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Terms in this set (194)
Maturity: most perpetual.
Dividends: fixed coupon, usually paid quarterly, may be cumulative or non-cumulative.
Par Value: typically $25, $50, or $100.
Rights: Non-voting, non-participating.
Basic Features: May carry credit ratings [like bonds], sometimes convertible [to CS], often callable.
Liquidation Priority: lower than debt, higher than common stock.
Dividends: fixed coupon, usually paid quarterly, may be cumulative or non-cumulative.
Par Value: typically $25, $50, or $100.
Rights: Non-voting, non-participating.
Basic Features: May carry credit ratings [like bonds], sometimes convertible [to CS], often callable.
Liquidation Priority: lower than debt, higher than common stock.
Five Requirements for Two Stage Growth Model1) Supernormal Growth Rate
2) Length of Supernormal Period
3) Industry Average Growth Rate
4) Required Return
5) Recent DividendCommon Stock (Two Stage Growth Model)-Public Company Elections: Cumulative VotingPermits Minority Participation
Total # Votes for Each Shareholder is Determined First [Vote
Calculation: # Shares x # Directors to be Elected]
Directors are Elected All at Once and Shareholder May
Distribute Votes Any Way He/She Wishes-Public Company Elections: Straight VotingDirectors are Elected One at a Time
Prevents Minority Influence
Each Shareholder Receives Full # Votes for Each BOD Seat
[Vote Calculation: # Shares = # Votes]-Dealeran agent who buys and sells securities from own inventory.Three Attributes of Dealers1) Profit From Bid/Ask Spread: buy at "bid" price and resell at slightly higher "ask" [i.e. offer] price.
2) Function as "Market Makers:" dealers at large international banks execute trade requests without confirmed counterparty.
3) Maintain "Inventory" Position: must stand willing at all times to buy and sell stocks in which they specialize; always maintain "inventory" position.Brokeragent who arranges security transactions among investors; does not sell from own accounts; receives commissions.Primary MarketPublic Offering vs. Private Placement
Private companies that seek to raise capital through issuing securities have two options: offering securities to the public or through a private placement.Secondary MarketOne owner or creditor selling to anotherDealer Market1) Dealer buy and sell for themselves at own risk
'2) Over-the-Counter [now electronically connected]
Example: NASDAQAuction Market1) Primary purpose to match other buyers and sellers
2) Exchange has a physical location [Wall Street]
Examples: NYSE, TSE, LSECapital Budgeting: process of planning for purchase of long-term assets3 Capital Budgeting Primary Concerns: size, timing and risk of cash flows.Payback Period:the number of years needed to recover the initial cash outlay.
How long will it take for the project to generate enough cash to pay for itself [not considering the time value of money]?4 Drawbacks of Payback Period1) Subjective Cutoffs
2) Ignores TVM
3) Ignores IRR: Not consider any required rate of return.
4) Ignores Some CF: Not consider all project cash flows [creates bias against LT projects and/or new projects].Net Present Valuethe total PV of the annual net cash flows less the initial outlay.
Is what we are receiving worth more today than what we have to give up? [Inflows:+; Outflows: -]
If NPV is positive = ACCEPT
If NPV is negative = REJECTSometimes qualitative factors lead to the decision to ACCEPT a BLANK NPV project.negativeProfitability Indexhelps interpret NPV. It allows the analyst to control [scale] for the initial outlay to give management the sense of return.
[Accept if PI>1.]How to solve for NPV?Year 0 = initial outlay
Solve for NPVInternal Rate of Returnrate of return the firm earns on its capital projects.
Considered differently, the IRR is the rate of return that makes the NPV equal to ZERO
[cash inflows = cash outflows].
no discount rate requirement for calculation.
If IRR is > or = to the required rate of return: ACCEPT.IRR cannot be used to choose betweenmutually-exclusive projects!MACRSDepreciation = cost x percentage
Cost [i.e. basis] NEVER changes
Percentage determined by life [see tax code]
Half Year Convention Adds ONE year to life
MACRS: Cost x Annual % From MACRSStraight-LineDepreciation = [(cost - salvage)/ life]Operating Cashflow formula =OCF = (Sales - Costs)*(1- Tax Rate) + (Depreciation * Tax Rate) +/- ∆NWC-Incremental Costsadditional cash in minus additional cash out. Capital budgeting focuses on the INCREMENTAL cash flows!-Opportunity CostsCONSIDER.
MUST consider; relevant to decision; finite capacity-Sunk CostsIGNORE.
Do NOT consider; irrelevant to decision; irretrievable-Variable Costs-Fixed CostsPotential Components for Initial Outlay(Purchase Price of the Asset)
+ (Sales Tax)
+ (Shipping and Installation Costs)
+ (Maintenance Costs)
= (Depreciable Asset)
+ (Investment in Working Capital)
+ After-Tax Proceeds from Sale of Old Asset
= (Net Initial Outlay)What incremental cash flows occur over the life of the project?+ Incremental Revenue
- Incremental Costs
- Depreciation on Project
= Incremental Earnings Before Taxes (EBT)
- Tax on Incremental EBT
+ Incremental Earnings After Taxes (or NI)
+ Depreciation Reversal
= Annual Cash FlowCapitalization of Initial Outlay (amount you will use for depreciation calculations)Capitalize ONLY expenses related to new project.
Annual Cash Flows [Use Formula]
Gain/Loss on Sale of Old Equipment
Potential Missed Old Depreciation
Change in NWCWhat is the cash flow at the end of the project's life?Use the Annual Cash Flows slide and also include:
+ Salvage Value
+/- Tax Effects of Sale Gain/Loss
+ Recapture of NWCWhat do you pay sales tax on in the initial outlay?ONLY on the equipment purchase. Nothing Else!Of the initial outlay, what amount do you capitalize (base your depreciation expense on)?EVERYTHING except for NWC.3 Steps to Solve Tax on Equipment Sales1) Calculate Current Book Value
2) Compare Book Value to Selling Price
- If BV > Selling Price = Loss = BV - Selling Price
- If BV < Selling Price = Gain = Selling Price = BV
3) Calculate Tax Shield/Liability
- Net Gain (Loss) * Tax Rate
- Loss = Cash Benefit = INFLOW
- Gain = Cash Deduction = OUTFLOWTotal Cash Flow From SaleSales Price +/- Tax Shield/LiabilityOrdinary vs Capital GainOrdinary Gain = Original Cost - BV
Capital Gain = Sales Price - Original Cost3 Capital Rationing IssuesRisk Evaluation: LT projects inherently risky [$ committed longer, estimation error increases, obsolescence, etc.].
Marginal Cost Varies: all capital not cost same [rate may increase = initial size increases, time lengthens, capital structure changes, # projects expand, etc.]
Patient Capitalism Focus: shareholder wealth being maximized? [wait for better opportunity ].Capital Rationing (Determine which of the many projects to choose - you don't have $ for all, so you just have to choose some)Step 1: Rank Projects By IRR
Step 2: Compare Marginal Cost of Capital to IRR
Step 3: Choose Project if IRR > Marginal Cost of CapitalTwo Problems with Project Ranking1) Size Disparity Problem: mutually exclusive projects of unequal size.
2) Time Disparity Problem: mutually exclusive projects of unequal lives.The project with the largest NPV does not also have the highest IRR or PI. What should you do?Select the projects with the largest NPV.Can you make a direct comparison of NPV for two capital budgeting projects if they have different lives?NO!Equivalent Annual Cost (EAC):method used to evaluate and rank projects of unequal lives, but equal risk.EAC Income Analysis:
& calculator stepsthe annual after-tax inflow in present value terms for each option; choose HIGHEST option.
Find NPV
cash0 = negative cash outlay
Use NPV as PV and find PMT.Annual After-Tax Operating Cash Flow =NEGATIVE Annual Before Tax Operating Cost x (1-Tax Rate)
PLUS
Depreciation Tax Shield: Annual Depreciation x Tax Rate
= Annual After-Tax Operating Cash FlowEAC Cost Analysis:
& calculator stepsthe annual after-tax cost in present value terms for each option; choose LOWEST value.
Find the Annual After Tax Operating Cash Flows
Find the PV of that for its life (using previous # as PMT)
Add that (PV) to the initial outlay (negative)
THIS EQUALS YOUR NPV
THEN FIND THE PMT OF THAT NPV using NPV as PV
CHOOSE THE LOWER COST4 Attributes of Project Financing ProjectsLong-Term Capital Projects
Long in Life
Large in Scale
Generally High in RiskAn NPV calculation is only correct on average;it will not be exactly right in any one case.Two Goals for What-If Analysis
3 different What-If-Analysis1) Assess Degree of Forecasting Risk
2) Identify Key Variable[s] with Greatest Impact on NPV
Scenario, Sensitivity & SimulationScenario Analysis:What happens to the NPV under different cash flow scenarios?
Begin with most likely CF estimates [base case], then apply an upper bound and lower bound on each component of project.What is typically the most difficult cash flow component to forecast?SalesSimulation Analysis:expanded sensitivity and scenario analysis that considers a large number of potential scenarios; computer assistance is typically needed.Why is the discounted cash flow (DCF) analysis not a perfect, holistic method of capital budgeting evaluation?DCF is unable to evaluate strategic alternate options available for an individual investment.Real options analysis isthe application of the option theory to capital budgeting decisions.
cross between decision-tree analysis [mutually exclusive choices and outcomes] and pure option-based valuation [rights vs. obligations].Four Alternatives Considered in Real Options Analysis1) Option to Defer
2) Option to Abandon
3) Option to Alter Capacity
4) Option to Start Up or Shut DownEight Complexities of Multinational Capital Budgeting
How Do We Account for These Complexities?1) Foreign Exchange Rate Risk
2) Host-Government Subsidized Loan
3) Potential Worldwide Cannibalization
4) Terminal Value Estimation
5) Political Risk
6) National Inflation Rate Differences
7) Market Segmentation
8) Differentiate Parent vs Project CF
Adjust cash flow estimates
Adjust discount rateWhat are Three Ways to Identify (Evaluate) Foreign Projects as "Good" Investments?1) Expected Return > Host Country Government Bond Yield
2) Expected Return > Local Competition Return
3) Expected Return > or = Shareholders' Expectations7 Firm Benefits from Mergers & Acquisitions1) Gain access to strategic, proprietary assets
2) Gain market power and dominance
3) Achieve synergies in local/global operations and across different industries
4) Become larger—reap benefits of size in competition and negotiation
5) Diversify and spread risks wider
6) Reduce taxes [use tax losses, unused debt capacity, surplus funds]
7) Capacity optimization and reduce capital needs by spreading fixed NWC over more assetsCross- Border Merger & Acquisitions PROS (4)1) Tend to be quicker to achieve than starting from scratch
2) May be cost-effective
3) Eliminate competition
4) International market imperfections may allow target firms to be undervaluedCross- Border Merger & Acquisitions CONS (4)1) Easy to pay too much
2) Corporate cultures may clash
3) Potential host government interference
4) Even if control, must use more negotiating for buy-in [support]MERGER PREMIUMS:
Acquiring firms must...pay a premium to takeover a target firmMERGER PREMIUMS:
Target firm's stand-alone value...is different than the value gained by the acquiring firm.MERGER PREMIUMS:
Why is there a premium? (2)Value of control
Value of synergiesHerfindahl-Hirschman Index (HHI):measure of industry concentration. Calculated by summing the squares of the individual firms' market share. The highest HHI measure is 10,000.HHI Example: Assume a market consisting of four firms with market shares of thirty percent, thirty percent, twenty percent, and twenty percent has an HHI of2600 (302 + 302 + 202 + 202 = 2600).Breakeven Point FormulaTotal FC
DIVIDED BY
Unite Contribution MarginContribution Margin Formula(Unit Sales Price - Unit VC)
DIVIDED BY
Unite Sales PriceHorizontal v. Vertical v. Conglomerate AqusitionsHorizontal: firms are in the same industry
Vertical: Firms are in different stages of the production process
Conglomerate: firms are unrelated.Three Evaluations of RISK:1) How to MEASURE Risk
2) How to REDUCE Risk
3) How to PRICE RiskHow to MEASURE Risk (3)variance, standard deviation, betaHow to REDUCE Risk (2)correlation, diversificationHow to PRICE Risk (3)security market line, CAPM, Build-UpRisk-Return Tradeoff:In order to increase potential return on an investment the corresponding risk must also increase. This line levels off rather than increasing forever due to the ability of an investor to diversify away firm-specific risk. Taking on greater risk does not guarantee greater return.Business Risk-Unsystematic Risk (i.e. Idiosyncratic or Firm Specific Risk)firm specific risk; can be diversified away.-Systematic Riskmarket risk; cannot be diversified away.Diversificationa portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio.Correlationrefers to the way two variables co-move. It is a unitless measure bounded by +1 and -1.-Variance-Standard Deviation (Definition)a measure of the dispersion of possible outcomes.
the greater the standard deviation...
the greater the uncertainty and...
the greater the RISK.-Standard Deviation (Calculation)[(Expected Return - TOTAL Expected Return) ^ 2] * Probability
PLUS
[(Expected Return - TOTAL Expected Return) ^ 2] * Probability
PLUS
[(Expected Return - TOTAL Expected Return) ^ 2] * Probability
= TAKE THE SQAURE ROOT OF ALL OF THOSE SUMMED.-Probability (Mutually Exclusive and Exhaustive)-Expected vs. Unexpected Return (Definition)Expected Return CalculationProbability per state * Expected Return per state
PLUS
Probability per state * Expected Return per state
PLUS
Probability per state * Expected Return per state-Required Returnreturn an investor requires on an asset given its particular risk.Security Market Line (SML)all stocks can be graphed on the security market line. As the risk for the individual security increase, the return also increases in a linear manner.
all stocks can be graphed on the security market line. As the risk for the individual security increase, the return also increases in a linear manner.
If every stock
is on the SML,
investors are being fully
compensated for risk.If a security is above the SML, it is...
If a security is
below the SML, it
is...If a security is above the SML, it is underpriced.
If a security is
below the SML, it
is overpriced.ESTIMATED BETA(Correlation between Security and Market) (Standard Deviation of Individual Security Returns)
DIVIDED BY
Standard Deviation of Market ReturnsHolding Period ReturnE(r) = (P1-P0)/P0-Overvalued vs. Undervalued StockCapital Asset Pricing Model (CAPM):describes the linear relationship between risk and expected return.
CAPM is the preferred method for pricing risky securities.CAPM Equation =expected required return on security + [beta * (expected required rate of return on market portfolio of stocks/market index - expected required return on security)]If not, if Liz sold the stock for $58 in one year, what price should she pay for Hanley Homes stock today to earn the CAPM return?FV = Listed Price in the future
N = 1
I = CAPM
PV = Solve ForIf Liz purchased the stock today for $52, what is the correct selling price in one year to earn the CAPM return?FV = Solve for
N = 1
I = CAPM
PV = Listed Selling Priceundervalued =
overvalued =undervalued = BUY
overvalued = SELLRegular Cash Dividend:most common; cash payments made directly to stockholders, usually each quarter."Extra" Cash Dividend:indication that the "extra" amount may not be repeated in the future."Special" Cash Dividend:similar to extra dividend, but definitely will not be repeated.Liquidating Dividend:some or all of the business has been sold.Declaration Date
(Definition/Calculation):board of directors declares the dividend.-Ex-Dividend Date
(Definition/Calculation):takes 2-3 business days for stock sale to "settle" and reflect ownership changes; reason ex-dividend date before record date; stock price drops by dividend amount
Calculation: 2 BUSINESS days before Declaration Date (can't be a weekend or a holiday)What is the effect on the share price on the ex-dividend date? Why?Share price generally drops by amount of the dividend. Everybody knows when dividend is paid and market sees dividend as a profit distribution. $42.61 - $0.75 = $41.86When does a shareholder have to own the stock to be entitled to a divdidendThey must purchase it BEFORE the ex-dividend date and not sell it before that date.-Record Date
(Definition/Calculation):owners of stock on this date receive dividend.-Date of Payment
(Definition/Calculation):checks are mailed or electronic funds transferred to owners as of record date.Qualified Dividendsa type of dividend to which capital gains tax rates are applied; lower rate than regular income tax rates.Qualified Dividends (Calculations)Qualified Dividends (Three Requirements)1) Dividend must be paid by an American company or a qualifying foreign company.
2) Dividends not specifically listed with IRS as dividends that do not qualify [Organized as regular corporation, not organized under special tax laws, e.g. REITS].
3) Required holding period has been met.-Dividend Yield (Definition)a dividend expressed as a percentage of a current share price.Dividend Yield (Calculation)Annual Dividend/Current Price-Capital Gain (Definition/Calculation)Price 2 - Price 1
DIVIDED BY PRICE 1Total One Year ReturnPrice 2 - Price 1 + DIVIDEND 2
DIVIDED BY
PRICE 1What 2 equations do you use to find out the Current Price of a Company?Use EPS and P/E Ratio to find outEPS =Net Income
DIVIDED BY
# of SharesP/E Ratio =Price
DIVIDED BY
EPSCompany's Total Holding Period =[(Current Price of Company - Purchase Price + Dividend Per Share Price + (Total Dividends / Total Shares)]
DIVIDED BY
Purchase Price-Stock Dividend (Definition/Impact)
-Large & Small DividendsFirm gives stockholders additional shares of own stock or shares in another corporation (such as subsidiary).
Small Dividends < 20 to 25%
Large Dividends > 20 to 25%Stock Dividend
5 Impacts1. New shares issued in proportion of shares owned.
2. Increases number of outstanding shares.
3. Increases market cap and total firm value.
4. Reduces the original cost basis per share.
5. Not included in gross income for tax purposes.-Stock Split (Definition)company divides existing shares into multiple shares; expressed as a ratio.
Firms do this to return price to "a more desirable trading range"Stock Split
2 Impacts1) Share Prices Reduced
2) Firm Value Unchanged: Doesn't add any real value; without information asymmetry overall firm market cap remains the same.-Stock Repurchase (Definition)reacquisition by a company of its own stock; more flexible way [relative to dividends] of returning money to shareholders-Stock Repurchase (Process)Shares either retired or kept as treasury stock, available for reissuance.-Stock Repurchase (Participants)Investors control decision to receive current cash flow and associated tax consequences.-Stock Repurchase vs. Cash Dividend Information ContentSTOCK REPURCHASES:
Sends a positive signal that management believes the current price is low (tender offers are a stronger signal than open market offers).
A repurchase today doesn't imply the timing of a future repurchase.
Sends a signal that managers are disciplined and don't plan on empire building.
Stock price often increases when repurchases are announced.-Stock Repurchase vs. Cash Dividend Information ContentCASH DIVIDENDS
Sends a signal that recent/current profitability will continue in the future.
Sends a signal that managers are disciplined and don't plan on empire building.
Can send a signal that current investments opportunities in the firm are limited.
Stock price often decreases by something close to the dividend amount on the ex-dividend date.-4 Guiding Principles for Payout Policy (List/Implication)1) SIGNALING
2) INVESTOR TAXATION
3) POTENTIAL AGENCY PROBLEMS
4) REDUCE FUTURE FLOTATION COSTSSIGNALINGManagers have inside information. If they choose to increase dividends it signals expectations for the future financial health of the firm.INVESTOR TAXATIONInvestors with high tax rates for dividends would prefer capital gains created by the firm holding the cash and/or using it rather than paying it out as a dividend.POTENTIAL AGENCY PROBLEMSCapital market interaction provides management oversight. Huge cash balances may lead to agency problems as managers use internal funding without any capital market monitoring or feedback.REDUCE FUTURE FLOTATION COSTSAccumulating cash rather than distributing cash reduces the need for future security issues. This reduces future flotation costs.-Dividends: What We Know (And Do Not Know)
(3)1. Corporations "smooth" dividends.
2. Dividends provide valuable information to market.
3. Corporations rarely change their dividend policy.Firms Should Follow a Sensible Dividend Policy:
(3)1. Don't forgo positive NPV projects to pay a dividend.
2. Avoid issuing stock to pay dividends.
3. Consider stock repurchase when there are limited better uses for excess cash.Payout RatioDIV / NET INCOMESGR =ROE x b
DIVIDED BY
1 - (ROE x B)GROWTH MODEL STOCK PRICEDividend0 * (1 + SGR)
DIVIDED BY
(Required Rate of Return - SGR)LIFE CYCLES OF BUSINESSDevelopment: Seed & Launch
Start-Up: Growth
Expansion: Team Building
Maturity: Sustain & Produce
Transition: Sell/ReinventLifecycle of a BusinessStartup
Rapid Growth
Maturity
Decline
Rebirth OR DeclineFive Primary Methods for Firms to Acquire Capital1) Issue Bonds
Example: corporate bonds, zero coupon, eurobonds, foreign bonds, etc.]
2) Borrow Funds
Example: bank loans, syndicated credits, commercial paper, credit lines, euronotes]
3) Issue Preferred Stock
4) Issue Common Stock
5) Use Profits [Retained EarningsCapital Source: How Do Firms Decide?Industry and Life Cycle Stage of Firm
Volatility of Sales and EBIT
Collateral Value of Assets
Availability of Capital
Diversification of Cash Flows
Foreign Exchange Risk
Credit Risk vs. Repricing Risk
Investor Return Expectations
Existing vs. Target Capital Structure
FRICTO Analysis [Flexibility, Risk, Income, Control, Timing, Other]Weighted Average Cost of Capital (WACC):weighted average cost of pooled financing sources; the cost for a firm to hold $1 of capital for 1 year.WACC Calculation Steps:1) Determine unique costs of each individual financing source.
2) Use market values to determine weight of each individual source relative to the entire pool of funds.
3) Multiply individual costs by weight and apply tax shield [if applicable].WACC FormulaInitial Public Offering (IPO):first public issue of a firm's equity shares.External Equity(i.e. new common stock issue)Internal Equity(i.e. retained earnings)Is the cost the same for external equity and internal equity?It Depends...But External Equity Usually More ExpensiveWhy is External Equity More Expensive?Flotation CostsSince external equity is more expensive than internal equity, why do firms use it?Increase Growth Rate Potential: To grow faster than the sustainable or internal growth rate, a firm must raise external funds.Six Categories of Flotation Costs1) Gross ["Underwriting"] Spread: paid to underwriting syndicate for assistance
2) Other Direct Expenses: fees not paid to underwriter (e.g. filing, legal, trustee, etc.)
3) Indirect Expenses: opportunity costs, not listed in prospectus (e.g. management time)
4) Abnormal Returns: SEOs; may be viewed as sign of financial problems; 3% price drop
5) Underpricing: sold below true value
6) Green Shoe Option: underwriters' right to buy up to 15% additional shares within 30 days at offer price to cover overallotmentsGross [Underwriting] Spread:difference between underwriting price received by firm and actual price offered to investing public.Gross [Underwriting] Spread Components:1) Takedown: underwriter compensation for selling issue [i.e. commission].
2) Management Fee: paid to lead manager of a syndicate for investment banking services, managing affairs of syndicate and/or structuring the new issue.
3) Underwriter Expenses: miscellaneous fees (counsel, CUSIP, wire, electronic order monitoring, day loan, road show, etc.)Role of an Investment BankOfficial Advisor Role: early appointment of an investment bank is often key for firm success.
Why? Interact with potential investors and know current requirements.
Provide reality check * help navigate:
Institutional Requirements
Regulatory Barriers
Red Herring & Stock Prospectus
Pricing of Equity Issue
Aftermarket to Maintain Initial PriceRights Offering [aka Privileged Subscription]:new issue of common stock offered to existing shareholders to prevent potential dilution; rights may be traded OTC or on exchange.Three Specific Elements of Rights Offering:Number of shares that can be purchased
Purchase price
Time frame until rights "expire"How many rights shall be issued =$ Amount Needed to be Raised
DIVIDED BY
Subscription PriceHow many rights will it take to purchase one share of Horace Heroes?Total Shares Outstanding
DIVIDED BY
# of shares that must be issuedValue of one right =Current Stock Price - X
X = [(# Rights to Buy One Share * Stock Price) + Subscription Price]
DIVIDED BY
# Rights to Buy One Share + 1WACC =(market value of the firm's debt / total market value of the firm's debt & equity) * before-tax cost of debt * (1 - marginal tax rate) + (Market value of the firm's equity / total market value of firm's debt & equity) * risk-adjusted cost of equityWhen is WACC the appropriate discount rate?The WACC is the discount rate for "extensions" of the firm.Can you use WACC for new projects?NO! Each project differs from existing projects in business or financial risk.Pre-Tax Cost o Debt =The prime rate plus basis pointsCost of Equity =The long-term T-bond rate + the equity-risk premium * amount more risky than the marketFinancial Distress definitionCondition when firm's promises to creditors are broken or honored with difficulty. May lead to bankruptcy.Bankruptcy:Legally declared inability [or impairment of ability] of individual or organization to pay creditors. This is a legal proceeding for liquidating assets.What are examples of financial distress costs?Legal costs
Managers' time and lost focus
Employee disruption
Lost trade credit
Lost salesFirms in distress do what?burn up real resourcesLiquidation:Process by which a company [or part of a company] is brought to an end, and the firm's assets and property is sold and redistributed.Operating Leverage:use of fixed production costs rather than variable production costs.Financial Leverage:use of fixed cost sources of financing [i.e. debt or preferred stock] rather than variable cost sources [i.e. common stock].Pecking Order:firms prefer internal funds, then debt, then equity funding.
Very profitable firms may never need external financing; end up with little or no debt.Three Pecking Order Implications1) No Target Capital Structure
2) Profitable Firms Use Less Debt
3) Companies Want Financial SlackStatic Tradeoff:tradeoff between benefits of tax shield with costs of financial distress.Franco Modigliani and Merton Miller:credited with forming the basis of modern thinking on capital structure.M&M Theorem:Under specific conditions, there is no unique capital structure that maximizes firm value.
[Firm market value is independent of the choice of financing policy.]Capital Restructuring:changing the firm's financial leverage without changing the firm's assets.How do you increase leverage?issue new debt and/or repurchase outstanding sharesHow do you decrease leverage?issue new shares and/or retire outstanding debtBreakeven Point:when revenue received equals the costs associated with receiving the revenue.Supply-Side Analysis:only analyzes costs of sales, not how demand is affected at different price levels.Industry Level Considerations for DebtVolatility of Cash Flows
Seasonality of Sales
Heavy Reliance on Intangibles (borrow less)
Sensitivity to Downturns (Elasticity)
Tangible Assets/Secondary MarketsFirm Level Considerations for DebtManagement Preferences
Exposure to Bankruptcy
Tax Rate(s)
Tax Shield Sources (i.e. accumulated losses, depreciation, etc.)Plowback Ratio =1-Payout Ratiob isthe plowback ratio
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