Adding Value by Post-loss Financing- I Lecture 7 Dr. Tahir Khan Durrani CEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD Meditation for the week: “When looked at with proper perspective, difficult situations always yield valuable lessons.” “Believing in yourself and your abilities is the first step to overcoming adversity.”
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Capital structure is irrelevant under certain conditions: no taxes
all investors are asymmetrically informed
no transaction costs
investment policy of the firm already determined. No advantage for a firm to manipulate its debt-to-equity ratio,
since the effect of any leverage choice on investors can bereplicated by the investors themselves in the management of their portfolios.
Capital structure matters, because of taxes, information cost,transaction costs, or interdependence between the firm’sfinancing and investment policies.
Optimal capital structure is a compromise between costs andbenefits of different sources of finance.
Corporate and Personal Taxes Deductibility of interest thereby increases the
value of disbursement that can be made to thecompany’s security holders.
The size of the pie has been increased by using
debt. But are investors necessarily better off? This depends on personal tax rates.
The slices of the bigger pie still have to be taxed at the personal rate.
It should be immediately apparent that if personaltaxes on equity income are sufficiently smallerthan on debt, investors could be better off without corporate borrowing.
If the risk of the cash flows is fixed, then the higher theleverage, the higher the probability of bankruptcy, andthe higher the expected value of bankruptcy costs.
Indirect costs of bankruptcy, share holders may fail toundertake positive NPV projects that simply shore up thevalue of debt
The question can be asked with a different emphasis.
Do the terms on which new money is raised
permit value to be created for existingshareholders?
More pointedly, if a firm has just suffered amajor setback, say a major liability suit, willinvestors have the confidence to buy newlyissued securities and can the firm raise enoughmoney for its investment needs?
Firm refinances using debt / equity raises amount denoted by
S. The PV of dividends / interest payment is denoted by R.
Cost of new investment is Kt
V(E) = V0 + L + (S - R - Kt ) + Vt - D -T
Term R represents a set of future payments expressed as thevalue raised S, times the expected rate of return “r”.
R = rS/r = S
R and S cancel out, as these are competitively priced
If existing share holders can attract capital in a competitivecapital market, they only offer a competitive rate of return oncapital raised. They need not share added value with newinvestors. All NPV of new investment is captured by existingshare holders.
If post-loss investment is fundable, it does not followthat it should be undertaken.
Example:
Chair and Wares makes furniture and expects an earningsstream of £1,000 (after deduction of costs of renewing
plant) indefinitely from its current operations. The firm canreinvest two-year earnings in some product improvement,and expect earnings stream to grow by 2%. Cash at hand is£1,000, with the existing plant and other productive assetshave a replacement cost of £8,000 with a salvage value of £5,000.
The firm has existing debt of £5,000; the cost of debt is 0.05,The firm’s WACC is 0.1. The owners hold 1,000 shares of stock.
The new investment adds value (6331 is more than 6000) andshould be undertaken.
Suppose the existing plant suffers an explosion and is uninsured.The plant can still partly operate, and earnings are reduced to£300, but this figure is not expected to grow. However, an
investment of £3,000 will fully restore the plant, and earnings willreturn to the pre-loss level of £1,000.
The firm must raise new money for this reconstruction, but stillplans to pay for the new investment in two years from retainedearnings.
Does the reinvestment add value to equity? What opportunities exist for raising new money by an equity
No Future Risk It would seem that because the value of equity is
positive after reinvestment, the firm hadsufficient value to pay off all debt (senior debt of 5000 and junior debt of 3200) and still have aresidual value of 3131.
Suppose that the story was as follows. The firm takes the reinvestment and is then is
immediately obligated to sell off the firm anddischarge all claims to existing credits.
The firm would receive the full firm value, 11,331(the earnings stream is worth 10,331 and there iscash of 1000), in a competitive market, and pay5000 to senior creditors and 3200 to juniorcreditors, leaving 3131 to shareholders.
No Future Risk Then investors would be willing to pay at par for debt
with a face value of 3200.
But now suppose there is no such obligation to sell thefirm in this way. Can junior bondholders always be surethat they will paid in full in the future?
If the earnings stream of 1000, growing at 2%, wereentirely risk- free, there would be no problem and theanalysis of this paragraph would still apply; the juniordebt would still be worth its face of 3200.
Since there is no future risk, the simply fundabilitycondition for news investors to subscribe fully to new
debt is fulfilled. The condition was V’(F) – D – C > 0, where V’(F) is post -
loss firm value after reinvestment, D is preexisting debt,and C is the capital cost.
The condition fills out as 11,331 – 5000 – 3200 > 0.Dr. Tahir Khan Durrani 25
To see whether investor in a new debt issuewould be willing to pay a sufficient amount forthe firm’s debt to pay for the direct cost, C, wewill simply the default assumption.
The firm may become insolvent directly as aresult of the risky event (i.e., the post-lossvalue of equity, even with reinvestment, is
negative). But even if the post-loss equity value is
The firm needs an amount of C to pay for the direct costs.
If debt is raised, the amount subscribed is S, but theface value of the debt is C. the amount S will be equal
to C if the value of the firm, after payment for any seniordebt, exceeds C. In equation, the firm did have pressingdebt of D, so we will call the value of the firm after lossV (F) = V0 + L – Kt +Vt - T.
Furthermore, this value is risk-free because we haveignored future risk.
If the existing debt is senior to any post loss issue, thecondition for S to equal C is that V (F) - D – C > 0.
But notice that when discussing post-loss debt wehad defined ET= V0 + L – Kt + Vt –D –T.
So clearly, V = ET + D.
Thus, the fundability condition that V(F) – D – C ispositive the same as ET – C is positive.
This is exactly the same fundability condition wederived for post-loss equity financing.
Whether debt or equity is used, investors will bewilling to subscribe a sufficient amount to fund thenew investment if the post-loss value of the form,minus any pressing debt, exceeds the direct cost,C.
Effects of Loss of Productive Assets The event itself will fall disproportionate on
equity; probably increasing leverage to some
point such as B. If no post-loss investment activity is undertaken,
the firm is likely to be over levered, and positionB does not indeed shows this.
Depending on what level of post-loss investment is undertaken and how it is financed, the post-loss leverage will resettle at some point such as Con the recaptured value curve.
The post-loss optimal capital structure may not be the same as the pre-loss capital structure.
As shown, the optimal post-loss leverage, C, ishigher than pre-loss, B, but it could go the other