BUAD 306 Chapter 16
Interest Tax Shield
1. Annual interest tax shield - Tax rate times interest payment - 6,250 in 8% debt = 500 in interest expense - Annual tax shield = .34(500) = 170 2. Present value of annual interest tax shield - Assume perpetual debt for simplicity - Use 8% (Rd for debt) because the tax shield is generated by paying interest on this debt (has same risk as debt) PV = 170 / .08 = 2,125 PV = D(RD)(TC) / RD = DTC PV = 6,250(.34) = 2,125
Observed Capital Structure
1. Capital structure does differ by industry 2. Differences according to Cost of Capital 2008 Yearbook by Ibbotson Associates, Inc - Lowest levels of debt Computers with 5.61% debt Drugs with 7.25% debt - Highest levels of debt Cable television with 162.03% debt Airlines with 129.40% debt --> In general, corporations have not issued debt up to the point that tax shelters have been completely used up and therefore there must be limits to the amount of debt corporations can use
Quick Quiz 1. Explain the effect of leverage on EPS and ROE 2. What is the break-even EBIT, and how do we compute it? 3. How do we determine the optimal capital structure? 4. What is the optimal capital structure in the three cases that were discussed in this chapter? 5. What is the difference between liquidation and reorganization?
1. Explain the effect of leverage on EPS and ROE - Increasing leverage (increasing) debt will increase your ROE → return on equity/cost of equity increases as it's more risky now with additional debt (greater risk you won't get paid back) - Will also increase your EPS (EBIT / shares) → number of outstanding shares decrease as you use debt to repurchase shares - ALSO: --> 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 2. What is the break-even EBIT, and how do we compute it? - Find EBIT where EPS is the same under both the current and proposed capital structures 3. How do we determine the optimal capital structure? - The optimal capital structure is one that maximizes the value of the marketed claims and minimizes the value of the non-marketed claims (such as taxes/bankruptcy) 4. What is the optimal capital structure in the three cases that were discussed in this chapter? - Case I: no optimal capital structure - Case II: almost 100% debt financing - Case III: mix between equity/debt financing 5. What is the difference between liquidation and reorganization? - Liquidation: sell off/liquidate assets, pay off liabilities - Reorganization: refiling to continue with firm with provision to pay creditors on defaulted loans
The Effect of Leverage
1. How does leverage affect the EPS and ROE of a firm? - ROE can go negative during these current bad times!! 2. When we increase the amount of debt financing, we increase the fixed interest expense 3. If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders 4. If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders 5. Leverage amplifies the variation in both EPS and ROE - Increasing leverage (increasing) debt will increase your ROE → return on equity/cost of equity increases as it's more risky now with additional debt (greater risk you won't get paid back) - Will also increase your EPS (EBIT / shares) → number of outstanding shares decrease as you use debt to repurchase shares
Bankruptcy Process - Part II Liquidation
1. Liquidation - termination of firm as a going concern, involves selling off the assets of the firm (proceeds net of selling costs are distributed to creditors in order of established priority) *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 (APR) -After payment of bankruptcy administration costs, proceeds distributed among creditors - If any proceeds remain they're distributed to shareholders
Case III
1. Now we add bankruptcy costs 2. As the D/E ratio increases, the probability of bankruptcy increases 3. This increased probability will increase the expected bankruptcy costs --> If a company is thought to be going bankrupt, people won't buy as many cars from this company → bankruptcy cost of lower sales 4. At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost 5. At this point, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added
Managerial Recommendations
1. The tax benefit is only important if the firm has a large tax liability - Firms with substantial accumulated losses will receive little value from the interest tax shield - Firms with substantial tax shields from other sources (such as depreciation tax shield) will get less benefit from leverage - The higher the effective tax rate, the greater the incentive to borrow 2. Risk of financial distress - The greater the risk of financial distress, the less debt will be optimal for the firm - The greater the volatility in EBIT, the less a firm should borrow --> The cost of financial distress varies across firms and industries, and as a manager you need to understand the cost for your industry --> Financial distress costs will be determined by how easily ownership of a firm's assets can be transferred → less tangible assets are more financially distressing/less liquid and will decrease incentive to borrow
Case II - Proposition I
1. The value of the firm increases by the present value of the annual interest tax shield - Value of a levered firm = value of an unlevered firm + PV of interest tax shield - Value of equity = Value of the firm - Value of debt 2. Assuming perpetual cash flows VU = EBIT(1-T) / RU VL = VU + DTC - Value of Firm L (firm with leverage/interest) exceeds the value of Firm U by the present value of the interest tax shield - Value of a firm goes up by $.21 (21% = Tc = slope) for every $1 in debt - NPV per dollar of debt is $.21
Capital Restructuring
1. We are going to look at how changes in capital structure affect the value of the firm, all else equal 2. Capital restructuring involves changing the amount of leverage a firm has without changing the firm's assets 3. The firm can increase leverage by issuing debt and repurchasing outstanding shares - Increase debt and use debt to re-purchase outstanding shares 4. The firm can decrease leverage by issuing new shares (sell stock) and retiring outstanding debt - Use money from newly issued shares to pay off debt
Choosing a Capital Structure
1. What is the primary goal of financial managers? --> Maximize stockholder wealth 2. We want to choose the capital structure that will maximize stockholder wealth --> Any change in the value of a firm is the same as the net effect on the stockholders --> Shareholders will experience a capital loss that is exactly offsetting the extra debt (increase in debt financing) 3. We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
Bankruptcy Process - Part II Reorganization
2. Reorganization - keep the firm a going concern, issue new securities to replace old securities (liquidation/reorganization a result of bankruptcy proceeding) *Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors - Creditors/shareholders divided into classes - Class of creditors accepts the plan if a majority of the class agrees - After acceptance by creditors, the plan is confirmed by the court - Payments in cash, property, and securities are made to creditors and shareholders - Plan may provide for issuance of new securities - For fixed length of time, firm operates according to provisions of reorganization plan Bankruptcy Creditors paid first in bankruptcy Preferred stock paid in total before common stock gets paid If you skip a preferred dividend you can't skip it or pay common until you pay preferred Cumulative dividends: pay all preferred cumulative dividends before paying any common stock
Case I: Propositions I and II
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
Conclusions Case I, Case II, Case III
Case I - no taxes or bankruptcy costs 1. No optimal capital structure - With no taxes, bankruptcy costs, or other real-world imperfections, we know the total value of a firm is not affected by its debt policy so VL is constant - WACC is also constant (not affected by debt policy) → bottom graph Case II - corporate taxes but no bankruptcy costs 1. Optimal capital structure is almost 100% debt 2. Each additional dollar of debt increases the cash flow of the firm - Value of firm critically depends on its debt once taxes are introduced - The more the firm borrow, the more it's worth (more CF saved from taxes) - Gain in firm value = PV of interest tax shield - WACC declines as firm uses more debt financing → bottom graph - As firm increases financial leverage, cost of equity does increase but this increase is more than offset by the tax break associated with debt financing (cheaper cost of debt from tax shield) - Therefore, the firm's overall cost of capital declines (WACC) Case III - corporate taxes and bankruptcy costs 1. Optimal capital structure is part debt and part equity 2. Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs - Value of firm will not be as large as in Case II because the firm's value is reduced by the PV of future bankruptcy costs - These costs continue to grow as firm borrows more, eventually overwhelming the tax advantage of debt financing Optimal capital structure - D* = the point at which tax savings from an additional dollar in debt financing is exactly balanced by increased bankruptcy costs associated with additional borrowing - The optimal debt level is the optimal debt-equity ratio: D*/E* --> At this level of debt financing, the lowest possible WACC occurs (before it increases on the graph) → point at which tax savings from an additional dollar in debt financing is exactly balanced by the increased bankruptcy costs associated with the additional borrowing
Case 1 - The CAPM, the SML and Proposition II
How does financial leverage affect systematic risk? CAPM: RA = Rf + bA(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) If your structure is 0% debt with 100% equity (1+D/E) = (1 + 0/1) = 1 RE = Rf + bA(RM - Rf) → same as first equation
How do you create/undo homemade leverage - Ch. 16
If you don't like the fact that a company made your equity riskier, just hold half the investment in equity and half in debt to eliminate this risk (decreased stock (equity) and buy more bonds (debt)) The fact that the cost of debt is lower than the cost of equity (as you increase debt you get more tax deduction and therefore lower cost of debt) is exactly offset by the increase in the cost of equity from borrowing Cost of equity increases because increasing leverage raises the risk of equity and therefore the required return or cost of equity Change in weights E/V and D/V is exactly offset by change in cost of equity Re so WACC stays the same Create leverage: borrow money and use own money to purchase shares --> pay interest Undo leverage: buy or sell shares (if you start with 100 shares decrease shares to 50 for ex) and buy bonds --> receive interest
Figure 16.7
Illustrates Static Theory of capital structure in terms of WACC and costs of debt/equity WACC line declines at first as D/E increases --> This is because the after tax cost of debt is CHEAPER than equity (you get a tax deduction for debt resulting in a lower cost of debt) At some point cost of debt begins to rise, and the fact that debt is cheaper than equity is more than offset by the financial distress costs from increasing your financial leverage, resulting in an INCREASING WACC Minimum WACC occurs at point D*/E*
If you change D/E ratio, you change cost of equity
Increasing D/E ratio will increase cost of equity → equity is riskier Decreasing D/E ratio will decrease cost of ratio For case I: - Change in weights E/V and D/V is exactly offset by change in cost of equity Re so WACC stays the same
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?
Bankruptcy Costs Direct Costs Financial Distress
Legal, lawyer fees 1. Direct costs - Legal and administrative costs --> If a value of a firm's assets = value of its debt then the firm is economically bankrupt in the sense that the equity has no value --> But the formal turning over of the assets to bondholders is a legal process, not an economic one - Ultimately cause bondholders to incur additional losses --> Bondholders won't get all they they are owed due to expenses associated with bankruptcy - Disincentive to debt financing --> Borrowing saves a firm money on its corporate taxes, but the more a firm borrow the more likely it will go bankrupt and have to pay the bankruptcy tax (tax that occurs when firm goes bankrupt) 2. Financial distress (not financial distress costs - these are indirect costs) - Significant problems in meeting debt obligations (We say this firm is experiencing financial distress_ - Firms that experience financial distress do not necessarily file for bankruptcy --> They're able to recover or otherwise survive → the costs associated with avoiding a bankruptcy filing incurred by a financial distressed firm can be direct and indirect costs
Bankruptcy Costs Indirect Costs
Lost employees, lost customers, management distraction costs 1. Indirect bankruptcy costs → costs of avoiding a bankruptcy by a financially distressed firm --> Financial distress costs: direct/indirect costs associated with going bankrupt or avoiding a bankruptcy filing - Larger than direct costs, but more difficult to measure and estimate - Stockholders want to avoid a formal bankruptcy filing → stockholders control a firm until it is legally bankrupt/stockholders can be wiped out in a legal bankruptcy --> Strong incentive to avoid bankruptcy - 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 →Assets of the firm lose value because management is busy trying to avoid bankruptcy instead of running the business → Loss in confidence of company to consumers → it's the possibility of this loss in value in a firm that limits the amount of debt a firm will choose
Capital Structure Theory Proposition I and II
Modigliani and Miller (M&M) Theory of Capital Structure Proposition I - firm value - The Pie Model - it's completely irrelevant how a firm chooses to arrange its finances - A firm with equal amounts of assets will have equal amounts of total L + E (even if the slicing/proportion of debt to equity is different for each firm) Proposition II - WACC - Although changing the capital structure of a firm doesn't change the firm's total value (total L + E stays the same), it does cause important changes to the firm's debt/equity --> WACC will vary as D/E ratio changes 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
Bankruptcy Process - Part 1
Possibilities of Bankruptcy: 1. Business failure - business has terminated with a loss to creditors (an all equity firm can still fail) 2. Legal bankruptcy - firm or creditors petition federal court for bankruptcy (legal proceeding for liquidation or reorganization) 3. Technical insolvency - firm is unable to meet debt obligations (financial obligations) 4. Accounting insolvency - book value of equity is negative (book value of total liabilities exceed book value of assets)
Figure 16.3
RE = RA + (RA - RD)(D/E) Re straight line with a slope of Ra - Rd --> When a firm raises its D/E ratio the increase in leverage increases the risk of equity and therefore the required return or cost of equity Y-intercept: firm with a D/E ratio of 0 so Ra = Re WACC (Ra) stays same no matter what D/E ratio is - The firm's overall cost of capital is unaffected by its capital structure (Proposition I) - The fact that the cost of debt is lower than the cost of equity (as you increase debt you get more tax deduction and therefore lower cost of debt) is exactly offset by the increase in the cost of equity from borrowing --> Cost of equity increases because increasing leverage raises the risk of equity and therefore the required return or cost of equity - Change in weights E/V and D/V is exactly offset by change in cost of equity Re so WACC stays the same
Business Risk and Financial Risk - important slide
RE = Rf + bA(1+D/E)(RM - Rf) CAPM: RE = Rf + bE(RM - Rf) bE = bA(1 + D/E) RE = RA + (RA - RD)(D/E) Therefore, the systematic risk of the stock (cost of equity) depends on: 1. Systematic risk of the assets, bA, (Business risk - WACC, unaffected by capital structure) - riskiness of the assets in your firm (Ra/WACC) → unaffected by your capital structure - Risk in the assets based on the business you choose/you're in - Ra is the required return on the firm's overall assets and depends on the nature of the firm's operating activities - The risk inherent in a firm's operations → business risk depends on the systematic risk of the firm's assets (Beta) - The greater the business risk, the greater Ra and the greater the firm's cost of equity (all other things being the same) 2. Level of leverage, D/E, (Financial risk) - extra risk that arises from the use of debt financing/degree of financial leverage (Ra - Rd) * D/E - For an all equity firm this component is 0 → 0 debt, 0 D/E ratio - As a firm relies on debt financing, the required return on equity rises - Debt financing increases the risks borne by stockholders - If more creditors are welcomed as debt financing increases, these bondholders get paid out before stockholders now → increasing risk! --> Cost of equity (Re) rises when the firm increases its use of financial leverage because the financial risk of equity increases while the business risk remains the same!
Figure 16.6
Static theory of capital structure: firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress Vu - value of firm is unaffected by capital structure Vl = value of firm with leverage/interest deductions Actual firm value: value of a firm rises to a maximum and then declines beyond that point Maximum value Vl is reached at D* → this point is the optimal amount of borrowing Firm's optimal capital structure D*/VL* - debt 1-D*/VL* - equity Difference between value of firm in our static theory (curved line) and M&M value of a firm with tax = loss in value from the possibility of financial distress Difference between value of firm in our static theory (curved line) and M&M value of a firm with no tax = gain in value from leverage, net of distress costs (not including distressed costs)
Figure 16.9
The bondholder's claim pie slice increases as D/E ratio increases Because taxes are reduced as leverage increases, the value of the government's claim on a firm's cash flow decreases with more leverage The value of the bankruptcy costs on a firm's cash flow also rises with an increase in debt/equity ratio Cash Flow = Payments to stockholders Payments to creditors Payments to government Payments to bankruptcy courts/lawyers Payments to any and all other claimants to cash flows of firm → a firm's capital structure slices up/proportions the cash flow of the firm into pieces without altering the total value! (value of firm depends on total cash flow of firm)
Pecking Order Theory at Odds with Tradeoff Theory When is Static Theory or Pecking Order Theory Best Used?
The pecking-order theory is at odds with the tradeoff theory: 1. There is no target D/E ratio - Instead a firm's capital structure is determined by its need for external financing which dictates the amount of debt the firm will have 2. Profitable firms use less debt - B/c profitable firms have greater internal CF, they will need less external financing 3. Companies like financial slack - To avoid selling new equity, companies want to stockpile internally generated cash - Cash reserve is known as financial slack → allows management ability to finance projects as they appear and move quickly → Static theory better for long-term financial goals or strategies (issues of tax shield and financial distress costs are important in this context) → Pecking order theory is more concerned with the shorter-run, tactical issue of raising external funds to finance investments
Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA - RD)(D/E) Total systematic risk of a firm's equity has two parts: 1. RA is the "cost" of the firm's business risk, i.e., the risk of the firm's assets (depends on systematic risk of firm's assets) 2. (RA - RD)(D/E) is the "cost" of the firm's financial risk, i.e., the additional return required by stockholders to compensate for the risk of additional leverage (cost of equity) The cost of equity (Re) depends on three things: 1. Required rate of return on the firm's assets, Ra 2. Firm's cost of debt, Rd 3. Firm's debt-equity ratio, D/E - If you don't like the fact that a company made your equity riskier, just hold half the investment in equity and half in debt to eliminate this risk (decreased stock (equity) and buy more bonds (debt)) - Reduce volatility by having a mix between debt and equity
Case II - Proposition II
→ Case Includes taxes! 1. 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) --> Solve RE to plug into RA
Break-Even EBIT
→ both capital structure are even or will deliver the same EBIT 1. Find EBIT where EPS is the same under both the current and proposed capital structures 2. If we expect EBIT to be greater than the break-even point, then leverage may be beneficial to our stockholders 3. If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders If EBIT above break even point, financial leverage is beneficial If EBIT below break even point, financial leverage is is not beneficial
The Value of a Firm
→ depends on total CF of firm 1. Value of the firm = marketed claims + nonmarketed claims -Marketed claims are the claims of stockholders and bondholders --> Marketed claims can be bought/sold in financial markets -Nonmarketed claims are the claims of the government and other potential stakeholders (claims of taxes bankruptcy, litigation) --> Non Marketed claims can't be sold in financial markets 2. The overall value of the firm is unaffected by changes in capital structure - Value of all claims Vt = Vm + Vn - This total is unaltered by a firm's capital structure (if Vm increases, Vn must decrease) 3. The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions -The optimal capital structure is one that maximizes the value of the marketed claims and minimizes the value of the nonmarketed claims (such as taxes/bankruptcy)
Capital Structure Theory Under Three Special Cases
→ no taxes included b/c vary from individual to individual 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
The Pecking Order Theory
→ use internal financing as much as possible (this is why highly profitable firms actually have little debt despite the tax advantages) Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. → company look to finance themselves internally first (internally generated funds aka profits) → finance themselves through debt second → pecking order of when you access capital and from what sources Rule 1 - Use internal financing first → selling securities to make cash can be expensive so it makes sense to avoid doing so if possible - If a firm is very profitable, it may never need external financing so it would end up with little or no debt Rule 2 - Issue debt next, new equity last - If you issue equity when it's undervalued you'll sell at too low of a price - If you issue equity when it's overvalued it may signal to the market that the price is too high and that's why you're selling it - Companies rarely sell new equity and the market reacts negatively to such sales when they occur