FIN 302- Final Cheat Sheet (Madalyn)

FIN 302- Final Cheat Sheet (Madalyn) - Capital Structure...

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Capital Structure affects the WACC, lower can find more +NPV proj, fund proj with all debt or all eq, similar for firms in similar industries Mgrs like mostly eq firms (less risk of bankruptcy) 1. No taxes, no bankruptcy = cap structure irrelevant value if all debt=coup/disc, value if all eq=div/disc 2. No bankruptcy, +Tc = 100% debt (EBIT-Int=EBT-Tax=NI), V all debt=int/r, V all eq=div/r, V lev =V unlev +TcD 3. Cost of debt ≠ eq , as leverage inc, cost of eq inc V (L) = V (U) + T c D r E,(levered) = r (E, unlev) + (r (E, unlev) – r D ) (1- T c )(D/E) 4. +Tc, no personal taxes, bankruptcy costs (BC increase as $D increases) = optimal cap structure, if high Tc, high slope, D* shift right if high fin distress costs, D* shift left R e,L = WACC= No taxes, no bankruptcy = irrelevant Corp taxes+, no bankruptcy = 100% debt Costs of Financial Distress: loss in firm value as likelihood of bankruptcy increases: Cost of lost business , Cost of lost employees , Under-investment Problem , Variability of the market value of their assets Bankruptcy costs =Legal fees, Costs of FIN distress (V firm goes down as bankruptcy likelihood up) 1. Cost of lost business (higher with co’s that produce goods w/ valuable warranties, durable good, Ford>Kroger) 2. Cost of lost employees (higher for co’s w/ high- skilled or industry w/ worker shortage, Pfizer>McDs) 3. Under- investment problem (reject +NPV b/c can’t raise capital, esp. not eq) 4. Variability of MV of assets (assets lose value if bankruptcy coming, high for retail w/ seasonal inv, high for software with new tech coming quickly, low for stable value like Marriott (vs. Encore Software). Firms with high variance (MV) assets should use less debt. Games firms play: a) Asset substitution =substitute risky assets for safe, 90% chance lose all 10,000, 10% chance earn 50,000+10,000 invested NPV=-4000 Firm= A: 15,000 / L+E: 12000 D, 3000 E Upside= A: 65000 / L+E: 12000 D, 53000 E Downside= A: 5000 / L+E: 5000 D (owe 12000), 0 E Incentive for higher risk investment b4 bankruptcy E[eq]=.9(0)+.1(65000-12000)=5300, only issue eq if less than 5300 for this investment. b) Underinvestment c) Cash-in & Run (Take money out of a financially-distressed firm) d) Bait (Start with a conservative policy, change to a risky one) Allow firm to issue a cheaper debt. Personal taxes ≠0 Tpd=personal T of debt, Tpe=personal T of eq (only div, not cap gain), Tc=corp tax rate BC= bankruptcy costs. $1EBIT(1-Tc)(1-Tpe)>$1EBIT(1- Tpd) chose all eq if BC or no +BC $1EBIT(1-Tc)(1-Tpe)=$1EBIT(1- Tpd) irrelevant if no BC, chose all eq if +BC $1EBIT(1-Tc)(1-Tpe)<$1EBIT(1- Tpd) chose all debt if no BC, optimal level if +BC V L = V L = V U + [1 – (1-T c ) (1- T pE ) ] D (1-T pD ) ***Debt reduces agency costs / Firms become takeover target if under or overuse debt / cost of FIN distress increases, use less debt / cost of eq increase, use more debt / if div tax rate permanent, less tax on eq, use more eq less debt / larger firms
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FIN 302- Final Cheat Sheet (Madalyn) - Capital Structure...

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