CORPORATE FINANCE BOOK

CHAPTER 2 – INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

Financial statements are accounting reports with past performance information that a firm
issue periodically.

- Quarterly basis on form 10-Q

- Annually basis on form 10-K

Useful because:
- Gives information for outside parties: investors, financial analysist, creditors etc.
- Gives information for inside parties: help managers for corporate financial
decisions

Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a
standard format for public companies to use when they prepare their reports. Also, useful to
compare different firms.

- An auditor has the responsibility to check the annual financial statements,

ensure that it is reliable and prepared according to GAAP, normally the auditor is
external to the company

GAAP differ among countries, for this reason in 1973 10 representatives of 10 countries
established the International Accounting Standards Committee. The effort led to the creation
of the International Accounting Standards Board (IASB) in 2001 located in London. Now
the IASB has issued a set of International Financial Reporting Standards (IFRS). The
IFRS is accepted in more than 120 jurisdictions, including EU, Australia, Brazil, Canada,
Russia, India etc. Except for USA and China which maintain their local GAAP.
GAAP is based on accounting rules with specific guidance in applying them, whereas IFRS
are based more on principles requiring professional judgment by accountants. GAAP prohibit
the upward revaluation of non-financial assets, while the IFRS allow the revaluation of some
such assets to fair value.

TYPES OF FINANCIAL STATEMENTS

Companies must prepare 4 different financial statements: balance sheet, income statement,
cash flow and stockholders’ equity.

1. THE BALANCE SHEET

The balance sheet, or statement of financial position, lists the firm’s assets and liabilities
providing a snapshot of the firm’s financial position at a given point in time.
The balance sheet is divided into two parts, on the left we have assets and on the right, we
have liabilities.
The assets list the cash, inventory, property, plant, and equipment, and other investments the
company has made. Assets show how the firm uses its capital, its investments.
The liabilities show the firm’s obligations to creditors, under liabilities we also have
stockholders’ equity. Liabilities show how a firm raises the money it needs.

Assets = liabilities + stockholders’ equity

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Stockholders’ equity is an accounting measure of the new worth of the firm.

Assets
-Many of the assets listed on the balance sheet are valued based on their historical
cost rather than their true value
- The value of an asset today may be very different from its book value
1. Current assets
Current assets are cash or assets that could be converted into cash within one years.
- Cash and other marketable securities: short-term, low-risk investments that can
be easily sold and converted to cash
- Account receivable: amounts owed to the firm by customers who have purchased
on credit
- Inventories: raw materials, work-in-progress, and finished goods
- Other current assets: prepaid expense, such rent and insurance, expenses paid in
advance

2. Long-term assets
- Net property, plant, and equipment: include assets that produce tangible benefits
for more than one year, such as real estate or machinery. The value of the
equipment is subject to depreciation expenses. Accumulated depreciation is the
total amount deducted over its life.
Book value = acquisition cost – accumulated depreciation
- Goodwill and intangible assets: in the case in which the intangible assets are
subject to depreciation we will call it as amortization or impairment charge.

Liabilities
1. Current liabilities
Current liabilities will be satisfied within one year.
- Account payable: amounts owed to suppliers for products or services purchased
with credit by company
- Short term debt or note payable: all repayments of debt that will occur within the
next year
- Salaries, taxed, that are owed but have not yet been paid
- Deferred or unearned revenue, which is revenue that has been received for
products that have not yet been delivered

2. Long-term liabilities
Long-term liabilities are extended beyond one year
- Long-term debt: any loan or debt obligation with a maturity of more than a year
- Capital leases: lease contracts that obligate the firm to make regular lease
payments in exchange for use of an asset
- Deferred taxes: taxes that are owed but have not yet been paid.
Net working capital = current assets – current liabilities
Firms with low or negative net working capital may face a shortage of funds

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MARKET VALUE VS BOOK VALUE
The book value of equity is an inaccurate assessment of the true value of the firm’s equity.
- The book value of equity will often differ substantially from the amount
investors are willing to pay for the equity

Market value of equity = share outstanding x market price per share

The market value of equity is referred to as the company’s market capitalization, or market
cap.
- The market value of a stock depends on what investors expect those assets to
produce in the future

Market Value: This is the current price at which an asset, such as a stock or real estate
property, can be bought or sold in the open market. It represents the value that investors and
buyers are willing to pay based on supply and demand.

Book Value: This is the value of an asset as recorded on a company's balance sheet. It's the
historical cost of the asset minus accumulated depreciation or amortization. Book value is
often used for accounting and financial reporting purposes.

Market-to-book ratio
The Market-to-Book Ratio, often abbreviated as the "M/B ratio" or "Price-to-Book Ratio
(P/B ratio)," is a financial metric that compares a company's market value (the current market
price of its stock) to its book value (the value of its assets minus liabilities as recorded on its
balance sheet).

The market-to-book ratio is the ratio of its market capitalization to the book value of
stockholders’ equity.

𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

𝑚𝑎𝑟𝑘𝑒𝑡 − 𝑡𝑜 − 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

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 - Market-to-book ratio for most successful films exceeds 1, indicating that the
value of the firm’s assets when put to use exceeds their historical cost
- Variation in the ratio refect differences in fundsmentsl firm characteristics as
well as the value added by management
PayPal had a ratio of 6.9.
- Firms with low ratio: value stocks
- Firms with high ratio: growth stocks

ENTERPRISE VALUE
A firm’s market capitalization measures the market value of the firm’s equity, or the value
that remains after the firm has paid its debts.

The enterprise value a firm assesses the value of the underlying business assets,
unencumbered by debt, and separate from any cash and marketable securities.

Enterprise Value (EV) is a financial metric that represents the total value of a company,
including its equity (common and preferred shares), debt, minority interests in subsidiaries,
and cash or cash equivalents.

Enterprise value = market value of equity + debt – cash

2. INCOME STATEMENT

The income statement lists the firm’s revenues and expenses over a period. The last or
“bottom” line of the income statement shows the firm’s net income, which is a measure of its
profitability during the period.

Total sales: revenue from sales of products

Cost of sales: costs incurred to make and sell the product, costs related to producing the
goods or services being sold (manufacturing costs)
Gross profit: total sales – cost of sales
Operating expenses: all the expenses not related with the production, included
administrative expenses and overhead, salaries, marketing costs, research and development
expenses, depreciation, and amortization
Operating income: gross profit – operating expenses
Other income: that can arise from activities that are not the central part of a company’s
business
Earnings before interest and taxes (EBIT): operating income – other income
Interest expenses
Pretax income: EBIT – interest expenses
Taxes
Net income: pretax income – taxes

Net income: net income represents the total earnings of the firm’s equity holders.

Often reported as the firm’s earnings per share EPS

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐸𝑃𝑆 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

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Share outstanding can increase due to:
- Shock options, the company compensates its employees or executives with the
right to buy a certain number of shares by a specific date
- Convertible bonds, debt converted to shares

3. CASH FLOWS

The firm’s statement of cash flows utilizes the information from the income statement and
balance sheet to determine how much cash the firm has generated, and how that cash has
been allocated, during a set period.
It is divided in 3 sections:
1. Operating activity
2. Investment activity
3. Financial activity

Operating activity
Starts with net income from the income statement, then adjusts this number by adding back
all non-cash entries related to the firm’s operating activities
- Depreciation is deducted when computing net income, but it is not an actual
cash outflow, so we will add it back when calculating the amount of cash the
firm has generated
- Other non-cash items: we add back it
- Account receivable: when a sale is recorded as part of net income, but the cash
has not yet been received from the customer, we must adjust the cash flow by
deducting the increase

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 - Account payable: we add increases in A/P. account payable represents
borrowing by the firm from its suppliers. This borrowing increases the cash
available to the firm.
- Inventory: we deduct increases to inventory. Inventory are not recorded as an
expenses and do not contribute to net income.
- Other: deduct the increase in any other current assets net of liabilities

Investment activity
Lists the cash used for investments
- Capital expenditures: purchases of new property, plant and equipment, subtract
the actual capital expenditure that the firm made.
- Acquisitions and other investing activity: deduct other assets purchased or
long-term investments

Financial activity
Shows the flow of cash between the firm and its investors
- Dividends paid: cash outflow
the different between. firm’s net income and the amount are spends on dividends
is referred as retained earning
retained earnings = net income – dividends
- Sale (or purchase) of stock
- Increase in borrowing

4. STATEMENT OF STOCKHOLDERS’ EQUITY

The statement of stockholders’ equity breaks down the stockholder’s equity computed on
the balance sheet into the amount that come from issuing shares versus retained earnings.

Change in stockholders’ equity = retained earnings + net sales of stock

= net income – dividends + sales of stock – repurchases of stock

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Management discussion and analysis: preface to the financial statements in which the
company’s management discusses the recent year.

Off balance sheet transactions: transactions that are not recorded in the balance sheet but
that can have an impact on the firm’s future performance.

Notes to the financial statements

FINANCIAL STATEMENT ANALYSIS

Investors often use accounting statements to evaluate a firm in one of two ways:
1. Compare the firm with itself by analyzing how the firm has changed over time
2. Compare the firm to other similar firms using a common set of financial ratios

PROFITABILITY RATIOS

Gross margin reflects the ability to sell a product for more than the cost of producing it.

𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝑔𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑠𝑎𝑙𝑒𝑠

Operating income reveals how much a company earns before interest and taxes from each
dollar of sales.
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑠𝑎𝑙𝑒𝑠

𝑒𝑏𝑖𝑡
𝑒𝑏𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑠𝑎𝑙𝑒𝑠

By comparing operating or EBIT margins across firms within an industry, we can assess the
relative efficiency of the firm’s operations.

The net profit margin shows the fraction of each dollar in revenues that is available to
equity holders after the firm pays interest and taxes.

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑠𝑎𝑙𝑒𝑠

LIQUIDITY RATIOS
Financial analysts often use the information in the firm’s balance sheet to assess its financial
solvency or liquidity.

The current ratio compares assets and liabilities to assess whether the firm has sufficient
working capital to meet its short-term needs.

𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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The quick ratio compares only cash and near cash assets, such as short-term investments and
accounts receivable, to current liabilities.

𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝑞𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

A higher current or quick ratio implies less risk of the firms experiencing a cash shortfall in
the near future.

The cash ratio, firms need cash to pay employees and meet other obligations, running out of
cash can be very costly for a firm.

𝑐𝑎𝑠ℎ
𝑐𝑎𝑠ℎ 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

WORKING CAPITAL RATIO

We can use the combined information in the firm’s income statement and balance sheet to
gauge how efficiently the firm is utilizing its net working capital.

Accounts receivable days, also known as "receivables turnover" or "debtor days," represent
the average number of days it takes a company to collect payment from its customers after
making a sale. In the case of accounts receivable days, a lower figure is generally considered
better for a company.
𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠

Accounts payable days, also known as "payables turnover" or "creditor days," indicate the
average number of days it takes a company to pay its suppliers or creditors after receiving
goods or services. In general, a higher accounts payable days figure is often considered better
for a company.

𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

Inventory turnover is a financial ratio that measures how efficiently a company manages its
inventory. It indicates how many times a company's inventory is sold and replaced over a
specific period, typically a year. A higher inventory turnover is generally considered better for
a company.

𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠

𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Average daily sales = sales / 365

Average daily cost of sales = cost of sales / 365

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INTEREST COVERAGE RATIOS
Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings
with its interest expenses using the interest coverage ratio.
A higher ratio indicates that the firm is earning much more than is necessary to meet its
required interest payments.

When the ratio falls below 1.5 lenders may begin to question a company’s ability to repay its
debts.

𝐸𝐵𝐼𝑇
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

𝐸𝐵𝐼𝑇𝐷𝐴
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

𝐸𝐵𝐼𝑇𝐷𝐴 = 𝐸𝐵𝐼𝑇 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛

LEVERAGE RATIOS
The debt-equity ratio is a common ratio used to assess a firm’s leverage. Since it is difficult
to now the book value of equity, the ratio is not really useful.

- Low D/E Ratio (Less than 1): Indicates lower financial risk, as the company
relies more on equity financing. Considered conservative but may limit growth
potential.
- Moderate D/E Ratio (Around 1): Represents a balanced mix of debt and equity
financing. Common and often viewed as a healthy financial balance.
- High D/E Ratio (Greater than 1): Suggests substantial debt relative to equity,
increasing financial risk. Can magnify returns but may pose challenges in
meeting debt obligations.
- Very High D/E Ratio (Significantly Greater than 1): Indicates high financial
leverage and potential distress. Higher probability of defaulting on debt.

𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑑𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

Debt-to-Capital Ratio assesses a company's financial leverage by comparing its total debt to
its total capital, offering insights into its risk profile and financing structure.
- Lower Debt-to-Capital Ratio Indicates Less Reliance on Debt: A lower Debt-to-
Capital Ratio signifies that a company depends less on debt financing,
potentially reducing financial risk and increasing its ability to weather economic
challenges.

𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
𝑑𝑒𝑏𝑡 𝑡𝑜 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑎𝑡𝑖𝑜 =
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡

𝑛𝑒𝑡 𝑑𝑒𝑏𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 − 𝑐𝑎𝑠ℎ & 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠

A lower Debt to Enterprise Value Ratio signals that the company has a smaller debt burden
relative to its total enterprise value, suggesting a reduced level of financial risk and leverage.

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 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
𝑑𝑒𝑏𝑡 𝑡𝑜 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡
𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡

VALUATION RATIOS
The P/E ratio is the ratio of the value of equity to the firm’s earnings.
The Price-earning ratio is a simple measure that is used to assess whether a stock is over or
under-valued based on the idea that the value of a stock should be proportional to the level of
earnings it can generate for its shareholders.
- It tends to be highest for industries with high expected growth rates

𝑃 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

𝑟𝑎𝑡𝑖𝑜 = =
𝐸 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

OPERATING RETURNS

Return on equity (ROE) provides a measure of the return that the firm has earned on its past
investments.
- High ROE may indicate the firm is able to find investment opportunities that are
very profitable

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑅𝑂𝐸) =
𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

Return of assets (ROA) has the benefit that it is less sensitive to leverage than ROE.
- Higher ROA is considered better

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑅𝑂𝐴) =
𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠

The return on invested capital measures the after-tax profit generated by the business itself,
excluding any interest expenses, and compares it to the capital raised from equity and debt
holders that has already been deployment.
- Higher is better
- Most useful between operating returns

𝑒𝑏𝑖𝑡 (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑎𝑙 (𝑅𝑂𝐼𝐶) =
𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑒𝑡 𝑑𝑒𝑏𝑡

10
11
CHAPTER 26 – WORKING CAPITAL MANAGEMENT
We defined a firm’s net working capital as its current assets minus its current liabilities. Net
working capital is the capital required in the short term to run the business.
- Most projects require the firm to invest in net working capital. The main
components of net working capital are cash, inventory, receivables, and
payables. Working capital includes the cash that is needed to run the firm on a
day-to-day basis.

THE CASH CYCLE

The level of working capital reflects the length of time between when cash goes out of a firm
at the beginning of the production process and when it comes back in.
A firm’s cash cycle is the length of time between when the firm pays cash to purchase its
initial inventory and when it receives cash from sale of the output produced from that
inventory.

The cash conversion cycle (CCC) is defined as

CCC = accounts receivable days + inventory days – accounts payable days

𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑠𝑎𝑙𝑒𝑠

𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

The firm’s operating cycle is the average length of time between when a firm originally
purchases its inventory and when it receives the cash back from selling its product.
- If the firm pays cash for its inventory, this period is equal to the firm’s cash cycle
- Most firms buy their inventory on credit, which reduces the amount of time
between the cash investment and the receipt of cash from that investment

The longer a firm’s cash cycle, the more working capital it has.

12
FIRM VALUE AND WORKING CAPITAL
Any reduction in working capital requirements generates a positive free cash flow that the
firm can distribute to shareholders. Similarly, reducing the project’s net working capital needs
over the project’s life reduces the opportunity cost associated with this use of capital.

TRADE CREDIT
Account receivables represent the credit sales for which a firm has yet to receive payment.
The account payables represent the amount that a firm owes its suppliers for goods that it
has received but for which it has not yet paid.
The credit that the firm is extending to its customer is known as trade credit.

Trade credit terms

“Net 30”: payment is not due until 30 days from the date of the invoice
“2/10, net 30”: the firm will receive a 2% discount if it pays for the goods within 10 days,
otherwise the full amount is due in 30 days

Suppose a firm sells a product for $100 but offers its customer terms of 2/10, Net 30. The customer doesn't have
to pay anything for the first 10 days, so it effectively has a zero-interest loan for this period. If the customer
takes advantage of the discount and pays within the 10-day discount period, the customer pays only $98 for the
product. The cost of the discount to the selling firm is equal to the discount percentage times the selling price. In
this case, it is 0.02 × $100, or $2. Rather than pay within 10 days, the customer has the option to use the $98 for
an additional 20 days (30 - 10 = 20). The interest rate for the 20-day term of the loan is $2/$98 = 2.04%. With a
365-day year, this rate over 20 days corresponds to an effective annual rate of: EAR = (1.0204)^365/20 -1 =
44.6%. Thus, by not taking the discount, the firm is effectively paying 2.04% to borrow the money for 20 days,
which translates to an effective annual rate of 44.6%! If the firm can obtain a bank loan at a lower interest rate, it
would be better off borrowing at the lower rate and using the cash proceeds of the loan to take advantage of the
discount offered by the supplier.
So, the Effective Annual Rate (EAR) in this scenario is approximately 44.6%. This means that by not taking the
2% discount and effectively borrowing the money for 20 days, the firm is effectively paying an annualized
interest rate of 44.6% on the amount of the discount ($2) over that 20-day period.
The significance of this calculation is to highlight that forgoing the early payment discount can be costly for the
firm, as it effectively incurs a high annualized interest rate on the unpaid amount. If the firm can obtain a lower
interest rate through a bank loan, it would be financially advantageous to borrow from the bank and use the
borrowed funds to take advantage of the supplier's discount. This demonstrates the importance of analyzing the
cost of trade credit relative to other financing options.
In other words, when the customer chooses not to use the discount and pays the full amount after 30 days
instead of taking advantage of the 2% discount and paying within 10 days, the result is that, in percentage terms,
they are actually paying a higher amount compared to what they would have paid by using the discount. The
44.6% represents the implicit "interest" rate in the additional cost of $2 borne by the customer for not utilizing
the discount. However, this "interest" doesn't actually go to anyone; it's simply a way to quantify the additional
cost incurred by the customer for their decision to delay payment.

EAR = (1 + Periodic Interest Rate)^(365/days) – 1

Periodic interest rate = discount / $paid before the n days

*days: suppose 2/10, net 30, days are equal to 20 (30 – 10)

Suppose term 1/15 net 40, suppose you have to pay $100
Discount: 100 x 0.01 = 1
If pays before 15 days I will pay $99 instead of $100.
Periodic interest rate = 1 / 99 = 0.0101
EAR = (1 + 0.0101) ^365/(40-15) – 1 = 0.158 = 15.8%

13
Benefits on trade credit
- Trade credit is simple and convenient to use, and it has lower transaction costs
than alternative sources of funds
- Flexible source of funds, and can be used as needed

MANAGING FLOAT
Collection float is the amount of time it takes for a firm to be able to use funds after a
customer has paid for its goods. Firms can reduce their working capital needs by reducing
their collection float.
Collection float is determined by three factors:
1. Mail float: How long it takes the firm to receive the check after the customer has
mailed it
2. Processing float: How long it takes the firm to process the check and deposit it in the
bank
3. Availability float: How long it takes before the bank gives the firm credit for the
funds

Disbursement float is the amount of time it takes before payments to suppliers actually
result in a cash outflow for the firm. Like collection float, it is a function of mail time,
processing time, and check-clearing time.
Although a firm may try to extend its disbursement float in order to lengthen its payables and reduce its working
capital needs, it risks making late payments to suppliers. In such a case, the firm may be charged an additional
fee for paying late or may be required to pay cash before delivery (CBD) or on delivery (COD) for future
purchases. In some cases, the supplier may refuse to do business in the future with the delinquent firm.

The check clearing for the 21st century act eliminated the disbursement float due to the
check-clearing process.

RECEIVABLE MANAGEMENT
Determining the credit policy
Three steps:
1. Establishing credit standards
2. Establishing credit terms (period)
3. Establishing a collection policy

There are two tools used to monitor the account receivable: accounts receivable days and
aging schedule:
Accounts receivable days
The accounts receivable days is the average number of days that it takes a firm to collect on
its sales. A firm can compare this number to the payment policy specified in its credit terms to
judge the effectiveness of tis credit policy.
- If the ratio increase company needs to reexamine its credit policy

Aging schedule
An aging schedule categorizes accounts by the number of days they have been on the firm’s
books.

14
If the percentage increases, then they need to revisit their credit policy.

PAYABLES MANAGEMENT
Calculate the accounts payables days outstanding and compare it to the credit terms in order
to monitor its accounts payable.

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑

INVENTORY MANAGEMENT
We can classify the direct costs associated with inventory into three categories:
- Acquisition costs are the costs of the inventory itself over the period being
analyzed (usually one year).
- Order costs are the total costs of placing an order over the period being
analyzed.
- Carrying costs include storage costs, insurance, taxes, spoilage, obsolescence,
and the opportunity cost of the funds tied up in the inventory.

Some firms seek to reduce their carrying costs as much as possible. With «just-in-time" (IT)
inventory management, a firm acquires inventory precisely when needed so that its
inventory balance is always zero, or very close to it. This technique requires exceptional
coordination with suppliers as well as a predictable demand for the firm's products.

CASH MANAGEMENT
Motivation for holding cash
1. Transactions balance
A firm must hold cash to pay its bills. The amount of cash a firm needs to be able to
pay its bills is sometimes referred to as a transactions balance, and it depends on
both the average size of the transactions made by the firm and the firm’s cash cycle.
- Useful to pay near-term liabilities
- To know if the firm has adequate liquidity to meet its needs we can use the quick
ratio, by increasing its cash balance the firm can raise its quick ratio

2. Precautionary balance
The amount of cash a firm holds to counter the uncertainty surrounding its future cash
needs is known as precautionary balance. The size of the balance depends on the
degree of uncertainty.

3. Compensating balance
A firm’s bank may require it to hold a compensating balance in an account at the
bank as compensation for services that the bank performs.

15
16
CHAPTER 14 – CAPITAL STRUCTURE IN A PERFECT MARKET
The relative proportions of debt, equity, and other securities that a firm has outstanding
constitute its capital structure.

FINANCING A FIRM WITH EQUITY

Example
Initial investment = $100
Generated cash flow strong economy = $1400
Generated cash flow weak economy = $900
Risk-free interest rate = 5%
Risk premium = 10%
Given the two risks the cost of capital = 5% + 10% = 15%

Expected cash flow = ½ (1400) + 1/2 (900) = $1150 --> ½ since the risk is equally distributed

NPV = -800 + (1150 / 1+0.15) = $200

PV (equity cash flows) = 1150 / (1 + 0.15) = 1000

The entrepreneur can raise $1000 by selling the equity in the firm. The entrepreneur can leep
$200 as a profit from NPV.
The project’s NPV represents the value to the current owners of the firm created by the
project.
Equity in a firm with no debt is called unlevered equity.

FINANCING A FIRM WITH DEBT AND EQUITY

Equity in a firm that also ha debt outstanding is called levered equity. Promised payments to
debt holders must be made before any payments to equity holders are distributed.
Modigliani and Miller “with perfect capital markets, the total value of a firm should not
depend on its capital structure.” --> the firm’s total cash flows still equal the cash flows of the
project, and therefore have the same present value.

THE EFFECT OF LEVERAGE ON RISK AND RETURN

- Firm 100% equity financed, the equity holders will require 15% of expected
return
- Firm 50% financed with debt and 50% financed with equity, debt holders will
receive 5% of return, and equity holders will require 25% of return

Leverage increases the risk of equity even where there is no risk that the firm will default

17
MODIGLIANI-MILLER I
MM perfect capital markets conditions:
1. Investors and firms can trade the same set of securities at competitive market price
equal to the present value of their future cash flows
2. There are no taxes, transaction costs or issuance costs associated with security trading
3. A firm’s financing decisions do not change the cash flows generated by its
investments, nor do they reveal new information about them

MM proposition I: in a perfect capital market, the total value of a firm’s securities is equal
to the market value of the total cash flows generated by its assets and is not affected by its
choice of capital structure

In simple words, this passage is talking about how a company's value is not affected by how
it decides to finance itself (whether through borrowing or selling shares) as long as there are
no extra costs like taxes or fees involved.

- if there are no extra costs involved (like taxes or fees), the total amount of money
paid to the shareholders is the same as the money the company makes from its
assets (like factories or investments).
- Because of something called the "Law of One Price," it means that the
company's shares and its assets are worth the same amount in total.
- Therefore, if the company's choice of how to raise money (by selling shares or
taking loans) doesn't change the amount of money its assets make, it won't
change the total value of the company or how much money it can get from
investors.
- if the company's shares are priced fairly (not overvalued or undervalued), then
buying or selling them shouldn't change the company's overall value. This is
because when a company borrows money (takes on debt), it has to pay it back
later, and that payment is already accounted for in the value of the loan it
received. So, using debt (borrowing) doesn't create any extra profit or loss for the
company.

Homemade leverage
When investors use leverage in their own portfolios to adjust the leverage choice made by the
firm, we say that they are using homemade leverage.

The market value balance sheet

A market value balance sheet:
- all assets and liabilities of the firm are included – even intangible assets
- all values are current market value rather than historical costs

the market value balance sheet captures the idea that value is created by a firm’s choice of
assets and investment.

Market value of equity = market value of assets – market value of debt and other liabilities

A LEVERAGED RECAPITALIZATION
Leveraged recapitalization: transaction where a firm repurchases a significant percentage of
its outstanding shares.

18
MODIGLIANI – MILLER II: Leverage, risk and cost of capital
Debt itself may be cheap, it increases also the risk and therefore the cost of capital of the
firm’s equity.

MM I states:
E+D=U=A

Where, E and D denote the market value of equity and debt if the firm is levered,
U market value of equity if the firm is unlevered,
And A be the market value of the firm’s assets.

The levered equity return equals the unlevered return, plus an extra “kick” due to leverage.
This effect pushes the returns of levered equity even higher when the firm performs well
(RU> RD), but makes them drop even lower when the firm does poorly (RU < RD).
The amount od additional risk depends on the amount of leverage, measured by the firm’s
market value debt-equity ratio, D/E.

MM proposition II:
The cost of capital of levered equity increases with the firm’s market value debt-equity ratio

CAPITAL BUDGETING AND THE WEIGHTED AVERAGE COST OF CAPITAL

If a firm is financed with both equity and debt, then the risk of its underlying assets will
match the risk of a portfolio of its equity and debt. Thus, the appropriate cost of capital for
the firm’s assets is the cost of capital of this portfolio, which is simply the weighted average
of the firm’s equity and debt cost of capital:

The WACC, or after tax weighted average cost of capital, is computed using the firm’s after
tax cost of debt.
Since we are in a setting of perfect capital markets, there are no taxes, so the firm’s WACC
and unlevered cost of capital coincide:

19
That is, with perfect capital markets, a firm’s WACC is independent of its capital structure
and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of
its assets.

As the fraction of the firm financed with debt increases, both the equity and the debt become
riskier and their cost of capital rises. Yet, because more weight is put on the lower-cost debt,
the weighted average cost of capital remains constant.

We measure the firm’s leverage in terms of its debt-to-value ratio, D/(E+D), which is the
fraction of the firm’s total value that corresponds to debt. With no debt, the WACC is equal to
the unlevered equity cost of capital.

As the amount of debt increases, the debt becomes riskier because there is a chance the firm
will default., moreover, the debt cost of capital R D also rises.

With perfect capital markets, the firm’s weighted average cost of capital, and therefore the
NPV of the expansion, is unaffected by how EBS chooses to finance the new investment.

COMPUTING THE WACC WITH MULTIPLE SECURITIES

If the firm’s capital structure is more complex, the R u and the Rwacc are calculated by
computing the weighted average cost of capital of all of the firm’s securities.

Suppose, a capital structure with debt, equity and the warrant:

LEVERED AND UNLEVERED BETAS

The unlevered beta measures the market risk of the firm’s underlying assets, and thus can be
used to assess the cost of capital for comparable investments. When a firm changes its capital
structure without changing its investments, its unlevered beta will remain unaltered.

20
However, its equity beta will change to reflect the effect of the capital structure change on its
risk.

The assets on a firm’s balance sheet include any holdings of cash or risk-free securities
because these holdings are risk-free, they reduce the firm of the firm’s assets.
For this reason, holding excess cash has the oppositive effect of leverage on risk and return.
We can view cash as negative debt.

CAPITAL STRUCTURE FALLACIES

Leverage and earnings per share

Leverage can increase a firm’s expected earnings per share. This increase might appear to
make shareholders better off and could potentially lead to an increase in the stock price.

The sensitivity of EPS to EBIT is higher for a levered firm than for an unlevered firm. Thus,
given assets with the same risk, the EPS of a levered firm is more volatile.

Because the firm’s earnings per share and price-earnings ratio are affected by leverage, we
cannot reliably compare these measures across firms with different capital structures.

Equity issuances and dilution

Another often heard fallacy is that issuing equity will dilute existing shareholder’s ownership,
so debt financing should be used instead. By dilution, the proponents of this fallacy mean
that if the firm issues new shares, the cash flows generated by the firm must be divided
among a larger number of shares, thereby reducing the value of each individual share.

In general, if the firm sells the new shares of equity at a fair price, there will be no gain or
loss to shareholders associated with the equity issue itself. The money taken in by the firm as
a result of the share issue exactly offsets the dilution of shares.

21
CHAPTER 15 – DEBT AND TAXES
The interest tax deduction
Corporations must pay taxes on the income that they earn. Because they pay taxes on their
profits after interest payments are deducted, interest expenses reduce the amount of corporate
tax firms must pay. This feature of the tax code creates an incentive to use debt.

The value of a firm is the total amount it can raise from all investors, not just equity holders.
Because leverage allows the firm to pay out more in total to its investors it will be able to
raise more total capital initially.

The gain to investors from the tac dudctuibility of interest payments is referred to as the
interest tax shield. The interest tax shield is the additional amount that a firm would have
piad in taxes if it did not have leverage.

Interest tax shield = corporate tax rate x interest payments

VALUING THE INTEREST TAX SHIELD

The firm uses some fraction to pay taxes, and it pays the rest to investors. By increasing the
amount paid to debt holders through interest payments, the amount of the pre-tax cash flows
that must be paid as taxes decreases. The gain in total cash flows to investors is the interest
tax shield.

Change to MM proposition I in the presence of taxes:

The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt.

This from the Law of One Price, because the cash flows of the levered firm are equal to the
sum of the cash flows from the unlevered firm plus the interest tax shield, and by the law the
same must be true for the present values of these cash flows.

The interest tax shield with permanent debt

22
The above calculation assumes the debt is risk free and the risk-free interest rate is constant.

The weighted average cost of capital with taxes

With tax-deductible interest, the effective after-tax borrowing rate is r(1-c)

The tax-deductibility of interest payments, howver, lowers the effective after tax cost of debt
to the firm.

The WACC represents the effective cost of capital to the firm, after including the beneifts of
the interest tax shield. It is therefore power than the pre-tax WAACC, which is the average
return paid to the firm’s investors.

The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the
lower its WACC is.

The interest tax shield with a target debt-equity ratio

It is unrealistic to have a constant level of debt, for this many firms target a specific debt-
equity ratio. Normally, the level of debt will grow with the size of the firm.

When a firm adjusts its debt over time so that its debt equity ratio is expected to remain
constant, we can compute its value with leverage, V L by discounting its free cash flow using
the WACC. The value of the interest tax shield can be found by comparing V L to the
unlevered value, VU of the free cash flow discounted at the firm’s unlevered cost of capital,
the pre tax WACC.

The WACC declines with leverage as the interest tax shield grows.

23
RECAPITALIZING THE CAPTURE THE TAX SHIELD
Recapitalizing: firm makes a significant change to its capital structure.

When securities are fairly priced, the original shareholders of a firm capture the full benefit
of the interest tax shield from an increase in leverage.

PERSONAL TAXES
Personal taxes reduce the cash flows to investors and diminish firm value. As a result, the
actual interest tax shield depends on the reduction in the total taxes that are paid.
- Personal taxes have the potential to offset some of the corporate tax benefits of
leverage

Determining the actual tax advantage of debt

The effective tax advantage of debt depends upon the tax treatment of investment income for
investors.
In our estimation we have thus far focused on investors in the top tax bracket. However, most
investors’ investment income is actually taxed at the highest rate.

Aat lower rates, the effects of personal taxes are less substantial. But more importnaalty,
many investors face no personal taxes on their investments.
- For example, Stocks or bonds are held in many types of retirement savings
accounts, any income or capital gains are not subject to taxes
Another factor that affects tax rates is the holding period. Individuals who are only short-term
investors in a stock will fail to qualify for the lower tax rates on equity. Instead, dividends
and capital gains will be taxed at the ordinary income tax rate, just like interest income.
- Both investors saving for retirement, as well as short-term investors and
securities dealers, are taxes on interest, dividends, and capital gains. From the
perspective of these investors the effective tax advantage of debt is simply the
corporate tax rate.

Valuing the interest tax shield with personal taxes

As long as t*>0, then despite any tax disadvantage of debt at the personal level, a net tax
advantage for leverage remains. In the case of permanent debt, the value of the firm with
leverage becomes

Because the personal tax disadvantage of debt implies t* < tc we see that the benefit of
leverage is reduced.

24
While we still compute the WACC using the corporate tax rate, tc, with personal taxes the
firm’s equity and debt costs of capital will adjust to compensate investors for their respective
tax burdens. The net result is that a personal tax disadvantage for debt causes the WACC to
decline more slowly with leverage than it otherwise would.

Optimal capital structure with taxes

In Modigliani and Miller's setting of perfect capital markets, firms could use any combination
of debt and equity to finance their investments without changing the value of the firm. In
effect, any capital structure was optimal. In this chapter we have seen that taxes change that
conclusion because interest payments create a valuable tax shield. While this tax benefit is
somewhat offset by investor taxes, it is likely that a substantial tax advantage to debt remains.

Do firms prefer debt? (USA date)

Firms prefer debt when raising external funds, but not all investment is externally founded.
Capital expenditures greatly exceed firms’ external financing, implying that most investment
and growth is supported by internally generated funds, such as retained earnings.
Two important tendencies:
1. The use of leverage varies greatly by industry
2. Many firms retain large cash balances to reduce their effective leverage

Limits to the tax benefit of debt

To receive the full tax benefits of leverage, a firm need not use 100% debt financing. A firm
receives a tax benefit only if it is paying taxes in the first place. Meaning that the firm must
have taxable earnings.
No corporate tax benefit arises from incurring interest payments that regularly exceed the
income limit. Because interest payments constitute a tax disadvantage at excess leverage,
making them worse off. We can quantify the tax disadvantage for excess interest payments by
setting tc= 0,

The t(ex) is negative because equity is taxes heavily than interest for most investors.

The optimal level of leverage from a tax saving perspective is the level such that interest just
equals the income limit.

Growth and debt

In a tax optimal capital structure, the level of interest payments depends on the level of EBIT.
Examine young technology or biotechnology firms, we find that these firms do not have any
taxable income. They value comes from the prospect of future profits. Since they are recent
firms, they do not have any revenues, and so will not have any tremendous potential. In this
case, a tax optimal capital structure does not include debt, but only equity financed. To avoid
excess interest, this type of firm should have debt with interest payments that are below its
expected taxable earnings. That is, if the limit of the interest deduction is k x EBIT, then…

From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings.

25
However, the value of the firm’s equity will depend on the growth rate of earnings: the higher
the growth rate, the higher the value of equity is. As a result, the optimal proportion of debt in
the firm’s capital structure [D / (D+E)] will be lower, the higher the firm’s growth rate.

26
CHAPTER 16 – FINANCIAL DISTRESS, MANAGERIAL INCENTIVES AND
INFORMATION
debt financing puts an obligation on a firm. A firm that fails to make the required interest or
principal payments on the debt is in default. After the firm defaults, debt holders are given
certain rights to the assets of the firm. In the extreme case, the debt holders take legal
ownership of the firm’s asset through a process called bankruptcy. Equity financing does not
carry this risk, while equity holders hope to receive dividends, the firm is not legally
obligated to pay them.

If a firm has access to capital markets and can issue new securities at a fair price, then it need
not default as long as the market value of its assets exceeds its liabilities. Whether default
occurs depends on the relative values of the firm’s assets and liabilities, not on its cash flows.

Example: Armin company, its revenue has fallen to recover they have created a new product,
do not know if the product will be a success or not, it can use equity or debt. If success the
product will be worth 150 million if it fails only 80 million. The debt matures with a tot
amount of 100 million.
Suppose product succeeds:
- Only equity financing: equity holders own the full amount
- With leverage: company must make 100 million debt payment, and equity
holders will own the remaining 50 million
But what if Armin does not have 100 million in cash available at the end of the year? If
Armin has debt, will it be forced to default? In perfect capital markets, the answer is no. as
long as the value of the firm’s assets exceeds its liabilities, Armin will be able to repay the
loan.
If a firm has access to capital markets and can issue new securities at a fair price, then it need
not default as long as the market value of its assets exceeds its liabilities. Whether default
occurs depends on the relative values of the firm’s assets and liabilities, not on its cash flows.

Suppose product fails:

- All equity financing: nothing happens
- If debt financing: company will experience financial distress. The firm has the
only possibility to default.

Overall, if the new product fails, the company’s investors are equally unhappy whether the
firm is levered and declares bankruptcy or whether it is unlevered and the share price
declines.

Moreover, if the product fails the company will also experience economic distress, which is
a significant decline in the value of aa firm’s assets.

Bankruptcy and capital structure

While it is true that bankruptcy results from a firm having leverage, bankruptcy alone does
not lead to a greater reduction in the total value to investors. Thus, there is no disadvantage to
debt financing, and a firm will have the same total value and will be able to raise the same
amount from investors with either choice of capital structure.

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THE COST OF BANKRUPTCY AND FINANCIAL DISTRESS
The bankruptcy code
When a firm fails to make a require payment to debt holders, it is in default. Debt holders can
then take legal action against the firm to collect payment by seizing the firm’s assets.
Because most firms have multiple creditors, without coordination it is difficult to guarantee
that each creditors will be treated fairly. Moreover, because the assets of the firm might be
more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy
much of the remaining value of the firm.
Firm can file for two forms of bankruptcy protection:
- Liquidation, a trustee is appointed to oversee the liquidation of the firm’s assets
through an auction. The proceeds from the liquidation are used to pay the firm’s
creditors, and the firm ceases to exist.
- Reorganization, all pending collection attempts are automatically suspended,
and the firm’s existing management is given the opportunity to propose a
reorganization plan. The plan specifies the treatment of each creditor of the firm.
In addition to cash payment, creditors may receive new debt or equity securities
of the firm. The value of cash and securities is generally less than the amount
each creditor is owed, but more than the creditors would receive of the firm were
shut down immediately and liquidated.

Direct costs of bankruptcy

- Professionals

Direct costs of bankruptcy reduce the value of the assets that the firm’s investors will
ultimately receive. Many aspects of the bankruptcy process are independent of the size of the
firm, the costs are typically higher in percentage terms, for smaller firms.
When a financially distressed firm is successful at reorganizing outside of bankruptcy, it is
called workout. The direct costs of bankruptcy should not substantially exceed the cost of a
work-out.
Another approach is prepackaged bankruptcy in which a firm will first develop a
reorganization plan with the agreement of its main creditors, and then file to implement the
plan. With a prepack the firm emerges from bankruptcy quickly and with minimal direct
costs.

Indirect costs of financial distress

- Loss of customers: impact low on the value of firm that produces raw materials
for example
- Loss of suppliers: the bankruptcy filing itself can alleviate these problems
through debtor-in-possession (DIP) financing. DIP financing is a new debt
issued by a bankrupt firm. Because this kind of debt Is senior to all existing
creditors, it allows a firm that has filed for bankruptcy renewed access to
financing to keep operating
- Loss of employees
- Loss of receivables
- Fire sales of assets: sales assets at lower price to raise cash quickly
- Inefficient liquidation
- Cost of creditors

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OPTIMAL CAPITAL STRUCTURE: THE TRADEOFF THEORY
The tradeoff theory weights the benefits of debt that result from shielding cash flows from
taxes against the costs of financial distress associated with leverage.
According to this theory, the total value of a levered firm equals the value of the firm with-
out leverage plus the present value of the tax savings from debt, less the present value of
financial distress costs.

VL = VU + PV(interest tax shield) – PV(financial distress costs)

The present value of financial distress costs

Three key factors determine the present value of financial distress costs:
1. The probability of financial distress
Depends on the likelihood that a firm will be unable to meet its debt commitments
and therefore default. This probability increases with the amount of a firm’s liabilities
and with the volatility of a firm’s cash flow and asset values.
2. The magnitude of the costs if the firm is in distress
Depends on the relative importance of the costs (direct and indirect costs of
bankruptcy). For example, technology firms, whose value comes largely from human
capital, are likely to I cur high costs when they risk financial distress, due to the
potential for loss of customers and the need to hire the retain key personnel, as well as
aa lack of tangible assets that can be easily liquidates. Oppositive is for firms whose
main assets are physical capital, real estate.
3. The appropriate discount rate for the distress costs
Depends on the firm’s market risk. The higher the firm’s beta, the more likely it will
be in distress in an economic downturn, and thus the more negative the beta of its
distress costs will be. The present value of distress costs will be higher for high beta
firms.

Optimal leverage

The value of levered firm, VL, depends on the value of debt, D.

With no debt, the value of the firm is VU, value unlevered.
With low level of debt, the risk of default remains low, but we have an increase in leverage
and an increase in the interest tax shield, t*D, where t* is the effective tax advantage of debt.
The costs of financial distress reduce the value of the levered firm, V L.
The tradeoff theory states that firms should increase their leverage until it reaches the level
D* for which VL is maximized. D*low will be lower for firms with higher cost of financial
distress.

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EXPLOITING DEBT HOLDERS: THE AGENCY COSTS OF LEVERAGE
Agency costs, costs that arise when there are conflicts of interest between stakeholders.
When a firm faces financial distress, shareholders can gain from decisions that increase the
risk of the firm sufficiently, even if they have a negative NPV. Because the leverage gives
shareholders an incentive to replace low-risk assets with riskier ones, this result is often
referred to as the asset substitution problem.
If the firm increases risk through a negative NPV decision or investment, the total value of
the firm will be reduced.

Debt overhang and under-investment

Debt overhang is a financial term used to describe a situation in which a company or
individual has taken on a significant amount of debt, to the point where it impairs their ability
to make new investments.
When a firm faces financial distress, it may choose not to finance new, positive NPV projects.
In this case, when shareholders prefer not to invest in a positive NPV project, we say there is
a debt overhang or under-investment problem. This failure to invest is costly for debt
holders and for the overall value of the firm.
How much leverage must a firm have for there to be a significant debt overhang problem?
Equity holders will benefit from the new investment only if:

𝑁𝑃𝑉 𝐷 𝐷
>
𝐼 𝐸 𝐸

NPV / I: project’s profitability index, must exceed a cutoff equal to the relative riskiness of
the firm’s debt 𝐷 /𝐸 times its debt-equity ratio (D/E).

Agency costs and the value of leverage

The magnitude of the agency costs increases with the risk, and therefore the amount, of the
firm’s debt. Agency costs, therefore, represent another cost of increasing the firm’s leverage
that will affect the firm’s optimal capital structure choice.

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CHAPTER 17 – DISTIRBUTIONS TO SHAREHOLDERS
Payout policy: alternative uses of free cash flow.

A firm can retain its free cash flow, either investing or accumulating it, or pay out its free
cash flow through a dividend or share repurchase. The choice between holding cash,
repurchasing shares, or paying dividends in determined by the firm’s payout policy.

Dividends
A public company’s board of directors determines the amount of the firm’s dividend. the
declaration date is the date on which the board authorizes the dividend. after the board
declares the dividend, the firm is legally obligated to make the payment.
The record date is the date at which the firm will pay the dividend to all shareholders. To be
registered as a shareholder it will take three days, for this reason only shareholders who
purchased shares three days before the record date are legit for receiving dividends. The date
two business days prior to the record date is known as the ex-dividend date, anyone who
purchases the stock on or after the ex-dividend date will not receive the dividend.
On the payable date, or distribution date, which is generally about a month after the record
date, the firm mails dividend checks to the registered shareholders.

In a stock split or stock dividend, the company issues additional shares rather than cash to
its shareholders.

Dividends are a cash outflow for the firm. From an accounting perspective, dividends
generally reduce the firm’s current retained earnings.

Share repurchases
An alternative way to pay cash to investors is through a share repurchase or buyback.

1. Open market repurchase is the most common way that firms repurchase shares. A
firm announces its intention to buy its own shares in the open market, and then
proceeds to do so over time like any other investor.
2. Tender offer, a firm can repurchase shares through a tender offer in which it offers to
buy shares at a specific price during a short time – within 20 days. Related method –
Dutch auction.

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 3. Targeted repurchase, the firm purchase shares directly from a major shareholder in a
targeted repurchase. In this case the purchase price is negotiated with the seller.

Comparison of dividends and share repurchases

If a corporation decides to pay cash to shareholders, it can do so through either dividend
payments or share repurchases. In perfect capital markets setting of Modigliani and Miller,
the method of payment does not matter.

Alternative policy 1: pay dividend with excess cash

The board opt for the first alternative and uses all excess cash to pay a dividend. the share
price falls when a dividend is paid because the reduction in cash decreases the market value
of the firm’s assets. Although the stock price falls, holders of stock do not incur a loss overall.
The fact that the stock price falls by the amount of the dividend aalso follows from the
assumption that no opportunity for arbitrage exists. If it fell by less than the dividend, an
investor could earn a profit by buying the stock just before it goes ex-dividend and selling it
just after.
In a perfect capital market, when a dividend is paid, the share price drops by the amount of
the dividend when the stock begins to trade ex-dividend.

Alternative policy 2: share repurchase (no dividend)

The market value of assets falls when the company pays out cash, but the number of shares
outstanding also falls. The two changes offset each other, so the share price remains the same.

By not paying a dividend today and repurchasing share instead, the firm is able to raise its
dividends per share in the future.

In perfect capital markets, an open market share repurchase has no effect on the stock price,
and the stock price is the same as the cum-dividend price if a dividend were paid instead.

In perfect capital markets, investors are indifferent between the firm distributing fund via
dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate
either payout method on their own.

Alternative policy 3: high dividend (equity issue)

Suppose the company wants to pay 48 million in dividends starting next year, but firm wants
to pay the amount today. Since it has only 20 million in cash today, firm needs an additional
28 million. It could raise cash by scaling back its investment. But if the investments have
positive NPV, reducing them would lower firm value. An alternative way to raise more cash
is to borrow money or sell new shares.

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MM dividend irrelevance: in perfect capital markets, holding fixed the investment policy of
a firm, the firm’s choice of dividend policy is irrelevant and does ot affect the initial share
price.

Because a share repurchase reduces the number of shares outstanding, it increases earnings
per share (EPS).

THE TAX DISADVANTAGE OF DIVIDENDS

Shareholders must pay taxes on the dividends they receive. They must also pay capital gains
taxes when they sell their shares. When a firm pays a dividend, shareholders are taxed
according to the dividend tax rate.
If the firm repurchases shares instead, and shareholders sell shares to create a homemade
dividend, the homemade dividend will be taxed according to the capital gains tax rate.
If dividends are taxed at a higher rate than capital gains, shareholders will prefer share
repurchases to dividends.
Nowadays, the tax code equalized the tax rates on dividends and capital gains, because
capital gains taxes are deferred until the asset is sold, there is still a tax advantage for share
repurchases over dividends for long-term investors.

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