Key Concepts in Bankruptcy and Capital Structure

Bankruptcy

A legal process to get out of debt when you can no longer make all your required payments

Direct Bankruptcy Costs

Costs associated with the legal and administrative process of bankruptcy

CAPM

Capital Asset Pricing Model, used to estimate cost of equity

Indirect Bankruptcy Costs

Direct and indirect costs associated with going bankrupt or experiencing financial distress

Financial Distress Costs

Bondholders may be more comfortable with bankruptcy as they are guaranteed to be paid; Shareholders own equity and will resist bankruptcy

Static Theory of Capital Structure

A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

Business Risk

Equity risk that comes from the nature of the firm's operating activities; Unaffected by financial structure

Financial Risk

Equity risk that comes from the financial policy/capital structure of the firm; risk that arises as a result of debt financing

Interest Tax Shield

Tax savings attained by a firm from interest expense; Formula: T * D

Unlevered Cost of Capital

Cost of capital for a firm that has no debt

Optimal Capital Structure

Debt-equity ratio that results in the lowest possible WACC

WACC

Weighted Average Cost of Capital, weighted average cost of equity and the aftertax cost of debt; overall return a firm must earn on assets to maintain value of stock; Equation: Re(E/V)+Rd(D/V)*(1-t)

Cost of Capital

The rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders; Depends on the use of funds not the source

Financial Leverage

The extend to which a firm relies on debt; When EBIT (earnings before interest and taxes) is relatively high, leverage is beneficial

Cost of Debt

The return lenders require on the firm's debt; Think about YTM on bonds, that is the cost of debt the interest due

Cost of Preferred Stock

Fixed dividend that is paid every period perpetually; Formula: Rp = D/P0

Cost of Equity

The return that equity investors require on their investment, can only be estimated

Debt-Equity Ratio

Ratio of debt or equity to the total of both debt and equity

Dividend Growth Model

Used to estimate the cost of equity; Equation: Re = D1/P0+g

SML (Security Market Line) Approach

Used to estimate cost of equity; Equation: Re = Rf+Beta(Rm-Rf)

Pecking Order Theory

Firm will use internal financing first then will issue debt if necessary and equity will be sold only as a last resort

Observed Capital Structure

Company's with stable cash flow will feel more comfortable taking on debt

Legal Bankruptcy

Firm or creditors bring petitions to a federal court for bankruptcy

Technical Insolvency

Firm is unable to meet its financial obligations - literally has no cash

Liquidation

Termination of the firm as a going concern

Absolute Priority Rule (APR)

Rule establishing priority of claims to a liquidation - the higher the claim on a list the more likely it is to be repaid

Pure Play Approach

Use of WACC that is unique to a particular project based on the company's similar businesses

Weight of Debt

The percentage of the firm's capital budget that is made up of debt (D/V)

Weight of Equity

The percentage of the firm's capital budget that is made up of equity (E/V)

Company Valuation

Valuing a firm using WACC and adjusting the cash flow to look at the 'left over' income after expenses for operating costs; Equation: V0 = CFA/1+WACC + (CFA2/1+WACC)^2

Flotation Costs

The transaction cost incurred when a firm accepts a new project and raises funds by issuing a particular type of security (bonds, float, stock, etc)

M&M Proposition I

Value of the firm is independent of the firm's capital structure; Firm's overall cost of capital is unaffected by capital structure

M&M Proposition II

Firm's cost of equity is directly related to percentage of debt in the firm's capital structure; As % of debt increases, cost of equity increases