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M&M Capital Structure Theory

Including Bankruptcy/Financial Distress

Advantages of Debt
– Cheaper cost
– Tax Shield creates value for shareholders
– Avoid dilution of ownership
– Discipline
• increased leverage correlated with higher
operating margins and returns
• Firms subject to hostile takeovers were usually
underleveraged and had lower returns
• LBO resulted in higher subsequent share prices
Disadvantages of Debt
• Decreased Flexibility; less cash
• Agency costs (debt holder equity holder agency
costs) ie covenants or other restrictions places
on firm by lenders (leverage (debt), liquidity
(cash), dividend)
• Cost increases as risk increases (marginal cost
of debt increases by some premium or taking
collateral to compensate for risks of bankruptcy)
• Expectation of bankruptcy/financial distress
– Increases with EBITDA/(Principle + interest)
– Variability of EBITDA
The Optimal Capital Structure
and Firm Value
The Optimal Capital Structure
and the Cost of Capital

TC )
Three Cases of Capital
• With financial distress
• As debt pass optimal level, return for debt
increase and tax rate decrease but at a
slower pace
Financial Distress Definitions
Default- anytime if contract is violated and lender
have right to call the loan

Consequences of insolvency
• Bankruptcy
– Petition for bankruptcy
• Bankruptcy Liquidation
• Bankruptcy Reorganization
• Trustee put in place to allow for orderly disposal of asset
(more time given, like by unprotected creditor)
• Might get the debt contract changed or more investment
M&M and bankruptcy
Direct Costs
- legal, accounting, trustee fee

Indirect Costs
- Lose of customer payments,
reputation/credibility, employee efficiency
reduce, lost of talents, might result in over or
under investment projects, no tax shield,
competitor might move in
Vfirm (with debt, tax and bankruptcy)

V unlevered
+ PV tax shield -
- PV costs of financial distress.
Balance Sheet considering bankruptcy
Assets Liabilities and OE

Business Assets Debt*

PV of Interest Tax Shield
-PV of Bankruptcy Costs Equity*
Total Assets Total Liab & OE

*both debt and equity have lower values when there

is increased risk of bankruptcy (compared to no risk
of bankruptcy)
Vfirm (with debt, tax and bankruptcy)
Expected cost of bankruptcy

= Cost bankruptcy x Probability bankruptcy

Probability bankruptcy increases with:

- economy
- operating risk (cash flows)
- leverage
- nature of asset
Bankruptcy Question #3 Chrysler p23
Security # units Price/ Market
OS Unit Value
Common Stock 115,000,000 $26.00 $2.99 billion
Preferred Stock 10,000,000 $32.50 $.325 billion
Warrants 14,400,000 $13.50 $.194 billion
Bonds 2,000,000 $650.00 $1.3 billion

$ 2 billion loss carry forwards,

estimated 5 years before profits exceed $2 billion
Warrents – option to buy the firms shares at a
price in future
- Result in diluted CS if exercise
- From bond, see that hugly discount, so market
rate is much higher, will have to issue higher
coupon rate
- No more tax shield benefit, so cost of equity will
go up by a lot, higher financial distress cost
- So better to issue CS
Bankruptcy Question #4 Nadir Inc
Value of Debt Probability of Failure %
$2,500,000 0.0
$5,000,000 8.0
$7,500,000 20.5
$8,000,000 30
$9,000,000 45
$10,000,000 52.5
$12,500,000 70
Tax rate =40%
Unleverage return= 15%
EBIT 2 million
Value = 12 million

PV of bankruptcy cost is 8 million

• If a big company get broken down, cause
operating risk to increase, lead to lower
financial risk
• A high operating risk company wants
lower financial risk, less use of debt
(reduce cash flow, make firm less flexible)
• As company/ industry matures, operating
risk tends to reduce (lower return, higher

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