Fundamentals of corporate finance 5e mcgraw chapter 015

Debt and Value in a Tax Free EconomyCapital Structure and Corporate Taxes Cost of Financial Distress Explaining Financial Choices... Modigliani & Miller When there are no taxes and

Finance

Fifth Edition

Slides by Matthew Will

Debt and Value in a Tax Free Economy

Capital Structure and Corporate Taxes

Cost of Financial Distress

Explaining Financial Choices

Assets Liabilities and Stockholder’s Equity

Value of cash flows from

firm’s real assets and

Modigliani & Miller

 When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure In other words, financial managers cannot increase

value by changing the mix securities used to finance the company

By issuing 1 security rather than 2, company

diminishes investor choice This does not reduce value if:

 Investors do not need choice, OR

 There are sufficient alternative securities

Capital structure does not affect cash flows e.g

12.5%

7.5%

shares on

Return

1.75 1.25

$.75 share

per Earnings

175,000 125,000

$75,000 Income

Operating

Boom Expected

Slump

Economy the

of State

Outcome

million 1

$ Shares of

Value Market

$10 share

per Price

100,000 shares

of Number

Data

2.50 1.50

$.50 share

per Earnings

125,000 75,000

$25,000 earnings

Equity

50,000 50,000

$50,000 Interest

175,000 125,000

$75,000 Income

Operating

Boom Expected

Slump

Economy the

of State

Outcome

500,000

$ debt

of ue Market val

500,000

$ Shares of

Value Market

$10 share

per Price

50,000 shares

of Number Data

- Debt replicated by investors

25% 15%

5%

investment

$10 on

Return

2.50 1.50

$.50 investment

on earnings Net

1.00 1.00

$1.00 10%

@ Interest :

LESS

3.50 2.50

$1.50 shares

two on

Earnings

Boom Expected

Slump

Economy the

of State

Outcome

Example - River Cruises – Firm debt at 50%

- Investor can unwrap debt

17.5% 12.5%

7.5%

investment

$10 on

Return

3.50 2.50

$1.50 investment

on earnings

Net

1.00 1.00

$1.00 10%

@ Interest :

PLUS

2.50 1.50

$0.50 share

one

on Earnings

Boom Expected

Slump

Economy the

of State

Outcome

operating income.

Financial Risk - Risk to shareholders resulting from

the use of debt.

Financial Leverage - Increase in the variability of

shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from

deductibility of interest payments.

) ( assets debt

assets

E

D r

E r

E D

D r

T

D V

r D

r E

r A

Includes Bankruptcy Risk

r

D V

D V

r D

r E

WACC

WACC with no bankruptcy risk

Example - You own all the equity of Space Babies

Diaper Co The company has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to exchange part of your

equity position for 6% bonds with a face value of

$50,000

Should you do this and why?

and taxes The corporate tax rate is 35% You have the option to exchange part of your equity position for 6% bonds with a face value of

$50,000

Should you do this and why?

4,550 6,500

Flow Cash

Net

2,450 3,500

35%

@ Taxes

7,000 10,000

Income Pretax

3,000 0

Pmt Interest

10,000 10,000

EBIT

Debt 1/2

Equity All

Total Cash Flow

All Equity = 6,500

*1/2 Debt = 7,550

(4,550 + 3,000)

Example - You own all the equity of Space Babies Diaper Co The company

has no debt The company’s annual cash flow is $10,000, before interest and taxes The corporate tax rate is 35% You have the option to

exchange part of your equity position for 6% bonds with a face value of

$50,000

Should you do this and why?

4,550 6,500

Flow Cash

Net

2,450 3,500

35%

@ Taxes

7,000 10,000

Income Pretax

3,000 0

Pmt Interest

10,000 10,000

EBIT

Debt 1/2

Equity All

Costs of Financial Distress - Costs arising from

bankruptcy or distorted business decisions before bankruptcy.

PV of interest tax shields

Costs of financial distress

Value of levered firm

Optimal amount

of debt

Trade-off Theory - Theory that capital structure is

based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms

prefer to issue debt rather than equity if internal finance is insufficient.

Financial Slack