Topic 3

Equity in disguise

Preferred Stock
- Takes priority over common stock when receiving dividends.
- Gains some voting rights if corporation fails to pay preferred dividend.

Real estate investment trust (REIT)
- Limited to real estate
- Not taxed

Partnerships
- Avoid corporate income tax
- Limited Lifespan

Trusts
- Passive ownership of assets

What are dual class shares?

When a company has two classes of shares, one that has voting power and is private and one sold to the public

What is the advantage of dual class shares?

- same cashflow rights different control rights
- greater control rights grant private benefits

Default risk

the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily.

Bond ratings

something that helps investors assess the default risk of a firm.

Considerations when issuing Debt

• Should the company borrow short term or long term?
• Should the debt be fixed or floating rate?
• Should the company borrow dollars or some other currency?
• What promises should the company make to the lender?
• Should the company issue straight or convertible bonds?

Debt in disguise

• Some debts treated differently in accounts
Accounts payable - good received, not yet paid for.
Like short-term debt.

• Unfunded obligations
Senior debt, such as, employee pensions.

• Financial lease hidden as operating lease

• Special-purpose entities (SPEs)
Raise cash through equity and debt.
Do not show up on balance sheet - used to separate out the financial risks

Capital Structure: Pie Theory

Changes in capital structure benefit the stockholders if and only if the value of the firm increases

Capital structure: what is the Value of the firm?

Value of firm is the sum of the value of the firm's debt and the firms equity

V = D + E

What should a firm management do to make the firm as valuable as possible?

Pick the debt-equity ratio that makes the pie as big as possible

How do we maximize stockholder wealth?

By Maximizing cashflow to firm or minimizing WACC

Why is debt lucrative?

Tax Deductibility of Interest
- The tax deductibility of interest increases the total income that can be paid out to bondholders and stockholders.

Annual tax shield formula

Debt outstanding x Interest rate on debt x Corporate tax rate

Annual tax shield

Annual interest Payment x Corporate Tax rate

Annual tax shield 1

D x rD x Tc

PV (Tax shield)

(Corporate tax rate x interest payment)/expected return on debt

PV(tax shield)

[Tc x (rD x D)] / rD
= Tc x D

Miller-Modigliani Proposition 1

Changing the capital structure does not change the fortune of individual investors. They can do/undo the capital structure changes on their own.
- the proposition that the value of the firm is independent of the firm's capital structure

M&M Prop 1

VL = VU; EL = EU

M&M prop 2

The rate of return equity holders can expect to receive on their shares increases as the firm's debt-equity ratio increases.

Shareholders are indifferent to increased leverage as the increases in their expected return is EXACTLY offset by an increase in financial risk.

Leverage and Expected Returns: Expected Return on assets

Expected operating income / Market value of all securities

Expected return on assets (rA)

[( D/(D+E)) x rD] + [( E /(D + E)) x rE]

rE formula

rE = rA + (rA - rD) x (D/E)

rE

= rA = expected operating income / market value of all securities

Leverage and the Cost of Equity

- If leverage increases, the risk of lenders increases, and they require higher returns.
- Equity holders required return increases slowly as debtholders bear some of the operating risks.
- As the firm borrows more, more of the risk is transferred from stockholders to bondholders.

What happens if the firm increases leverage?

The change in capital structure does NOT affect the amount or risk of cash flows on the total amount of debt and equity combined.

What is β?

Market risk

β < 1

Stock is less risky, relative to the market

β > 1

Stock is riskier than the market

Asset beta in current capital structure

βA = βportfolio = [βD x (D/V)] + [βE x (E/V)]

Asset beta after more levered capital structure

βA = βportfolio = [βD x (D/V)] + [βE x (E/V)]

βE = βA + (βA - βD) x (D/E)

What factors does M&M+ consider when drawing conclusions on if debt policy is relevant or not?

-Tax
-Bankruptcy costs
- signalling and asymmetry of information
- conflicts of interests of different stake holders and incentive problems

what type of financing is tax deductible?

service debt

Value of levered firm is equaled to

Value of the unlevered firm + PV of interest tax shield

VL =

Vu + Tc x D

What is an objective when discussing personal tax of investors?

minimize the pv of all taxes paid on corporate income

What is the simple decision rule?

plan the capital structure to move operating income down to where the tax is least

What are some problems in the simple decision rule?

- who are our equity holders
- What Tax on percentage is to be used on equity holders (Tpe)
-How much tax should bondholders pay (Tpd)

What is the solution to the hitch in the simple decision rule?

Take the marginal client into consideration to determine the net tax advantage of debt,
Identify the tax rate faced by a marginal investor whose tax payment on debt and equity earnings are the same

What don't managers consider when they are planning their capital structure to minimize the PV of tax payments

tax- exempt entities

even though there is a moderate tax advantage of using debt, the company needs to generate high enough earnings to ensure ________ ___ ______ is used

interest tax shield

The amount of ____ outstanding cannot be a static number and ____ is not perpetual, unlike equity

debt; debt

Borrowing increases the risk of

financial distress

Borrowing can lead to

bankruptcy

investors take the risk of financial distress in consideration when

valuig a firm

What is the cost of distress

a function of the probability of distress and the magnitude of costs to be incurred of distress occurs

Value of Firm (formula)

Value if all equity financed + PV tax shield - Pv cost of financial distress

What is Bankruptcy

Something that occurs when stockholders exercise their right to default on payment to debt holders

What is the purpose of limited liability?

It allows the stockholders to walk away from the firm when it is in dire straits - that leaves the debt-holders to become new stockholders of the troubled firm

What is Ace limited?

limited liability of shareholders

What is ace unlimited

unlimited liability of shareholders

Ace limited defaults

share holders walk away with nothing and bondholders receive some money

What causes bankruptcy?

It is caused by a reduction in the value of the assets which is an operational failure of the managers, not necessary a financing issue

Is bankruptcy the cause or result of the decline in the value of the assets?

the result

What is affected by the probabilities of financial distress and the possible legal fees that come in case the firm files for bankruptcy?

the market value of the firm

Where does the cost of bankruptcy come from?

the shareholders pockets

What do creditors do?

foresee the costs of potential default and require a higher coupon payment; this reduces the possible payoffs to the shareholders reflected in the lowered firm value

Direct costs of bankruptcy

legal fees and administrative fees; mostly out of pocket and trackable

Indirect costs of bankruptcy

soft costs, like involvement of time and effort in managing a financially distressed firm; often not measurable but is high

What is the result of indirect costs of bankruptcy?

- Impatient creditors
- uncertain shareholders
- overworked managers with the best ones leaving
- Not well thought out bankruptcy court judgements allowing the company to run on its knees
- Creditors shying away from bankruptcy due to worry about violation of absolute priority

Who is the threat of financial distress costly too?

the threatened firm

What is the reaction of customers during bankruptcy?

they are cautious as they worry about the resale value and after sales services

What is the reaction of suppliers during bankruptcy?

they are cautious and less willing to allow trade credit and special arrangments

What is the reaction of employees during bankruptcy?

recruitment and retention is challenging

During Bankruptcy, the appetite for ________ risk is lowered; manager are afraid to take on high NPV and high risky venture

Business

Who does increased business risk benefit at the expense of the creditors

shareholders

What is risk shifting?

Hail mary attempted by managers

What is an agency issue in a financially distressed firm

Pass-up positive NPV projects as they benefit bondholders at the expense of the shareholders

When a firm is financially distressed, why are shareholders unwilling to benefit the creditors?

As they would not receive the full benefit of the positive NPV project

What happens when shareholders cash in (dividends) and run?

Market price of share drops by an amount lesser than dividend paid as the declined firm vale us shared with shareholders

What is playing for time?

Delaying the inevitable bankruptcy and eroding the value of firm to the creditors

What is a bait and switch?

Start with a conservative amount of debt, then later switch and issue a lot more debt making all debt risky

What leads to poor operational and financial decisions

agency issues

The higher the debt, the larger the ______ _____ becomes

agency issue

What do investors do when the see agency costs?

they read the market and estimate the possibility of such agency issues to rear their heads as D/E increases and promptly mark down the value of the firm

How do you avoid these agency issues?

Limit borrowing to levels at which the firm's debt is safe

What is the trade-off theory?

Capital structure (and the choice of level of debt) is based on trade-off between Tax savings from debt in the form of interest tax shield and distress costs of debt in the form of financial distress cost

At what level of debt is the possibility of financial distress little, and the tax savings dominate?

Low levels

What happens at higher levels of debt?

- the possibilities of financial distress increases
- the use of tax shield slows down as the firms EBIT ought to be high

What is the theoretical optimum debt?

when the PV of tax shields with one additional dollar of borrowing is ofset by increases on the PV of financial distress costs due to that additional debt

What are some trademarks of the tradeoff theory?

- Helps explain why debt ratios vary from firm to firm
- In the absence of taxes, capital structure is irrelevant and in presence of taxes, unlimited debt is optimal capital structure, the trade-off theory is more aligned with reality
- Managers mention of working towards a target debt rating

What type of companies have a higher threshold for debt

Firms with safe, tangible assets and high EBIT

Wha type of comapanies would have to rely on equity financing

Firms with risky, intangible assets and low EBIT

What are some weaknesses of trade-off theory?

- some successful firms have low debt

What is the pecking order theory?

firms prefer to issue debt over equity if internal finances are insufficient

What is the order of finances managers use?

- Internal funds
- New debt
- New equity (only when cost of financial distress outweighs the tax benefit of it)

What is the pecking order theory based on?

Asymmetric information and signalling
- Managers know more about their companies' prospects, risks, and values than outsiders
- Investors receive signals from the corporate fund raising

What is the order in the pecking order theory?

1. firm prefer internal financing
2. Firms follow sticky dividend policy - they adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends
3. If internally generated cash flow different than capital expenditures, managers use options available to them
4. if external finance is required, firms issue the safest security first

What is the security order for external finance?

- Plain vanilla debt
- hybrid securities like convertible bonds and preffered stocks
- equity as last resort

If FCF> CapEx

firm pays off debt or invest in marketable securities

If FCF< CapEx

firm first draws down cash balance or sells holdings of marketable securities

Why is the flotation cost in this order?

- Flotation cost of issuing new security
- best possible use of internally generated funds
- signal sent to market

What will happen if equity is used and manager knows that the shares are overvalued in the market?

the market will catch up to that information

What will happen if manager knows that the shares are undervalued in the market?

The market will receive wrong signal and depress the price considering manager's access to a asymmetrical information

Why do successful firms issue less debt?

Tx shield from debt id not their primary concern

Why do firms resort to debt?

Because they don't generate enough FCF to finance CapEx needs

What does large successful firms issuing new equity mean?

they are rebalancing their capital structure- Market may not necessarily see this as bad news and it lowers the probability of financial distress

What type of financing does high tech companies use and why?

they use equity as a safer mode of financing for such risky ventures; it saves them from going bankrupt

What is vital for the success of the company as it allows the manager to take advantage of investment opportunities and saves the cost in times of sudden need?

Having excess cash, investment in marketable assets, readily salable real assets and ready access to borrowing

What happens with managers with financial slack?

manager agency issues might be rampant and need to be monitored