I.%20Debt%20and%20value

I.%20Debt%20and%20value - 1 I. Debt and value We examine...

Info iconThis preview shows pages 1–10. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: 1 I. Debt and value We examine two important stories for the benefit and cost tradeoffs from using debt. Later we will examine more stories A. Tax shields and bankruptcy cost B. Agency costs of debt and equity C.Sum up 2 Income Statement Sales t COGS and SG&A t EBDITA t Earnings before depreciation, interest and taxes D DEP t Depreciation EBIT t Earnings before interest and taxes Interest Expense t The borrowing rate times the par value; r B B EBT t Earnings before taxes Taxes t T x [ EBIT r B B ], where T is the tax rate NI t Net Income ( Profit ); (1 T )x[ EBIT r B B ] 3 A. Debt tax shields and bankruptcy cost Look at the tax shield from the debt, Company U Company L TxEBIT Tx[EBIT - r B B] TxEBIT TxEBIT - Txr B B Co. L pays Tr B B less in taxes. This is worth L u B B Tr B TxB. So V V TB r = = + 4 Example I.1, Debt tax shield EBIT = $150, T=30%, and r A = 13.33%. The firm issues $375 in perpetual bonds, at interest cost of 8%. By how much does firm value change? Per period tax savings are Tr B B = $9.The present value of these savings is Tr B B/ r B = TB = $9/.08 = $112.5! 5 Bankruptcy The firm is in financial distress when operating cash flows are insufficient to meet current obligations, and the firm must take some sort of corrective action. But bankruptcy alone does not destroy value (it is priced in-a zero sum game in which some win and some lose). It is bankruptcy cost that destroys value. 6 The Absolute Priority Rule Claims are fully satisfied by seniority. Creditors: n Secured: Paid first, may not be paid in f ull n Unsecured: Paid after secured is paid in f ull may receive nothing Equity holders: Paid last and likely paid nothing 7 How to go bankrupt? Private workout: n Lower direct costs than bankruptcy n Fewer advantages f or stockholders, since absolute priority tends to be violated in bankruptcy settlements Formal bankruptcy: n Allows DIP debt that is senior to outstanding n Tax carry-forwards are preserved n Easier for more complicated capital structures 8 Expected bankruptcy cost Direct costs (2% to 5%) are legal expenses, accounting fees, and administrative costs. Indirect (17%) costs are sales lost due to heightened chance of bankruptcy. Ex ante, expected costs are smaller depending on the probability of bankruptcy E[BCost] = P bankrupt (Lev) x BankruptcyCosts 9 2. Non-debt tax shields Firms may have non -debt tax shields, like depreciation expense, investment tax credits, and loss -carry forwards that compete with the debt interest tax shield....
View Full Document

This note was uploaded on 03/09/2008 for the course FINC 725 taught by Professor Hansen during the Spring '08 term at Tulane.

Page1 / 36

I.%20Debt%20and%20value - 1 I. Debt and value We examine...

This preview shows document pages 1 - 10. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online