Financing Decision: The Costs and Benefits of Debt

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Financing DecisionThe Costs and Benefits of Debt
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Capital Structure Decision

• How much debt is prudent?
• What return can be achieved?
• What risk is involved?
• Is the return worth the risk?

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Firm Value and Capital StructureMM I No Taxes
No Distress
Firm Value
Firm Value
Stockholder Claim
Stockholder Claim
Bondholder Claim
Bondholder Claim
High Leverage
Low Leverage
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MM I No Taxes No Distress Cost of Capital
Cost of Capital () Cost of Capital ()



Debt/Value Ratio ()

10 20 30 40 50
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MM I No Taxes No Distress Value of Firm
Value of the Firm () Value of the Firm ()



Debt/Value Ratio ()
Firm Value

10 20 30 40 50
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Firm Value and Capital StructureMM II Taxes
No Distress
Firm Value
Firm Value
Tax Claim
Tax Claim
Stockholder Claim
Stockholder Claim
Bondholder Claim
Bondholder Claim
High Leverage
Low Leverage
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MM II Taxes No Distress Cost of Capital
Cost of Capital Cost of Capital



Debt/Value Ratio ()

10 20 30 40 50
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MM II Taxes No Distress Value of Firm
Value of the Firm () Value of the Firm ()



Debt/Value Ratio ()
Firm Value
tD

10 20 30 40 50
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Firm Value and Capital StructureMM III Taxes
Distress
Firm Value
Firm Value
Distress Claim
Tax Claim
Bondholder Claim
Stockholder Claim
Stockholder Claim
Bondholder Claim
Distress Claim
Tax Claim
High Leverage
Low Leverage
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MM III Taxes Distress Cost of Capital
Cost of Capital () Cost of Capital ()



Debt/Value Ratio ()
WACC
D/V
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MM III Taxes Distress Value of Firm
Value of the Firm Value of the Firm



Debt/Value Ratio ()
Present value of tax shield on debt
Financial distress costs
D
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Implications of Capital Structure Theory

• Other things held constant
• Firms with high tax rates should use more
  leverage than firms with low tax rates, because
  the value of debt financing is its tax
  deductibility, and this value increases with tax
  rate.
• Firms with more inherent risk (business risk),
  should use less leverage than low-risk firms,
  because riskier firms have higher probabilities
  of facing financial distress.
• Firms with high potential financial distress
  costs, such as firms whose value is derived from
  intangible assets which can not be readily sold,
  should use less leverage than firms with low
  potential distress costs.
• Firms characterized by high degree of information
  asymmetry, such as those with highly confidential
  research and development programs, should
  maintain a larger reserve borrowing capacity, and
  hence use less leverage, than firms with a low
  degree of asymmetry.
• Non-debt tax shield results in less debt (i.e.
  depreciation, depletion, tax credits, )

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Asymmetric Information Theory

• The symmetric information theory of capital
  structure is based on two
• assumptions
• Managers have better information about their
  firms future prospects than do investors. Thus,
  asymmetric information exists.
• Managers act in the best interests of the current
  shareholders in the sense that managers act to
  maximize current shareholders wealth.

• Under these assumptions, if outside capital is
  needed, managers would issue
• new stock if they believed their firms stock to
  be overvalued, but they would
• issue new debt if they believed the stock to be
  undervalued.
• Investors recognize this, and thus tend to view a
  new common stock offering as a negative signal.
  Therefore, the price of a companys stock
  typically declines if it announces a new stock
  offering.
• Since managers are reluctant to take actions
  which lower their firms stock price, they avoid
  issuing stock when they believe investors will
  react negatively,
• However, since external capital may still be
  needed to fund especially good investment
  opportunities, financial managers try to maintain
  a reserve borrowing capacity that they can tap if
  needed.

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FRICTO Analysis

• Flexibility (Reserves)
• Risk (Coverage)
• Income (EPS)
• Control (Ownership)
• Timing (When?)
• Other (Speed, Market Exposure)

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Flexibility

• Need for future funds
• Growth opportunities
• Profitability
• Competition
• Lender attitudes

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Risk

• Sales stability
• Operating leverage
• Cash flow
• Management attitudes
• Asset structure

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Risk Measures

• Debt ratio
• Times interest earned ratio (XIE)
• Leverage measures
• Standard Deviation
• Beta

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Income

• Impact on EPS
• Higher on average with debt
• More volatile with debt
• Impact on value

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Control

• Ownership control
• Possibly diluted with equity
• Maintained with debt

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Timing

• Capital Market Conditions
• Stock market
• Bond market
• Economic Cycles
• Politics

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Other

• Lead time to set up new financing
• Broaden market exposure by issuing new shares
• Asset structure
• Market valuation

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What is the impact of debt on

• ROE
• EPS
• Cost of equity and cost of capital
• Stock price or value of firm

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Debts Effect on ROE
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Debts Effect on EPS Range of Earnings Chart
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EPS Indifference
Problem Find level of EBIT where
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Example (cont.)

• Equate EPS for debt and equity options
• Solve for EBIT

EBIT Indifference level of EBIT
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Example
Debt Equity
Interest 10,000 0
Number of Shares 1,000 2,000
Tax Rate .5 .5
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Debts Effect on Stock Price(The 60 Million
Question)

• EPS will be higher as long as EBIT gt EBIT
• But risk will also be higher
• Does the extra EPS swamp the extra risk?

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Debts Effect on Stock Price

• Suppose at EBIT of 50,000 P/Es will be 16 if
  equity is issued and 10 if debt is issued
• Equity Debt
• EPS 12.5 EPS 20
• P/E 16 P/E 10
• P 200 P 200

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Insolvency

• Stock-base insolvency the value of the firms
  assets is less than the value of the debt.

Debt
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Insolvency

• Flow-base insolvency occurs when the firms cash
  flows are insufficient to cover contractually
  required payments.

Firm cash flow
time
Insolvency
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What Happens in Financial Distress?

• Financial distress does not usually result in the
  firms death.
• Firms deal with distress by
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and research and
  development.
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

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What Happens in Financial Distress
Financialdistress
Source Karen H. Wruck, Financial Distress
Reorganization and Organizational Efficiency,
Journal of Financial Economics27 (1990), Figure
2. See also Stuart C. Gilson Kose John, and
Larry N.P. Lang, Troubled Debt Restructurings
An EmpiricalStudy of Private Reorganization in
Firms in Defaults, Journal of Financial
Economics 27 (1990) and Lawrence A.
Weiss,Bankruptcy Resolution Direct Costs and
Violation of Priority Claims, Journal of
Financial Economics 27 (1990).
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Bankruptcy Liquidation and Reorganization

• Firms that cannot meet their obligations have two
  choices liquidation or reorganization.
• Liquidation (Chapter 7) means termination of the
  firm as a going concern.
• It involves selling the assets of the firm for
  salvage value.
• The proceeds, net of transactions costs, are
  distributed to creditors in order of priority.
• Reorganization (Chapter 11) is the option of
  keeping the firm a going concern.
• Reorganization sometimes involves issuing new
  securities to replace old ones.

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Bankruptcy Liquidation

• Straight liquidation under Chapter 7 usually
  involves
• A petition is filed in a federal court. The
  debtor firm could file a voluntary petition or
  the creditors could file an involuntary petition
  against the firm.
• A trustee-in-bankruptcy is elected by the
  creditors to take over the assets of the debtor
  firm. The trustee will attempt to liquidate the
  firms assets.
• After the assets are sold, after payment of the
  costs of administration, money is distributed to
  the creditors.
• If any money is left over, the shareholders get
  it.

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Bankruptcy Liquidation Priority of Claims

• The distribution of the proceeds of liquidation
  occurs according to the following priority
• Administration expenses associated with
  liquidation.
• Unsecured claims arising after the filing of an
  involuntary bankruptcy petition.
• Wages earned within 90 days before the filing
  date, not to exceed 2,000 per claimant.
• Contributions to employee benefit plans arising
  with 180 days before the filing date.
• Consumer claims, not exceeding 900.
• Tax claims.
• Secured and unsecured creditors claims.
• Preferred stockholders claims.
• Common stockholders claims.

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Bankruptcy Reorganization Chapter 11

• A typical sequence
• A voluntary petition or an involuntary petition
  is filed.
• A federal judge either approves or denies the
  petition.
• In most cases the debtor continues to run the
  business.
• The firm is given 120 days to submit a
  reorganization plan.
• Creditors and shareholders are divided into
  classes. Requires only approval by 1/2 of
  creditors owning 2/3 of outstanding debt
• After acceptance by the creditors, the plan is
  confirmed by the court.
• Payments in cash, property, and securities are
  made to creditors and shareholders.