Final exam - Chapter 11 Flashcards by l l l l

 Does the debt and equity mix matter for the firm
value?
ttt

Yes, as
If the financing mix matters for the firm value, we
would choose the capital structure that maximizes
stockholders’ wealth.

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 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.

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 The effect of financial leverage on cash flows and
cost of equity.
ttt

 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

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 The impact of taxes and bankruptcy on capital
structure choice.
ttt

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)

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Choosing a financing mix of debt and equity

(Capital Structure)

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 Primary firm’s goal

Maximize stockholder wealth

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 If the financing mix matters for the firm value, we would choose the capital structure

that maximizes stockholders’ wealth.

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 We maximize the stockholders’ wealth by maximizing

the firm value given a level of debts.

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Firm Value

is the market value of assets
Or
sum of the market values of debt & equity

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Capital restructuring involves

“changing the amount of leverage” a firm has without changing the firm’s assets

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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

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We want to see how changes in capital structure

affect the value of the firm, ____ ____ ____ ____

all else being equal

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Since we want to see the effect of capital
restructuring on the firm value, we assume that
firm’s investment opportunity is _____.

fixed

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What does the effect of capital restructuring (everything is fixed) imply?

no new net capital spending and no new NWC.

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unlevered firm

(100% equity financing company)

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unlevered firm formula for CFFA

Operating cash flow

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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.

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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 ?)

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unlevered

CFFA becomes the

(=Net
Income in this
case)

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 How does leverage (debt) affect the EPS and

ROE of a firm? (4)

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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

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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

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Cost of Equity
The variability of RA
is the firm’s ___ _____,
i.e., the risk of the firm’s assets

business risk

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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

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____ ___ ____ (__) increases as leverage | increases.

Cost of Equity (RE)

Therefore, the systematic risk of the stock | depends on: (2)

1. Systematic risk of the assets, B^lowera , (Business risk) 2. 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

1. Direct costs 2. Financial distress cost 3. 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.

1. 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:

1. Profitability of the project should be independent of financing decision. 2. 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

Final exam - Chapter 11 Flashcards

(77 cards)