Financing Decision: The Costs and Benefits of Debt

1. Financing Decision:The Costs and Benefits of Debt The Costs and Benefits of Debt

2. Capital Structure Decision How much debt is prudent? What return can be achieved? What risk is involved? Is the return worth the risk? The Costs and Benefits of Debt

3. Firm Value and Capital StructureM&M I: No Taxes & No Distress Firm Value Firm Value Stockholder Claim Stockholder Claim Bondholder Claim Bondholder Claim High Leverage Low Leverage The Costs and Benefits of Debt

4. M&M I: No Taxes & No Distress Cost of Capital | | | | | 10 20 30 40 50 The Costs and Benefits of Debt

5. M&M I: No Taxes & No Distress Value of Firm Firm Value | | | | | 10 20 30 40 50 The Costs and Benefits of Debt

6. Firm Value and Capital StructureM&M II: Taxes & No Distress Firm Value Firm Value Tax Claim Tax Claim Stockholder Claim Stockholder Claim Bondholder Claim Bondholder Claim High Leverage Low Leverage The Costs and Benefits of Debt

7. M&M II: Taxes & No Distress Cost of Capital | | | | | 10 20 30 40 50 The Costs and Benefits of Debt

8. M&M II: Taxes & No Distress Value of Firm Firm Value t*D | | | | | 10 20 30 40 50 The Costs and Benefits of Debt

9. Firm Value and Capital StructureM&M 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 The Costs and Benefits of Debt

10. M&M III: Taxes & Distress Cost of Capital WACC* D/V* The Costs and Benefits of Debt

11. M&M III: Taxes & Distress Value of Firm Present value of tax shield on debt Financial distress costs D* The Costs and Benefits of Debt

12. 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, …) The Costs and Benefits of Debt

13. The symmetric information theory of capital structure is based on two assumptions: Managers have better information about their firm’s 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 shareholder’s wealth. Under these assumptions, if outside capital is needed, managers would issue new stock if they believed their firm’s 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 company’s stock typically declines if it announces a new stock offering. Since managers are reluctant to take actions which lower their firm’s 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. Asymmetric Information Theory The Costs and Benefits of Debt

14. FRICTO Analysis • Flexibility (Reserves) • Risk (Coverage) • Income (EPS) • Control (Ownership) • Timing (When?) • Other (Speed, Market Exposure) The Costs and Benefits of Debt

15. Flexibility Need for future funds • Growth opportunities • Profitability • Competition Lender attitudes The Costs and Benefits of Debt

16. Risk Sales stability Operating leverage Cash flow Management attitudes Asset structure The Costs and Benefits of Debt

17. Risk Measures Debt ratio = Times interest earned ratio (XIE) = Leverage measures: Standard Deviation Beta The Costs and Benefits of Debt

18. Income Impact on EPS • Higher on average with debt • More volatile with debt Impact on value The Costs and Benefits of Debt

19. Control • Ownership control • Possibly diluted with equity • Maintained with debt The Costs and Benefits of Debt

20. Timing Capital Market Conditions • Stock market • Bond market Economic Cycles Politics The Costs and Benefits of Debt

21. Other Lead time to set up new financing Broaden market exposure by issuing new shares Asset structure Market valuation The Costs and Benefits of Debt

22. What is the impact of debt on: ROE EPS Cost of equity and cost of capital Stock price or value of firm The Costs and Benefits of Debt

23. Debt’s Effect on ROE The Costs and Benefits of Debt

24. Debt’s Effect on EPS Range of Earnings Chart The Costs and Benefits of Debt

25. EPS Indifference Problem: Find level of EBIT where The Costs and Benefits of Debt

26. Example (cont.) Equate EPS for debt and equity options: Solve for EBIT: EBIT = Indifference level of EBIT The Costs and Benefits of Debt

27. Example The Costs and Benefits of Debt

28. The Costs and Benefits of Debt

29. Debt’s Effect on Stock Price(The $60 Million Question) • EPS will be higher as long as EBIT > EBIT* • But risk will also be higher • Does the extra EPS swamp the extra risk? The Costs and Benefits of Debt

30. Debt’s Effect on Stock Price • Suppose at EBIT of $50,000: P/E’s will be 16 if equity is issued and 10 if debt is issued • EquityDebt • EPS = 12.5 EPS = 20 • P/E = 16 P/E = 10 • P = $200 P = $200 The Costs and Benefits of Debt

31. The Costs and Benefits of Debt

32. Solvent firm Insolvent firm Debt Assets Assets Debt Equity Equity Note the negative equity Insolvency • Stock-base insolvency; the value of the firm’s assets is less than the value of the debt. Debt The Costs and Benefits of Debt

33. Cash flow shortfall Contractual obligations Insolvency • Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments. $ Firm cash flow Insolvency time The Costs and Benefits of Debt

34. What Happens in Financial Distress? • Financial distress does not usually result in the firm’s 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. The Costs and Benefits of Debt

35. No financialrestructuring 49% Privateworkout 47% 51% Financialrestructuring Reorganize and emerge 83% 53% Merge withanother firm Legal bankruptcyChapter 11 7% 10% Liquidation 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). The Costs and Benefits of Debt

36. 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. The Costs and Benefits of Debt

37. 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 firm’s 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. The Costs and Benefits of Debt

38. 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. The Costs and Benefits of Debt

39. 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. The Costs and Benefits of Debt