Debt Policy

Introduction

• A firm’s basic financial resource is the stream of cashflows produced by its assets and operations.

• Firm financed entirely by common stocks, all cashflows belong to stockholders.

• Firm’s mix of securities is known as capital structure

• If debt and equity, firm splits cashflows– Relatively safe stream that goes to debtholders– More risky that goes to stockholders

Example - River Cruises - All Equity Financed

• River Cruises is entirely equity financed. Although it expects to have an income of $125,000, but this income is not certain.

• Following table shows return to stockholders under different assumptions about operating income. Assumption no taxes.

Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

Example - River Cruises - All Equity Financed

• River Cruises is wondering to issue $500,000 of debt at an interest rate of 10% and repurchase 50,000 shares.

• Return to shareholder under different assumptions about operating income

• Returns to stockholders are increased in normal and boom times but fall in slumps.

Example cont.50% debt

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

DataM&M (Debt Policy Doesn’t Matter)

i. Operating Risk (business risk) – Risk in the firm’s operating income.

ii. Financial Risk - Risk to shareholders resulting from the use of debt.

iii. Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Definitions

• Financial leverage refers to the extent to which a firm relies on debt financing. The more debt a firm uses, relative to equity, the more financial leverage it employs.

Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return.

Financial Leverage

River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders.

48,75081,250FlowCash Net

26,25043,75035% @ Taxes

75,000125,000IncomePretax

50,0000PmtInterest

125,000125,000EBIT

Debt 1/2Equity All

C.S. & Corporate Taxes

Financial Distress

• Financial distress occurs when promises to creditors are broken or honored with difficulty.

• Sometimes financial distress leads to bankruptcy, sometimes it means only skating on thin ice.

• Financial distress is costly option i.e. costs of Financial distress.

• Costs arising from bankruptcy or distorted business decisions before bankruptcy.

• Low rate of interest is charged if probability of default is minimal

Bankruptcy Procedures

• Workout: agreement between a company and its creditors establishing the steps the company must take to avoid bankruptcy.

• Bankruptcy: the reorganization or liquidation of a firm that cannot pay its debts.

• Liquidation: sale of bankrupt firm’s assets.• Reorganization: restructuring of financial claims on failing firm

to allow it to keep operating.

Bankruptcy Procedures

• A firm that cannot meet its obligations may try to arrange a workout with its creditors to enable it to settle its debts. If this is unsuccessful, the firm may file for bankruptcy, in which case the business may be liquidated or reorganized.

• Liquidation means that the firm’s assets are sold and the proceeds used to pay creditors.

• Reorganization means that firm is maintained as an ongoing concern and creditors are compensated with securities in the reorganized firm.

• Ideally, reorganization should be chosen over liquidation when firm as a going concern is worth more than its liquidation value. However, conflicting interests of the different parties can result in violations of this principle.