McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.0 Chapter 13 Leverage and Capital Structure.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.1 Key Concepts and Skills Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.2 Chapter Outline 13.1 The Capital Structure Question 13.2 The Effect of Financial Leverage 13.3 Capital Structure and the Cost of Equity Capital 13.4 Corporate Taxes and Capital Structure 13.5 Bankruptcy Costs 13.6 Optimal Capital Structure 13.7 Observed Capital Structures 13.8 A Quick Look at the Bankruptcy Process

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.3 Introduction – Capital Structuring Thus far, we’ve taken the firm’s capital structure (debt-equity ratios) as given. Capital Structure decisions can have important implications for the value of the firm and its cost of capital In this chapter, we’ll look at how changes in capital structure affect the value of the firm, all else equal

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.4 Introduction – Capital Structuring Capital Restructuring - involves changing the amount of leverage (debt) a firm has without changing the firm’s assets Increase leverage (debt) by issuing debt and repurchasing outstanding shares of stock with the proceeds from the debt issue Decrease leverage (debt) by issuing new shares of stock and using the proceeds to retire outstanding debt

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.6 Choosing a Capital Structure The primary goal of financial managers is to maximize stockholder wealth = maximizing the firm value We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing firm value or minimizing WACC

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.7 Choosing a Capital Structure The capital structure that results in the lowest Weighted Average Cost of Capital (WACC) is the best: “Optimal Capital Structure”, the firm’s “Target” capital structure So: what happens to the cost of capital when we vary the amount of debt financing, or the debt-equity ratio?

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.9 The Effect of Leverage How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.10 Example: Financial Leverage, EPS and ROE We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock? The Trans Am Corp Example – bottom of page 369

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.11 Example: Financial Leverage, EPS and ROE Variability in ROE Current: ROE ranges from 6.25% to 18.75% Proposed: ROE ranges from 2.50% to 27.50% Variability in EPS Current: EPS ranges from $1.25 to $3.75 Proposed: EPS ranges from $0.50 to $5.50 The variability in both ROE and EPS increases when financial leverage is increased Financial leverage acts to magnify gains and losses to shareholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.12 Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures – the Break-Even EBIT If we expect EBIT to be greater than the break- even point, then leverage is beneficial to our stockholders If we expect EBIT to be less than the break- even point, then leverage is detrimental to our stockholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.13 Break-Even EBIT Set the two expressions for EPS equal to each other and solve for the break-even EBIT (Table 13.1) : With no-debt EPS = EBIT / 400,000 shares o/s With debt EPS = (EBIT - 400,000) / 200,000 shares o/s EBIT / 400,000 = (EBIT - $400,000) / 200,000 EBIT = (400,000 / 200,000)(EBIT - $400,000) EBIT = 2 x (EBIT - $400,000) EBIT = $800,000

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.14 Break-Even EBIT When EBIT is $800,000, EPS is $2.00 per share under either capital structure This is labeled as the break-even point Proof: No-debt: $800,000 / 400,000 = $2.00 EPS With-debt: ($800,000 - $400,000) / 200,000 = $2.00 EPS At any EBIT above $800,000, the increased financial leverage will increase The Trans Am Corporation’s EPS

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.15 Corporate Borrowing and Homemade Leverage It actually makes no difference whether or not Trans Am adopts the proposed capital structure, because any stockholder who prefers the proposed capital structure for The Trans Am Corp can simply create it using “homemade leverage”. Shareholders can adjust the amount of financial leverage by borrowing and lending on their own. This is called “homemade leverage” - the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.18 M & M Proposition I: The Pie Model The case that capital structure is irrelevant is based on a famous argument advanced by Modigliani and Miller (M&M) M&M Proposition I: states that the value of the firm is independent of its capital structure.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.19 M & M Proposition I: The Pie Model Imagine two firms that are identical on the left- hand side of the balance sheet Their assets and operations are exactly the same The right-hand sides are different because the two firms finance their operations differently Different levels of debt and equity In this case, we can view the capital structure question in terms of a “pie” model

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.20 M & M Proposition I: The Pie Model Figure 13.2 – page 374: gives two possible ways of cutting up the pie between the equity slice and the debt slice The size of the pie is the same for both firms because the value of the assets is the same. This is precisely what M&M Proposition I states: The size of the pie doesn’t depend on how it’s sliced

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.21 M & M Proposition I: The Pie Model The Trans Am Corporation Example is a special case of M&M Proposition I: which states that the value of the firm is independent of its capital structure Trans Am’s Current Capital Structure: 400,000 shares o/s x $20 = $8,000,000 0% debt - 100% equity Trans Am’s Proposed Capital Structure: 4,000,000 debt + 200,000 shares o/s x $20 = $8,000,000 50% debt - 50% Equity The “size” of the pie doesn’t depend on “how it’s sliced”

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.22 M & M Proposition II: The Cost of Equity and Financial Leverage Although changing the capital structure of the firm may not change the firm’s total value, it does cause important changes in the firm’s debt and equity.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.23 M & M Proposition II: The Cost of Equity and Financial Leverage Remember the WACC (ignoring taxes) is: WACC = (E/V) x R E + (D/V) x R D Where V = market value of E (Equity) + D (Debt) One way of interpreting WACC is as the required return on the firm’s overall assets: WACC = R A = (E/V) x R E + (D/V) x R D If we rearrange this formula to solve for the cost of equity capital: R E = R A + (R A – R D ) x (D/E)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.24 M & M Proposition II: The Cost of Equity and Financial Leverage R E = R A + (R A – R D ) x (D/E) This is the famous M&M Proposition II: which tells us that the cost of equity depends on three things: The required rate of return on the firm’s assets R A The firm’s cost of debt, R D The firm’s debt-equity ratio, D/E As the firm raises its debt-equity ratio, the increase in leverage raises the risk of the equity and therefore the required return, or cost of equity (R E )

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.25 M & M Proposition II: Example R E = R A + (R A – R D ) x (D/E) Suppose Required return on assets = 16%, cost of debt = 10%; percent of debt = 45% What is the cost of equity? R E =.16 + (.16 -.10)(.45/.55) =.2091 = 20.91% Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?.25 =.16 + (.16 -.10)(D/E) D/E = (.25 -.16) / (.16 -.10) = 1.5

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.26 M & M Proposition II: Business and Financial Risk R E = R A + (R A – R D ) x (D/E) M&M Proposition II shows that the firm’s cost of equity can be broken down into two components: R A (R A – R D ) x (D/E) R A – the required return on the firm’s assets overall, which depends on the nature of the firm’s operating activities. Business Risk: Is the equity risk that comes from the nature of the firm’s operating activities. This Business Risk depends on the systematic (market) risk of the firm’s assets

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.27 M & M Proposition II: Business and Financial Risk R E = R A + (R A – R D ) x (D/E) (R A – R D ) x (D/E) – the second component in the cost of equity, is determined by the firm’s financial structure. For an all equity firm the component is zero. As the firm begins to rely on debt financing, the required return on equity rises. The debt financing increases the risks borne by the stockholders and is called the Financial Risk: The equity risk that comes from the financial policy (i.e., capital structure) of the firm.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.28 M & M Proposition II: Business and Financial Risk R E = R A + (R A – R D ) x (D/E) The total systematic risk of the firm’s equity thus has two parts: Business Risk - R A : depends on the firm’s assets and operations and is not affected by capital structure Financial Risk (R A – R D ) x (D/E) : is completely determined by financial policy

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.30 Corporate Taxes and Capital Structure Debt has two distinguishing features: First: Interest paid on debt is tax deductible Good for the firm May be an added benefit to debt financing Second: Failure to meet debt obligations can result in bankruptcy Not good for the firm May be an added cost of debt financing

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.31 Corporate Taxes and Cash Flows Since Interest is tax deductible: When a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.32 Example: Page 377 Assume that EBIT is expected to be $1,000 every year forever for both firms, U and L. The difference between the two firms is that Firm L has issued $1,000 worth of perpetual bonds on which it pays 8 percent interest each year. The interest bill is thus.08 x $1,000 = $80 every year forever. Also, we assume that the corporate tax rate is 30 percent.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.34 Interest Tax Shield The Interest tax shield is the tax savings attained by a firm from the tax deductibility of interest expense Annual interest tax shield in the prior example: Tax rate (.30) times the interest (coupon) payment Annual tax shield =.30(80) = $24

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.35 Cash Flow From Assets (CFFA) Firm U Firm L EBIT1000 1000 - Taxes (30%) 300 276 CFFA 700 724 Cash Flow From Assets for Firm L is $24 more than Firm U. Assuming: No Depreciation, Capital Spending, or Changes in NWC OCF = EBIT + Depreciation – Taxes CFFA = OCF, Capital Spending, and Changes in NWC

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.36 Cash Flow to: Stockholders and Bondholders Firm U Firm L Stockholders 700 644 Bondholders 0 80 Total 700 724 Total cash flow to Firm L is $24 more Interest Tax Shield =.30(80) = $24 Interest Tax Shield: the savings attained by a firm from the tax deductibility of interest expense

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.37 Taxes and M&M Proposition I Since the debt issued was perpetual, the same $24 shield will be generated every year forever. Since firm L will earn the additional $24 from the tax shield indefinitely it is worth more than firm U by the value of this $24 perpetuity. Since the tax shield is generated by paying interest, we use the interest rate associated with the debt that generated the interest (the bond coupon rate) to compute the present value of the tax shield

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.38 Taxes and M&M Proposition I V L = V U +T C x D The value of the tax shield is: PV = 24 /.08 = 300 Can also be written as: T C x D =.30 x 1000 = 300 The value of the firm L increases by the present value of the annual interest tax shield Value of a levered firm = value of an unlevered firm + PV of interest tax shield V L = V U +T C x D

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.39 Taxes and M&M Proposition I V L = V U +T C x D Example: Problem 10 – Pg 393 (Part 1) Angstrom Corp. uses no debt. The weighted average cost of capital is 14%. The current market value of the company is $30 million. The corporate tax rate is 40%. What is the value of the company if: Angstrom converts to debt-equity ratio of 1? (Implies 50% debt) V L = V U +T C x D V L = 30M +.40(15M) V L = 30M + 6M V L = 36M

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.40 Taxes and M&M Proposition I V L = V U +T C x D Example: Problem 10 – Pg 393 (Part 2) Angstrom Corp. uses no debt. The weighted average cost of capital is 14%. The current market value of the company is $30 million. The corporate tax rate is 40%. What is the value of the company if: the debt- equity ratio is 2? (Implies 67% debt) V L = V U + T C x D V L = 30M +.40(.67 x 30M) V L = 30M +.40(20M) V L = 30M + 8M V L = 38M

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.41 Taxes and M&M Proposition I Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 per cent debt. A firm’s weighted average cost of capital, WACC, decreases as the firm relies more heavily on debt financing. WACC = (E/V) x R E + (D/V) x R D x (1 – T C ) If the tax rate is 30%, the value of the firm goes up by $.30 for every $1 in debt The NPV per dollar of debt is $.30 It’s difficult to imagine why any corporation would not borrow to the absolute maximum under these circumstances

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.42 Taxes and M&M Proposition I Once we include taxes, capital structure “definitely” matters. We immediately reach the “illogical” conclusion that the optimal capital structure is 100% debt. However, we haven’t yet considered the impact of bankruptcy! Recap on Table: Table 13.4, Page 379

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.44 Bankruptcy One limit to the amount of debt a firm might use comes in the form of bankruptcy costs. As the debt-equity ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised. At that point, ownership of the firm’s assets is ultimately transferred: from the stockholders to the bondholders.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.45 Bankruptcy In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt Value of equity is zero Stockholders turn over control of the firm to the bondholders The bondholders hold assets whose value is exactly equal to what is owed on the debt It’s expensive to go bankrupt The costs associated with bankruptcy may eventually offset the tax-related gains from leverage.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.46 Direct Bankruptcy Costs The formal turning over of the assets to the bondholders is a legal process Direct Bankruptcy Costs – are the costs that are directly associated with bankruptcy, such as legal and administrative expenses. Due to these legal and administrative expenses associated with bankruptcy, bondholders won’t get all that they are owed

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.47 Indirect Bankruptcy Costs When a firm is having difficulty meeting its debt obligations, it is experiencing financial distress. Most firms do not file for bankruptcy because they’re able to recover or otherwise survive. Because it’s expensive to go bankrupt, a firm will spend resources to avoid doing so. Indirect Bankruptcy Costs – are the costs of avoiding a bankruptcy filing incurred by a financially distressed firm

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.48 Indirect Bankruptcy Costs Financial Distress Costs – are the direct and indirect costs associated with going bankrupt or experiencing financial distress. Financial distress costs are larger when the stockholders and the bondholders are different groups. Until the firm is legally bankrupt, the stockholders control. Since they can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing and will take actions in their own economic interests

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.49 Indirect Bankruptcy Costs The bondholders are primarily concerned with protecting the value of the firm’s assets and will try to take control away from the stockholders. They have a strong incentive to seek bankruptcy to protect their interests. The net effect is usually a long, drawn-out, and expensive legal battle.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.50 Indirect Bankruptcy Costs While the judicial system proceedings slowly proceed, the assets of the firm lose value because: Management is busy trying to avoid bankruptcy instead of running the business Normal operations are disrupted Sales are lost Valuable employees leave Potentially fruitful programs are dropped to preserve cash Otherwise profitable investments are not taken

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.51 Indirect Bankruptcy Costs These are all indirect bankruptcy costs, or costs of financial distress. Whether or not the firm ultimately goes bankrupt, the net effect is loss of value because the firm chose to use debt in its capital structure. This possibility of loss limits the amount of debt that a firm will choose to use.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.53 The Static Theory of Capital Structure It would appear that an optimal capital structure exists somewhere between the extremes of relatively low debt levels and very high debt levels. Strategic Theory of Capital Structure – is the theory that a firm borrows 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.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.54 Optimal Capital Structure and the Cost of Capital With no taxes, bankruptcy costs, or other real world imperfections: The total value of the firm is not affected by its debt policy The overall cost of capital is not affected by debt policy

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.55 Optimal Capital Structure and the Cost of Capital Once taxes are introduced, the firm’s value critically depends on its debt policy The more the firm borrows, the more it is worth Interest payments are tax deductible The gain in firm value is just equal to the present value of the interest shield The firm’s overall cost of capital declines due to the tax break associated with debt financing

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.56 Optimal Capital Structure and the Cost of Capital When bankruptcy, or financial distress costs are introduced: The firm’s value is reduced by the present value of the potential future bankruptcy costs These costs grow as the firm borrows more. They eventually overwhelm the tax advantage of debt financing

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.57 Optimal Capital Structure and the Cost of Capital The optimal capital structure occurs at the point at which: the tax saving from the additional dollar in debt financing is exactly balanced by the increased bankruptcy costs associated with the additional borrowing. At this level of debt financing, the lowest possible weighted average cost of capital, WACC, occurs.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.58 Capital Structure: Some Managerial Recommendations Taxes: The tax benefit from leverage (interest tax shield) is only important if the firm has a large tax liability and does not have substantial tax shields from other sources such as depreciation The higher the tax rate, the greater the incentive to borrow

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.59 Capital Structure: Some Managerial Recommendations Risk of financial distress: Firms with a greater risk of experiencing financial distress will borrow less than firms with a lower risk of financial distress The greater the volatility in EBIT, the less a firm should borrow The cost of financial distress is more costly for some firms than for others. Depending primarily on the firm’s assets and how easily ownership of those assets can be transferred: tangible (sold easily) vs. intangible (employee talent and growth opportunities – assets which cannot be sold)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.60 Capital Structure: Some Managerial Recommendations For firms that rely heavily on “intangibles”, debt will be less attractive, since these assets effectively cannot be sold

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.62 Observed Capital Structure Most U.S. corporations seem to have relatively low debt-equity levels Corporations have not, in general, issued debt up to the point that tax shelters have been completely used up (Table 13.5, Page 385) Capital structure does differ by industry Different industries have different EBIT volatility and Asset types

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.64 A Quick Look at: The Bankruptcy Process Business failure – business has terminated with a loss to creditors, but even an all-equity firm can fail Legal bankruptcy – firms or creditors bring petitions to a federal court for bankruptcy. Bankruptcy – is a legal proceeding for liquidating or reorganizing a business (operating in default) Technical insolvency – occurs when a firm is unable to meet its financial obligations Accounting insolvency – total book liabilities exceed the book value of the total assets. Book value of equity is negative.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.65 A Quick Look at: The Bankruptcy Process Firms that cannot or choose not to make contractually required payments to creditors have two basic options: Liquidation: termination of the firm as a going concern Involves selling off the assets of the firm The proceeds, net of selling costs, are distributed to creditors in order of established priority Reorganization: financial restructuring of a failing firm to attempt to continue operations as a going concern Often involves issuing new securities to replace old securities Which occurs, liquidation or reorganization depends on whether the firm is worth more “dead or alive”

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.66 Bankruptcy Liquidation Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978 deals with “straight” liquidation A petition is filed in federal court: voluntary or involuntary A trustee-in-bankruptcy is elected by the creditors to liquidate the assets Proceeds, after bankruptcy administration costs, are distributed among the creditors Remaining proceeds, after expenses and payment to creditors, are distributed to shareholders.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.67 Bankruptcy Liquidation Distribution of proceeds according to the Absolute Priority Rule (APR) – the rule establishing priority of claims in liquidation: 1. Admin expenses associated with the bankruptcy 2. Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of trustee 3. Wages, salaries, and commissions 4. Contributions to employee benefit plans 5. Consumer claims 6. Government tax claims 7. Payment to unsecured creditors 8. Payment to preferred stockholders 9. Payment to common stockholders

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.68 Bankruptcy Liquidation Two qualifications: 1. Secured Creditors are entitled to the proceeds from the sale of the security and are outside the order If liquidation of the secured property provides insufficient cash to cover the amount owed, the secured creditors fall in line with the unsecured creditors 2. Who gets what in the event of bankruptcy, is subject to much negotiation, as a result, the APR is frequently not followed.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.69 Bankruptcy Reorganization Corporate Reorganization takes place under Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructuring the corporation with a provision to repay creditors

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.70 Bankruptcy Reorganization Firms typically file bankruptcy to seek protection from their creditors – admitting that they cannot meet their financial obligations as they are presently structured. Once in bankruptcy, the firm attempts to reorganize its financial picture so that it can survive A key to this process is that the creditors ultimately must give their approval to the restructuring plan The time a firm spends in Chapter 11 depends on many things, but usually mostly on the time it takes to get creditors to agree to a plan of reorganization

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.71 Bankruptcy Reorganization Typical “Reorganization” sequence of events: 1. A voluntary or involuntary petition is filed 2. A federal judge either approves or denies the petition 3. In most cases, the corporation (the “debtor in possession”) continues to run the business 4. The corporation (and, in certain cases, the creditors) submits a reorganization plan 5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if a majority of the class agrees to the plan

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.72 Bankruptcy Reorganization 6. After creditor acceptance, the plan is confirmed by the court 7. Payments are made to the creditors and shareholders and may provide for the issuance of new securities 8. The firm operates according to the provisions of the reorganization plan for some fixed length of time The corporation may wish to allow the old stockholders to retain some participation in the firm – however, the holders of unsecured debt will most likely protest

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.73 Bankruptcy Reorganization Prepackaged (prepack)bankruptcies: Prior to filing bankruptcy, the firm approaches its creditors with plan for reorganization The two sides negotiate a settlement and agree on the details of how the firm’s finances will be restructured in bankruptcy The firm puts together the necessary paperwork for the bankruptcy court prior to filing for bankruptcy The firm walks into court and, at the same time, files a reorganization plan complete with documentation of the approval of its creditors.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.74 Bankruptcy Reorganization Prepackaged bankruptcies: The key to the prepackaged reorganization process is that both sides have something to gain and something to lose. If bankruptcy is imminent, it may make sense for the creditors to expedite the process even though they’re likely to take a financial loss in the restructuring. The faster the firm is reorganized, the faster it can concentrate on the business of making money to repay its obligations In some cases, the bankruptcy procedure is needed to invoke the “cram-down” – a certain class of creditors is forced to accept a bankruptcy plan even if they vote not to approve it. Some of the creditors may receive common stock in exchange for their debt Holders of common stock before the bankruptcy may end up getting nothing

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.75 Bankruptcy Reorganization Operating in bankruptcy can be a difficult process: The bankruptcy court typically has a great deal of oversight over the firm’s day-to-day operations Putting together a reorganization plan to emerge from bankruptcy is a tremendous drain on management time Time that would be better spent making the firm profitable again News that a firm is in bankruptcy can make skittish customers turn to competitors, endangering the future health of the firm A “Prepack” helps by speeding up the bankruptcy process

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.76 Suggested Homework and Test Review Know chapter theories, concepts, and definitions Know Bankruptcy Info Know Table 13.4 and how to compute the following: Cost of Equity Chapter Review & Self-Test Problem 13.2 – page 390 PV of Interest Tax Shield Chapter Review & Self-Test Problem 13.3 – page 390 Value of a Levered firm: Chapter Review & Self-Test Problem 13.3 – page 390 Questions and Problems 10 – page 393 Questions and Problems 11 – page 393 Breakeven EBIT Chapter Review & Self-Test Problem 13.1 – page 390 Questions and Problems 4(c) – page 392 Note: this presentation also contains examples of the above computations

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.0 Chapter 13 Leverage and Capital Structure.

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McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 13.0 Chapter 13 Leverage and Capital Structure.

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