The Z-Score Model: Private, Non- Manufacturers Altman ’ s Z-Score = 6.56*(NWC/Total Assets) + 3.26*(Accumulated RE / Total Assets) + 1.05* (EBIT/Total Assets) + 6.72* (BV Equity / Total Liabilities) Z-Score < 1.23 indicates high probability of bankruptcy Z-Score between 1.23 and 2.90 is a grey area Z-Score > 2.90 indicates a low probability of bankruptcy
31 Tax Effects and Financial Distress There is a trade-off between the tax advantage of debt and the costs of financial distress. The firm ’ s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. It is difficult to express this with a precise and rigorous formula. Tax Effects and Financial Distress
32 The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy lawyers, respectively. Tax Effects and Financial Distress
33 The Pie Model Revisited V T = S + B + G + L The essence of the M&M intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie. S G B L Tax Effects and Financial Distress
34 Tax Effects and Financial Distress Maximum firm value Optimal amount of debt Debt ( B ) Value of firm ( V ) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B * Tax Effects and Financial Distress
35 Tax Effects and Financial Distress Optimal amount of debt Debt ( B ) Cost of Capital (%) 0 B * Tax Effects and Financial Distress R WACC R o
36 Other theories that address the level of debt 1. Signaling Investors view debt as a signal of firm value. Firms with low anticipated profits will take on a low level of debt. Firms with high anticipated profits will take on a high level of debt. Signaling
37 Signaling A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run. Signaling
38 2. Agency Cost of Equity An individual will work harder for a firm if he is one of the owners than if he is one of the “ hired help. ” While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. Agency Cost of Equity
39 Agency Cost of Equity The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases. Agency Cost of Equity
40 3. The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.
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- Fall '15