7. Capital Structure (Part 2) Flashcards
What is bankruptcy?
Bankruptcy is a legal proceeding initiated when a business is unable to repay outstanding debts or obligation (financial distress). All of the debtor’s assets are measured and evaluated and the assets may be used to repay a portion of the outstanding debt.
Who incur costs during the bankruptcy process?
Creditors & Shareholders
What are some examples of the direct costs of bankruptcy?
Costly outside experts such as:
- Lawyers for legal proceedings
- Accountants for valuation
What are some examples of indirect costs of bankruptcy?
- Losing potential sales or customers
- Fire sale of assets (heavily discounted sale of assets)
- Delayed liquidation (storing goods that can’t yet be sold)
- Costs to creditors (suppliers)
The indirect costs are often much larger than direct costs of bankruptcy.
What is the trade off theory/approach of capital structure?
The optimal capital structure is a trade-off between debt tax shields and the cost of financial distress.
Value of geared company = The value of an un-geared company + The value of tax benefits - The value of financial distress costs
The optimum debt/equity ratio for maximising value for current shareholders is the maximum of this curve.
What are the downsides of debt?
- Increased chance of bankruptcy, more importantly, increased cost of bankruptcy/financial distress.
- Reduces financial flexibility to make value creating investments (due to reduce free cash flow).
What are the upsides of debt?
- Tax shield/tax reduction as tax is paid on income after interest payments.
- Increases managers’ discipline as companies need to make regular interest payments and have less free cash flow.
What are agency costs of leverage?
The costs that arise due to conflicts of interest between the firm’s management/shareholders and debtholders/creditors.
Management will generally make decisions that increase the value of the firm’s equity. However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lowers the total value of the firm (as the cost of debt capital is higher).
When a firm has debt, conflicts of itnerest arise between shareholders and bondholders. Because of this, shareholders are tempted to pursue selfish strategies. These conflicts of interest, which are magnified when financial distress is incurred, impose agency costs on the firm (e.g., increased cost of debt capital) and lower the market value of the whole firm.
What are protective covenants? What is their purpose?
Agreements between shareholders and bondholders which are incorporated as part of the loan/bond document. They are used to increase protection for debtholders and consequently reduce agency costs and increase firm value.
What is a positive covenant? Give two examples.
A covenant which specifies an action that the company agrees to take or a condition the company must abide by. For example,
- The company agrees to maintain its working capital at a minimum level.
- The company must furnish periodic financial statements to the lender.
What is a negative covenant? Give some examples.
A covenant which limits or prohibits actions that the company may take. For example:
- Limitations are placed on the amount of dividends a company must pay.
- The firm may not merge with another firm.
- The firm may not issue additional long-term debt.
- The firm may not pledge any of its assets to other lenders (ensures sole entitlement to collateral).
