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Corporate Finance Topic 6

Corporate Finance Topic 6. Capital Structure: Tax & Costs of Financial Distress. Part 1a: Capital Structure Decision with No Taxes. V alue of a firm is the sum of the debt and equity values V = B + S T he goal of the management should be to make the firm as

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Corporate Finance Topic 6

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  1. Corporate FinanceTopic 6 Capital Structure: Tax & Costs of Financial Distress

  2. Part 1a: Capital Structure Decision with No Taxes • Value of a firm is the sum of the debt and equity values • V =B + S • The goal of the management should be to make the firm as valuable as possible • When debtholders get only a fair rate of return on the debt, maximising firm value (V) also means maximising shareholder value (S) • Firm should pick the debt-equity ratio that makes the pie as big as possible S B Value of the Firm

  3. Financial Leverage, EPS, and ROE • Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Proposed Assets $20,000 $20,000 Debt $0 $8000 Equity $20,000 $12000 Debt/Equity ratio 0.00 2/3 Interest rate n/a 8% Shares outstanding 400 240 Share price $50 $50

  4. EPS and ROE Under Both Capital Structures Current All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares Proposed Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

  5. Homemade Leverage: An Example Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% • Buying 40 shares of the unlevered firm on margin (by borrowing $800)gives the ROE of the levered firm • Our personal debt equity ratio is:

  6. Homemade (Un)Leverage: An Example Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 Plus interest on $800 (8%) $64 $64 $64 Net Profits $100 $200 $300 ROE (Net Profits / $2,000) 5% 10% 15% • Buying 24 shares of an other-wise identical levered firm along with $800 of the firm’s debt gives the ROE of the unlevered firm • This is the fundamental insight of M&M

  7. Assumptions ofModigliani-Miller Model • Perpetual Cash Flows • Perfect and Efficient Capital Markets: • Perfect competition: Individuals and firms are price takers • No Information Asymmetry: Corporate insiders have the same set of information as investors • No Transaction Costs: Firms and investors can borrow/lend at the same rate • No Taxes • No Bankruptcy Costs: firm’s cashflows do not depend on its financial policy • No Agency Problems or Costs: Interests of all stakeholders (e.g., managers, shareholders etc) are aligned • Rationality: Investors rational and markets are efficient

  8. The MM Propositions I & II (No Taxes) • Proposition I • Firm value is not affected by leverage VL = VU • Proposition II • Leverage increases the risk and return to stockholders Rs= R0+ (B / SL) (R0- RB) RBis the interest rate (cost of debt) Rsis the return on (levered) equity (cost of equity) R0is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity

  9. Derivation ofThe MM Proposition I (No Taxes) • In a levered firm: Shareholders receive & Bondholders receive EBIT – RB×B RB×B • Total cash flow to all stakeholders is: (EBIT – RB×B) + RB×B Cash Flow of Levered Firm • Present value of this stream of cash flows is VL • Clearly: (EBIT – RBB) + RBB = EBIT Cash Flow of Unlevered Firm • Present value of this stream of cash flows is VU VL = VU

  10. Intuition behindMM Proposition I (No Taxes) All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Total Cash Flow to S/H $1000$2,000$3,000 Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($8000 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Total Cash Flow $360+640$1,360+$640 $2,360+$640 (to both S/H & B/H): $1000$2,000$3,000 EBIT 640 1,360 2,000 EBIT B/H S/H S/H

  11. Intuition behindMM Proposition II (No Taxes) Rs= R0+ (B / SL) (R0- RB) where: B / SL= $8,000 ÷ $12,000 = 2/3 r0= E(EBIT/V) = E(EBIT/S) = $2,000 ÷ 20,000 = 10% rB= 8% MM II rs= 10% + (2/3) * (10% - 8%) rs= 11.33% Proof: rs= E(ROE) = E(EBT/SL) = $1,360/ $12,000 = 11.33%

  12. The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital (no taxes) Cost of capital: r (%) R0 RB RB Debt-to-equity Ratio

  13. Part 1b: Introducing Corporate Taxes MM Proposition I (with Corporate Taxes) • Firm value increases with leverage VL = VU + TC B MM Proposition II (with Corporate Taxes) • Some of the increase in equity risk and return is offset by interest tax shield RS = R0 + (B/SL)×(1−TC)×(R0−RB) RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity

  14. Derivation ofThe MM Proposition I (with Corp. Taxes) • In a levered firm, Shareholders receive & Bondholders receive (EBIT – RBB)×(1-Tc) RB×B • Total cash flow to all stakeholders is: (EBIT – RBB)×(1-Tc) + RBB Cash Flow of Levered Firm • Present value of this stream of cash flows is VL • Clearly: (EBIT – RBB)×(1-Tc) + RBB = EBIT×(1–Tc) – RBB×(1–Tc) + RBB = EBIT(1–Tc) – RBB + RBBTc+ RBB • The present value of the first term is VU • The present value of the second term is TcB VL = VU + TcB Cash Flow from Interest Tax Shields Cash Flow of Unlevered Firm

  15. Financial Leverage andCost of Debt and Equity Capital Cost of capital: R(%) R0 RB Debt-to-equityratio (B/SL)

  16. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($8000 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $884+$640 $1,534+$640 (to both S/H & B/H): $874 $1,524 $2,174 EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224 $874 $1,524 $2,174 All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Taxes (Tc = 35%) $350 $700 $1,050 Total Cash Flow to S/H $650 $1,300 $1,950 EBIT(1-Tc)

  17. Total Cash Flow to Investors underEach Capital Structure with Corp. Taxes All-equity firm Levered firm S G S G B • Levered firm pays less in taxes than all-equity firm • Debt plus equity value of levered firm is greater than equity value of unlevered firm

  18. Part 1c: Introducing Personal Taxes: The Miller Model • Miller (1977) shows that value of levered firm: VL = VU + T* B Where: TS= personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate T* = effective tax advantage of debt (gain from leverage) • If TB = TS, we return to M&M with only corporate taxes:

  19. Intuition behind the Miller Model (1) • TC = 0 • TS = 0 • TB = 0 • TC = 0.40 • TS = 0 • TB = 0 • TC = 0.40 • TS = 0.10 • TB = 0.10

  20. Intuition behind the Miller Model (2) • TC = 0.40 • TS = 0 • TB = 0.40 • TC = 0.40 • TS = 0.30 • TB = 0.10 • TC = 0.40 • TS = 0.10 • TB = 0.50

  21. Effect of Financial Leverage on Firm Value with Corporate and Personal Taxes VL = VU+TCB when TS =TB Value of firm (V) VL < VU + TCBwhen TS < TB but (1-TB) > (1-TC)×(1-TS) VU VL =VU when (1-TB) = (1-TC)×(1-TS) and TS << TB VL < VU when (1-TB) < (1-TC)×(1-TS) and TS <<< TB Debt (B)

  22. Summary: MM with No Taxes and with Corporate Taxes • With no taxesand no bankruptcy costs: • M&M Proposition I: • Value of the firm is unchanged with leverage • VL = VU • M&M Proposition II: • Leverage increases the risk and return of stockholders • With corporate taxes, but no bankruptcy costs: • M&M Proposition I: • Value of the firm increases with leverage • VL = VU + TC B • M&M Proposition II: • Leverage increases the risk and return of stockholders

  23. Summary: Miller: Corporate and Personal Taxes • With corporate and personal taxes, value of levered firm is: • If distributions to equity holders are taxed at a lower personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset • In fact, the advantage of debt is eliminated if: (1-TC) × (1-TS) = (1-TB)

  24. Part 2: Costs of Financial Distress & the Trade-off Theory • MM with corporate taxes suggest that the optimal financial structure is 100% debt • We now introduce an offsetting cost that limits the use of debt: Costs of Financial Distress (bankruptcy costs) • Costs Of Financial Distress (COFD) • The possibility of bankruptcy has (incremental) negative effects on the cash flows and the value of the firm • This is due tothe costs associated with bankruptcy • It is the stockholders who bear these costs

  25. COFDDirect Costs • Direct Costs • If the firm has so much debt that it is forced to formally renegotiate its debt or enter into bankruptcy it will incur: • Court costs • Other legal expenses, such as lawyer fees • Costs of consultants • Direct costs tend to be a small percentage of firm value

  26. COFDIndirect Costs More on this in Lecture 7 • Indirect Costs • Impaired ability to conduct business (e.g., lost sales) • Agency Costs of debt • Costs due to the conflicts of interests between the firm’s debtholders and equityholders • Conflicts arise when the managers (acting in the shareholders’ interest) pursue certain wealth transferring (selfish) strategies that benefit shareholders at the expense of debtholders

  27. Selfish Strategies: Risk-shiftingand Debt Overhang • Risk-shifting/Asset substitutions - Overinvestment • Incentive to take large risks • When a firm faces financial distress, shareholders can gain at the expense of debtholders by taking high-risk negative NPV projects • Debt Overhang - Underinvestment • Incentive to underinvest • When a firm is in financial distress, equityholders may choose not to invest in a positive NPV project because the value of undertaking the investment will accrue to bondholders rather than themselves

  28. Selfish Strategies: Cashing Out • Cashing Out / Milking the Property • Incentive for excessive dividend payment • When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm, if possible • May liquidate assets at prices below their actual value to pay dividends

  29. Can Agency Costs of Debt Be Reduced?Protective Covenants: Negative Covenants • The agency costs of debt may be reduced if the company agrees to covenants protecting the bondholders • Negative Covenants • Limit or prohibit actions that the company may take • Examples • Limitations on the amount of dividends a company may pay • Restrictions on mergers and major asset sales • Restriction on issue of additional long‑term debt • Firm may not pledge any of its assets to other lenders

  30. Protective CovenantsPositive Covenants • Positive Covenants • Specifies actions that the company agrees to take or a condition the company must abide by • Examples • Maintain a minimum level of working capital • Furnish periodic financial statements to the lender • Maintain a range of financial ratios

  31. Trade-off Theory: Tax Effects and Financial Distress Costs Trade-off Theory • Firm pick capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress (including agency costs of debt) • Value of a levered firm equals the value of the firm without leverage plus the present value of the expected tax savings from debt, less the present value of the expected financial distress costs • VL = VU + PV[E(Interest Tax Shield) – PV[E(Financial distress costs)] Net Benefit of Debt

  32. Determinants of the Present Value of Financial Distress Costs • Present value of expected costs of financial distress (COFD) depends on: • The probability of financial distress This probability increases with the: • Cyclicality and volatility of a firm’s revenues, cash flows and asset values • Operating leverage • Amount of a firm’s liabilities relative to its assets and cash flows • A firm with high leverage ratio, or low interest coverage ratio (EBIT or EBITDA/Interest) has a higher probability of bankruptcy

  33. Determinants of PV(COFD) • The magnitude of costs once a firm is in distress • Financial distress costs vary by industry • Asset type (R&D Intensity) • Real estate firms are likely to have low costs of financial distress since their assets can be sold relatively easily • Technology companies with more intangible assets have high costs of financial distress since intangible assets lose more value in bankruptcy • Growth opportunities (M/B or P/E ratios) • High growth firms have high financial distress costs since many positive NPV projects may not be undertaken in bankruptcy

  34. Trade-off Theory: The Optimal Leverage • For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in interest tax shield • As the level of debt increases, probability of default increases, increasing expected costs of financial distress • Trade-off Theory: • Firms should increase leverage until they reach the optimal level where the firm value (and the net benefit of debt) is maximized • At the optimal leverage: • The marginal benefits of interest tax shields that result from increasing leverage are perfectly offset by the marginal costs of financial distress

  35. Trade-off Theory: The Optimal Leverage Present value offinancial distress costs Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Maximumfirm value VU = Value of firm with no debt VL= Actual value of levered firm 0 Debt (B) B* Optimal amount of debt

  36. CFO Survey:Optimal/Target Debt-equity Ratios • Fig. 6. Survey evidence on whether firms have optimal or target debt-equity ratios. The survey is based on the responses of 392 CFOs.

  37. Trade-off Theory:Application • The trade-off theory can help explain: • Why firms choose debt levels that are too low to fully exploit the interest tax shield • Due to the presence of financial distress costs • Differences in the use of leverage across industries • Financial distress costs differ across industries based on asset type • Intangible assets lose more value in bankruptcy • Example: Hi Tech industries have low leverage • High volatility of cash flows increases the expected COFD • Example: Resources industries have low leverage

  38. The Pie Model Revisited • Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm • Let G and L stand for payments to the government and direct and indirect bankruptcy costs, respectively • VT = S + B + G + L • The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie S B G L

  39. Summary:Determinants of Optimal Leverage • Taxes (TS ,TB & TC) • If effective tax rate on interest income is lower than effective tax rate on equity income, there is a tax advantage to debt & more debt is optimal • Profitability (ROA) • More profitable firms are more likely to be able to utilise interest tax shields, and should have higher leverage • Uncertainty of Operating Income (β , σ) • Firms with risky and uncertain operating income have high probability of financial distress, higher expected COFD, and should have lower leverage

  40. Summary:Determinants of Optimal Leverage • Growth Opportunities (M/B or P/E) • High-growth firms should have lower leverage, since the growth opportunities may not be realised in bankruptcy • Types of Assets (R&D Intensity, NPPE/Assets) • Firms with more intangible assets should have lower leverage since bankruptcy is more costly for these firms • Firms with more tangible assets should have higher leverage

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