what action generally occurs first in a bankruptcy reorganization?
filing proofs of claim
under Bankruptcy Abuse Prevention & Consumer Protection Act of 2005, how long after a firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?
180
the optimal capital structure maximizes
shareholder value
principal payment on long-term debt is a
marketed claim against a firm's cash flows
homemade leverage is
the use of personal borrowing to alter the individual's degree of financial leverage
minimizing the WACC will
maximize the value oft he firm's cash flows (WACC is the discount rate for the firm's overall cash flows)
financial leverage
the extent to which a firm relies on debt
the effect of financial leverage depends on the company's EBIT
when EBIT is relatively high, leverage is beneficial
M&M Proposition I
it is completely irrelevant how a firm chooses to arrange its finances, no optimal capital structure
M&M proposition II
cost of equity depends on required rate of return, cost of debt, debt-equity ratio.
as a firm raises its D/E ratio, increase in leverage raises the risk of the equity and therefore
the required rate of return or cost of equity
business risk
the equity risk that comes from the nature of the firm's operating activities (not affected by capital structure)
as the firm begins to rely on debt ifnancing
required return on equity rises (debt financing increases the risks borne by stockholders)
financial risk
extra risk that arises from the use of debt financing (dependent on firm's cap. structure)
total systematic risk of the firm's equity has two parts
business and financial risk
states that a firm's cost of equity capital is directly/proportionally related to the firm's capital structure
M&M proposition II
equity risk most related to the daily operations of a firm
business risk
as debt-equity ratio rises, so does the probability
that the firm will be unable to pay its bondholders what was promised to them
direct bankruptcy costs
legal and administrative expenses associated
indirect bankruptcy costs
the costs of avoiding a bankruptcy filing incurred by a financially distressed firm
financial distress costs
direct/indirect costs associated with going bankrupt or experiencing financial distress
static theory of capital structure
firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress
implications of the pecking order
no target capital structure, profitable firms use less debt, companies will want financial slack
unlevered cost of capital refers to the cost of capital for
an all-equity firm
reorganization
when a business is unable to meet financial obligations and forced into using legal proceedings to restructure in order to continue as a viable business
absolute priority rule determines
which parties receive payment first in a bankruptcy proceeding
value of a firm is maximized when the
weighted average cost of capital is minimized
optimal capital structure has been achieved when the
debt-equity ratio results in the lowest possible weighted average cost of capital
relationship between a levered and unlevered capital structure (ignore taxes)
at the break even point, there is no advantage to debt
what makes the capital structure of a firm irrelevant
homemade leverage
homemade leverage is most associated with
M&M proposition I w/ no tax
according to M&M proposition II, without taxes
required return on assets is equal to the WACC
M&M prop II without taxes
firm's cost of equity is a linear function with a slope equal to Ra - Rd
the business risk of a firm has a
positive relationship with the firm's cost of equity
according to M&M prop U w/ tax
firm's weighted average cost of capital decreases as the firm's d/e ratio increases
value of a firm increases as firm's debt increases because of the interest tax shield (which proposition? )
M&M prop I w/ taxes
PV of interest tax shield is expressed as
Tc X D
Interest tax shield is a key reason why
net cost of debt to a firm is generally less than the cost of equity
bankruptcy is a
legal proceeding
what has the greatest tendency to increase % of debt included in optimal capital structure of a firm?
low probability of financial distress
optimal capital structure
will vary over time as taxes and market conditions change
basic lesson of M&M theory is that the value of a firm is dependent upon
total cash flow of the firm
which form of financing do firms prefer to use first according to the pecking order theory?
internal funds
according to pecking-order theory
firms stockpile internally generated cash
corporations in the US tend to
underutilize debt
in general, capital structures used by US firms
vary significantly across industries
firm is technically insolvent when
it is unable to meet its financial obligations
under a CH. 7 bankruptcy, a trustee will assume control of a firm's assets until
those assets can be liquidated
highest priority when assets are distributed in a bankruptcy proceeding
payment of employee wages
firms may file for CH. 11 bankruptcy in an attempt to gain
competitive advantage
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
permits key employee retention plans only in an employee has another job offer
financial distress can be defined in several ways
business failure(termination of business), legal bankruptcy, technical insolvency (when firm unable to meet fin. obligations), accounting insolvency (insolvent on the books)
firms that cannot make required payments to creditors have two options
liquidation (termination of firm, selling assets) OR reorganization - is the firm worth more dead or alive?
sequence of events of a bankruptcy
petition is filed in court, trustee elected by creditors to take over assets and attempt liquidation, proceeds distributed, remaining proceeds distributed to shareholders
absolute priority rule
administrative exp, S&W, employee benefit plans, consumer claims, gov tax claims, payment to creditors, then preferred stockholders, then common stock
bankruptcy reorganization
petition filed, judge approves/denies, corp continues to run business, corp submits reorg plan, creditors/shareholders divided into classes, plan accepted/confirmed, payments made to creditors/shareholders, firm operates according to provisions of the reo
interest tax shield
tax savings obtained from interest expense
unlevered cost of capital
cost of capital for a firm that has no debt
____ is sold as last resort for financing
equity
effects of leverage (in a world with no taxes/bankruptcy)
^ risk to shareholders because ^leverage=great variability of eps and roe, ^ expected rate of return (greater return due to greater risk)
how much debt a firm has is irrelevant
firm value cannot be higher if WACC is constant across all debt levels
since interest is tax deductible, as debt increases...(M&M II)
more cash flows are reserved for the shareholders and debt holders. increases the value of the firm
annual interest tax savings
D(Rd)(Tc)
the lower the WACC
higher the value of the firm
M&M II. optimal capital structure is where...
debt is maximized
M&M case III: as debt increases,
risk of bankruptcy and associated costs increase
companies that lower the business risk
can have more debt outstanding, they can handle increased financial risk
rules of the pecking order
internal financing first (no floatation cost), next issue debt (lower floatation), new equity last (most expensive to issue)