Ch 16- Financial Leverage Flashcards
what is a recap? is it like big big vast changes?
no! it can even be small changes
what is capital restructiing
involves changing the amount of leverage a firm has without chagingin the firms assets
how can we increase leverage
by issuing debt and repurchasing outstanding shares
how do we decrease leverage
issue new shares, retiring outstanding debt
what is the primary goal o financial managers
MAXIMIZE STOCKHOLDER WEALTH
- you can do this by minimizing ther weighted average cost of capital or maxiziming firm value
- choose the cap structure that will maximize stockholder weatlh
what si the total value of the firm
value of debt + value of equity
if a firm is a growth firm, what is happening over time?
it is improving its ROE over years
So the formula of ROE is NI/equity right?
YES!
we want to grow ROE, and how can you do this,
maximize NI
minimize equity [not sure about this future yushi double check]
what is break even ebit
find ebit where eebit is the same under current and proposed scenarios- formula
EBIT breakeven/ Shares (w/o leverage) =
EBIT breakeven - interest/ (Shares w leverage)
business reisk
equity risk!!
does adding debt create vallue for a frim?
yes! it reduces equity for sure but also it is important because it can create value through interest
Prop 1 is def gonna be on the final
the vlaue of a the firm increaes by the present value of the annual interst tax shield
val of levered firm = val of an unlevered firm + pv of interest tax shield
VL = Vu + VdTc
pv of int tax shield is VdTc
Prop 2
the wacc decrease as debt: equity increases because of the govt subsidy on interest payments
AS LONG AS DEBT IS CHEAPER THAN EQUITYY
A = L + SE
We can change L + SE weights without impactin assets, so what does this mean?
that we can examine the cap structure decision separately from other activities / in isolation
Do we consider long term sources of financing or short term?
only long term cuz sohrt term financing are not included in cap structure weights
If a firm wanted to increase its D/E how can it do that?
get more debt (bonds) and buy back shares
If a firm wanted to decrease its D/E how can it do that
sell shares and pay off debt
WHAT IS THE GUIDING GOAL BEHIND CAP RESTURCTUING
maximize shareholder value or
maximize val of firm (same thing)
the value of the firm is maximized when the WACC is…
minimized!
bc WACC is the disc rate right
and disc rates and value move in opposite directions
so min WACC is max value
When does a debt equity ratio represent the optimal cap structure/target cap structure?
if it results in the lowest possible WACC (cost of capital)
HIGHER FINANCIAL LEVRAGE MEANS ___ DEBT
MORE
What does financial leverage impact and not impact?
-impacts the payoffs to shareholders
- does not impact the overall cost of capital
What is ROE
return on equity!
Net Income/TE = ROA * EM = Profit Margin * TAT * EM
EPS
Earnings/Share
NI/SHARE
hOW CAN lEVERAGE IMPACT EPS AND ROE?
- both formulas deal with net income
- more debt =more fixed interest expense = lower income
BUT ALSO, more debt means less common shares! so they have an impact
LEVERAGE AMPLIFIES HE VARIATION IN EPS AND ROE
(if there is a good year, you do A LOT better; if it is a bad year, you do a LOT WORSE)
Degree of financial leverage
Percent change EPS / Precent change in EBIT = ebit/ebit-int
DO THIS CALC 2X (once for current cap structure and one for proposed)
(Higher DFL = more debt), basically this says that EPS increases/decreases by a factor of the DFL times the percent increase or decrease in EBIT
Basically, at a certain level of EBIT you are indifferent ot having debt or no deb, but after this level (higher EBIT) debt is better cuz the impact of int payments is not significant enough to lower EPS
AND below this EBIT point the int payments are too high so no debt is better
WHEN EBIT IS EXPECTED TO INCREASE…
DEBT IS BETTER
UNDER A SCENARIO WHERE EBIT IS EPXECTED TO INCREASE
LEVERAGE INCREASES BOTH ROE AND EPS
with more debt, shareholders are exposed to more risk under the proposed cap structure, since EPS and ROE are more sensitive to change than EBIT
BUT is cap structure an important consideration IN A PERFECT CAPITAL MARKET?
NO! they can use homemade leverage
- basically as long as they can borrow money a the same rate as corporations, they can target the SAME D-E ratio they want the firm to target, and then earn the amount they want
- to create leverage (increase D-E ratio) investors borrow money on their own and buys shares of stock (IN THE SAME PROORTPTION AS THE COMPANY)
- to decrease leverage (decrease D-E ratio), investors lend out money IN THE SAME PROPORTION as the company (if comp does 50% so does the investor on a personal elvel)
WHY DOES the stock price not change depenidng on the cap structure of a company?
because investors can borrow or lend on their own!!! so its irrelavant
Prop 1: pie model
as long as the assets for two firms are the same, it does not make a difference if a firm finances assets w more debt or equity, the size of the pie is he same!
it is irrelevant how it finacnes itself cuz the WACC is the same no matter the mix of debt and equity
Prop 1 formula
Vu = EBIT/REu = VL = EL + DL
VL= Vu
Prop 2
Return on equity depends on 2 things:
business risk and financial risk
more debt = more cost of equity
(derived from WACC) = Ra
Re = (Ra- Rd)(D/E) + Ra
y=mx+b
Relating SML -> Re
What are the two types of risk when we talk about equity?
Ra= Rf + (RM-Rf)Ba
THIS IS SML, rewrite it for Re
Re= Rf + (RM-Rf)Be
since we talking risk, iso for Be
Be = Ba x (1+D/E) (WE R USING MARKET VALS)
Be= Ba + Ba(D/E)
Ba= business risk (its out of firms control)
Ba(D/E) financial risks!!!!!!! so as D/E increases so does risk of equity, so does cost of equity
How do taxes impact the proopostions?
so we know that interest on debt is tax deducitble righgt, basically you pay less tax if you have debt
SO!! this creates a tax shield (interest tax shield)
think about it like an annuity that pays you money every year!!! so that is why it is very good to have debt!!!!
what is the val of the interest tax shield
Tc x Debt
How does taxes impact the Prop 1?
basically we earlier had Val of lever firm = val of unlever firm
now it is
VL =Vu +( Tc xD )
DEBT FINANCING IS THE GOAT AND YOU SOHULD HAVE 100% DEBT, WACC DECREASES AS DEBT INCREASES
How does taxes impact prop 2?
Re = Ra + (Ra - Rd)(D/E) ORIGINAL PROP 2
Re = Ra + (Ra - Rd)(D/E)(1-Tc) MOD PROP 2
NOT VEYR MUCH IMPACT ON PROP 2
dIRECT BANKRUPTCY COST
BANKRUPTCY TAX!
the more firm borrows the more likely they are to have to pay legal costs of banruptcy and lose a lot of firm value
indirect bakruptcy costs
financial distress costs, when a firm knows its aboutta go bankrupt ,the focus turns away from max shareholder value to avoiding bankruptcy so a lot of opp costs occur
agency costs of equity
agency costs are when an owner-entreprenue issues debt, they are more likely to work harder because they wanna earn more than the fix int cost of debt, if theres more equtiy, entreprenur doesnt wanna work harder
what addresses agency costs of equtiy L
LBOS! leverage buy outs, basically a purchaser buys out the sharehodlers stck at a higher price than market and since company is private, owners work harder cuz they are teir own employees now
why is there an optimal cap structure?
a firm borrows cuz int tax shield helps, but tey dont borrow 100% cuz they dont wanan riksk bankrutpcy
recoendations from the static model
Taxes: frims that pay taxes should use debt as leverage (if u have net loss, plz dont), and firms that get other BIG tax shields like PVCAATS get less benefit, also higher the tax rate, you should use debt
Bankruptcy costs: firms that have volatile EBIT should not borrow, if fin distressc osts high (Transferring ownership is hard) dont borrow
change in pie structure PROP 1, now that we know taxes r real LOL
Basically its still true, but there r more than just the slices of Bondholders and shareholders, ,u also have bankkruptcy claim and tax claim
marketed cliam
non makreted claim
marketed cliams: can be bought and sold in fin markets (sharehodlers, bonds)
non-marketed claims: cant be bough and sold (bankruptcy costs and taxes)
Value of the firm = val of the marketed cliam (Vm) not non marketed claims (Vn)
Val of total firm = Vm + Vn
Bascially in modified pie structure, Vt is not imapct by cap structure, but the Vm can be affected by changes in cap structure. any increase in Vm must be a decrease in Vn, so the OPTIMAL CAP STRUCTURE MAXIMIZES THE VAL OF VM and MINIMZED THE VAL OF VN
why do big firms the ones that could get the greatest tax shield often not use debt?
pecking order theory: (Alt to static theory)
- firms wanna use internal finacning whe possible, selling securities to raise cash is expensive
- if FIRMS HAVEEEE TO CHOOSE BETWEEN DEBT OR EQUITY, managers wanna keep the profits of a firm internal, so they often issue DEBT
- firms RARELY sell equity cuz it signals to the market that stock overvalues
so internal -> debt -> equity
pecking order theory insights
- no target cap structure (we are not targeting a D-E ratio)
2, profitable firms use less debt : generate enough CFs - companies want financial slack: companies tockpile cash so they dont have to sell equuity
WHAT IS FINANCL SLACK
cash reserve internally
pecing order theory is short run
static trade off theory is long run
we can use industry average to determine what optimal cap structure should be
in real estate dev, ebit is not too voaltile so there is more debt!!
in r&d fields a lot less debt
What are 4 types of fin distress
- business failure
- legal bankruptcy: legal prcoeeding for liquidating and reorg
- tech insolvency: firm defaults on legal obligations (cant pay bills), short term condition and can be reversed to avoid bankruptcy
- acct insolvency: firm with negative net worth are insolvent in the books, happens when book liabilities > book assets
liquidations
end the firm as a going concern, sell assets of the firm , proceeds- selling costs go to creditors then shareholders
reorg
option of keeping the firm a going concern, issuing new suecrities to replace old sec
bankruptcy liquidation proces
- petition filed in court
- trustee in bankruptcy is elected by creits to take over assets of debtor corp, attmept to liquidate assets
- proceeds less eslling costs are distributed among criedtors
- if anything remains, sharehdolers paid
claims during bankruptcy
- Administrative expenses associated with the bankruptcy.
- Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of
a trustee. - Wages, salaries, and commissions.
- Contributions to employee benefit plans.
- Consumer claims.
- Government tax claims.
- Unsecured creditors.
- Preferred shareholders.
- Common shareholders.
secured creditors are not included: entitled to proceeds from the sale of sevcurity
courts cn also change this
bankruptcy reorg
- voluntary petition filed from corp or involuntary from creditors
- fed judge approces or denies
- in most cases corp conitnues to run business
- corp requried to submit reord plan
- creditors and sh separate into classses, must vote on plan
-> sec creditors must vote before the unsecured - after acceptacne, plan is confirmed by court
- pay in cash , prop, sec are made to creditors and sh
a firm can default and still avoid bankruptcy, like work it out before filing for bankruptcy
this can inovled EXTENSION (POSTPONING DATE OF PAY) or compositon (Which inovles a reduced pay)
