OM FINAL

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

CHAPTER FIVE: CAPITAL STRUCTURE

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

MODIGLIANI–MILLER’S (MM) ASSUMPTIONS MODIGLIANI–MILLER PROPOSITION I & II

MODIGLIANI–MILLER’S (MM) ASSUMPTIONS

Modigliani–Miller’s (MM) assumptions are unrealistic, but they help us work through the effects of the capital structure decision:

1 Investors have homogeneous expectations about future cash flows.

2 Bonds and stocks trade in perfect markets. 3 Investors can borrow and lend at the same rate. 4 There are no agency costs. 5 Investment and financing decisions are independent of one

another.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

MODIGLIANI–MILLER’S (MM) ASSUMPTIONS MODIGLIANI–MILLER PROPOSITION I & II

MODIGLIANI–MILLER PROPOSITION I & II

Modigliani–Miller (MM) Proposition I (No tax): The market value of a company is independent of its capital structure.

Modigliani–Miller (MM) Proposition II (No tax): The cost of equity is a linear function of the company’s capital structure (debt/equity ratio).

RA = WACC = E V

× RE + D V

× RD

RE = RA + (RA − RD) × D E

RA is the business risk, (RA − RD) × DE is the financial risk.

Here, for simplicity, we don’t consider preferred stocks.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

M&M PROPOSITION I WITH TAXES MODIGLIANI AND MILLER SUMMARY

M&M PROPOSITION I WITH TAXES

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

M&M PROPOSITION I WITH TAXES MODIGLIANI AND MILLER SUMMARY

TAXES

The tax shield lowers the cost of debt.

The tax shield lowers the WACC as more debt is used.

The tax shield increases the value of the firm by tD.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

M&M PROPOSITION I WITH TAXES MODIGLIANI AND MILLER SUMMARY

MODIGLIANI AND MILLER SUMMARY

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

FINANCIAL DISTRESS COST THE STATIC THEORY OF CAPITAL STRUCTURE OBSERVED CAPITAL STRUCTURES

BANKRUPTCY COSTS

Direct bankruptcy cost: the costs that are directly associated with bankruptcy, such as the legal and administrative expenses associated with the bankruptcy proceeding.

Indirect bankruptcy cost: the costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

Financial distress cost: the direct and indirect costs associated with going bankrupt and/or avoiding a bankruptcy filing.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

FINANCIAL DISTRESS COST THE STATIC THEORY OF CAPITAL STRUCTURE OBSERVED CAPITAL STRUCTURES

FINANCIAL DISTRESS COST

The stockholders and the bondholders are different groups. Until the firm is legally bankrupt, the stockholders control it. They, of course, will take actions in their own economic interests. Because the stockholders can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing.

The bondholders, on the other hand, 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 and keep stockholders from further dissipating the assets of the firm. The net effect of all this fighting is that a long, drawn-out, and potentially quite expensive legal battle gets started.

Meanwhile, the assets of the firm lose value because management is busy trying to avoid bankruptcy instead of running the business. Normal operations are disrupted, and sales are lost. Valuable employees leave, potentially fruitful programs are dropped to preserve cash, and otherwise profitable investments are not taken.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

FINANCIAL DISTRESS COST THE STATIC THEORY OF CAPITAL STRUCTURE OBSERVED CAPITAL STRUCTURES

THE STATIC THEORY OF CAPITAL STRUCTURE

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

FINANCIAL DISTRESS COST THE STATIC THEORY OF CAPITAL STRUCTURE OBSERVED CAPITAL STRUCTURES

OBSERVED CAPITAL STRUCTURES

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

LIQUIDATION REORGANIZATION

LIQUIDATION

The situation in which assets are sold and then the proceeds distributed to claimants. Chapter 7 of the Federal Bankruptcy Reform Act of 1978 deals with “straight" liquidation. The following sequence of events is typical:

A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation by several of its creditors.

A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor corporation. The trustee will attempt to liquidate the assets.

When the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors.

If any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

LIQUIDATION REORGANIZATION

THE DISTRIBUTION OF THE PROCEEDS

The distribution of the proceeds of the liquidation occurs according to the following priority list:

Administrative expenses associated with the bankruptcy.

Other expenses arising after the filing of an involuntary bankruptcy petition but before the appointment of a trustee.

Wages, salaries, and commissions.

Contributions to employee benefit plans.

Consumer claims.

Government tax claims.

Payment to unsecured creditors.

Payment to preferred stockholders.

Payment to common stockholders.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE

MODIGLIANI–MILLER (MM) PROPOSITION I & II CORPORATE TAXES AND CAPITAL STRUCTURE

OPTIMAL CAPITAL STRUCTURE BANKRUPTCY PROCESS

LIQUIDATION REORGANIZATION

REORGANIZATION

The restructuring of claims, with the expectation that the company will be able to continue, in some form, as a going concern. Corporate reorganization takes place under Chapter 11 of the Federal Bankruptcy Reform Act of 1978. The general objective of a proceeding under Chapter 11 is to plan to restructure the corporation with some provision for repayment of creditors.

A voluntary petition can be filed by the corporation, or an involuntary petition can be filed by creditors.

A federal judge either approves or denies the petition. If the petition is approved, a time for filing proofs of claims is set.

In most cases, the corporation (the “debtor in possession”) continues to run the business.

The corporation (and, in certain cases, the creditors) submits a reorganization plan.

Creditors and shareholders are divided into classes. A class of creditors accepts the plan if a majority of the class agrees to the plan.

After its acceptance by creditors, the plan is confirmed by the court.

Payments in cash, property, and securities are made to creditors and shareholders. The plan may provide for the issuance of new securities.

For some fixed length of time, the firm operates according to the provisions of the reorganization plan.

YI ZHOU CHAPTER FIVE: CAPITAL STRUCTURE