Capital Structure Flashcards
Why not use the WACC approach? What to use instead?
- APV, because
- flotation costs on debt issuance
- effects of debt maturity
- specifics of bond being floated
When should you use each of the 3 ‘“tools” to assess “financial benefits” of changing
corporate leverage?
2 ways to calculate WACC:
Calculating TSV (Tax Shield Value) with the interest coverage ratio (k)
Difference yield vs expected return on debt
- the yield is a “promised rate of return.”
- i.e. bond is priced to yield XY percent
- We value bonds discounting promised payments at the yield
- We can value TSV by discounting “promised tax savings” at the yield
Perpetuity and annuity formulas
Problem with estimating TSV by taking the tax rate and multiplying it by debt value?
Only true for the unrealistic case where 100% of debt value comes from deductible interest expense (e.g. consol bond with infinite
maturity)
Fixed coupon bonds - higher yields - how does that affect TSV?
- Holding fixed coupons, bonds with higher yields generate higher TSV/Debt—provided the firm
does not get into a tax loss situation –> the deeper the original issue discount, the higher the TSV - but: In many real-world settings higher yields imply higher risk of distress—and distress is associated with low corporate tax rate.
Formula for modelling uncertain cash flows
Value of a levered firm with debt coupon B and EBIT X - including Vu, TSV, and BC (Leland model)
Valuation of debt with the Leland model
What is the definition of a bond yield?
PROMISED payments (IRR) - not EXPECTED IRR - key difference
The yield(y) is whatever rate I need to discount promised payments to explain the observed bond price –> D = B/y
Leland model - putting all the pieces together - formula for V-leverd with V-unlevered, TSV, and BC
Marginal benefits equal
marginal costs
Black Scholes differential equation (not expiring - this is an ordinary differential equation, if it expires, it is a partial differential equation, which is more difficult to solve)
How do you get to this equation:
By “constructing” a risk-free portfolio - Black-Scholes used a trick there to get to this equation (i.e. long position in this stock, short there, etc.)
Initial guess for Leland model and substitute guess into the ODE
Get from subbing into ODE to
Boundary conditions for solving the ODE
