm's unlevered value. III. The weighted average cost of capital (WACC) is constant. IV. The optimal capital structure is zero debt.
II Only
Which one of the following terms applies to the costs incurred by a firm which is trying to avoid filing for bankruptcy?
Indirect bankruptcy costs
Which one of the following is a direct bankruptcy cost?
Legal and accounting fees related to a bankruptcy proceeding
Gabe's Market is comparing two different capital structures. Plan I would result in 11,000 shares of stock and $225,000 in debt. Plan II would result in 14,000 shares of stock and $150,000 in debt. The interest rate on the debt is 8 percent. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $45,000. The all-equity plan would result in 20,000 shares of stock outstanding. Of the three plans, the firm will have the highest EPS with _____ and the lowest EPS with ____
Plan I; all-equity plan
shareholders are exposed to more risk with more leverage
ROE and EPS are more sensitive to changes in EBIT when a firm is using debt
Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation?
Reorganization
the firm borrows up to the point that the extra benefit from an extra $ in debt is exactly equal to the cost that comes from the increased probability of financial distress
STATIC THEORY OF CAPITAL STRUCTURE
Which one of the following is minimized when the value of a firm is maximized?
WACC
According to M&M Proposition 2, when there are only taxes and no bankruptcy costs,
WACC decreases and cost of equity increases
When is a firm insolvent from an accounting perspective?
When the firm has a negative net worth
causing bankruptcy to be expensive and slow: Section 363
auction-like bankruptcy
accounting insolvency
book value of equity is negative
Which one of the following is the equity risk arising from the daily operations of a firm?
business risk
business failure
businesses terminated with a loss to creditors
Capital Restructuring=
changing the amount of leverage WITHOUT CHANGING THE FIRMS ASSETS
leverage increases, risk increases,
cost of equity increases
M&M Proposition II, without taxes, states that the:
cost of equity increases as a firm increases its debt-equity ratio.
causing bankruptcy to be expensive and slow: cram-downs
court-ordered plan acceptance
when the value of the firms assets equals the value of the firms debt then the firm is
economically bankrupt in the sense that the equity has no value
Which one of the following is the equity risk arising from the capital structure selected by a firm?
financial risk
technical insolvency
firm unable to meet debt obligations
the higher the tax rate,
greater incentive to use debt
The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:
homemade leverage.
Under the "expected" scenario leverage
increases ROE and EPS
Variability in both ROE and EPS increase when financial leverage
is increased
A prepack:
is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan.
direct bankruptcy costs
legal and administrative costs - quantifiable - measurable *Bondholders incur additional losses - because of expenses associated with the process, bondholders won't get all they are owed
Which one of the following terms refers to the termination of a firm as a going concern?
liquidation
capital structures differ by industries
lowest: computer equipment, drugs highest: pay television, airlines
the primary goal of financial managers:
maximize stockholder wealth
causing bankruptcy to be expensive and slow: workouts
negotiated extensions or payments
capital structure
percent of debt and equity used to fund the firms assets
legal bankruptcy
petition filed in federal court for bankruptcy
causing bankruptcy to be expensive and slow: prepacks
prepackaged filings
Modigliani and Miller capital structure theory
proposition I: the pie model proposition II: risk free and financial leverage
Homemade leverage
suggests there is nothing special with corporate borrowing * any stockholder who prefers leverage can create their own "homemade" leverage and replicate the payoffs - you are taking on the debt by yourself
ANNUAL INTEREST TAX SHIELD
tax rate times interest payment $1000 in 8% debt = $80 in interest expense annual tax shield= .25(80)= 20 every year
The tax benefit is only important if
the firm has a large tax liability
the greater the risk of financial distress,
the less debt will be optimal for the firm
Case I: No corporate or personal taxes and no bankruptcy costs
the pie model: the value of the firm is not affected by changes in the capital structure, the cash flows are not changing risk free and financial leverage - the WACC of the firm is not affected by capital structure
As the D/E ratio increases,
the probability of bankruptcy increases. - This increased probability will increase the expected bankruptcy costs.
proposition II: risk free and financial leverage
the systemtice risk of the stock depends on * systematic risk of assets Ra (business risk) * level of leverage D/E (financial risk)
"leverage"
the use of debt in capital structure
According to M&M Proposition 1, when there are only taxes and no bankruptcy costs,
the value of the firm increases as total debt increases because of the interest tax shield
if we expect EBIT to be GREATER than the break-even point
then leverage is beneficial to our stockholders
if we expect EBIT to be LESS than the break-even point
then leverage is detrimental to our stockholders
Modigliani and Miller capital structure theory The value of the firm is determined by the cash flows to the firm and the risk of the firms assets
to change firm value - change the risk of cash flows - change the cash flows
leveraging affects variability on ROE
when D/E= 1 the highs are higher and the lows are lower for ROE between a recession and expansion than when using all equity
leveraging affects variability on EPS
when D/E=1 highs are higher and lows are lower than between a recession and expansion than when using all equity
Interest on debt is tax deductible
when a firm adds debt, it reduces taxes all else equal * this reduction of taxes INCREASES THE CASH FLOW OF THE FIRM
LIQUIDATION BANKRUPTCY (CHP 7)
where businesses end not all creditors rank on the same level
present value of annual interest tax shield
*assume perpetual debt PV= 20/.08= 250
leverage amplifies the variation in both
- EPS (ni/shares outstanding) - ROE (ni/te)
THE STRATEGIC VALUE OF THE RIGHT TO FILE BANKRUPTCY
- IMMEDIATE "STAY" ON CREDITORS - ABILITY TO TERMINATE LABOR AGREEMENTS - ABILITY TO LAY OFF LARGE NUMBERS OF WORKERS - ABILITY TO REDUCE WAGES
indirect bankruptcy costs
- LARGER THAN DIRECT COSTS, but more difficult to measure and estimate - stockholders want to avoid a formal bankruptcy - bondholders want to keep existing assets intact so they can at least receive that money - assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business - lost sales, interrupted operations and loss of valuable employees, low morale, inability to purchase goods on credit
Capital Restructuring:
- increase leverage by issuing debt and repurchasing outstanding shares - decrease leverage by issuing new shares and retiring debt
maximizing shareholder wealth equals...
- maximizing firm value - minimizing WACC *objective: choose the capital structure that will minimize WACC and maximize shareholder wealth
Which one of the following best defines legal bankruptcy?
A legal proceeding for liquidating or reorganizing a business
In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first?
Absolute priority rule
Which one of the following statements concerning financial leverage is correct?
Changes in the capital structure of a firm will generally change the firm's earnings per share.
Observed Capital Structures. Which of the following is not correct?
The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use less financial leverage
