Capital Structure

Question 1

Why not use the WACC approach? What to use instead?

Answer 1

• APV, because
• flotation costs on debt issuance
• effects of debt maturity
• specifics of bond being floated

Question 2

When should you use each of the 3 ‘“tools” to assess “financial benefits” of changing corporate leverage?

Answer 2

Question 3

2 ways to calculate WACC:

Answer 3

Question 4

Calculating TSV (Tax Shield Value) with the interest coverage ratio (k)

Answer 4

Question 5

Difference yield vs expected return on debt

Answer 5

• 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

Question 6

Perpetuity and annuity formulas

Answer 6

Question 7

Problem with estimating TSV by taking the tax rate and multiplying it by debt value?

Answer 7

Only true for the unrealistic case where 100% of debt value comes from deductible interest expense (e.g. consol bond with infinite maturity)

Question 8

Fixed coupon bonds - higher yields - how does that affect TSV?

Answer 8

• 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.

Question 9

Formula for modelling uncertain cash flows

Answer 9

Question 10

Value of a levered firm with debt coupon B and EBIT X - including Vu, TSV, and BC (Leland model)

Answer 10

Question 11

Valuation of debt with the Leland model

Answer 11

Question 12

What is the definition of a bond yield?

Answer 12

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

Question 13

Leland model - putting all the pieces together - formula for V-leverd with V-unlevered, TSV, and BC

Answer 13

Question 14

Marginal benefits equal

Answer 14

marginal costs

Question 15

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)

Answer 15

Question 16

How do you get to this equation:

Answer 16

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.)

Question 17

Initial guess for Leland model and substitute guess into the ODE

Answer 17

Question 18

Get from subbing into ODE to

Answer 18

Question 19

Boundary conditions for solving the ODE

Answer 19

Question 20

The KMV-Merton Model

Answer 20

• KMV Corporation - first to apply market measures to credit risk based upon options pricing tools.
• KMV was acquired by Moody’s for $70M in 2002 and now markets its credit risk metrics under the title of MKMV.
• Intuition: Instead of BS, use market price of equity to infer “distance to default.”

Question 21

Estimating Default Probability - Formula and what it means

Answer 21

• T is maturity date T
• V is value of debt + equity
• No coupons
• F is Face Value
• sigma is annualized volatility
• mu is the expected growth in asset value

Question 22

Pricing of Risky and Hybrid Debt - Black-Scholes assumed asset value follows a geometric Brownian motion. So at any future date t - formula for Vt at V0 with GMB

Answer 22

• little t is an arbitrary date
• T is the maturity date (not yet in the formula)

Question 23

Get from GBM formula for Vt to “Distance to Default” formula:

Answer 23

Question 24

to exploit the put-call parity equation to find the face value F of the bonds (also by using a Risk Free Zero Coupon Bond)

Answer 24

Question 25

Answer 25

Question 26

How to value the TSV of e.g. a 10-year bond of 100m with the coupon yielding 6% with 10% taxes?

Answer 26

Question 27

Answer 27

Question 28

Answer 28

Question 29

Answer 29

Question 30

List the key parameter inputs into the Leland Model. For each parameter, list some of the real-world data you might look to in order to calibrate your model so that it lines up reasonably well with observable empirical features.

Answer 30

Question 31

V-levered based on V-unlevered + TSV with APV, formula:

Answer 31

Question 32

Answer 32

Question 33

Answer 33

Question 34

Answer 34

Question 35

Answer 35

Question 36

APV for Constant Coverage Ratio

Answer 36

Question 37

APV: Constant Perpetual Debt

Answer 37

Question 38

Moral hazard...

Answer 38

* ...(debt) contracts change the behavior * If no debt already outstanding: “Max value of claim held by current shareholders” → Undertake all positive NPV projects. * Today: Outstanding debt biases equity away from NPV rule. * This is a form of moral hazard: contracts signed changes behavior of an economic agent (here equity).

Question 39

Why would one do a negative NPV merger?

Answer 39

* Positive/negative externalities on current lenders * NPV=NPVCS+NPVCL * --> e.g. NPV of project is -10m, but because everything becomes riskier, -15m NPV for lenders, thus +5m for shareholders * “If market rationally anticipates such behaviour at time bond is floated, shareholders bear the cost in terms of lower equity value.” * “In a rational debt market, equity will try to pre-commit against behaving badly in the future via covenants that limit discretion of equity.” * Notice—this gives RATIONAL support to CEOs and CFOs taking a “stakeholder” approach. Want to pre-commit against hurting company stakeholders.

Question 40

Debt Covenants - “Debt Overhang” - Lesson from Moral Hazard:

Answer 40

* Message 1: Levered equity is biased against real investments if some of the NPV is captured by holders of outstanding debt. * Message 2: If it is impossible to write binding covenant committing firm to (only) undertake positive NPV projects, then equity finance looks more attractive. * Message 3: Although covenants are typically viewed as good for lenders, covenants can make shareholders better off if they move equity back to using NPV rule.

Question 41

More evidence that debt overhang concern influences firms: Growth firms carry lower debt

Answer 41

Question 42

Separating equilibrium:

Answer 42

An equilibrium where the actions taken by the informed parties fully reveal their private information.

Question 43

Pooling equilibrium:

Answer 43

An equilibrium where the informed parties take the same action, so investors cannot infer anything about the firm based on actions.

Question 44

Debt finance and asymmetric info - vs equity financing

Answer 44

* When there is asymmetric info between insiders and investors, finance with securities that are least sensitive to the private info—generally debt. * In this simple example the I.O.U. written by either type of firm was worth 100—insensitive to private info. * Investors are less vulnerable to “lemons problem” with debt than with equity since equity value is (generally) more sensitive to private info.

Question 45

Signaling thru Debt

Answer 45

* CEO has superior info regarding probability distribution of future cash flows, e.g. thickness of left tail of distribution. * CEO bears private costs of distress/bankruptcy. * CEO can signal belief in high/stable cash flows by taking on high leverage. * CEO of low quality firm has higher expected distress costs per dollar of debt—will not mimic high type. * Evidence: Large positive abnormal returns in reaction to debt-for-equity substitutions.

Question 46

Signaling thru cash distributions

Answer 46

* It is costly to go external for funds: flotation costs; hassle; covenants; investors demand premia for agency costs or asymmetric information concerns. * Willingness to distribute funds is similar to willingness to take on debt. Signals confidence. * Low quality firms find in costly to mimic the payouts/dividends of high quality firms. * Market reaction to announcement of increase in payouts is generally positive.

Question 47

Yield estimation

Answer 47

1) Conjecture bond rating and find yield 2) Calculate implied EBIT/INT ratio 3) Get implied bond rating 4) If consistent with conjecture in step 1, stop 5) Otherwise, try another bond rating

Question 48

Characteristics indicative of high benefits to recap transaction?

Answer 48

* High taxable income before interest expense (high profit margin and lack of non-debt tax shields) * Stable taxable income * Operating in jurisdiction with high federal and local corporate income tax rates—with projected future tax rates remaining high * Access to long-maturity debt markets * Strong bargaining position relative to underwriters

Question 49

What is “adverse selection”?

Answer 49

* If Good, SIV would turn down your offer. * If Toxic, SIV would accept your offer. * So, if you offer 6.5, SIV will accept only if the CDO is toxic. This is “adverse selection.” * When there is asymmetric information between the buyer and seller of a financial asset the market can break down. * Only the Toxic assets are traded. * The market for higher quality assets freezes.

Question 50

What makes a signal credible?

Answer 50

* The marginal cost of the signaling action must be higher for the Low type. * High types should choose the lowest level of the costly signal sufficient to separate from the low ability types. * Same story functions in financial markets.