lecture 8: leverage and capital structure Flashcards
capital structure of a firm
the amount of debt and equity making up its asset base
why is the capital structure decision referred as the debt-capacity decision?
because it involves a consideration of how much debt a firm should have
Indifference EBIT
the EBIT at which EPS with debt financing is equal to EPS with equity financing
in the Indifference EBIT, when is leverage beneficial?
why?
when EBIT is expected to increase
because it increases the return to shareholders in term of EPS
M&M (Modigliani and Miller) proposition
Unlevered value = Levered value = Levered Equity + Levered debt = EBIT / (unlevered cost of equity)
Vu = VL = EL + DL = EBIT / Reu
Reu: unlevered cost of equity
M&M (Modigliani and Miller) proposition assumptions
individuals can borrow or lend at the same market value of interest as firms
no bankruptcy costs
no transaction costs
np inside information
no corporate takes
how do we find the cost of equity using the M&M (Modigliani and Miller) proposition?
what can we conclude from this
Re = RA + (RA - RD) · D/E
RA: Wacc
we can conclude:
a) market price of a firm is independent of its capital structures
b) the higher the D/E, the higher the Re that reflects addition risk burned by equity holders
or
Re = ((EBIT) · (1 - Tc)) / Eu
where does the M&M proposition way of finding our cost of equity come from?
what does this do to our Equity Beta?
from the SML
Equity beta (BE) = BA · (1 + D/E)
–> risk premium of a firms equity increase alongside the D/E ratio
BA: Asset beta
BE: Equity beta
M&M proposition with taxes
VL formula
VL = Vu + (I · Tc) / i
I = annual interest payments
Tc = corporate tax rate
I: interest on debt
but since I = i · D
VL = Vu + Tc · D
–> Tc · D: market premium levered shares, which makes these higher than that of unlevered firms
why is it the, the greater proportion of debt in the capital structure, the greater the value of the firm?
M&M proposition with taxes
VL = Vu + Tc · D
Tc · D: market premium levered shares, which makes these higher than that of unlevered firms
cost of equity with the M&M proposition with taxes
Re = RA + (RA - RD) · D/E · (1 - Tc)
what is the ultimate risk when the D/E of a firm rises?
the firm could fail to meet its payments
when is a firm considered economically bankrupt?
when the value of the assets are equal to its debt
what is the trade for a firm’s capital structure?
what is the name of this trade off
trade off between the tax benefit of debt and the costs of financial distress
static trade-off theory
the implication of the static trade-off theory
there an optimal amount of debt for any individual firm
–> becomes the targeted debt level
Value of firm when considering distress costs and bankruptcy?
V = D + E + G + L
V = VM + VN
D + E = VM: Marketed claim
G + L = VN: non-marketed claim
G: government’s claim on the value of the firm for taxes owed
L. the claim by lawyers and other parties involved in the bankruptcy
when does a firm become insolvent?
when it experiences financial distress
when does a firm experience financial distress?
when it cannot generate enough cash flows to pay off its obligations
signs that point at an insolvent firm
reduction or total elimination of dividends
plant clsoings
massive layouts
CEO resignaitons
plummeting stock prices+
etc
how can a firm deal with permanent financial distress
selling major assets
drastically reducing or curtailing capital spending and R&D
negotiating with major creditors
exchanging equity for debt (financial restructuring)
filing for bankruptcy
the points that indidvade a point has hit the point of no return, where it can no longer exist in its current form
exchanging equity for debt (financial restructuring)
filing for bankruptcy
2 ways to define insolvency
stock based insolvency
flow based insolvency
stock based insolvency
when a firm has negative net worth
–> value of assets less than debt
–> negative equity
flow based insolvency
firm is unable to meet all its contractual obligations such as interests and principal payments
when a firm declares bankruptcy and liquidation, the proceeds of the asset selling go in which order?
- unpaid taxes and employment insurance premiums
- secured creditors
- administrative expenses associated with bankruptcy
- wages salaries, commissions
- municipal tax claims
- rent
- unsecured creditors
- preferred shares
- common shares
reorganization
option of keeping the firm as a going concern
using new securities to replace the old one
the amount stockholders receive yearly including personal tax
(EBIT - D · RD) · (1 - Tc) · (1 - Te)
RD: cost of debt
TC: corporate tax rate
Te: combined dividend and capital gain tax rate
the amount bondholders receive yearly including personal tax
D · RD · (1 - Td)
Td: tax rate on ordinary income such as interest
total cash flow stockholders and bondholders receive yearly
(EBIT - D · RD) · (1 - Tc) · (1 - Te) + D · RD · (1 - Td)
value of a levered firm with all taxes involved
VL = Vu + D · ((1 - ((1 - Tc) · (1 - Te)) / (1 - Td))
if Td = Tc, is the value of a firm with or no personal tax bigger?
what happens if Td > Tc
none, they are the same
if Td > Tc, the the value of a firm with no personal tax is bigger than the one with personal tax
formula to find which level of EBIT would make the issue of bonds than the issue of shares
indifference EBIT formula
((EBIT - I) · (1 - Tc)) / (# of shares outstanding with bonds issued)
=
((EBIT - I) · (1 - Tc)) / (# of shares outstanding with more shares issued)
how to find the cost of equity of an unlevered firm considering taxes
((EBIT - I) · (1 - Tc)) / Total equity
how to find the cost of equity of an levered firm considering taxes
((EBIT - I) · (1 - Tc)) / (Value of levered firm - debt)
