corporate finance ch21

7/28/2019 corporate finance ch21

1/96

Prepared byKen Hartviksen

INTRODUCTION TO

CORPORATE FINANCELaurence Booth W. Sean Cleary


2/96

CHAPTER 21

Capital Structure Decisions


3/96

CHAPTER 21 Capital Structure Decisions 21 - 3

Lecture Agenda

Learning Objectives

Important Terms

Financial Leverage

Determining Capital Structure

M&M Irrelevance Theorem Impact of Taxes

Financial Distress, Bankruptcy and Agency Costs

Other Factors affecting Capital Structure

Capital Structure in Practice Summary and Conclusions

Concept Review Questions

Appendix 1 Thunder Bay Industries Indifference Analysis


4/96


Learning Objectives

1. How business risk and financial risk affect a firms ROE and EPS

2. How indifference analysis may be used to compare financing alternativesbased on expected EBIT levels

3. Modigliani and Millers irrelevance, argument, as well as the key assumptions

upon which it is based4. How the introduction of corporate taxes affects M&Ms irrelevance argument

5. How financial distress and bankruptcy costs lead to the static trade-off theoryof capital structure

6. How information asymmetry problems and agency problems may lead firms tofollow a pecking order approach to financing

7. How other factors such as firm size, profitability and growth, asset tangibility,and market conditions can affect a firms capital structure.


5/96


Important Chapter Terms

Agency costs Bankruptcy Business risk Cash flow-to-debt ratio

Corporate debt tax shield Direct costs of bankruptcy EPS indifference point Financial break-even points Financial distress

Financial leverage Financial leverage risk

premium

Financial risk Fixed burden coverage ratio Homemade leverage Indifference point

Indirect costs of bankruptcy Invested capital M&M equity cost equation Modigliani and Miller Pecking order Profit planning charts

Return on equity (ROE) Return on invested capital Risk value of money Static tradeoff


6/96


The Focus of this Chapter

You know: It is the responsibility of the financial manager to maximize

shareholder wealth.

The after-tax cost of debt is significantly lower than the cost of

equity primarily because of the tax-deductibility of interestexpensetherefore, using debt has a cost advantage overequity.

The lower the cost of capital, the greater the value of the firm.

This chapter addresses the question:

Does the relative mix of financing used by a firm affect its value?If so, how and why and are what are the other impacts thatcapital structure can have on the firm?


7/96


In this Chapter You Will Learn

1. The optimal (target) capital structure is the one thatmaximizes the value of the firm and minimizes the cost ofcapital.

2. How lenders seek to protect themselves from excessive useof corporate leverage through the use of protectivecovenants.

3. The tax advantage to debt is offset at higher levels offinancial leverage by costs associated with financial distress

and bankruptcy.4. Firms depart from the target capital structure in practice

because of financing preferences and capital marketconditions.


8/96


LeverageWhat is it?

The increased volatility in operating income overtime, created by the use of fixed costs in lieu ofvariable costs. Leverage magnifies profits and losses.

There are two types: Operating leverage

Financial leverage

Both types of leverage have the same effect onshareholders but are accomplished in very differentways, for very different purposes strategically.


9/96


Leverage Effects on Operating Income

Years

When a firm increases the

use of fixed costs it

increases the volatility of

operating income.

Normal volatility ofoperating income

Operating

Income

+

0

-


10/96


Operating LeverageWhat is it? How is it Increased?

Operating leverage is:

The increased volatility in operating income caused by fixedoperating costs.

You should understand that managers do make decisionsaffecting the cost structure of the firm.

Managers can, and do, decide to invest in assets that giverise to additional fixed costs and the intent is to reducevariable costs.

This is commonly accomplished by a firm choosing to becomemore capital intensive and less labour intensive, therebyincreasing operating leverage.


11/96


Operating LeverageAdvantages and Disadvantages

Advantages: Magnification of profits to the shareholders if the firm is

profitable.

Operating efficiencies (faster production, fewer errors, higher

quality) usually result increasing productivity, reducingdowntime etc.

Disadvantages: Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.

Higher break even point High capital cost of equipment and the illiquidity of such an

investment make it: Expensive (more difficult to finance)

Potentially exposed to technological obsolescence, etc.


12/96


Financial LeverageWhat is it? How is it Increased?

Your textbook defines financial leverage as: The increased volatility in operating income caused

by the corporate use of sources of capital that carry

fixed financial costs. Financial leverage can be increased in the firm by:

Selling bonds or preferred stock (taking on financialobligations with fixed annual claims on cash flow)

Using the proceeds from the debt to retire equity (ifthe lenders dont prohibit this through the bondindenture or loan agreement)


13/96


Financial LeverageAdvantages and Disadvantages

Advantages: Magnification of profits to the shareholders if the firm is

profitable.

Lower cost of capital at low to moderate levels of financial

leverage because interest expense is tax-deductible.Disadvantages: Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.

Higher break even point.

At higher levels of financial leverage, the low after-tax cost ofdebt is offset by other effects such as: Present value of the rising probability of bankruptcy costs

Agency costs

Lower operating income (EBIT), etc.


14/96


Effects of Operating and Financial LeverageSummary

Equity holders bear the added risks associated with the use ofleverage.

The higher the use of leverage (either operating or financial) the

higher the risk to the shareholder. Leverage therefore can and does affect shareholders required rate

of return, and in turn this influences the cost of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITAL


15/96


Business Risk

All firms experience variability in sales and operating (fixedand variable) operating costs over time.

Some firms operate in a highly volatile industry (for example oiland gas) and we would say the firm has a high degree ofbusiness risk.

Other firms operate in a very stable industry where revenues andexpenses dont change much from year to year throughout the

business cycle; these firms have low business risk.

Business risk is the variability of a firms operating incomecaused by operational risk.

Business risk is measured by the standard deviation of EBIT.


16/96


Financial LeverageRisk and Leverage

Lenders to the firm insulate themselves from risk throughfinancial contracting:

Lending money through a formal, legally-binding contract.

Demanding a fixed rate of return on the money they lend to thefirm, in-keeping with their required return on monies borrowed.

Demanding other promises that will protect the lenders interestsover the life of the loan/investment.

Demanding a high priority in the priority of claims list in the eventof corporate dissolution/bankruptcy.

Shareholders bear the risk associated with business risk,and the added risks associated with the use of leveragebecause they are residual claimants of the firm.


17/96


Return on Investment (ROI)Financial Leverage

Return on Investment (ROI) is the return on all the capital provided by investors; EBIT

minus taxes divided by invested capital.

Invested Capital (IC) is a firms capital structure consisting of

shareholders equity and short- and long-term debt.

)1(

BSE

TEBIT

ROI

[ 21-2]

But we know the claims

on the numerator

(operating income after

taxes) are very

different, and so too arethe risks each provider

of capital is exposed.


18/96


Return on Equity (ROE)Financial Leverage

ROE is the return earned by equity holders ontheir investment in the company

ROE = net income divided by shareholders equity.

)1)((

SE

TBREBITROE D

[ 21-1]


19/96


ROI versus ROEFinancial Leverage

If the firm is completely financed by equity: ROE =ROI.

Let us examine the effects of sales volatility on ROIand ROE given different levels of financialleverage.


20/96



Using this base income statement:

The following three slides show three different financing strategies and theimpacts on ROE, ROI, EPS for break-even, normal, and high sales levels:

Sales $1,000Variable costs 300

Fixed costs 158

EBIT $542

Interest 42

Taxable Income $500

Tax (40%) 200

Net Income $300

Table 21-1 Example Income Statement


21/96


Financial LeverageIncome Statement No Financial Leverage

-77.5% 100.0% 140.0%

Sales $225 $1,000 $1,400

Variable costs 68 300 420

Fixed costs 158 158 158

EBIT -$1 $542 $822

Interest 0 0 0

Taxable Income -$1 $542 $822

Tax (40%) 0 217 329

Net Income -$0 $325 $493

Invested capital = $1,700 100.0%

Debtholders' investment = $0 0.0%Shareholders' Equity = $1,700 100.0%

ROI = 0.0% 19.1% 29.0%

ROE = 0.0% 19.1% 29.0%

EPS (1,700 shares) = $0.00 $0.19 $0.29


This assumes a 0.0

debt/equity ratio

ROE = ROI because no use

of debt financing.


22/96


Financial LeverageIncome Statement Base Case

-71.5% 100.0% 140.0%

Sales $285 $1,000 $1,400



EBIT $42 $542 $822

Interest 42 42 42

Taxable Income -$0 $500 $780

Tax (40%) 0 200 312

Net Income -$0 $300 $468


Debtholders' investment = $700 41.2%Shareholders' Equity = $1,000 58.8%

ROI = 1.5% 19.1% 29.0%

ROE = -0.1% 42.9% 66.9%

EPS (1000 shares) = $0.00 $0.30 $0.47


This assumes a 0.70

debt/equity ratio

ROE is levered compared to

ROI because of the moderateuse of debt financing.


23/96


Financial LeverageIncome Statement with High Financial Leverage

-65.4% 100.0% 140.0%

Sales $346 $1,000 $1,400



EBIT $84 $542 $822

Interest 84 $84 $84

Taxable Income $0 $458 $738

Tax (40%) 0.08 183.2 295.2

Net Income $0 $275 $443


Debtholders' investment = $1,400 82.4%Shareholders' Equity = $300 17.6%

ROI = 3.0% 19.1% 29.0%

ROE = 0.0% 91.6% 147.6%

EPS (300 shares) = $0.00 $0.92 $1.48


ROE is more volatile than

ROI because of the high useof financial leverage.


24/96



Consider the equation for ROE:

)1)((

SE

TBREBITROE D

[ 21-1]

EBIT Interest expense = EBTEBT times (1 T) = Net Income

The equation reduce to net income

divided by BV of shareholders equity.


25/96



Equation 21 2 is the definition of ROI:

If we re-express EBIT (1-T) in the ROE equation, weget:

)1(BSETEBITROI

[ 21-2]


26/96



This is the financial leverage equation:

ROI measures the return that the firm earns fromoperations, but DOES NOT explicitly consideredhow the firm is financed.

)1((SEBTRROIROIROE D

[ 21-3]


27/96



If we rearrange Equation 21 3, grouping like terms involvingROI we get:

The second term is fixed. The first term depends on the firms uncertain ROI. This means we can graph ROE against ROI as a straight line.

See Figure 21 -1 on the following slide.

)1()1( SE

B

TRSE

B

ROIROE D [ 21-4]


28/96



21 - 1 FIGURE

ROE

80

60

40

20

ROI

-20

-40

-60

All Equity

D/E =0.70

-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40

Slope of the

all equity

line is = 1.0.

In this case

ROI = ROE.

D/E = 0.70.

Slope of the

line > 1.0.

Above the

intercept

with the

horizontal

axis, ROE

>ROI.

Financial Break-even

points where ROE = 0

Indifference point where

ROEs for different financing

strategies are equal.


29/96



Financial Break-even point:

Points at which a firms ROE is zero.

Indifference Point: Points at which two financing strategies provide the

same ROE.


30/96


Financial LeverageThe Rules of Financial Leverage

For value-maximizing firms, the use of debt increasesthe expected ROE so shareholders expect to be betteroff by using debt financing, rather than equity financing.

Financing with debt increases the variability of the firmsROE, which usually increases the risk to the commonshareholders.

Financing with debt increases the likelihood of the firmrunning into financial distress and possibly evenbankruptcy.


31/96



70% D/E Ratio 100% Equity

ROI (%)10 14.48 10

30 48.48 30

Range 34 20

Table 21-2 Varying ROI Values

ROE (%)

ROI reflects the business risk of the firm.

ROE =ROI in the all equity firm.

ROE increases as the firm finances with more debt.


32/96



70% D/E Ratio 100% Equity

ROI (%)-10 -19.52 -10

40 65.48 40

Range 85 50

Table 21-3 Wider Variation ROI Values

ROE (%)

Wider variation in ROI means magnified ROE over a still

wider range than ROI.


33/96


Financial LeverageInvesting Using Leverage

Figure 21-2 illustrates the monthly returns frominvesting in the S&P/TSX Composite Index usingtwo different financing strategies:

1. Investing in the index (all equity)

2. Investing in the index with 80% borrowed on margin.

The added volatility of gains and losses over timeis clearly evident.

These principles of leverage apply to corporationsas well as households

(See Figure 21 2 on the following slide)


34/96


Financial LeverageInvesting Using Leverage

21 - 2 FIGURE


35/96


Financial LeverageIndifference Analysis

Is a profit planning technique used to forecast theEPS-EBIT relationships under different financingscenarios.

The indifference point is where:

EPS(Financing strategy 1)=EPS(Financing strategy 2)


36/96



The formula for EPS, given EBIT, interest on debt (RDB), the corporate taxrate (T), and the number of common shares outstanding (#):

We can rearrange the definition of EPS and show how it varies with EBIT:

#

)1)(( TBREBITEPS D

[ 21-5]


37/96



EPS is a simple linear function of EBIT:

This is illustrated in the EPS-EBIT graph in Figure21 3 found on the following slide:

#)1(

#)1( TEBITTBREPS D [ 21-6]


38/96


Financial LeverageEPS-EBIT (Profit Planning) Charts

21 - 3 FIGURE

0.8

0.6

0.4

0.2

0

-0.2

-0.4

-0.6 EPS 0% D/E EPS 70% D/E

-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 1048 1133

Indifference

point.

The horizontal intercept of the 70% D/E line isgreater by the added interest expense that must be

covered before producing earnings available for

common shareholders.


39/96


Financial LeverageEPS-EBIT (Profit Planning) Charts

The slope of the lines are a function of the numberof common shares outstanding (dilution of EPS).

The all equity line will have a lower slope becauseevery dollar of net income is divided by more commonshares.

The horizontal intercept is greater for the debtfinancing line because the firm must cover itsinterest expense before earnings begin to accrue tothe benefit of shareholders.


40/96



Table 21 4 demonstrates the 1990 results of aConference Board survey of 119 U.S. companies todetermine their capital structure.

External sources of information include: (#2) checking with their advisors, and

(#5) examining other firms in the industry.

The three primary sources of information are:

(#4) impact on profits (#3) risk

(#1) analysis of cash flows


41/96



1. Analysis of cash flows 23.0%

2. Consultations 18.3%3. Risk considerations 16.5%

4. Impact on profits 14.0%

5. Industry comparisons 12.0%

6. Other 3.4%

Source: Data from Conference Board, 1990

Table 21-4 Determinants of Capital Structure

Primary sources include:

Analysis of cash flows

Risk consideration

Impact on profits


42/96


Determining Capital StructureUseful Ratios

Stock ratios (balance sheet ratios) that are helpfulinclude:

Total debt to total assets

Debt to equity ratio

Flow ratios make use of information taken from theincome statement and when combined with balance

sheet data help to determine the ability of the firm toservice its debt.


43/96



Fixed Burden Coverage Ratio:

An expanded interest coverage ratio that looks at abroader measure of both income and theexpenditures associated with debt.

)1/()Pref.Div.( TSFIEBITDACoverageBurdenFixed

[ 21-7]


44/96



Cash-flow-to-debt ratio (CFTD)

A direct measure of the cash flow over a period that isavailable to cover a firms stock of outstanding debt.

DebtEBITDACFTD[ 21-8]


45/96



IG Non-IG

Coverage 4.01 1.45

Leverage (%) 46.2 67.4Cash flow-to-debt (%) 18.3 8.10

Liquidity (%) 3.66 4.45

Profit margin (%) 6.26 1.39

Return on assets (%) 8.41 6.92

Sales stability 7.14 5.60

Total assets ($ billion) 6.31 1.19

Altman Z score 2.17 1.62

Table 21-5 Moody's Average Credit Ratios

Source: Data from M oo dy's Investo r Services, "The Distribution o f Co mmon Financial Ratios by Rating and

Industry fo r No rth American No n-Financial Corporations," December 2004.

Investment

grade (IG)

companies

have at

least a BBB

bond rating.

Altman Z score is

a weighted

average of

several key ratios

and is a useful

predictor of afirms probability

of bankruptcy.


46/96


Determining Capital StructureAltman Z Score

Altmans prediction of bankruptcy equation:

Where:X1 = working capital divided by total assets

X2 = retained earnings divided by total assetsX3 = EBIT divided by total assets

X4 = market values of total equity divided by non-equity book liabilities

X5 = sales divided by total assets

999060334121 54321 X.X.X.X.X.Z [ 21-9]


47/96

The Modigliani and Miller Irrelevance

Theorem

Capital Structure Decisions

The Modigliani and Miller (M&M)


48/96


The Modigliani and Miller (M&M)Irrelevance Theorem

M&M and Firm Value

The theorem that concludes (under some simplifyingassumptions) that the value of the firm should not beaffected by the manner in which it is financed.

How the firm is financed is irrelevant.


49/96


(M&M) Irrelevance TheoremAssumptions

Assumptions about the Real World: Markets are perfect in the sense that there are no

transactions costs or asymmetric information problems

No taxes There is no risk of costly bankruptcy or associated financial

distress

Modeling Assumptions: There exist two firms in the same risk class with different

levels of debt

The earnings of both firms are perpetuities


50/96


(M&M) Irrelevance TheoremArbitrage Argument

Arbitrage is a powerful economic force in capitalmarkets.

Where two identical assets trade at different prices,market traders will spot the opportunity to earn

riskless profits. Traders will sell the overvalued asset and buy the

undervalued asset.

This activity will cause the price of the overvalued asset tofall, and the price of the undervalued asset to rise until the

two are priced the same. The traders will earn abnormal profits from these trades untilthe prices of the two securities move into equilibrium.

Table 21 6 illustrates the two different positions and the equal payoffs


51/96


(M&M) Irrelevance TheoremArbitrage Argument

Market participants who find levered investmentstrading for a greater value, can undo the leverage andearn abnormal profits.

Arbitrage will force assets with equal payoffs to trade forthe same price.

Table 21 6 illustrates the two different positions and the equal payoffs


52/96


(M&M) Irrelevance TheoremM&M and Firm Value

Portfolios (Actions) Cost Payoff

Portfolio A: VU EBIT

Buy of unlevered firm

Portfolio B:

Buy of levered firm's equity SL (EBIT KD D )

Buy of levered firm's debt D KD D

Total portfolio (SL + D) EBIT

Table 21-6 M&M Arbitrage Table I

Net payoffs

are equal

Portfolio A and B must be priced equally despite their different financial

structures because the payoffs are equal.


53/96


(M&M) Irrelevance TheoremM&M and Firm Value

Where payoffs are identical for two different assets, bothshould be priced the same.

The value of the levered firm (VL)is equal to the value of its debt plusthe value of its equity (SL + D)and this must equal the value of theunlevered firm (VU).

Debt cannot destroy v alue.

LLU VDSV [ 21-10]


54/96


(M&M) Irrelevance TheoremPersonal Leverage and Corporate Leverage


Portfolio C: SL (EBIT - KD D )


Portfolio D:

Buy of levered firm's equity VU EBIT

Buy of levered firm's debt D - KD D

Total portfolio (VU - D) (EBIT - KD D )

Table 21-7 M&M Arbitrage Table II


55/96


(M&M) Irrelevance TheoremHomemade Leverage

Homemade leverage is the creation of the sameeffect of a firms financial leverage through the use

of personal leverage.

This means that individuals can: Buy an unlevered firm, and through the use of

personal debt, replicate corporate leverage, or

Buy a levered firm, and undo its effects.


56/96


(M&M) Irrelevance TheoremM&M and The Cost of Capital

M&M made a modeling assumption (to simplify the calculations andfocus analysis on the leverage issue) that the firms earnings

represent aperpetuity:

K

D)(EBIT-KS

e

DL

[ 21-11]


57/96



The cost of equity capital is simply the earnings yield and isestimated as follows:

S

D)(EBIT-KK

L

De

[ 21-12]


58/96



Since the value of the firm is unchanged by leverage, we can definethe unlevered value (VU) by discounting the firms expected EBIT byit unlevered equity cost (KU):

VDSV

EBITV LL

U

U [ 21-13]


59/96


(M&M) Irrelevance TheoremM&M Equity Cost Equation

To determine who equity cost varies with the debt-equity ratio, wesolve for EBIT, and substitute it for EBIT in the leveraged equity costequation:

If the firm has no debt, the equity investor requires KU (cost of

unlevered equity). KU depends on business riskof the firm.

As the firm uses debt, the equity cost increases due to the financialleverage risk premium.

/)( SDKKKK LDUue [ 21-14]


60/96



In a world without taxes, the WACC (KU) is simply the weightedaverage of the cost of debt and the cost of equity:

Figure 21 4 illustrates M&M without corporate taxes (theirrelevance model) where the cost of equity (KE) rises in a prescribedmanner to offset the lower cost of debt (KD) producing WACC thatremains unchanged by the use of financial leverage.

VDK

VSKK DEU [ 21-15]


61/96



20 - 4 FIGURE

Debt-Equity Ratio

Debt Cost KD

Equity Cost KE

WACC

%


62/96



If WACC remains the same regardless of the financialstrategy used by the firm:

VL = VU

Financial strategy is irrelevant As the use of debt financing is increased, the cost of equity

will riseso even if EPS is increased through the use of debt

financing, that benefit is offset by a higher discount rate.

From a shareholder wealth perspective, under the M&M

assumptions, financing strategy is irrelevant.


63/96


The Impact of TaxesIntroducing Corporate Taxes

The value of firms drop in the presence of corporate taxes.

The higher the tax rate, the lower the value of the firm.

)1(

K

TEBITV

U

U

[ 21-16]


64/96


The Impact of TaxesCorporate Tax Effect on Levered Equity


Portfolio E: SL (EBIT - KD D )(1-T)


Portfolio D:

Buy of levered firm's equity VU EBIT(1-T)

Buy of levered firm's debt D(1-T) - KD D

Total portfolio (VU - D)(1-T) (EBIT - KD D )(1-T)

Table 21-8 M&M with Taxes


65/96



To avoid arbitrage the value of the firm must equal:

VU D(1-t) = SL

VL = SL + D, therefore:

The value of the firm with leverage is the value without leverage plus thecorporate debt tax shield from debt financing.

DTVV UL [ 21-17]

Corporate DebtTax Shield

Th I f T


66/96



The total claims of corporate taxes, debt holders,and equity holders are borne by the pre-tax cashflow produced by the firm.

If the firm uses more debt, and interest on that debtis tax-deductible, this produces a greater tax shield,reducing the government share of the value of theprivate enterprise, the WACC must go down.

Here we assume a zero-sum game (that value is notdestroyed through the use of financial leverage)

Th I t f T


67/96


The Impact of TaxesFirm Value with Corporate Taxes

Taxes

EquityDebt

21 - 5 FIGURE

Th I t f T


68/96



The taxcorrected value of Equation 21-14 is:

Both the interest cost and the financial leverage risk-premium on the equitycost are reduced by (1- T)

As the use of debt increases, WACC decreases, and therefore the value ofthe firm in a world with corporate taxes should increase

(See Figure 21 6 on the following slide)

/)1)(( SDTKKKK LDUUe [ 21-18]

Th I t f T


69/96


The Impact of TaxesM&M with Corporate Taxes

21 - 6 FIGURE

Debt-Equity Ratio

Debt Cost KD(1-T)

Equity Cost KE

WACC

%

Th I t f T


70/96


The Impact of TaxesWACC with Corporate Taxes

WACC declines continuously with the use of debt financing. WACC equation corrected for the tax-deductibility of interest

expense is:

)1( TKV

DK

V

SWACC De

[ 21-19]

Th I t f T


71/96


The Impact of TaxesTax-Extended M&M Equity Cost Equation

The beta version of Equation 21 18 allows us to adjust for the systematicrisk of the firm:

Equity cost without any debt is the risk-free rate plus the market riskpremium (MRP) times the unlevered beta coefficient.

This equation allows us to unlever betas to get the unlevered equity cost.

There is one important flaw in this equation it is assumed that 100% debtfinancing is optimal. To address that issue, we must relax M&Ms assumptions regarding risk of

financial distress or bankruptcy.

)/)1(1( SDTMRPRFK LUe [ 21-20]

B k t


72/96


BankruptcyIntroduction

Bankruptcy is a state of insolvency that occurs whena firm commits an act of bankruptcy, such as non-payment of interest, and creditors enforce their legal

rights to recoup money, or when a firm voluntarilydeclares bankruptcy in an effort to be protectedwhile reorganizing to become solvent again.


73/96


Reorganization

Firms can be reorganized under:

Companies Creditors Arrangements Act (CCAA) Used by larger more complex firms with debt > $5m

Flexible allowing the firm to pursue agreements with

creditors/employees, to raise new financing

Trustee is appointed by the court and there is a stay-of-proceedings

Bankruptcy Insolvency Act (BIA)

Limited scope to prevent creditors from seizing assets No DIP financing

No provision to impose a settlement on all creditors

C t f B k t


74/96


Costs of BankruptcyDirect Costs

Direct Costs:

Costs incurred as a direct result of bankruptcyincluding:

Liquidation of assets Loss of tax losses (potential tax shield benefits)

Legal and accounting costs

C t f B k t


75/96


Costs of BankruptcyIndirect Costs

Indirect Costs: Financial distress costs are losses to a firm prior to declaration of

bankruptcy including: Agency costs Increasing costs of doing business:

Creditors tightening trade credit terms

Lending increasing risk premiums and increasing monitoringsurveillance

loss of key staff and increases in recruitment and retention costs Distracted management focused on financing and not on management

of business operations.

Reduced sales revenue: Management is distracted by financial issues

Customers may become wary and look for other suppliers

(Figure 21 8 illustrates the rising value of distress costs with increasing debt)

Static Tradeoff


76/96


Static TradeoffFirm Value and Financial Distress Costs

21 - 8 FIGURE

Distress Costs

VU + DT

Debt Ratio

Value

Costs of Bankruptcy


77/96


Costs of BankruptcyAgency Costs

Agency Costs: It is possible for shareholders (and Board of Directors) to act in their

own best interests at the expense of debt holders. When under financial stress sometimes:

Preferential treatment of creditors. Assets may be dissipated to related but solvent companies. Moral hazard (where management may take extraordinary risks that will be

ultimately borne by the debt holders, not the equity holders) (asymmetricpayoff of an option)

Being aware of these risks, lenders take action to protect their interestsincluding:

Moratorium on further debt. Increases in rates on adjustable-rate debt. Demands for additional surveillance of financial performance. Take the firm to court to enforce rights.

(Figure 217 illustrates the shareholders one year call option value on the underlying firm)

Financial Distress, Bankruptcy, and


78/96


, p y,Agency Costs

The Firm Value as a Call Option for Shareholders

21 - 7 FIGURE

UnderlyingFirm Value

No limitedliability

$50 million debt

EquityPayoff

0

Costs of Bankruptcy


79/96


Costs of BankruptcySummary

Costs of Bankruptcy are very high.

Probability of Bankruptcy and Financial Distress costs

rise exponentially as the use of debt increases.These costs rob value from both shareholders and

potentially debt holders.

Costs of Bankruptcy


80/96


Costs of BankruptcyStatic Tradeoff Model

Figure 21 9 illustrates the impact of bankruptcy and financialdistress costs on M&M with corporate taxes.

Cost of equity rises throughout as more debt is added.

The cost of debt rises at higher levels of debt.

WACC falls initially because the benefits of the tax-deductibilityof interest expense out-weigh the marginal increases incomponent costs, however, at higher levels of debt, the tax-advantage of debt is offset and the value of the firm falls when

WACC starts to rise.

Static Tradeoff Model


81/96


Static Tradeoff Model21 - 9 FIGURE

WACC

Ke

D/E*

Cost (%)

KD

Debt-to-equity

FirmValue

Other Factors Affecting Capital Structure


82/96


Other Factors Affecting Capital StructurePecking Order

Static Trade off model ignores two issues:

1. Information asymmetry problems

2. Agency problems

These factors are likely responsible for what Myersand Donaldson call the pecking order.

The pecking order is the order in which firms preferto raise financing

1. starting with internal cash flow,2. debt and

3. finally issuing common equity.

C S


83/96


Capital Structure in Practice

Factors favouring corporate ability and willingness toissue debt:

Profitability (so the firm can use the tax shield benefitof interest-deductibility).

Unencumbered tangible assets to be used ascollateral for secured debt.

Stable business operations over time.

Corporate size.

Growth rate of the firm.

Capital market conditions

S d C l i


84/96


Summary and Conclusions

In this chapter you have learned: The three effects of leverage: expected ROE tends to increase,

the variability of the ROE increases, and the risk of financialdistress increases.

The major determinants of the firms capital structure decisionare its impact on profits, risk and cash flows.

Impacts can be assessed by profit planning charts, financialbreak-even analysis and use of standard ratios

Debt creates value because interest on debt is tax-deductible The tax incentive to use debt is offset by the resulting financial

distress and bankruptcy costs

In a dynamic world, firms depart from the static trade-off optimaldebt ratio over time, then refinance to bring it back in line withthe target debt ratio.

Actual capital structures are constantly changing as firms takeadvantage of market conditions.


85/96

Appendix 1Thunder Bay Industries

Exercise in Indifference Analysis

Thunder Bay Industries


86/96


Thunder Bay IndustriesThe Problem

Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. Thecompany is now operating at 100% of capacity and must expand in order to meet the demand for its newline of video games.

The current financial statements for Thunder Bay Industries are as follows:

Thunder Bay IndustriesBalance Sheet

as at December 31, 20xx($ '000s Cdn.)

Assets: Liabilities and Owner's Equity:Cash 1,000 Accounts payable 550

Accounts receivable 2,100 Accruals 249Inventories 2,766 Other current liabilities 1Net Fixed Assets 16,244 8% bonds maturing in 10 years 5,000

_______ Common stock (100,000 outstanding) 1,000Retained earnings 15,310

Total Assets $22,110 Total Liabilities and Owner's Equity $22,110

The most recent income statement is found on the following slide:



87/96



Thunder Bay IndustriesIncome Statement

for the year ended December 31, 20xx($ '000s Cdn)

Sales $25,002Cost of Goods Sold 18,252

Gross Margin on Sales $ 6,750Administrative and Selling Expenses 4,000Earnings before Interest Expense and Taxes 2,750Interest expense 400Earnings before tax $ 2,350Taxes 1,011Net Income $1,339

If the firm does not expand, it sales growth will stall at the current $25m level orless. If the company undertakes the planned expansion management hasidentified a probability distribution for possible EBIT levels:



88/96



If the firm does not expand, it sales growth will stall at the current $25m level or less. If thecompany undertakes the planned expansion management has identified a probabilitydistribution for possible EBIT levels:

Possible EBIT Probability$2,200 .1$2,700 .4

$3,200 .4$3.700 .1

The planned expansion will require Thunder Bay Industries to raise $10,000,000 in newcapital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. Newcommon stock could be sold for $250.00 per share.

Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater thanthe indifference point? Which method of financing is most likely to maximize earnings pershare? What method of financing do you recommend? Why? Discuss the limitations ofindifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.



89/96


Thunder Bay IndustriesThe Solution

You can first determine the expected EBIT for next year and using that, determine thestandard deviation of that EBIT. These calculations will be useful later when we try todetermine the probability that EBIT will be less than, or greater than the indifferencepoint.

Possible EBIT Probability Wtd EBIT

$2,200,000 10.0% $220,0002,700,000 40.0% 1,080,0003,200,000 40.0% 1,280,0003,700,000 10.0% 370,000

Expected EBIT = $2,950,000

110,403$

11.403

500,162

56250000,25000,2556250

)750(1.)250(4.)250(4.)750(1. 2222

EBIT



90/96



Next set up equations for EPS for each alternative source offinancing, equate them, substitute in known values and solvefor the common EBIT.

000,675,2$

000,100

)43.1)(000,650000,400(

000,40000,100

)43.1)(000,400(

)1)(()1)((

)1)((

)1)((

1

21

21

1

1

21

21

1

EBIT

EBITEBIT

n

TBRBREBIT

nn

TBREBIT

EPSEPS

n

TBRBREBITEPS

nn

TBREBITEPS

DDD

debtcommon

DD

debt

D

common



91/96



Our prediction for EPS at EBIT=$2,675,000 for the common sharefinancing alternative is:

26.9$000,100

)43.1)(000,050,1$000,675,2($

26.9$000,140

)43.1)(000,400$000,675,2($

Debt

ecommonshar

EPS

EPS



92/96



The probability than EBIT will favour common stock financing (ie. beless than the indifference point) is:

Where:z= the number of standard deviations away from the mean

X= the point of interest= the standard deviation of the probability distribution

= the mean of the probability distribution

X

z 6822.0110,403

000,950,2000,675,2

z

Thunder Bay Industries 110403000,950,2000,675,2

z


93/96



The negative sign indicates that the point of interest (X) or (indifference point)lies on the left-hand side of the mean. It lies .6822 of 1 standard deviation awayfrom the mean.

Going to the table for Values of the Standard Normal Distribution Function we

find the area under the curve between the point of interest and the mean of thedistribution to be:

.2517 or 25.27%

Therefore, the probability that EBIT will exceed the indifference point (favouringdebt financing) is 75.17% The probability that EBIT will be below the

indifference point (favouring equity financing is (1- .7517) 24.83%.

(These normal distribution is plotted on the following chart.)

6822.0

110,403

Thunder Bay Industries 110403000,950,2000,675,2

z


94/96



(These relationships are now plotted on the following indifference chart.)

6822.0

110,403

=$2,950,000X=$2,675,000

Area =

.2517

Area = .5



95/96



(This chart illustrates that debt financing is forecast to produce higher EPS than the equityalternative.)

=$2,950,000

X=$2,675,000

Area =.2517

Area = .5

EPS

EquityFinancing

DebtFinancing

$400,000 $1,050,000

$9.26

Copyright


96/96

Copyright

Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved.Reproduction or translation of this work beyond that permitted by AccessCopyright (the Canadian copyright licensing agency) is unlawful.Requests for further information should be addressed to the PermissionsDepartment, John Wiley & Sons Canada, Ltd. The purchaser may makeback-up copies for his or her own use only and not for distribution or

resale. The author and the publisher assume no responsibility for errors,omissions, or damages caused by the use of these files or programs orfrom the use of the information contained herein.

corporate finance ch21

Documents