Corporate finance 7e ross ch16

16-1 CHAPTER 16 Capital Structure: Limits to the Use of Debt McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-2 Chapter Outline 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 Signaling 16.6 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 16.7 The Pecking-Order Theory 16.8 Growth and the Debt-Equity Ratio 16.9 Personal Taxes 16.10 How Firms Establish Capital Structure 16.11 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-3 16.1 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 the costs associated with bankruptcy It is the stockholders who bear these costs McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-4 16.2 Description of Costs Direct Costs Legal and administrative costs (tend to be a small percentage of firm value) Indirect Costs Impaired ability to conduct business (e.g., lost sales) Agency Costs Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-5 Balance Sheet for a Company in Distress Assets BVMVLiabilities Cash $200$200LT bonds Fixed Asset $400$0Equity $300 Total $600$200Total $600 BVMV $300 $200 $200 $0 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-6 Selfish Strategy 1: Take Large Risks The Gamble Win Big Lose Big Probability 10% 90% Payoff $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 + (1.10) NPV = –$133 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-7 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: PV of Stocks With the Gamble: McGraw-Hill/Irwin Corporate Finance, 7/e $30 $20 = (1.50) $70 $47 = (1.50) © 2005 The McGraw-Hill Companies, Inc All Rights 16-8 Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $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 or reject? McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 16-9 Selfish Stockholders Forego Positive NPV Project Expected CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 – $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project: PV of Stocks With the Project: McGraw-Hill/Irwin Corporate Finance, 7/e $300 $272.73 = (1.10) $50 – $100 $54.55 = (1.10) © 2005 The McGraw-Hill Companies, Inc All Rights 1610 Selfish Strategy 3: Milking the Property Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders Such tactics often violate bond indentures Increase perquisites to shareholders and/or management McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1617 16.6 Shirking, Perquisites, and Bad Investments: The Agency Cost of Equity An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help” Who bears the burden of these agency costs? While managers may have motive to partake in perquisites, they also need opportunity Free cash flow provides this opportunity The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1618 16.7 The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Rule Use internal financing first Rule Issue debt next, equity last The pecking-order Theory is at odds with the trade-off theory: There is no target D/E ratio Profitable firms use less debt Companies like financial slack McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1619 16.8 Growth and the Debt-Equity Ratio Growth implies significant equity financing, even in a world with low bankruptcy costs Thus, high-growth firms will have lower debt ratios than low-growth firms Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1620 16.9 Personal Taxes: The Miller Model The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:  (1 −TC ) × (1 −TS )  VL = VU + 1 − × B −TB   Where: TS = personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1621 Personal Taxes: The Miller Model The derivation is straightforward: Shareholders in a levered firm receive ( EBIT −rB B ) × (1 −TC ) × (1 −TS ) Bondholders receive rB B × (1 −TB ) Thus, the total cash flow to all stakeholders is ( EBIT −rB B ) × (1 −TC ) × (1 −TS ) + rB B × (1 −TB ) This can be rewritten as  (1 −TC ) × (1 −TS )  EBIT × (1 −TC ) × (1 −TS ) + rB B × (1 −TB ) × 1 −  − TB   McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1622 Personal Taxes: The Miller Model (cont.) The total cash flow to all stakeholders in the levered firm is:  (1 −TC ) × (1 −TS )  EBIT × (1 −TC ) × (1 −TS ) + rB B × (1 −TB ) × 1 −  − TB   The first term is the cash flow of an unlevered firm after all taxes A bond is worth B It promises to pay rBB×(1- TB) after taxes Thus the value of the second term is:  (1 − TC ) × (1 − TS )  B × 1 −  − TB The value of the sum of these   two terms must be VL  (1 −TC ) × (1 −TS )  ∴VL = VU + 1 − × B −TB   Its value = VU McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1623 Personal Taxes: The Miller Model (cont.) Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:  (1 −TC ) × (1 −TS )  = VUwe+return In the case where VTB 1 −to M&M with only corporate tax: × B L = TS, −TB   VL = VU + TC B McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1624 Effect of Financial Leverage on Firm Value with Both Value of firm (V) Corporate and Personal Taxes VU  (1 −TC ) × (1 −TS )  VL = VU + 1 − × B −TB   VL = VU+TCB when TS =TB V L < V U + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) VL =VU when (1-TB) = (1-TC)×(1-TS) VL < VU when (1-TB) < (1-TC)×(1-TS) Debt (B) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1625 Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Present value of financial distress costs Value of firm (V) Present value of tax shield on debt Value of firm under MM with corporate taxes and debt VL = VU + TCB 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 McGraw-Hill/Irwin Corporate Finance, 7/e Agency Cost of Debt Debt (B) B* Optimal amount of debt © 2005 The McGraw-Hill Companies, Inc All Rights 1626 16.10 How Firms Establish Capital Structure Most Corporations Have Low Debt-Asset Ratios Changes in Financial Leverage Affect Firm Value Stock price increases with increases in leverage and viceversa; this is consistent with M&M with taxes Another interpretation is that firms signal good news when they lever up There are Differences in Capital Structure Across Industries There is evidence that firms behave as if they had a target Debt to Equity ratio McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1627 Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt Types of Assets 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 Pecking Order and Financial Slack Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1628 16.11 Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of debt Direct costs Lawyers’ and accountants’ fees Indirect Costs 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1629 16.11 Summary and Conclusions Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt Value of firm (V) Present value of tax shield on debt Maximum firm value McGraw-Hill/Irwin Corporate Finance, 7/e Value of firm under 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) © 2005 The McGraw-Hill Companies, Inc All Rights 1630 16.11 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 (1-TC) × (1-TS) = (1-TB) Value of firm (V) Present value of financial distress costs Present value of tax shield on debt Value of firm under MM with corporate taxes and debt VL = VU + TCB 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 McGraw-Hill/Irwin Corporate Finance, 7/e Agency Cost of Debt B* Optimal amount of debt Debt (B) © 2005 The McGraw-Hill Companies, Inc All Rights 1631 16.11 Summary and Conclusions Debt-to-equity ratios vary across industries Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt Types of Assets 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... firms will not finance entirely with debt Value of firm (V) Present value of tax shield on debt Maximum firm value McGraw-Hill/Irwin Corporate Finance, 7/e Value of firm under MM with corporate taxes... McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1614 Integration of Tax Effects and Financial Distress Costs Value of firm (V) Value of firm under MM with corporate. .. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 1618 16.7 The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance