16 Flashcards
Capital Restructuring
involves changing the amount of leverage a firm has without changing the firm’s
assets.
* Increase leverage by issuing debt and repurchasing
outstanding shares.
* Decrease leverage by issuing new shares and
retiring outstanding debt.
Primary goal of financial mangers
Max. stockholder wealth. choose the cap. structure that will maximize wealth. we can maximize wealth by max. firm’s value or min. WACC
How does leverage affect the EPS and ROE of a firm?
−When we increase the debt financing, we increase the fixed interest expense.
− If we have a good year, then we pay our FC and we have more left over for our stockholders.
− If we have a bad year, we still have to pay our fixed costs and we have less left over for our stockholders.
* Leverage amplifies the variation in both EPS and ROE.
Capital Structure Theory
- Modigliani and Miller Theory of Capital Structure
− Proposition I - firm value
− Proposition II - WACC - The firm’s value is determined by the cash flows to the firm and the risk of the assets.
- Changing firm value
− Change the risk of the cash flows
− Change the cash flows
Assumptions of Capital Structure Theory
− No corporate or personal taxes
− No bankruptcy costs
Proposition I (without taxes/bankruptcy costs)
− The value of the firm is NOT affected by changes
in the capital structure.
− The cash flows of the firm do not change,
therefore value doesn’t change.
Proposition II(w/o taxes/bankruptcy cost)
The WACC of the firm is NOT affected by capital structure.
If you add corp. taxes to cap. structure theory
- Interest is tax deductible
- Therefore, when a firm adds debt, it reduces taxes, all else equal
- The reduction in taxes increases the cash flow of the firm
Proposition I (corp. tax)
The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = Value of an unlevered firm + PV of interest tax shield
Value of equity = Value of the firm – Value of debt
* Assuming perpetual cash flows
VU = EBIT(1 – TC)/RU
VL = VU + D*T
Proposition II
The WACC decreases as D/E increases because of the govt subsidy on int payments
If we add bankruptcy cost
- As the D/E ratio increases, the probability of
bankruptcy increases. - This increased probability will increase the expected bankruptcy costs.
- At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost.
- At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added.
Bankruptcy Costs
-Direct cost
-Financial distress
-Indirect bankruptcy cost
Direct Cost
− Legal and administrative costs
− Ultimately cause bondholders to incur additional losses
− Disincentive to debt financing
Financial distress
− Significant problems in meeting debt obligations
− Most firms that experience financial distress do not ultimately file for bankruptcy
Indirect bankruptcy costs
Indirect bankruptcy costs
* Larger than direct costs, but more difficult to measure and estimate.
* Stockholders wish to avoid a formal bankruptcy filing.
* 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.
* Also have lost sales, interrupted operations and loss of valuable employees.
Optimal capital structure
A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.
* This is the point where the firm’s WACC is
minimized.
Conclusion on optimal capital structure
- No taxes or bankruptcy costs
− No optimal capital structure - Corporate taxes but no bankruptcy costs
− Optimal capital structure is 100% debt
− Each additional dollar of debt increases the cash flow of the firm - Corporate taxes and bankruptcy costs
− Opt. cap. structure is part debt and part equity
− Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs
Managerial Recommendation for Optimal cs
*The tax benefit is only important if the firm has a large tax liability
* Risk of financial distress
− The greater the risk of financial distress, the less debt will be optimal for the firm
− The cost of financial distress varies across firms and industries. As a manager you need to understand the cost for your industry
Shortcoming of the static theory
Many large, profitable firms use little debt. Why?
− Selling securities is expensive and time
consuming.
− If a firm is very profitable, it might never need external financing.
Pecking order theory
- Firms will use internal financing first.
- They will issue debt if necessary.
- Equity is sold as a last resort.
* Managers are sensitive to the signals that they send with the issue of new securities
Implications of Pecking
- Firms don’t have a target capital structure.
- Profitable firms use less debt - they have greater internal cash flow and need less external financing.
- Companies want financial slack and stockpile internally generated cash as a result
Observed Capital Structure
- Capital structure does differ by industry.
- Seems to be a connection between different
industry’s operating characteristics and capital structure. - Firms and lenders look at the industry’s debt/equity ratio as a guide.
Bankruptcy Process
- Business failure - business has terminated with a loss to creditors.
- Legal bankruptcy - petition federal court for
bankruptcy. - Technical insolvency - firm is unable to meet debt obligations.
- Accounting insolvency - book value of equity is negative.
- Liquidation
− Covered under the Bankruptcy and
Insolvency Act (1992).
− Firm is terminated as a going concern.
− Trustee takes over assets, sells them and distributes the proceeds. - Reorganization
− Keep firm as growing concern.
− Involves issuing new securities to replace old securities. - Depends on whether the company is worth more dead or alive.
