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4- 1. Chapter 4 Captial Structure. Types of Financial Instruments 4- 2. Warrants (Options) Common Stock Preferred Stock Blank Preferred Cumulative Preferred Participating Preferred Convertible Preferred Short-Term Debt

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  1. 4-1 Chapter 4 Captial Structure

  2. Types of Financial Instruments4-2 • Warrants (Options) • Common Stock • Preferred Stock • Blank Preferred • Cumulative Preferred • Participating Preferred • Convertible Preferred • Short-Term Debt • Asset –based financing (receivables, inventory) (including structured financing) • Lines of credit for temporary working capital • Commercial Paper • Long-Term Debt • Bonds • Debentures • Capital Leases • Structured Finance

  3. Eliasen v. ITEL Corporation 4-3 • Class B Debentures suing to obtain residual value from sale of the Railroad

  4. Order of Creditor Priorities From 4-41896 Bankruptcy Reorganization • First mortgagees received common stock • New investors received Class A debentures • Second mortgagees and old shareholders received Class B debentures.

  5. The Class B Debenture Certificate 4-5 • [This[ … certifies that this is one of a series of seven thousand of its Class B Debentures, in the sum of ONE THOUSAND DOLLARS each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof as follows: viz., only in the event of a sale or reorganization of the Railroad and property of said Company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of a series of Debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Million Five Hundred Thousand Dollars to and among the stockholders of said Company.Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures.

  6. Questions on Eliason v. Itel4-6 • 1. What priorities does Plaintiff argue for? • 2. Does Plaintiff’s argument give any meaning to the face value of the Class B debentures? • 3. What priorities does Itel argue for? • 4. What does the plain language provide? • 5. Does Itel’s position give any meaning to the language that stockholders shall be paid $2.5 million? • 6. Why does the court look at ancient history and describe the bankruptcy priorities in 1896? • 7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be? • 8. Who had voting rights? Why is this relevant to determining priorities on payment? • 9. If the B debentures only receive “dividends” after the A debentures and stock, what does this suggest?

  7. Question 1 on Eliason v. Itel4-7 1. What priorities does Plaintiff argue for? • $600,000 to Class A; • $2,500,000 to shareholders; • (“and then only out of any net proceeds . . . which may remain after payment [of the previous sums]”), $7 million to Class B. • Residue (in excess of $7 million) to Class B holders (“Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures”)

  8. Question 2 on Eliason v. Itel4-8 2. Does Plaintiff’s argument give any meaning to the face value of the Class B debentures?

  9. Question 2 on Eliason v. Itel4-9 2. Does Plaintiff’s argument give any meaning to the face value of the Class B debentures? • Just the amount of the initial payment. • It doesn’t really mean much but neither does par value of Common in a liquidation.

  10. Question 3 on Eliason v. Itel4-10 3. What priorities does Itel argue for?

  11. Question 3 on Eliason v. Itel4-11 • What priorities does Itel argue for? • $600,000 to Class A holders (who invested new money in the reorganization). • $2,500,000 to Shareholders (who were creditors in the bankruptcy) • $7,000,000 to Class B holders, per the first sentence of the debentures. • Balance to Shareholders.

  12. Question 4 on Eliason v. Itel4-12 4. What does the plain language provide?

  13. The Class B Debenture Certificate 4-13 • [This[ … certifies that this is one of a series of seven thousand of its Class B Debentures, in the sum of ONE THOUSAND DOLLARS each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof as follows: viz., only in the event of a sale or reorganization of the Railroad and property of said Company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of a series of Debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Million Five Hundred Thousand Dollars to and among the stockholders of said Company.Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures.

  14. Question 4 on Eliason v. Itel4-14 • What does the plain language provide? Posner tries to reconcile the sentences. Yet language is ambiguous.

  15. Question 5 on Eliason v. Itel4-15 5. Does Itel’s position give any meaning to the language that stockholders shall be paid $2.5 million?

  16. Question 5 on Eliason v. Itel4-16 5. Does Itel’s position give any meaning to the language that stockholders shall be paid $2.5 million? • Yes it shows that the Common get contractual priority as to $2.5 M before B Debentures. Default priority would go to the B debentures.

  17. Question 6 on Eliason v. Itel4-17 6. Why does the court look at ancient history and describe the bankruptcy priorities in 1896?

  18. Question 6 on Eliason v. Itel4-18 • Why does the court look at ancient history and describe the bankruptcy priorities in 1896? Parole Evidence Rule. Even though the final esntence standing alone is clear; the paragraph as a whole is ambiguous.

  19. Question 7 on Eliason v. Itel4-19 7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be?

  20. Question 7 on Eliason v. Itel4-20 7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be? Posner argues the 2d mortgagees and shareholders got B Debentures which were meant to be the lowest value in the bankruptcy. It explained why the reading that B get $7.0 M and no more makes sense.

  21. Question 7 on Eliason v. Itel4-21 7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be? “The presumption in 1896 as now was (is) that the residual, unprovided-for value of a corporation belongs to the shareholders rather than to the holders of debentures or other bonds.” - page 205

  22. Question 7 on Eliason v. Itel4-22 7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be? The problem is that when the language was written the assumption was that the railroad would never be worth more than the $10.1 M provided distribution (there would be no residue upside). This shows the danger of drafting to present assumptions only.

  23. Question 8 on Eliason v. Itel4-23 8. Who had voting rights? Why is this relevant to determining priorities on payment?

  24. Question 8 on Eliason v. Itel4-24 • Who had voting rights? Why is this relevant to determining priorities on payment? Voting Rights should go to the holder of residual value so they will have an incentive to maximize value above the liquidation preferences. Having voting rights and a fixed return encourages play it safe.

  25. Question 8 on Eliason v. Itel4-25 • Who had voting rights? Why is this relevant to determining priorities on payment? Here holder of residual value was B until the full $$10.1 million achieved then the shareholders. “The only way to give the shareholders a robust incentive to maximize the railroad’s value is to give them an equity kicker above the Class B entitlement, and so the debenture contract can be presumed to have done this.” - page 207.

  26. Question 9 on Eliason v. Itel4-26 9. If the B debentures only receive “dividends” after the A debentures and stock, what does this suggest?

  27. Question 9 on Eliason v. Itel4-27 • If the B debentures only receive “dividends” after the A debentures and stock, what does this suggest? P argues it suggests the B are equity holders and Common are preferred. Posner says it suggests the Common really represents a combined preferred return of $2.5M and residual value after the payment of the B debeuntures (equity)

  28. Firm One – All Equity - $100,000 invested earning 4-28$12,000Firm Two – 50% Debt, 50% equity (times two) • Firm One: Operating income $12,000 • Firm Two: Operating income $24,000 • less interest @ 8% - 8,000 • Net Income $16,000 • Equity of Firm One: $12,000 = $100,000 • .12 • Equity of Firm Two: $16,000 = $133,333 • .12

  29. Effects of Leverage on Profits 4-29 • FIRM ONE • A B C • Assumed Operating • earnings $2,000 $12,000 $22,000 • Earnings to • shareholders $2,000 $12,000 $22,000 • FIRM TWO • Assumed operating • earnings $2,000 $12,000 $22,000 • Interest (4,000) (4,000) (4,000) • Earnings to • shareholders ($2,000) $8,000 $18,000

  30. Return to shareholders,4-30assuming equal probabilities • Rate of return on equity • Firm One: ($100,000 equity) • $2,000 2% • $12,000 12% • $22,000 22% • Expected returns: $12,000 12% • Firm Two: ($50,000 equity) • ($2,000) - 4% • $8,000 16% • $18,000 36% • Expected returns: $8,000 16%

  31. Pricing Default Risk – Valuing Firm Two4-31 • (1) $16,000 = $133,333 • .12 • (2) $16,000 = $114,285 • .14 • (3) $16,000 = $100,000 • .16

  32. Home Made Leverage4-32 • Choice One - An unleveraged investment. • You get expected 12% rate of return ($12,000 on $100,000) • Choice Two - A leveraged investment. • You invest $50,000 equity in each of two firms. • You borrow $100,000 at 8% to buy the balance of the equity in both firms. • Results: $24,000 total income • - 8,000 interest • $16,000 net income • You get expected 16% rate of return on your $100,000.

  33. Firm Leverage4-33 • Firm One is an all equity firm with $100,000 invested • Firm One would have an expected return to shareholders of $12,000. • Net income $12,000 • Firm Two has $100,000 equity and $100,000 borrowings • Firm two would have an expected return to shareholders of $16,000. • Operating income $24,000 • less interest - 8,000 • Net Income $16,000

  34. The Relation Between Risk and Return4-34 • Rate of • Return Expected Return on Equity • 16% • Expected Return on Assets • 12% • 8% Expected Return on Debt Low Debt Ratio High Debt Ratio

  35. The One-Owner Corporation4-35 • Firm One Firm Two • Gross income $12,000 $12,000 • Firm interest expense 0 - 4,000 • Net firm profits $12,000 $8,000 • Less interest paid by • shareholder - $4,000 0 • Net available to shareholder $8,000 $8,000

  36. The Impact of Taxes 4-36 • All Equity Firm:Corporate Shareholder Level • Level Payments Taxes@40% Net • Net Operating Income $12,000 • Less Corp. Taxes @ 35% (4,200) • Corp. Income after taxes $7,800 • Dividend to Shareholders ($7,800) $7,800 ($3,120)$4,680 • 50% Leveraged Firm: • Net Operating Income $12,000 • Less interest expense: (4,000) $4,000 (1,600) $2,400 • Net Corporate Income $8,000 • Less Corp. Taxes @35% (2,800) • Corp. Income after taxes $5,200 • Dividend to Shareholders ($5,200) $5,200(2.080)$3,120 • Totals $9,200 $3,680$5,520 • 100% Leveraged Firm: • Net Operating Income $12,000 • Less Interest (12,000)$12,000 ($4,800)$7,200

  37. Quick Check Question 4.1 4-37 • Rate of Tax on dividends falls to 15% what does this do to the return to investors?

  38. Quick Check Question 4.1 4-38 • Firm One – All Equity with $100,000 invested & expected return of $12,000 • Corporate Shareholder Level Level Payments Taxes @15%Net to s/h Net corp. income $12,000 Less taxes @ 35% (4,200) Net corp. income $7,800 • Dividend to s/h $7,800 ($1,150) $6,630 • Firm Two – 50% equity w/ $100,000 invested & expected return of $12,000 • Corporate Investor Level Level Payments Taxes Taxes Net to s/h @40% @15% Operating income $12,000 Less interest (4,000) $4,000 ($1,600) $2,400 Net income $8,000 Less 35% taxes (2,800) Net corp. income $5,200 Dividend to s/h $5,200 ($780) $4,420 Totals: $9,200 $6,820

  39. The Impact of Expected Bankruptcy Costs 4-39 • Rate of • Return Expected Return on Equity • 16% • Expected Return on Assets • 12% • Impact of bankruptcy • costs • 8% Expected Return on Debt • Low Debt Ratio High Debt Ratio

  40. Weighted Average Cost of Capital 4-40 • WACC = (Value of debt x int. rate) + (Value of Equity x capitalization rate) Value of Firm Value of Firm • After tax cost of debt = (interest rate) (1- corp. tax rate) • WACC = (Value of debt x int. – tax rate) + (Value of Equity x cap. rate) Value of Firm Value of Firm

  41. Agency Costs 4-41 • With 100% owner manager there are no agency costs. Mager bears all cost of fringe benefits as the owner. • The more outside equity the greater the agency costs as the owner only bears a pro rata portion of the costs of fringe benefits as manager. Overcome with monitoring and/or equity incentives. • Debt can act as a discipline on agency costs – Covenant restrictions and performance measures. Yet these have their own costs to administer. • At some point Debt increases agency costs by reducing risk and increasing reward. E.g. 1% owner manager has little risk but all the reward. More outside debt reduces Debt Agency costs. • Companies change mix to try to achieve most efficient structure.

  42. Agency Cost Model of Optimal Capital Structure 4-42 • Agency Costs • Total Agency Costs • Agency Cost Agency Cost • of Debt of Outside Equity • Optimal Structure % Outside Equity

  43. What are LBOs? 4-43 • A Sponsor organizes the acquisition of a business or part of a business from a sole owner (can be public company owner). • Combination of acquisition debt (gives discipline), LBO sponsor equity (reduces the excessive risk taking cost and monitors the managers) and management incentive equity (reduce manager shirking). • Likely candidates in the 1980s were stable cash flow businesses (tax payers) in mature industries with high agency costs (conglomorates)

  44. Simple LBO Model? 4-44 • Target enterprise value of $120M with $20M EBITDA (6x valuation) and $13M net income ($7M in taxes) • $90 M Debt at 10%, $30M Equity • Sponsor provides 90% of the equity and managers 10% (often cheaper for the managers) • After deal there will be $20M EBITDA and $7.15 net income ($9M interest and $3.85 taxes

  45. Simple LBO Model? 4-45 • Sponsor assumes it can increase EBITDA by $5M by cutting agency costs of management. • It uses $3.5M EBITDA a year to pay down debt. • In five years the Company will sell for $150M (6xEBITDA) divided among: • Debt (no premium) $72.5 • Sponsor (no preferred) $70.0 • Management $ 7.5 • Sponsor made $70 on an investment of $27 or 2.6x return

  46. New England Tel. Co. 4-46 • Regulated Utility Companies have their rates set by Commissions. • Supreme Court has held that Utilities are entitled to a reasonable return on capital for shareholders. If rates are too low to do that, there is a taking. • Rate setting involves finding invested capital amount, finding a weighted average cost of capital and then setting rates at a level to produce income to meet that return.

  47. New England Tel. Co. 4-47 Capital Structure: long-term debt $135 million AT&T advances 120 $255 million (62% of capital) Common Stock $155 • Current cost of debt was 3.61%. • Commission found cost of debt could be reduced to 3.45% with new debt financing. • Composite rate of return allowed by Commission was 4.7% or 4.8%.

  48. New England Tel. Co. 4-48 • Court found that Commission was not bound to debt equity ratio desired by the Company but could use 45% debt level. • Commission only allowed 6% on equity. • No witness, even the Commission’s, thought the cost of equity was less than 8%. • Court rejects Commission’s reasoning that 6% was adequate for “normal” times.

  49. New England Tel. Co. 4-49 • Takings Clause means company is entitled to earn actual cost of capital dedicated to public service. • Held: The minimum return permitted on equity should be 8.5%. At 45% debt, this results in the following weighted cost of capital: Debt: 3.45% x .45 = 1.55% Equity: 8.5% x .55 = 4.68% Composite Return: 6.23%

  50. Questions – New England Tel. Co. 4-50 1. Why do you suppose the Department uses the cost of debt and equity separately to determine the cost of capital?

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