Samenvatting
Finance Summary part II
Summary of the second part of the subject Finance for Premaster. The summary covers chapters 14-30 of the book Corporate Finance by Berk and Demarzo.
[Meer zien]Voorbeeld 3 van de 30 pagina's
Voorbeeld 3 van de 30 pagina's
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Finance for Premaster IISummary: Sheets & Literature
Chapters: 14 – 30 ex. 19 and 22
Chapter 14: Equity vs. Debt financing
[14.1]
Capital structure: The relative proportions of debt, equity and other securities of a firm.
When financing a company, it is common that either equity alone or a combination of equity and debt is used.
- Financing with equity alone:
Financing with equity alone is called unlevered equity because there is no debt.
- Financing with a combination of equity and debt:
Financing with equity and debt is called levered equity. The interest costs are deducted from the
cashflows. Hence the cashflows (and thus the NPV) will differ from a project with unlevered equity.
Modigliani and miller argued that the capital structure does not influence the total value of the firm,
because total cashflows equal cashflows of the project.
Leverage (having debt) increases risks of equity of a firm. Therefore the expected return of levered equity is
higher to compensate for the increased risk (table 14.5) but return on assets does not change (CF stays the
same)
[14.2] Modigliani and miller I
Perfect capital markets are markets where:
- Where investors and firms can trade securities for a competitive market price that equals the PV of
future cashflows. (Chapter 14)
- Where no taxes, transaction costs of issuance costs exist for security trading. (Chapter 15)
- Where financing decisions do not change cashflows (of investments) (Chapter 16)
This lead to M&M Proposition 1: The total value of firm’s securities is equal to the market value of total
cashflows and is not affected by the financing decisions.
This is linked to the law of one price. If the tax and other costs are 0, the total cashflows = cashflows from
assets. Therefore the securities and assets have the same market value. M&M also argued that investors could
add leverage to their portfolio by borrowing money (only if they can borrow at the same rate of the firm). This is
called home-made leverage.
Market value balance sheet : has (1) all assets and liabilities of the firm that are (2) valued according to current
market values. Thus:
Market value of equity= Assetsmarket value−Liabilities∧debt market value
Leverage recapitalization: repurchasing shares with debt.
[14.3] Modigliani and miller II
Capital costs of debt < Capital costs of equity. However issuing debt increases the risks (which lead to higher
compensation of equity holders. Which leads to a savings total of 0.
Equity Market value ( E ) + Debt Market value ( D ) =Unlevered equity Market value ( U )= Assets Market value (A )
Or: E+ D=U = A
E D
Unlevered Equity ( RU ¿= RE+ R
E+ D E+ D D
D
Return of levered equity( R E ¿=RU + ( RU −R D )
E
D
- Where RU = risk without leverage and ( RU −R D ) risk due to leverage.
E
- If Returns are replaced with expectations r Wacc =r u =r a
D
Cost of capital levered equity = r u + ( r u−r d ¿
E
E D
Unlevered Cost of capital (WACC pretax) = ( r U ¿= rE+ r
E+ D E+ D D
D
Debt-to-value ratio:
E+ D
The same thing can be done with beta’s. Unlevered beta: measures the market risk of the firm without leverage
E D
(which is equal to the asset beta). β asset =β unlevered equity = β + β
E+ D Equity levered E+ D Debt
D
And thus: β Equity levered=β u + ( β −β d)
E u
,Excess cash/securities/risk-free assets lower the risk of firm assets. Therefore they should always be deducted
from debt. Net debt = Debt – excess cash.
[14.4]
Capital structure fallacies:
- Leverage increases the stock price (X)
- More leverage increases the risk of a company and thus the Earnings Per Share (EPS), but does not
affect the share price.
- Issuing capital increases number of shares, and thus leads to share price decrease (X)
- New shareholders bring their own capital, share prices stay the same.
, [15.5]
The amount of debt that is present within a firm is determined by the industry: high capital intensive industries
require more capital and have therefore more debts. The effective tax advantage is only present when
τ c =0
(τ E−τ I )
Therefore: τ ¿ =1−
(1−τ I )
Other forms of tax shields are: Depreciations, investment tax credits and carryforwards of losses. However in
reality firms take less leverage than they should in order to profit from the tax shield. This is the Low leverage
puzzle. Two possible reasons are: reduce likelihood of bankruptcy and interest payments affect the cashflows.
Chapter 16: Financial Distress, Managerial Incentives and Information
[16.1]
Financial distress: Company has trouble meeting its debt obligations
Default: A situation where the firm fails to make the required interest or principal payments on the debt.
Bankruptcy: Debt holders take legal ownership of the firm’s assets.
[read through example page 584 – 585]
According to M&M there is no disadvantage of debt financing. A firm will still have the same total value and will be
able to raise the same amount from investors with debt or equity financing.
[16.2]
M&M state that bankruptcy does not influence the value of the company. It “Simply” shifts legal owner (from
equity to debt holders). This is far from realistic as bankruptcy is a long and costly process with direct and
indirect cost for the firm and its investors.
The bankruptcy code organizes the bankruptcy process in order to guarantee that creditors are treated fairly
and the value of assets is not needlessly destroyed.
- Chapter 7: Liquidation: Trustee is appointed to oversee liquidation of firm’s assets through auction.
The money earned from the action is used to pay off creditors
- Chapter 11: Reorganisation: All attempts of money collecting of creditors are stopped, firm’s existing
management is given the opportunity to propose a reorganization plan, management still keeps the
business operational, the reorganization plan specifies the treatment of creditors, creditors must vote
to accept plan and bankruptcy court must approve of this plan.
As said earlier, bankruptcy leads to both direct costs and indirect costs:
Direct costs:
- Hiring outside professionals (legal and accounting experts, auctioneers, appraisers (dutch: taxateurs)
- Creditors may incur costs due to costs of legal representation and/or professional advice.
The direct costs can be avoided by talking with the creditors first:
- Workout: successful reorganization outside of bankruptcy
- Pre-packed bankruptcy: development of reorganization in accordance with the main creditors, then file chapter
11 to execute plan. With a prepack, the direct costs are minimal.
Indirect costs: Loss of customers, Loss of suppliers, Loss of employees, fire sale of assets, loss of receivables, delayed
liquidation, costs to creditors (read through page 589 – 591)
Overall the impact of indirect costs of financial distress can be substantial. If you want to estimate this you have to take
into account the following:
- We need to identify losses to total firm value
- We need to identify the incremental losses that are associated with financial distress.
[16.3]
The presence of costs of financial distress do influence the cashflows, thus influence the way we finance a company.
- When securities are fairly priced, the original shareholders of a firm pay PV (Bankruptcy/FD costs).
[16.4]
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