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How Much Should a Firm Borrow?

This text explores the concept of tax shields in corporate finance and the impact they have on a firm's financing choices. It covers the calculation of the present value of tax shields for different debt issues and discusses the relative tax advantages of debt and equity. It also examines the costs of financial distress and the trade-off theory of capital structure. The text concludes by introducing the pecking order of financing choices and tests of this theory.

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How Much Should a Firm Borrow?

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  1. How Much Should a Firm Borrow? • Student Presentations • Why M & M Does Not Hold • Corporate Taxes • Personal Taxes • Financial Distress • Pecking Order of Financing Choices

  2. Corporate Taxes • Debt provides a tax shield • Interest is tax deductible • Government’s share of income declines • Value of bondholders’ and stockholders’ share increases

  3. Present Value of Tax Shield • Present value of tax shield • If debt is assumed to be a perpetuity

  4. Table 18.1: Comparison of Unlevered Firm and Levered Firm with $1000 of Debt at 8%

  5. Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue: 1 year $1,000,000 loan at 8% A) $25,926 B) $28,000 C) $35,000 D) $350,000 E) None of the above

  6. Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue: $1,000,000 perpetuity loan at 8% A) $28,000 B) $80,000 C) $324,074 D) $350,000 E) None of the above

  7. Claims on Firm • Bondholders: Debt • Government: Taxes • Equityholders: Remainder of firm value

  8. M&M and Taxes Value of firm = Value of all-equity-financed firm + PV(tax shield)

  9. Pfizer Balance Sheet 2004 and Adjusted for $1 billion Debt for Equity Trade ACTUAL ADJUSTED

  10. What’s Wrong with Pfizer’s CFO? • Should also consider personal taxes • Cost of financial distress

  11. Corporate and Personal Taxes Relative tax advantage of debt vs. equity If the relative advantage is > 1, debt is preferred If the relative advantage is < 1, equity is preferred

  12. Example – Advantage to Debt Assume dividends are 40% of earnings Each dollar of earnings generates $0.40 in dividends and $0.60 in capital gains Marginal investor is in the 35% tax bracket on interest and 15% on dividends and capital gains Deferral of capital gains reduces capital gains rate in half (to 7.5%)

  13. Example - continued

  14. Calculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ; Tp = Personal tax rate on interest income = 20% : A) 0.76 B) 1.16 C) 1.35 D) 1.76 E) None of the above

  15. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20% A) $0.66 B) $0.25 C) -$0.66 D) -$0.34 E) None of the above

  16. Costs of Financial Distress Value of firm = Value of all-equity-financed firm + PV(tax shield) – PV(costs of financial distress)

  17. Financial Distress Maximum value of firm Costs of financial distress PV of interest tax shields Market Value of The Firm Value of levered firm Value of unlevered firm Optimal amount of debt Debt

  18. Types of Financial Distress • Bankruptcy costs • Direct: legal and court costs • Indirect: Inefficient operations, creditors, employees, suppliers, customers • Financial distress without bankruptcy • Incentives for a firm in difficulty • Risk shifting • Refusing to contribute equity capital • Taking cash from firm • Delaying tactics • Bait and switch on use of funds from debt

  19. Costs of Financial Distress by Asset Type • Tangible assets unaffected by ownership • Real estate • Airplanes • Intangible assets • Brand image • Technology • Human capital

  20. Trade-off Theory of Capital Structure • Capital structure depends on trade-off between interest tax shield and financial distress • High debt firms • Safe, tangible assets • High taxable income • Low debt firms • Risky, intangible assets • Unprofitable companies • Does theory work? • Yes and no

  21. Pecking Order of Financing Choices • Firms prefer internal finance • Firms adapt payout targets to investment opportunities trying to avoid sudden changes • Sticky dividend policies and fluctuations in profitability and investment opportunities lead to cash flow shifts • If external finance is required, firms issue debt first, then equity

  22. Tests of Pecking Order • Large firms tend to have higher debt ratios • Firms with high ratios of fixed assets to total assets have higher debt ratios • More profitable firms have lower debt ratios • Firms with higher ratios of book-to-market values have lower debt ratios

  23. Next Class • Thursday, April 12 • Financing and Valuation – Chapter 19 • Problem Set 3

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