Final exam - Chapter 11 Flashcards
Does the debt and equity mix matter for the firm
value?
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Yes, as
If the financing mix matters for the firm value, we
would choose the capital structure that maximizes
stockholders’ wealth.
Does there exist the optimal financing mix of debt and Equity?
ttt
Yes
An optimal capital structure exists that just balances
the additional gain from leverage against the added financial distress cost.
The effect of financial leverage on cash flows and
cost of equity.
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When we increase the amount of debt financing,
we increase the fixed interest expenses.
If we have a really good year, then we pay our
fixed costs and we have more left over for our
stockholders
If we have a really 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
- Stock would be riskier
The impact of taxes and bankruptcy on capital
structure choice.
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Therefore, when a firm adds debt, it reduces tax obligations, all else being equal The reduction in taxes increases the cash flow to the firm (Can be viewed as a Government subsidy)
Choosing a financing mix of debt and equity
(Capital Structure)
Primary firm’s goal
Maximize stockholder wealth
If the financing mix matters for the firm value, we would choose the capital structure
that maximizes stockholders’ wealth.
We maximize the stockholders’ wealth by maximizing
the firm value given a level of debts.
Firm Value
is the market value of assets
Or
sum of the market values of debt & equity
Capital restructuring involves
“changing the amount of leverage” a firm has without changing the firm’s assets
How to do Capital restructruing?
Increase leverage by issuing debt and repurchasing
outstanding shares of stock.
Decrease leverage by issuing new shares and retiring
outstanding debt
We want to see how changes in capital structure
affect the value of the firm, ____ ____ ____ ____
all else being equal
Since we want to see the effect of capital
restructuring on the firm value, we assume that
firm’s investment opportunity is _____.
fixed
What does the effect of capital restructuring (everything is fixed) imply?
no new net capital spending and no new NWC.
unlevered firm
(100% equity financing company)
unlevered firm formula for CFFA
Operating cash flow
What are 2 things that unlevered firms entail?
- The firm value is the present value of all future CFFA’s
2. All future CFFA’s are expected to be constant like a perpetuity because of no new investment opportunity.
What are the 2 Unrealistic Assumptions for now.
We assume
1) No Corporate Taxes
2) interest rate is constant regardless of the size of debt. (Under what condition would the interest rate be constant ?)
unlevered
CFFA becomes the
(=Net
Income in this
case)
How does leverage (debt) affect the EPS and
ROE of a firm? (4)
When we increase the amount of debt financing,
we increase the fixed interest expenses.
If we have a really good year, then we pay our
fixed costs and we have more left over for our
stockholders
If we have a really 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
Ultimately, Stock would become riskier.
Modigliani and Miller Theory of Capital
Structure
Proposition I – Firm value The value of the firm is NOT affected by changes in the capital structure Proposition II – WACC The WACC of the firm is NOT affected by change in the capital structure
Proposition I – Firm value The value of the firm is NOT affected by changes in the capital structure Proposition II – WACC The WACC of the firm is NOT affected by change in the capital structure
Modigliani and Miller Theory of Capital
Structure
Cost of Equity
The variability of RA
is the firm’s ___ _____,
i.e., the risk of the firm’s assets
business risk
The variability of (RA
– RD)(D/E) is the firm’s
________ _____, i.e., the additional return
required by stockholders to compensate for the
risk of leverage
Financial risk
____ ___ ____ (__) increases as leverage
increases.
Cost of Equity (RE)
Therefore, the systematic risk of the stock
depends on: (2)
- Systematic risk of the assets, B^lowera , (Business
risk) - Level of leverage, D/E, (Financial risk)
Assumptions used: How realistic? 1. No Corporate Taxes 2. interest rate is constant regardless of the size of debt. How realistic?
Not realistic
What are these known as?
Assumptions used:
1. No Corporate Taxes
2. interest rate is constant regardless
of the size of debt.
These are known as the “Perfect Market”
assumptions
Now we formalize the Capital
Structure Theory Under Three
Special Cases
Case I – Assumptions (We have already discussed this case) ------No corporate taxes ------No bankruptcy costs Case II – Assumptions ------Corporate taxes ------No bankruptcy costs Case III – Assumptions ------Corporate taxes ------Bankruptcy costs
Interest payment is __ ______
tax deductible
Therefore, when a firm adds debt, it leads to
Therefore, when a firm adds debt, it reduces tax obligations, all else being equal
The reduction in taxes increases the cash
flow to the firm (Can be viewed as a ____ ______)
Government subsidy
Interest Tax Shield
Formula
Tax rate times interest payment
T^lower C X (R^lower D * D)
The interest tax shield every year will increase the firm value
by the PV of all
future interest tax shields
Interest Tax Shield
Firm Value
Formula
V^L = V ^ U + DxT^lowerC
Value of unlevered firm + PV (annual tax shield)
(R^lower D * D)
Interest payment
Interest payment formula
(R^lower D * D)
Firm Value future CFFA’s of unlevered firm =
CFFA^U
/
WAAC
Firm Value future CFFA’s of unlevered firm =
What does it do?
Increase in debt -> decreases WACC
The value of the firm increases by the present
value of the
annual interest tax shields
Value of levered firm =
value of unlevered firm + PV
of interest tax shield
Value of equity =
Value of the firm – Value of debt
“Maximize firm value” is equivalent to
“Minimize weighted average cost of capital”.
The WACC decreases as D/E increases
because of decrease in the after-tax cost of debt
(3) Bankruptcy Costs
- Direct costs
- Financial distress cost
- Indirect bankruptcy costs
Bankruptcy Costs
Direct costs
Direct costs
Legal and administrative costs (accountant &
lawyer fee)
Ultimately cause bondholders to incur additional
losses
Disincentive to debt financing
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
Bankruptcy Costs
Financial distress cost
Significant problems in meeting debt obligations
Most firms that experience financial distress do
not ultimately file for bankruptcy
(4) Bankruptcy related terms
Business failure
Legal bankruptcy
Technical insolvency
Accounting insolvency
Business failure –
business is 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
Trustee takes over assets, sells them and
distributes the proceeds according to the
absolute priority rule
Reorganization
Restructure the corporation with a provision to repay creditors
As the D/E ratio increases, (leads to)
the probability of
bankruptcy increases
This increased probability will increase the
expected bankruptcy costs
Case III: Non-zero bankruptcy costs
Thus the expected pizza size (CFFA) available
to creditors and shareholders ______.
shrinks
If the firm increases the debt,
the expected pizza
size for all future period would get smaller.
Case III: Non-zero bankruptcy costs
The creditor would not be comfortable to charge
the _____ interest rate any more.
same
Case III: Non-zero bankruptcy costs
This implies the interest is ____ ____ ______
no longer constant.
Case III: Non-zero bankruptcy costs
As the debt level increases, the additional value
of the ____ _____ ____ will be offset by the expected bankruptcy cost at some point.
interest tax shield
At this point, the value of the firm will start to
decrease and the WACC will start to ______ as
more debt is added because markets require
higher interest rate due to increase in default
chance (expected ____ ____ _____).
increase
financial distress costs
According to the static theory, .
the gain from tax shield on debt is offset by
financial distress costs
An optimal capital structure
exists that just balances
the additional gain from leverage against the added financial distress cost.
In Sum
Case I – no taxes and no bankruptcy costs
No optimal capital structure
In Sum
Case II – corporate taxes but no bankruptcy
costs
Optimal capital structure is 99.9999% debt
Each additional dollar of debt increases the cash
flow of the firm
In Sum
Case III – corporate taxes and bankruptcy costs
Optimal capital 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
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 ______ for the firm
optimal
Capital structure does differ by _____
industries
Two Important Decisions to be made by
Financial Managers.
- Investment Decision (Capital Budgeting decision)
2. Financing decision
It is generally considered incorrect to
deduct the interest charges associated
with a particular project for two reasons:
- Profitability of the project should be
independent of financing decision. - The cost of capital (discount rate) already
incorporates the cost of funds used to finance a
project.
Capital Structure definition:
Choosing a financing mix of debt and equity
Leverage amplifies the variation in both
EPS and ROE
Cost of Equity formula (R^lower E)
RE = RA + (RA – RD)(D/E)
What increases as leverage
increases.
Cost of Equity
