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Debt Policy

Debt Policy. Changing a firm’s capital structure should not affect its value to shareholders. This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm. Does Borrowing Affect Value?.

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Debt Policy

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  1. Debt Policy • Changing a firm’s capital structure should not affect its value to shareholders. • This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm.

  2. Does Borrowing Affect Value? A company’s choice of capital structure does not increase the value of the firm.

  3. MM’s Irrelevance Proposition The value of a firm does not depend on its capital structure. If this holds, can financial managers increase the value of the firm by changing the mix of securities used to finance the company?

  4. MM’s Irrelevance Proposition • Assumptions of MM’s argument: • “Well functioning” capital markets • Efficient capital markets • No taxes (therefore no distortion) • Ignore costs of financial distress

  5. MM’s Irrelevance Proposition Example: An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value? Before Restructuring: After Restructuring:

  6. How Borrowing Affects EPS Ceteris paribus, borrowing will increase earnings per share. However, this isn’t a source of value to shareholders. • Shareholders can easily replicate a firm’s borrowing on their own if they choose.

  7. How Borrowing Affects Risk and Return • Debt financing does not affect the operating risk of the firm. • Debt financing does affect the financial risk of the firm.

  8. How Borrowing Affects Risk and Return

  9. Debt and the Cost of Equity

  10. Debt and the Cost of Equity: Example What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 30% of assets?

  11. MM’s Proposition II Debt increases financial risk and causes shareholders to demand higher rates of return.

  12. Debt and Taxes Debt financing advantage: the interest that a firm pays on debt is tax deductible. Interest tax shield:

  13. Perpetual Tax Shield If the tax shield is perpetual, then:

  14. Perpetual Tax Shield: Example What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $12 million at an interest rate of 4% and a tax rate of 35%?

  15. Tax Shield and Shareholders’ Equity When accounting for taxes, borrowing increases firm value and shareholders’ wealth.

  16. Taxes and WACC Recall that the WACC takes into account the required after-tax rate of return

  17. Taxes and WACC: Example What is the expected rate of return to shareholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?

  18. Overall Market Value PV tax shield Value if all equity financed PV costs of financial distress – + = Costs of Financial Distress Investors factor the potential for future distress into their assessment of current value.

  19. Bankruptcy Costs If there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of all court expenses.

  20. Financial Distress Without Bankruptcy Even if a firm narrowly escapes bankruptcy, this does not mean that costs of financial distress are avoided. • Stockholders may be tempted to play games at the expense of creditors • Betting the Bank’s Money • Not Betting Your Own Money Loan Covenant: Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.

  21. Explaining Financing Choices • The Trade-off Theory • Debt levels are chosen to balance interest tax shields against the costs of financial distress. • A Pecking Order Theory: • Firms prefer to issue debt rather than equity if internal finance is insufficient.

  22. Financial Slack Financial Slack: Ready access to cash or debt financing. Financial managers usually place a very high value on having financial slack.

  23. Two Faces of Financial Slack • Benefits • Long run value rests more on capital investment and operating decisions than on financing. • Most valuable to firms with positive-NPV growth opportunities • Drawbacks • Too much financial slack may lead to lazy management. • Managers may try to increase their own perks or engage in empire-building.

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