Debt Policy

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Debt Policy

  1. 1. Debt Policy
  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.

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