2. Introduction
• A firm’s basic financial resource is the stream of
cashflows produced by its assets and operations.
• Firm financed entirely by common stocks, all
cashflows belong to stockholders.
• Firm’s mix of securities is known as capital
structure
• If debt and equity, firm splits cashflows
– Relatively safe stream that goes to debtholders
– More risky that goes to stockholders
3. Example - River Cruises - All Equity Financed
• River Cruises is entirely equity financed.
Although it expects to have an income of
$125,000, but this income is not certain.
• Following table shows return to stockholders
under different assumptions about operating
income. Assumption no taxes.
4. M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
Data
Number of shares
100,000
Price per share
$10
Market Value of Shares
$ 1 million
Outcome
State of the Economy
Slump
Operating
Income
Earnings
per share
Return on shares
Expected
Boom
$75,000
125,000
175,000
$.75
1.25
1.75
7.5%
12.5%
17.5%
5. Example - River Cruises - All Equity Financed
• River Cruises is wondering to issue $500,000
of debt at an interest rate of 10% and
repurchase 50,000 shares.
• Return to shareholder under different
assumptions about operating income
• Returns to stockholders are increased in
normal and boom times but fall in slumps.
6. M&M (Debt Policy Doesn’t Matter)
Data
Example
cont.
50% debt
Number of shares
50,000
Price per share
$10
Market Value of Shares
$ 500,000
Market val ue of debt
$ 500,000
Outcome
State of the Economy
Slump
Expected
Boom
$75,000
125,000
175,000
Interest
$50,000
50,000
50,000
Equity earnings
$25,000
75,000
125,000
Earnings
$.50
1.50
2.50
5%
15%
25%
Operating
Income
per share
Return on shares
7. Definitions
i.
Operating Risk (business risk) – Risk in the
firm’s operating income.
ii. Financial Risk - Risk to shareholders resulting
from the use of debt.
iii. Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.
8. Financial Leverage
• Financial leverage refers to the extent to which a
firm relies on debt financing. The more debt a
firm uses, relative to equity, the more financial
leverage it employs.
Generally, increases in leverage result in increases
in risk and return, whereas decreases in leverage
result in decreases in risk and return.
9. C.S. & Corporate Taxes
River Cruise DOES create value in a corporate tax environment by using
debt financing. This is done by maximizing the cash flows to both equity
and bondholders.
All Equity
EBIT
1/2 Debt
125,000
125,000
Interest Pmt
0
50,000
Pretax Income
125,000
75,000
Taxes @ 35%
43,750
26,250
Net Cash Flow
81,250
48,750
10. Financial Distress
• Financial distress occurs when promises to creditors are broken or
honored with difficulty.
• Sometimes financial distress leads to bankruptcy, sometimes it
means only skating on thin ice.
• Financial distress is costly option i.e. costs of Financial distress.
• Costs arising from bankruptcy or distorted business decisions
before bankruptcy.
• Low rate of interest is charged if probability of default is minimal
11. Bankruptcy Procedures
• Workout: agreement between a company and its creditors
establishing the steps the company must take to avoid
bankruptcy.
• Bankruptcy: the reorganization or liquidation of a firm that
cannot pay its debts.
• Liquidation: sale of bankrupt firm’s assets.
• Reorganization: restructuring of financial claims on failing firm
to allow it to keep operating.
12. Bankruptcy Procedures
• A firm that cannot meet its obligations may try to arrange a
workout with its creditors to enable it to settle its debts. If this
is unsuccessful, the firm may file for bankruptcy, in which
case the business may be liquidated or reorganized.
• Liquidation means that the firm’s assets are sold and the
proceeds used to pay creditors.
• Reorganization means that firm is maintained as an ongoing
concern and creditors are compensated with securities in the
reorganized firm.
• Ideally, reorganization should be chosen over liquidation
when firm as a going concern is worth more than its
liquidation value. However, conflicting interests of the
different parties can result in violations of this principle.
