ch 16

Interest Tax Shield

Annual interest tax shield Tax rate times interest payment 6,250 in 8% debt = 500 in interest expense Annual tax shield = .34(500) = 170 Present value of annual interest tax shield Assume perpetual debt for simplicity PV = 170 / .08 = 2,125 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125

Comprehensive Problem

Assuming perpetual cash flows in Case II - Proposition I, what is the value of the equity for a firm with following values?: EBIT = $50 million Tax rate = 40% Debt = $100 million Cost of debt = 9% Unlevered cost of capital = 12%

Bankruptcy Process - Part I

Business failure - business has terminated with a loss to creditors Legal bankruptcy - petition federal court for bankruptcy Technical insolvency - firm is unable to meet debt obligations Accounting insolvency - book value of equity is negative bbbbbbbbbb

How does financial leverage affect systematic risk?

CAPM: RA = Rf + A(RM - Rf) Where BA is the firm's asset beta and measures the systematic risk of the firm's assets Proposition II Replace RA with the CAPM and assume that the debt is riskless (RD = Rf) RE = Rf + BA(1+D/E)(RM - Rf)

Example: Case II - Proposition I

Data EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% VU = 25(1-.35) / .12 = $135.42 million VL = 135.42 + 75(.35) = $161.67 million E = 161.67 - 75 = $86.67 million

Example: Case I

Data Required return on assets = 16%; cost of debt = 10%; percent of debt = D/V = 45% What is the debt-to-equity ratio? D/E = (D/V) / (E/V) = (D/V) / (1 - D/V) D/E = (0.45) / (1 - 0.45) = 0.8182 What is the cost of equity? RE = 16% + (16% - 10%)(.8182) = 20.91% Suppose instead that the cost of equity is 25%, what would the the debt-to-equity ratio then to be? 25% = 16% + (16% - 10%)(D/E) D/E = (25% - 16%) / (16% - 10%) = 1.5

Bankruptcy Costs

Direct costs Legal and administrative costs Ultimately cause bondholders to incur additional losses Disincentive to debt financing Financial distress Significant problems in meeting debt obligations Firms that experience financial distress do not necessarily file for bankruptcy

Break-Even EBIT

Find EBIT where EPS is the same under both the current and proposed capital structures If we expect EBIT to be greater than the break-even point, then leverage may be beneficial to our stockholders If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders

The CAPM, the SML and Proposition II

How does financial leverage affect systematic risk?

Bankruptcy Process - Part II

Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978 Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule Reorganization Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors

How do changes in capital structure affect the value of the firm?

(all else equal) Capital restructuring involves changing the amount of leverage a firm has without changing the firm's assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt

Case III

As the D/E ratio increases, the probability of bankruptcy increases This increased probability will increase the expected bankruptcy costs At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost At this point, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added

Corporate Borrowing and Homemade Leverage

Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important consideration. Fourth conclusion is incorrect. The reason is that shareholders can adjust the amount of financial leverage by borrowing and lending on their own. This use of personal borrowing to alter the degree of financial leverage is called homemade leverage.

Capital Structure Theory Under Three Special Cases

Case I - Assumptions No corporate or personal taxes No bankruptcy costs Case II - Assumptions Corporate taxes, but no personal taxes No bankruptcy costs Case III - Assumptions Corporate taxes, but no personal taxes Bankruptcy costs

Conclusions

Case I - no taxes or bankruptcy costs No optimal capital structure Case II - corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm Case III - corporate taxes and bankruptcy costs Optimal capital structure is part debt and part equity Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

More Bankruptcy Costs

Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and estimate Stockholders want to avoid a formal bankruptcy filing Bondholders want to keep existing assets intact so they can at least receive that money Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business The firm may also lose sales, experience interrupted operations and lose valuable employees

Case II - Cash Flow

Interest is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows affect the value of the firm?

What is the primary goal of financial managers?

Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC

Capital Structure Theory

Modigliani and Miller (M&M)Theory of Capital Structure Proposition I - firm value Proposition II - WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets Changing firm value Change the risk of the cash flows Change the cash flows

Case I - Propositions I and II

Proposition I The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore, value doesn't change Proposition II The WACC of the firm is NOT affected by capital structure

Business Risk and Financial Risk

RE = Rf + BA(1+D/E)(RM - Rf) CAPM: RE = Rf + E(RM - Rf) BE = BA(1 + D/E) Therefore, the systematic risk of the stock depends on: Systematic risk of the assets, A, or "Business risk" Level of leverage, D/E, or "Financial risk"

Example: Case II - Proposition II

Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1. What will happen to the cost of equity under the new capital structure? RE = 0.12 + (0.12 - 0.09)(1)(1-.35) = 13.95% What will happen to the weighted average cost of capital? RA = 0.5(0.1395) + 0.5(.09)(1-.35) = 9.9%

Case II - Proposition II

The WACC decreases as D/E increases because of the government subsidy on interest payments RA = (E/V)RE + (D/V)(RD)(1-TC) RE = RU + (RU - RD)(D/E)(1-TC) Example RE = 0.12 + (0.12-0.09)(75/86.67)(1-.35) = 13.69% RA = (86.67/161.67)(0.1369) + (75/161.67)(9)(1-.35)RA = 10.05%

Example: Homemade Leverage

The following example illustrates that it actually makes no difference whether or not the company adopts the proposed capital structure, because any stockholder who prefers the proposed capital structure can simply create it using homemade leverage. Buying 100 shares within the proposed capital structure provides the same outcome as buying 200 shares within the original capital structure. Buying the extra 100 shares would require the investor to take on a loan for $2,000 This assumes that the investor can borrow at the same interest rate as the company.

Managerial Recommendations

The tax benefit is only important if the firm has a large tax liability Risk of financial distress The greater the risk of financial distress, the less debt will be optimal for the firm The cost of financial distress varies across firms and industries, and as a manager you need to understand the cost for your industry

The Pecking-Order Theory

Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1: Use internal financing first Rule 2: Issue debt next, new equity last The pecking-order theory is at odds with the tradeoff theory: There is no target D/E ratio Profitable firms use less debt Companies like financial slack

Case II - Proposition I

Value of a levered firm (VL) = value of an unlevered firm (VU) + PV of interest tax shield Value of equity = Value of the firm - Value of debt Assuming perpetual cash flows VU = EBIT(1-T) / RU VL = VU + DTC

The Value of the Firm

Value of the firm = marketed claims + nonmarketed claims Marketed claims are the claims of stockholders and bondholders Nonmarketed claims are the claims of the government and other potential stakeholders The overall value of the firm is unaffected by changes in capital structure The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions

Example: Financial Leverage, EPS and ROE - Part II

Variability in ROE Current: ROE ranges from 6% to 20% Proposed: ROE ranges from 2% to 30% Variability in EPS Current: EPS ranges from $.60 to $2.00 Proposed: EPS ranges from $.20 to $3.00 The variability in both ROE and EPS increases when financial leverage is increased

Case I - Equations

WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA - RD)(D/E) RA is the "cost" of the firm's business risk (RA - RD)(D/E) is the "cost" of the firm's financial risk

Corporate Borrowing Conclusions

When EBIT is relatively high, leverage is beneficial. Leverage increases the returns to shareholders, as measured by both ROE and EPS. Shareholders are exposed to more risk under a leveraged capital structure because the EPS and ROE are much more sensitive to changes in EBIT.

How does leverage affect the EPS and ROE of a firm?

When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE