Introduc corporate finance ch16

Chapter 16: Limits to the Use of Debt 16.1 Costs of Financial Distress 16.2 Description of Costs 16.3 Can Costs of Debt Be Reduced? 16.4 Integration of Tax Effects and Financial Distress Costs 16.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 16.6 The Pecking-Order Theory 16.7 Growth and the Debt-Equity Ratio 16.8 Personal Taxes 16.9 How Firms Establish Capital Structure 16.10 Summary and Conclusions M&M Assumptions  Homogeneous expectations  Homogeneous business risk classes  Perpetual cash flows: V = CF/r  Perfect capital markets  No market frictions:     corporate or personal taxes, issue costs, transactions costs, costs of financial distress The Modigliani-Miller Capital Structure Propositions NO TAX CASE: Proposition I: Proposition II: VL = VU rS = r0 +(B/S)(r0-rB) WITH CORPORATE TAXES: Proposition I: VL = VU + TCB Proposition II: rS = r0 +(B/SL)(1- TC) (r0-rB) MM Theory with Taxes VL = VU + TCB  implies firms should issue nearly all debt financing Extensions  personal taxes  financial distress costs Costs of Financial Distress  Bankruptcy risk versus bankruptcy cost  The possibility of bankruptcy has a negative effect on the value of the firm  However, it is not the risk of bankruptcy itself that lowers value  Rather it is bankruptcy  It is the stockholders who bear these costs the costs associated with Costs of Financial Distress  Direct costs  Indirect costs  Financial distress costs result in an interior solution in the determination of optimal capital structure VL = VU + PV(tax savings)-PV(costs of financial distress) Costs of Financial Distress  Direct Costs  Legal and administrative costs  Indirect Costs  Impaired ability to conduct business (e.g., lost sales)  Selfish strategy 1: Incentive to take large risks  Selfish strategy 2: Incentive toward underinvestment  Selfish Strategy 3: Milking the property Balance Sheet for a Company in Distress Assets BVMVLiabilities Cash $200$200LT bonds Fixed Asset$400 $0Equity Total $600$200Total $600 BVMV $300 $300 $200 $200 $0 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big Lose Big 10% 90% $1,000 $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 $100 NPV = −$200 + NPV = −$133 1.50 Selfish Stockholders Accept Negative NPV Project with Large Risks  Expected CF from the Gamble       To Bondholders = $300 × 0.10 + $0 = $30 To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble = $30 / 1.5 = $20 PV of Stocks With the Gamble = $70 / 1.5 = $47 Work the Web Example   You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Yahoo Marketguide Click on the web surfer to go to the site   Choose a company and get a quote Choose ratio comparisons Factors in Target D/E Ratio  Taxes   Types of Assets   The costs of financial distress depend on the types of assets the firm has Uncertainty of Operating Income   If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt Even without debt, firms with uncertain operating income have high probability of experiencing financial distress Pecking Order and Financial Slack  Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Example  EXES is an all equity firm (1,000 shares)  r0 = 20%  All earnings are paid as dividends  TC=TS=TB=0  Expected Operating Income (EBIT) Probability EBIT 0.1 $1,000 0.4 $2,000 0.5 $4,200 E(EBIT) = 1(1,000) + 4(2,000) + 5(4,200) = $3,000 Example, continued a What is the value of EXES Company? VU = SU = (EBIT)/r0 = $3,000/.2 = $15,000 b The president of EXES has decided that shareholders would be better off if the company had equal proportions of debt and equity He proposes to issue $7,500 of debt at an interest rate of 10% He will use the proceeds to repurchase 500 shares of common stock Example, continued i What will the new value of the firm be? Since we are in a world with no taxes: VL =VU= $15,000 ii What will the value of EXES’s debt be? B = $7,500 iii What will the value of EXES’s equity be? SL = VL-B = $15,000-$7,500 = $7,500 Example, continued c Suppose the president’s proposal is implemented i What is the required rate of return on equity? rS = r0 +(B/S)(r0-rB) = 20+(7500/7500)(.20-.10) = 0.30 = 30% ii What is the firm’s overall required return? WACC= (7500/15000)(10%) + (7500/15000)(30%) = 20%= r Example, continued d Suppose the corporate tax rate is 40% i What is the value of the firm? VU = SU = (EBIT) (1- TC) / r0 = $3000(1-.4)/.2 = $9,000 VL= VU +TC B =$9,000+ 40*$7,500 = $12,000 Example, continued Does the presence of taxes increase or decrease the value of the firm? ii  Taxes decrease the value of the firm because the government becomes a claimant on the firm’s assets How does the presence of bankruptcy costs change the effect of taxes on the value of the firm? iii  They will further lower the value of the firm Example, continued e Suppose TB=40% and TS=0 i What is the value of EXES? (1 − TC )(1 − TS ) VL = VU + [1 − ]B − TB = $9,000 + [1-(1-.4)(1-0)/(1-.4)]($7,500) = $9,000  The debt no longer adds value Example, continued ii Under the Miller model, what will happen to the value of the firm as the tax on interest income rises? (TB=55%) VL= $9,000+[1-(1-.4)/(1-.55)]($7,500) = $6,500 Summary and Conclusions  Costs of financial distress cause firms to restrain their issuance of debt  Direct costs   Indirect Costs      Lawyers’ and accountants’ fees Impaired ability to conduct business Incentives to take on risky projects Incentives to underinvest Incentive to milk the property Three techniques to reduce these costs are:    Protective covenants Repurchase of debt prior to bankruptcy Consolidation of debt Summary and Conclusions  Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt Value of firm under Value of firm (V) Present value of tax shield on debt Maximum firm value MM with corporate taxes and debt VL = VU + TCB Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt B* Optimal amount of debt Debt (B) Summary and Conclusions  If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset In fact, the corporate advantage to debt is eliminated if (1TC) × (1-TS) = (1-TB)Present value of Value of firm (V) Value of firm under MM with corporate taxes and debt VL = VU + TCB financial distress costs Present value of tax shield on debt VL < VU + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) Maximum firm value VU = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt B* Optimal amount of debt Debt (B) Summary and Conclusions   Debt-to-equity ratios vary across industries Factors in Target D/E Ratio  Taxes   Types of Assets   If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt The costs of financial distress depend on the types of assets the firm has Uncertainty of Operating Income  Even without debt, firms with uncertain operating income have high probability of experiencing financial distress The Bottom Line  The validity of the MM propositions depend on the nature and degree of market imperfections  Some market imperfections are important: corporate and personal taxes, agency costs, and other costs of financial distress  There is a target debt-to-equity range for most firms  A safe strategy is to stay close to the industry average since these firms represent the survivors ... income TC = corporate tax rate Personal Taxes: The Miller Model (cont.)  (1 − TC ) × (1 − TS )  VL = VU + 1 − × B − TB   • In the case where TB = TS, we return to M&M with only corporate. .. Structure Propositions NO TAX CASE: Proposition I: Proposition II: VL = VU rS = r0 +(B/S)(r0-rB) WITH CORPORATE TAXES: Proposition I: VL = VU + TCB Proposition II: rS = r0 +(B/SL)(1- TC) (r0-rB) MM... $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10% $350 NPV = −$300 + 1.10 NPV = $18.18 •Should we accept