Fundamentals of Corporate Finance Chapter 15 Debt Policy Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- Topics Covered Debt and Value in a Tax Free Economy Capital Structure and Corporate Taxes Cost of Financial Distress Explaining Financial Choices McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- Value and Capital Structure Assets Value of cash flows from firm’s real assets and operations Value of Firm McGraw-Hill/Irwin Liabilities and Stockholder’s Equity Market value of debt Market value of equity Value of Firm Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- Average Book Debt Ratios McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- M&M (Debt Policy Doesn’t Matter) Modigliani & Miller When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure In other words, financial managers cannot increase value by changing the mix securities used to finance the company McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- M&M (Debt Policy Doesn’t Matter) Assumptions By issuing security rather than 2, company diminishes investor choice This does not reduce value if: Investors not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g No taxes No bankruptcy costs No effect on management incentives McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed Data Number of shares 100,000 Price per share $10 Market Value of Shares $ million Outcome State of the Economy Slump Expected Boom Operating Income $75,000 125,000 175,000 Earnings per share $.75 1.25 1.75 Return on shares 7.5% 12.5% 17.5% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share Market Value of Shares Market value of debt Outcome State of the Economy Operating Income Interest Equity earnings Earnings per share Return on shares McGraw-Hill/Irwin 50,000 $10 $ 500,000 $ 500,000 Slump $75,000 $50,000 $25,000 $.50 5% Expected 125,000 50,000 75,000 1.50 15% Boom 175,000 50,000 125,000 2.50 25% Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed - Debt replicated by investors Outcome State of the Economy Earnings on two shares LESS : Interest @ 10% Net earnings on investment Return on $10 investment McGraw-Hill/Irwin Slump Expected Boom $1.50 $1.00 $.50 5% 3.50 1.00 2.50 25% 2.50 1.00 1.50 15% Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 10 M&M (Debt Policy Doesn’t Matter) Example - River Cruises – Firm debt at 50% - Investor can unwrap debt Outcome State of the Economy Earnings on one share Slump Expected Boom $0.50 1.50 2.50 PLUS : Interest @ 10% Net earnings on investment Return on $10 investment $1.00 $1.50 7.5% McGraw-Hill/Irwin 1.00 2.50 12.5% 1.00 3.50 17.5% Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 11 C.S & Corporate Taxes Operating Risk (business risk) – Risk in the firm’s operating income Financial Risk - Risk to shareholders resulting from the use of debt Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt Interest Tax Shield- Tax savings resulting from deductibility of interest payments McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 12 Cost of Capital requity = rassets D + (rassets − rdebt ) E D E WACC = (1 − Tc )rdebt + requity D+E D+E McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 13 MM’s Proposition II (w/fixed interest rate) r rE rA rD D V McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 14 MM’s Proposition II (w/risky debt) r rE rA rD Risk free debt Risky debt Includes Bankruptcy Risk McGraw-Hill/Irwin D V Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 15 Weighted Average Cost of Capital r rE WACC with no bankruptcy risk WACC rD D V McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 16 C.S & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co The company has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you this and why? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 17 C.S & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co The company has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you this and why? EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow McGraw-Hill/Irwin All Equity 1/2 Debt 10,000 10,000 3,000 10,000 7,000 3,500 2,450 6,500 4,550 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 18 C.S & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co The company has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you this and why? EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow McGraw-Hill/Irwin All Equity 1/2 Debt 10,000 10,000 3,000 10,000 7,000 3,500 2,450 6,500 4,550 Total Cash Flow All Equity = 6,500 *1/2 Debt = 7,550 (4,550 + 3,000) Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 19 Capital Structure PV of Tax Shield = (assume perpetuity) D x rD x Tc = D x Tc rD Example: Tax benefit = 10,000 x (.06) x (.35) = $210 PV of 210 perpetuity = 210 / 06 = $3,500 PV Tax Shield = D x Tc = 10,000 x 35 = $3,500 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 20 Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy Market Value = McGraw-Hill/Irwin Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 21 Financial Distress Market Value of The Firm Maximum value of firm Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 15- 22 Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Financial Slack McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... bankruptcy Market Value = McGraw- Hill/Irwin Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 21 Financial Distress Market Value of The Firm Maximum value of firm Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt McGraw- Hill/Irwin... Risky debt Includes Bankruptcy Risk McGraw- Hill/Irwin D V Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 15 Weighted Average Cost of Capital r rE WACC with no bankruptcy risk WACC rD D V McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 16 C.S & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co The company... flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you do this and why? McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 17 C.S & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co The company has no debt... 11 C.S & Corporate Taxes Operating Risk (business risk) – Risk in the firm’s operating income Financial Risk - Risk to shareholders resulting from the use of debt Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt Interest Tax Shield- Tax savings resulting from deductibility of interest payments McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill... © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 22 Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Financial Slack McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you do this and why? EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow McGraw- Hill/Irwin All Equity 1/2 Debt 10,000 10,000 0 3,000 10,000 7,000 3,500 2,450 6,500 4,550 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 18 C.S & Corporate. .. The McGraw- Hill Companies, Inc All rights reserved 15- 19 Capital Structure PV of Tax Shield = (assume perpetuity) D x rD x Tc = D x Tc rD Example: Tax benefit = 10,000 x (.06) x (.35) = $210 PV of 210 perpetuity = 210 / 06 = $3,500 PV Tax Shield = D x Tc = 10,000 x 35 = $3,500 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 20 Financial Distress Costs of. .. Example - You own all the equity of Space Babies Diaper Co The company has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000 Should you do this and why? EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow McGraw- Hill/Irwin All Equity 1/2... Companies, Inc All rights reserved 15- 12 Cost of Capital requity = rassets D + (rassets − rdebt ) E D E WACC = (1 − Tc )rdebt + requity D+E D+E McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 15- 13 MM’s Proposition II (w/fixed interest rate) r rE rA rD D V McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved