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(1-TC)

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

InsolvencyDefault- 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 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

OS

Price/

Unit

Market

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

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)