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COMM 122
Wei Wang

Chapter 16 16.1 • Pie model: Value of firm (V) = Market value of debt (B) + Market value of equity (S) 16.3 • MM proposition I: the value of the firm is always the same under different capital structures – no capital structure is any better or worse than any other capital structure for the firm’s shareholders • MM proposition I (no taxes): the value of the levered firm is the same as the value of the unlevered firm (assuming not taxes and individuals can borrow as cheaply as corporations) 16.4 • the responsiveness of ROE to changes in firm performance measures the risk to shareholders • MM Proposition II: the expected return on equity is positively related to leverage because the risk to equity-holders increases with leverage B o rs= r 0 S (r0– rB) Expectedearnings • r = cost of capital for an all-equity firm = ¿unleveredfirm ) 0 Unlevered equity 16.5 • due to the Canadian tax law allowing interest to be deducted from taxable income, the proportion of the pie allocated to taxes is less for the levered firm than it is for the unlevered firm • Dollar interest = Interest rate x Amount borrowed o Interest =Br x B • Reduction in corporate taxes = Corporate taxes x Dollar amount of interest o = Tc x Br x B) o Tax shield from debt TCr B • Present value tax shield = TcB = rB T r B • After-tax cash flow in levered firms = EBIT x (1 - Tc) B 1−T EBIT x(¿¿C) • VU= r0 ¿ o VU= present value of an unlevered firm o 0 = the cost of capital to an all-equity firm • MM Proposition I (corporate taxes) 1−T EBIT x(¿¿C) TCr B o VL= + = VU+ T C r0 rB ¿ • MM Proposition II (corporate taxes) B o S = 0 + x (1 – Tc) xC(r B r ) S EBIT−r BB 1−T ¿x(¿¿C) • Levered equity = S = ¿ ¿ 1–T rB(¿¿C) S ¿+ rS • WACC = V L B ¿ VL 1−T EBIT (¿¿C) • VL= WAXX ¿ 31.1 • Financial distress: occurs when a firm’s operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action o Dividend reductions, plant closings, losses, layoffs, CEO resignation, plummeting stock prices • Insolvency: inability to pay one’s debts; lack of means of paying one’s debts. Such condition of [one’s] assets and liability that the former made immediately available would be insufficient to discharge the latter 31.3 • Liquidation: termination of the firm as a going concern, and it involves selling off the assets of the firm • Reorganization: the option of keeping the firm a going concern; it often involves issuing new securities to replace old ones • Company’s creditors arrangement act: federal legislation originally enacted during the 1930s allows for the reorganization and continuation of insolvent businesses 31.4 • Private workout: direct negotiations between creditors and debtors • Prepackaged bankruptcy: a combination of private workout and legal bankruptcy 17.1 • Bankruptcy: ownership of the firm’s assets is legally transferred from the shareholders to the bondholders • The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather, it is the costs associated with bankruptcy that lower the value 17.2 • Agency costs: conflicts of interest which are magnified when financial distress occurs o Incentive to take larger risk o Incentive toward underinvestment o Milking the property 17.3 • Protective covenants: agreements incorporated as part of the loan document between shareholders and bondholders • Negative covenant: limits or prohibits actions that the company may take • Positive covenant: specifies an action that the company agrees to take or a condition the company must abide by 17.4 • Cash Flows (CF) = Payments to shareholders + Payments to bondholders + payments to the government + Payments to lawyers + Payments to any and all other claimants to the cash flows of the firms • Firms Value = V =TS + B + G + L o Stocks, bonds, government, lawyers • Value of firm: bankruptcy claims, tax claims, bondholder claims, shareholder claims • Marketed claims: can be bought and sold in financial markets • Nonmarketed claims: cannot be bought and sold in financial markets 17.5 • Exchange offers: a way for firms to change their debt levels 17.7 • Pecking order o Rule 1: Use internal financing o Rule 2: Issue the safest securities first o there is no target amount of leverage o profitable firms use less debt o companies like financial slack 18.1 • Adjusted present value: APV = NPV + NPVF o APV = value of a project to a levered firm o NPV = value of a project to an unlevered firm o NPVF = net present value of the financing side effects 18.2 • Flow to equity (FTE): an alternative capital budgeting approach Cashflow ¿ o ¿project¿equtiyholdersof theleveredfirm rs • UCF – LCF = (1 – Tc)B B 18.3 • Weighted average cost of capital (WACC): approach begins with insight that projects of levered firms are simultaneously financed with both debt and equity S B rs+ rB(1−T C o WACC = S+B S+B ∞ UCF ∑ t t−initalinvestment • Net present value of the project: t=1(!+WACC) UCF −initialinvestment • Net present value of perpetuity project: WACC 18.4 • Use WACC or FTE if the firm’s target debt-to-equity ratio applies to the project over its life. Use APV if the project’s level of debt is known over the life of the project 18.7 (1−T c)bt • The corporate-tax case: β equit[+ Equity ]βunleveredfirm Appendix 2B 21,1 • Maturity: on long-term debt refers to the length of time the debt remains outstanding with some unpaid balance • Bond Features: amount of issue, issue date, maturity date, annual coupon, face value, issue price, yield to maturity, coupon payment, security, call provision, rating 21.2 • Public issue: issues must be registered with the OSC and any other relevant provincial securities commissions • Indenture: a written agreement between the corporation (borrower) and a trust company o Trust company must: (1) be sure the terms of indenture are obeyed (2) manage the sinking fund and (3) represent bondholders if the company defaults on payments • Bond indenture includes : (1) the basic terms of the bonds, (2) a description of property used as security, (3) the seniority of the bonds, (4) details of the protective covenants, (5) the sinking fund arrangements, (6) the call provision • Registered: the company has a registrar who will record the ownership of each bond • Bearer form: ownership of a bon is not recorded in the company books • Debenture: an unsecured bond, for which no specific pledge of property is made • Protective covenant: is that part of indenture or loan agreement that limits certain actions of the borrowing company • Negative covenant: limits or prohibits actions that the company may take • Positive covenant: specifies an action that the company agrees to take or a condition the company must abide by • Sinking fund: an account managed by the bond trustee for the purpose of repaying the bonds o Provide extra protection to bondholders o Sinking funds give the firm an attractive option • Call premium: the difference between the call price and the face value • Deferred call: calls are not operative during the first few years of a bond’s life (call protected) • Canada plus call: new corporate debt features a different call provision that is designed to replace the traditional call feature by making it unattractive for the issuer ever to call the bonds 21.3 • Refunding: replacing all or part off an issue of outstanding bonds First−yearcoupon+Expected priceatendof year • Noncallable bond: ¨ 1+r • Callable bond: (1) determine end-of-year value it interest rates drop, (2) determine end- of-year value if interest rates rise, (3) solve for C • Reasons to call bonds o Superior interest rate predictions: company insiders may know more about interest rate changes on its bonds than does the investing public o Taxes: call provisions may have tax advantages if the bondholder is taxed at a lower rate than the company o Les interest-rate risk: call provisions will reduce the sensitivity of a bond’s value to changes in the level of interest rate 21.4 • Debt ratings depend on (1) the likelihood a firm will default and (2) the protection afforded by the loan contract in the event of default • Junk bonds: bonds with a rating of BB and below 21.5 • Zero-coupon bonds: a bonds that pays no coupons at all must be offered at a price that is much lower than its stated value • Floating-rate bonds: in coupon payments are adjustable – the adjustments are tied to the Treasury bill rate or another short-term interest rate o Put provision: the holder has the right to redeem his note at par on the coupon payment date o Floor-and-ceiling provision: the coupon rate is subject to a minimum and maximum • Income bonds: coupon payments are dependent on company income • Convertible bond: bond can be swapped for a fixed number of shares of stock any time before maturity at the holder’s option • Retractable bond: allows the holder to force the issuer to buy the bond back at stated price • Stripped real-return bond: a zero-coupon bond with inflation protection • Asset-backed bonds: backed by a diverse pool of assets, such as accounts receivable collections, credit card debt, or mortgages 21.6 • Term loans: direct business loans with maturities of one to five years • Private placements: long maturity and privately placed debt usually employs an investment dealer o Registration costs are lower for direct financing o Direct placement is likely to have more restrictive covenants o Easier to renegotiate private placement or term loan during default 21.7 • Most bank loans are made with a commitment to a firm • Syndicated loan: corporate loan made by a group (or syndicate) of banks and other institutional investors 25.4 • Convertible bonds: gives the holder the right to exchange ti for a given number of shares of stock at any time up to and including the maturity date of the bond 25.5 • Straight bond value: what the convertible bonds would sell for it they could not be converted into common stock • Conversion value: is what the bonds would be work if they were immediately converted into common stock at current prices • Option value to wait: raises the value over both the straight bond value and the conversion value • Value of convertible bond = the great of (straight and conversion value) + option value Appendix 2A Short Term Solvency Totalcurrentassets • Current ratio: measure of liquidity = Totalcurrentliabilities o Higher ratio - greater liquidity Quickassets • Quick ratio: measure of liquidity = Totalcurrentliabilities o Quick assets = (current assets – inventories) / difference Activity Totaloperatingrevenues • Total asset turnover = Averagetotalassets o How effectively a firm is using its assets (high is effective) Toaloperatingrevenues • Receivable turnover = Averagereceivables Days∈period o Average collection period = Recievablesturnover o Provide information on the success of the firm in managing its investments in accounts receivable o Liberal credit higher that restrictive credit COGS • Inventory turnover = AverageInventory Days∈period o Days in inventory = Inevnetoryturnover o Speed of production and selling Financial Leverage TotalDebt • Debt ratio = Total Assets Totaldebt o Debt-equity ratio = totalequity Totalassets o Equity multiplier = Totalequity EBIT • Interest coverage = Interest Expense Profitability Netincome • Profit margin = Totaloperatinrevenue o Reflect firm’s ability to produce a product or service at a low cost or to sell it at a high price NetIncome • Return on Assets = Averagetotalassets EBIT o Gross return on assets = Averagetotalassets o ROA = Profit margin x asset turnover Netincome Totaloperatinvrevenue o ROA = totaloperatingrevenue X averagetotalassets Netincome ' • Return on Equity = Averageshareholders equity o ROE = profit margin x asset turnover x equity multiplier Cashdividends • Payout ratio = Netincome annualretainedearnings • Retention ratio = netincome • Sustainable growth rate = ROE x Retention ratio • Market price: price that buyers and sellers establish when they trade the stock • Price / earnings ratio: the ratio of market price for a stock to its current annual earnings per share Divident pershare • Dividend yield = Market priceper share • Market / book value: calculated by dividing the market price per share by the book value per share 29.4 • Credit information: (1) financial statements (2) credit reports on customer’s payment history with other firms (3) banks (4) the customer’s payment history with the firm • 5 Cs of Credit o Character: the customer’s willingness to meet credit obligations o Capacity: the customer’s ability to meet credit obligations out of operating cash flows o Capital: the customer’s financial reserves, or how much net worth the borrower has o Collateral: a pledged asset in the case of default o Conditions: general business conditions, which affect the customer’s ability to repay • Credit scoring: (1) calculating a numerical rating for a customer based on information collected, (2) granting or refusing credit based on the result 20.1 • Securities act: sets forth the provincial regulations for all new securities issues involving he province of Ontario and the Toronto Stock Exchange 20.2 • Preliminary prospectus: contains some of the financial information that will be contained in the final; not price • Red herring: a name for preliminary prospectus because of bold red letters “approved” or “disapproved • Tombstone: ad that contains the name of the company whose securities are involved • Steps in public offering: (1)
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