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
VL=VU+TCXD

The Optimal Capital Structure and the Cost of Capital

Rdx(1TC )

Three Cases of Capital Structure

• With financial distress • As debt pass optimal level, return for debt increase and tax rate decrease but at a slower pace

Financial Distress Definitions
Insolvency 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. Vfirm

Balance Sheet considering bankruptcy
Assets Business Assets PV of Interest Tax Shield -PV of Bankruptcy Costs Total Assets Liabilities and OE Debt* Equity* 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 OS Price/ Unit $32.50 $13.50 Market Value $2.99 billion $.325 billion $.194 billion

Common Stock 115,000,000 $26.00 Preferred Stock 10,000,000 Warrants Bonds 14,400,000 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 $2,500,000 $5,000,000 $7,500,000 $8,000,000 $9,000,000 $10,000,000 $12,500,000 Probability of Failure % 0.0 8.0 20.5 30 45 52.5 70

Current
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 certainty)