FINA601 Lecture Notes - Lecture 7: Corporate Finance, Financial Distress, Capital Structure

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17 Nov 2018

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Week 7 lecture 7 (cid:3238) chapter 17: capital structure: limits to the use of debt. Bankruptcy risk or bankruptcy cost: as mentioned throughout the previous chapter, debt provides tax benefits to the firm. However, debt puts pressure on the firm because interest and principal payments are obligations. If these obligations are not met, the firm may risk some sort of financial distress: the ultimate distress is bankruptcy, where ownership of the firm"s assets is legally transferred from the stockholders to the bondholders. These debt obligations are fundamentally different from stock obligations. Although stockholders like and expect dividends, they are not legally entitled to dividends in the way bondholders are legally entitled to interest and principal payments. Interest from debts is tax-deductible, hence it is favoured to use debts to raise capital. In addition, we need to also consider personal taxes when considering the benefits of capital structure to investors.

Related Questions

[1] The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.
[A] beta conversion
[B] direct bankruptcy
[C] indirect bankruptcy

[2] An indirect cost of bankruptcy is the loss of key employees.
[A] True
[B] False

[3] A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a reorganization.
[A] True
[B] False

[4] The optimal capital structure has been achieved when the:
[A] weight of equity is equal to the weight of debt.
[B] debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
[C] cost of equity is maximized.

[5] The optimal capital structure will tend to include more debt for firms with:
[A] less taxable income.
[B] lower probability of financial distress.
[C] substantial tax shields from other sources.

[6] The optimal capital structure of a firm:
[A] will remain constant over time unless the firm makes an acquisition.
[B] will be the same for all firms in the same industry.
[C] will vary over time as taxes and market conditions change.

[7] In a world with corporate taxes, MM theory implies that that all firms should choose an all-debt capital structure.
[A] True
[B] False

[8] A firm is technically insolvent when:
[A] the value of its stock declines by more than 50 percent in any given 12-month period.
[B] the value of the firm's assets is less than the value of the firm's liabilities.
[C] it is unable to meet its financial obligations.

[9] Which one of the following statements is correct concerning a Chapter 7 bankruptcy?
[A] A firm reorganizes its operations in an effort to return to being a viable concern.
[B] A trustee will assume control of the firm's assets until those assets can be liquidated.

[10] If the net present value of a project is positive (non-zero), then the project's internal rate of return will exceed its required rate of return.
[A] True
[B] False

[11] Which one of these methods uses accounting values rather than financial values?
[A] AAR
[B] IRR
[C] NPV

[12] An investment should be accepted if the NPV is positive and rejected if it is negative.
[A] True
[B] False

[13] The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
[A] net present value.
[B] payback period.
[C] internal rate of return.

[14] An investment is acceptable if its average accounting return (AAR):
[A] exceeds the target AAR.
[B] is less than the target AAR.

[15] The discount rate that makes the net present value of an investment exactly equal to zero is called the internal rate of return.
[A] True
[B] False

[16] The most valuable investment given up if an alternative investment is chosen is referred to as a(n):
[A] sunk cost.
[B] opportunity cost.
[C] erosion cost.

[17] The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
[A] True
[B] False

[18] An asset will be depreciated faster using MACRS rather than the straight-line method.
[A] True
[B] False

[19] The financial break-even point determines which one of these values?
[A] Fixed costs
[B] Variable cost per unit
[C] Sales quantity

[20] The return earned in an average year over a multi-year period is called the _____ average return.
[A] arithmetic
[B] standard
[C] geometric

[21] The capital gains yield plus the dividend yield on a security is called the:
[A] geometric return.
[B] total return.
[C] variance of returns.

[22] Which one of the following is an example of a nondiversifiable risk?
[A] A poorly managed firm suddenly goes out of business due to lack of sales
[B] A key employee of a firm suddenly resigns and accepts employment with a key competitor
[C] A well respected chairman of the Federal Reserve suddenly resigns

[23] Beta values are highly dependent on the covariance of a security with the market.
[A] True
[B] False

[24] Insider trading does not offer any advantages if the financial markets are:
[A] inefficient.
[B] semiweak form efficient.
[C] strong form efficient.

[25] MM Propositions ignore bankruptcy costs.
[A] True
[B] False

blushspider431

1a- What are the direct costs and indirect costs of financial distress, from default that leads to bankruptcy? Explain in a well-stated description and discussion, not over a page in length.

1b- What are the impacts of the following on BECA Corporation's value, given the following information? SHOW ALL CALCULATIONS, and make a summary about the impact on equity owners between leveraged and unleveraged capital structures, and the impact on firm value from Financial Distress Costs.

BECA Corporation faces an uncertain future in a challenging business environment. Due to increased competition from foreign imports, its revenues have fallen dramatically in the past year. BECA's managers hope that a new product in the company's pipeline of new products will restore its fortunes. While the new product represents a significant advance over BECA's competition, whether that product will be a hit with consumers remains uncertain. If it is a hit, revenues and profits will grow, and BECA will be worth $200 million at the end of the year. If it fails, BECA will be worth only $130 million at the end of the year.

BECA Corporation may employ one of two alternative capital structures at the beginning of the year to provide the funding for this new project: (1) it can use all equity financing or (2) it can use debt that matures at the end of the year with a total of $150 million due.

Look first at the consequences of these capital structures when the new product succeeds, and when the new product fails, in a setting of perfect capital markets. Calculate what the debt and equity values will be for success and for failure, in both the unlevered and levered capital structures, at the end of the year. Show the totals to all investors (debt + equity) as well.

Now, since it has been assumed that BECA Corporation is operating in a perfect capital market, according to the M&M Proposition I, the investors (debt and equity total) will NOT be worse off because BECA may have some leverage at the beginning of the year. In other words, the value of BECA will be the same whether it has incurred the $150M of debt or not.

So, you are to show if that is indeed the case for BECA Corporation, under the following scenario.

Suppose the risk-free rate is 5%, and BECA's new product is equally likely to succeed or to fail. For simplicity, suppose that BECA's cash flows are unrelated to the state of the economy (i.e., the risk is diversifiable), so that the project has a Beta coefficient of 0 and the cost of capital is the risk-free rate. Compute the value of BECA's securities (that means both debt and equity, as applicable) at the beginning of the year with and without the $150M debt, and show whether or not the M&M Proposition I holds. That is, show if the value of the securities with or without leverage (the debt of $150M) have the same total value or not.

Now, to "get at" the value, VL or VU of the BECA Corporation, you have to discount the value of the cash flows to investors, per equation 9.23 in Chapter 9. But, what you need to know about the M&M Propositions is they assumed that the entire earnings (EBIT) in each year are paid out to the shareholders in the form of dividends or to the debtholders in the form of interest. So, regardless, the owners of the firm receive all the cash flows. So, for equation 9.23, you only have one year of FCFs, and the discount rate is 5%. What is the FCF? Since it is all of the cash flows with no taxes existing, and all of it is paid out to the equity and debt holders in a perfect capital market, what you find out is that the numerator is nothing more than the equity or debt values you calculated above. This is illustrated in Example 16.1 on page 554 of the texbook (I just provided an explanation of why the equity and debt values are used in the numerator instead of cash flows...in this case, they are the same).

2.Suppose you are a rational investor and looking at the following tax rates:

Year	Capital Gains Rate	Ordinary Income Rate	Dividend Rate
1997-2000	20%	40%	40%
2001-2002	20%	39%	39%
2003-2012	15%	35%	15%

(The 2012 tax rates were revised in 2013 by the U.S. Congress, and signed into law by the President, but that is for information only). The tax rates shown are for financial assets held for one year or more. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days.

Your assignment: What is the effective dividend tax rate for a buy and hold individual investor in 2006 ?

Show all of your calculations.

Please read the article and answer these THREE questions:

1. Why are conditions currently favorable for firms to issue debt and pay out the proceeds to stockholders?

2. What are dangerous impacts of issuing additional debt mentioned in the article?

3. TransDigm used the proceeds of their debt issue to pay a one-time dividend while Intel used the proceeds to repurchase shares. How does a repurchase differ from a one-time dividend? Why do you think the two firms chose different approaches to distributing cash to shareholders?

___________

"Borrowing for Dividends Raises Worries" at the Wall Street Journal on 10/06/2009

Rock-bottom interest rates and thawed credit markets are emboldening some companies to use bond-sale proceeds to go on the offensive, even if that means rewarding shareholders at the expense of bondholders.

The nascent trend is controversial because corporate borrowers are sinking themselves deeper into debt to pay out special dividends, buy back stock or finance acquisitions. While such moves were all the rage during the credit boom, most corporate-bond offerings during the recession have been used to reduce debt or stockpile cash.

Eric Felder, global head of credit trading at Barclays Capital, says the lure of low rates and companies' stables of cash increases "the risk of non-bondholder friendly events."

Last week's sale of $425 million of bonds by aircraft-parts manufacturer TransDigm Group Inc. is one of the back-to-the-past corporate-bond deals causing concern among some analysts. More than $360 million of the proceeds will be used to pay a special cash dividend to shareholders and management of the Cleveland company.

The added debt increased TransDigm's borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week's deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody's Investors Service.

Moody's said the dividend "illustrates the company's aggressive financial policy." Moody's gave the new debt a junk rating of B3, even though the ratings firm said TransDigm's "strong operating performance will enable the company to service the increased debt level."

Sean Maroney, director of investor relations at TransDigm, says the "stability of our business, high profit margins and consistent cash flow" give the company "the ability to support this level of leverage."

Borrowing from bondholders to pay shareholder dividends is "a hallmark of an earlier credit era," Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year.

Companies like Dex Media Inc. DEX -0.18% took on debt to pay dividends to its private-equity owners, including Carlyle Group and Welsh, Carson, Anderson & Stowe, before taking the companies public. Dex Media filed for bankruptcy earlier this year under a mountain of debt.

With the federal-funds rate at 0% for nine months now and confidence returning to the stock and debt markets, investors have been driven to take on more risk. That is flooding the corporate-bond market with cash. Investors poured $43 billion into investment-grade corporate-bond funds in the second quarter and nearly $40 billion in the third quarter -- almost double previous peak quarters, according to Lipper AMG Data Services.

The wave of buying drove down borrowing costs for the average highly rated corporation to about 5%, according to Merrill, a level not seen since 2005. In the heat of the crisis last October, such rates averaged 9%. Through the end of September, more than 1,000 high-rated companies borrowed a record $860 billion, according to Dealogic.

In July, Intel Corp. INTC 0.33% sold $1.75 billion of convertible bonds, planning to use $1.5 billion of the proceeds to buy back shares. A spokesman for Intel declined to comment.

The computer-chip giant has a strong credit rating of single-A, so it doesn't carry a burdensome debt load. Still, the deal raised eyebrows among some analysts and investors, who say floating debt to buy back stock could become more common as companies regain confidence.

And as merger-and-acquisition activity revs up, the cheaper cost of debt compared with equity is tempting companies to use bond sales as a deal-making war chest.

Analysts are watching Kraft Foods Inc. in anticipation that the company would finance its proposed purchase of U.K. chocolate, candy and chewing gum maker Cadbury PLC by raising tons of debt. Last month's unsolicited bid by Kraft was then valued at about $16.7 billion, but it could be weeks before Kraft submits a formal offer.

Three major credit-ratings agencies have warned Kraft that they could slash the company's debt ratings if the company reaches a deal agreement with Cadbury. At the current offering price, Kraft would need to shell out at least $6 billion in cash, much of it likely from the debt markets, according to corporate-bond research firm Gimme Credit.

"Kraft is committed to maintaining an investment-grade rating," a Kraft spokesman said, declining to comment further.

So far in 2009, returns to high-grade bond investors are 19%, according to Merrill. "We've seen a feeding frenzy" because of low interest rates, says Kathleen Gaffney, portfolio manager at Loomis, Sayles & Co. She sold some bonds recently to take profits from the rally. Loomis Sayles wants to have cash on the sidelines in case the Fed raises rates soon or Treasury bonds sell off.

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FINA601 Lecture Notes - Lecture 7: Corporate Finance, Financial Distress, Capital Structure

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