Complete Guide To Corporate Finance

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Financial Leverage And Capital Structure Policy - Extended Pie Model, Observed Capital Structures And Long-Term Financing

Extended Pie Model
The extended pie model draws upon Modigliani and Miller's capital structure irrelevance theory. This model considers both corporate taxes and bankruptcy costs to be a claim on the firm's cash flows and illustrates the proportion of each entity's claim on the company's cash flows using pie charts. These pie charts also show how an increase or decrease in the company's debt relative to its equity increases or decreases each entity's claim.
Under the extended pie model, stockholders, bondholders, the government, bankruptcy courts, lawyers and other entities are each considered to have a partial claim on the company's cash flows. The size of each slice of the pie represents each entity's percentage claim.

The extended pie model helps illustrate the relationship between the value of the firm and its cash flows. It is an extension of Modigliani and Miller's theory because it attempts to show a way in which capital structure does not affect the firm's value.

Observed Capital Structures
Observed capital structure refers to the real-life capital structures of various industries as a whole as well as the individual businesses within those industries. Different industries have different proportions of debt and equity because they require varying levels of investment in plant, property and equipment. For example, capital-intensive industries tend to have more debt because banks are willing to make loans against fixed assets. Within the same industry, firms may have similar capital structures because similar businesses may have similar assets and liabilities. However, within the same industry, a given business's capital structure may differ from industry norms because of factors such as firm size, technology requirements and growth stage. (Learn more about the differences among major industries in our Industry Handbook.)

The Ibbotson Cost of Capital Yearbook, which as of February 2012 is published annually and updated quarterly, is a comprehensive and authoritative source of business valuation statistics, including cost of equity, cost of debt and weighted average cost of capital. According to the 2008 yearbook, the industries with the lowest debt levels were computers (5.61%) and drugs (7.25%). The industries with the highest debt levels were cable television (162.03%) and airlines (129.04%).

These numbers can change significantly in even a short amount of time. The same survey in 2004 also found that the industries with the lowest debt levels were drugs (6.38%) and paper and computers (10.24% to 10.68%), but the industries with the highest debt levels were airlines (64.22%) and electric utilities (49.03%). Notice the dramatic increase in the debt levels of the high-debt industries from 2004 to 2008.

Large capital outlays are also a fact of life for most telecom industry players. To finance their CAPEX initiatives, they often rely on debt financing. Department stores and steel companies have also historically had relatively high levels of debt. On the whole, however, U.S. corporations generally prefer equity financing over debt financing and therefore have low debt-to-equity ratios.

Long-Term Financing under Financial Distress/Bankruptcy
Financial distress is a condition in which a company cannot meet or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has high fixed costs, illiquid assets or revenues that are sensitive to economic downturns.

A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise much-needed funds. In an effort to satisfy short-term obligations, management might forego profitable longer-term projects. Employees of a distressed firm usually have higher stress, lower morale and lower productivity caused by the increased chance of the company's bankruptcy, which would force them out of their jobs.

Bankruptcy is a legal proceeding involving a person or business that is unable to repay outstanding debts. The bankruptcy process begins with a petition filed by the debtor (most common) or on behalf of creditors (less common). All of the debtor's assets are measured and evaluated, whereupon the assets are used to repay a portion of outstanding debt. Upon the successful completion of bankruptcy proceedings, the debtor is relieved of the debt obligations incurred prior to filing for bankruptcy.

Bankruptcy offers an individual or business a chance to start fresh by forgiving debts that simply can't be repaid while offering creditors a chance to obtain some measure of repayment based on what assets are available.

Bankruptcy filings in the United States can fall under one of several chapters of the Bankruptcy Code, such as Chapter 7 (which involves liquidation of assets), Chapter 11 (company or individual "reorganizations") and Chapter 13 (debt repayment with lowered debt covenants or payment plans). Bankruptcy filing specifications vary widely among different countries, leading to higher and lower filing rates depending on how easily a person or company can complete the process.

Some firms are at greater risk of financial distress than others. Any firm with volatile earnings has an increased risk of financial distress. For example, a retail company might be considered at greater risk of financial distress because many retail companies have dramatically higher sales in the fourth quarter than in other quarters. Firms whose value largely derives from intangible assets are also at higher risk of financial distress since they have little that can be sold off to repay debt. (For related reading, see
Well-Established Brands Worth Billions and June Retail Sales: Worthless Data Or Valuable Tool?)

Firms with a higher risk of financial distress are well advised to issue bonds with caution since they may struggle to repay the debt. Financial distress does not just harm bondholders and stockholders who stand to lose their investments; it also harms the firm in ways that make a bad situation worse. As we mentioned above, a firm in financial distress will find it more difficult and more expensive to borrow. Difficulty in borrowing or in obtaining credit from suppliers can diminish inventory and make it harder to make sales and to retain and attract customers. Existing and potential customers may seek alternatives with companies that have better inventories and that they are confident they can return to for repeat business. Financial distress can also cause the firm to lose key talent to more stable job opportunities. Finally, filing for bankruptcy requires expensive legal assistance.

The costs of financial distress and bankruptcy thus illustrate once again why choosing an optimal capital structure and not taking on too much long-term debt are crucial to a firm's vitality and longevity. (Read more in The 5 Best Corporate Comebacks and Cash In On Companies With Declining Sales.)

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