Debt Policy

Introduction
A firms 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. Firms 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

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.

M&M (Debt Policy Doesnt Matter)

Example - River Cruises - All Equity Financed
Data Number of shares Price per share 100,000 $10

Market Value of Shares $ 1 million Outcome Operating Income Earnings per share Return on shares State of the Economy Slump Expected Boom 175,000 1.75 17.5% $75,000 125,000 $.75 1.25 7.5% 12.5%

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.

M&M (Debt Policy Doesnt Matter)

Data

Example cont. 50% debt

Number of shares

50,000

Price per share $10 Market Value of Shares $ 500,000 Market value of debt $ 500,000 Outcome Operating Income Interest Equity earnings Earnings per share Return on shares State of the Economy Slump $75,000 $50,000 $25,000 $.50 5% Expected Boom 125,000 50,000 75,000 1.50 15% 175,000 50,000 125,000 2.50 25%

Definitions
i. Operating Risk (business risk) Risk in the firms 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.

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.

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.

EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow

All Equity 1/2 Debt 125,000 125,000 0 50,000 125,000 75,000 43,750 26,250 81,250 48,750

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

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 firms assets. Reorganization: restructuring of financial claims on failing firm to allow it to keep operating.

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 firms 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.