Principles of Corporate Finance Brealey, Myers, Partington and Robinson 1st Australian Edition How Much Should a Firm Borrow? Slides by Matthew Will and Graham Partington Chapter 18 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al Irwin/McGraw Hill 18- Topics Covered Corporate Tax and Debt Tax Shields Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- Debt Tax Shields Interest payments are tax deductible So debt provides a tax shield This is very good news under a classical tax system, but less good under an imputation system Under imputation, less corporate tax paid means less franking credits for investors For the time being we will concentrate on the firm’s tax position only Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- Value of Tax Shield Consider firm U (Unlevered) and firm L (Levered) L is identical to U, except that L has borrowed $1,000 at 8% Earnings before interest and taxes Interest paid to bondholders Pretax income Tax at 36 percent Net income to shareholders Total income to both bondholders and shareholder Interest tax shield (0.36 x interest) Income Statement of Firm U $1,000 1,000 360 $640 $0 + 640 = $640 Income Statement of Firm L $1,000.00 80.00 920.00 331.20 $588.80 $80 + 588.80= $668.80 $0 $28.80 Tax Saving is $28.80 per year Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- Value of Tax Shield What is the value of $28.80 in perpetuity? If the tax shield has the same risk as the debt then the value is: 28.80/ 0.8 =$360 1,000 x 0.08 x 0.36 = $28.80 In general: PV of Tax Shield = (assume perpetuity) D x rD x Tc = D x Tc rD Check: $1000 x 0.36 = $360 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- M&M and Taxes By reducing the governments claim on the firm more of the pre-tax value becomes after tax value NORMAL BALANCE SHEET (MARKET VALUES) Asset value Debt =(PV of after-tax cash flows) Equity Total assets Total liabilities and equity EXPANDED BALANCE SHEET (MARKET VALUES) Pretax asset value Debt =(PV of pretax cash flows) Government’s claim (PV of future taxes) Equity Total pretax assets Total liabilities and equity VL = VU + PV (tax shield) Irwin/McGraw Hill = Tc D if debt is permanent ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- A Problem with M&M Firm value is maximised with 100% debt Hardly sensible! Possible ways out of this difficulty: A personal tax disadvantage to debt outweighs its corporate tax advantage The value of debt tax shields is smaller if the tax deduction is risky Borrowing creates additional costs and risks that offset the debt tax benefit Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- Debt and Taxes (Personal & Corp.) Operating Income $1 Paid as interest Theory Paid as equity Income (no tax) $1.00 $1.00 Corporate tax None TC Income after corp' tax $1.00 Investor tax TP $1.00 - T C MM (no tax) V L = V U MM (corporate tax) V L = V U + T C D T PE (1.00 - T C ) Classical Tax Income after all tax (1.00 - T P ) ($1.00 -T C ) - T PE (1.00 - T C) = (1.00 -T C )(1 - T PE ) Irwin/McGraw Hill Miller (1 − T C )( − T PE ) V L = V U + D 1 − (1 − T P ) ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- Debt and Taxes (Personal & Corp.) TPE can effectively be less than TP because part the return comes as capital gains, or because of imputation tax credits Relative Advantage Formula ( Debt vs Equity ) 1-TP (1-TC) (1-TPE) Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18- 10 Debt and Taxes (Personal & Corp.) Relative Advantage Formula (RAF) Debt over Equity 1-TP (1-TPE) (1-TC) RAF > Advantage Debt RAF < Equity Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 10 18- 17 Miller’s Model and Imputation O p e tin g In c om e $1 P a id a s in te re s t In c om e (n o ta x) $ 0 C o rp o te ta x N o ne In c om e a fte r c o rp' ta x $ 0 Inv esto r ta x ,2 In c om e a fte r a ll ta x T P (1 0 - T P ) R e ta in e d P a id a s d iv id e n ds $ 0 T T C $ 0 - T T G (1 0 ($ 0 -T - T C) C $ 0 - T C = (1 0 - T Irwin/McGraw Hill $ 0 C) - T C )(1 T G (1 0 -T G) - T C) PE C - γ T (1 0 -T C) C -(T = (1 0 - T P) P -γ T - T C) C (1 -γ ) ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17 18- 18 Miller’s Model and Imputation If firms payout a fraction δ of their income and retain (1- δ) then the income to shareholders is: δ[(1-Tp)-TC(1-γ)] + (1-δ)[(1-Tc)(1-TG)] So we can re-write Miller’s Model as: δ[(1− Tp) − TC(1− γ )] + (1− δ )[(1− TC)(1− TG)] VL = VU +D 1− (1− Tp) If δ =1 and γ =1 then VL = VU Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18 18- 19 Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy Market Value = Irwin/McGraw Hill Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 19 18- 20 Financial Distress Market Value of The Firm Maximum value of firm PV(Costs of financial distress) PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 20 18- 21 Conflicts of Interest Circular File Company has $50 of 1-year debt Circular File Company (Book Values) Net W.C 20 50 Bonds outstanding Fixed assets 80 50 Common stock Total assets 100 100 Total liabilities Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 21 18- 22 Conflicts of Interest Circular File Company has $50 of 1-year debt Circular File Company (Market Values) Net W.C 20 25 Bonds outstanding Fixed assets 10 Common stock Total assets 30 30 Total liabilities Why does the equity have any value ? Shareholders have an option they can obtain the rights to the assets by paying off the $50 debt Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 22 18- 23 Conflicts of Interest Circular File Company has may invest $10 as follows Now Possible Payoffs Next Year $120 (10% probability) Invest $10 $0 (90% probability) Assume the NPV of the project is (-$2) What is the effect on the market values? Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 23 18- 24 Conflicts of Interest Circular File Company value (post project) Circular File Company (Market Values) Net W.C 10 20 Bonds outstanding Fixed assets 18 Common stock Total assets 28 28 Total liabilities Firm value falls by $2, but equity holder gains $3 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 24 18- 25 Conflicts of Interest Circular File Company value (assumes a safe project with NPV = $5) Circular File Company (Market Values) Net W.C 20 33 Bonds outstanding Fixed assets 25 12 Common stock Total assets 45 45 Total liabilities While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 25 18- 26 Other Financial Distress Games Cash In and Run Playing for Time Bait and Switch Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 26 18- 27 Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt E.g Firms with tangible assets and high profits should use more debt Explains similarity of debt ratios by industry, but not why profitable firms use less debt Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 27 18- 28 Issues and Share Prices Why security issues affect share price? The demand for a firm’s securities ought to be flat Any firm is a drop in the bucket Plenty of close substitutes Large debt issues don’t significantly depress the share price But the evidence is that share price falls in response to a rights issue Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 28 18- 29 Pecking Order Theory Consider the following story: The announcement of a share issue drives down the share price because investors believe managers are more likely to issue when shares are overpriced Therefore firms prefer internal finance since funds can be raised without sending adverse signals If external finance is required, firms issue debt first and equity as a last resort The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 29 18- 30 Pecking Order Theory Some Implications: Internal equity may be better than external equity Financial slack is valuable If external capital is required, debt is better (There is less room for difference in opinions about what debt is worth) Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 30 18- 31 One Final Benefit of Debt Shareholders worry about managers misusing free cash flow Using more debt reduces the available free cash flow It also forces managers to work harder and run a tighter ship Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 31 ... Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17 18- 18 Miller’s Model and Imputation If firms payout a fraction δ of their income and retain (1- δ) then... McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 13 18- 14 Example Imputation tax system with less than 100% dividend payout and less than full use... Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16 18- 17 Miller’s Model and Imputation O p e tin g In c om e $1 P a id a s in te re s t In c om e (n o ta