Introduc corporate finance ch16

Chapter 16: Limits to the Use of Debt 16.1 Costs of Financial Distress 16.2 Description of Costs 16.3 Can Costs of Debt Be Reduced?. 16.4 Integration of Tax Effects and Financial Distres

Chapter 16: Limits to the Use of

Debt

16.1 Costs of Financial Distress

16.2 Description of Costs

16.3 Can Costs of Debt Be Reduced?

16.4 Integration of Tax Effects and Financial Distress Costs

16.5 Shirking, Perquisites, and Bad Investments: A Note on

Agency Cost of Equity 16.6 The Pecking-Order Theory

16.7 Growth and the Debt-Equity Ratio

16.8 Personal Taxes

16.9 How Firms Establish Capital Structure

16.10 Summary and Conclusions

M&M Assumptions

 Homogeneous expectations.

 Homogeneous business risk classes.

 Perpetual cash flows: V = CF/r.

 Perfect capital markets

The Modigliani-Miller Capital Structure Propositions

MM Theory with Taxes

Costs of Financial Distress

effect on the value of the firm.

 However, it is not the risk of bankruptcy itself that lowers value.

Costs of Financial Distress

Costs of Financial Distress

 Selfish strategy 1: Incentive to take large risks

 Selfish strategy 2: Incentive toward

underinvestment

 Selfish Strategy 3: Milking the property

Balance Sheet for a Company

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

$200

$0

Selfish Strategy 1: Take

100

$ 200





NPV

Selfish Stockholders Accept Negative NPV Project with Large Risks

 Expected CF from the Gamble

 To Bondholders = $300 × 0.10 + $0 = $30

 To Stockholders = ($1000 - $300) × 0.10 + $0 = $70

 PV of Bonds Without the Gamble = $200

 PV of Stocks Without the Gamble = $0

 PV of Bonds With the Gamble = $30 / 1.5 = $20

PV of Stocks With the Gamble = $70 / 1.5 = $47

Selfish Strategy 2:

Underinvestment

 Consider a government-sponsored project that

guarantees $350 in one period

 Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an

additional $100 to finance the project

 Required return is 10%

18 18

$

10 1

350

$ 300

Should we accept or reject?

Selfish Stockholders Forego Positive NPV Project

 Expected CF from the government sponsored project:

 To Bondholder = $300

 To Stockholder = ($350 - $300) = $50

 PV of Bonds Without the Project = $200

 PV of Stocks Without the Project = $0

 PV of Bonds With the Project = $300 / 1.1 = $272.73

 PV of Stocks with the project = $50 / 1.1 - $100 = -$54.55

Selfish Strategy 3: Milking the Property

 Suppose our firm paid out a $200 dividend to the shareholders This leaves the firm insolvent, with nothing for the bondholders, but plenty for the

former shareholders.

 Such tactics often violate bond indentures.

management

Can Costs of Debt Be

Protective Covenants

 Agreements to protect bondholders

 Negative covenant: Thou shalt not:

 Pay dividends beyond specified amount.

 Sell more senior debt & amount of new debt is limited.

 Refund existing bond issue with new bonds paying lower interest rate.

 Buy another company’s bonds.

 Positive covenant: Thou shall:

 Use proceeds from sale of assets for other assets.

 Allow redemption in event of merger or spinoff.

 Maintain good condition of assets.

 Provide audited financial information.

Integration of Tax Effects and

Financial Distress Costs

 There is a trade-off between the tax advantage of debt and the costs of financial distress.

 It is difficult to express this with a precise and rigorous formula.

Integration of Tax Effects and

Financial Distress Costs

Value of firm (V)

Present value of tax shield on debt

Present value of financial distress costs

Value of firm under

MM with corporate taxes and debt

V L = V U + T C B

V = Actual value of firm

V U = Value of firm with no debt

Maximum

firm value

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

bankruptcy lawyers, respectively

 V T = S + B + G + L

 The essence of the M&M intuition is that V depends on the

S

G B

L

Pie Again

VT = S + B + G + L = VM + VN

VM= marketed claims = debt and equity.

VN= non-marketed claims

= tax liabilities G plus other claimants L such

as potential lawsuits or pension fund liabilities.

 any change in the size of one piece of the pie must

be offset by a change in the size of one or more of the other pieces.

 the manager’s objective is to maximize the value of the marketed claims while minimizing the value of the non-marketed claims.

1986:

 Pennzoil was awarded $10.3 billion from

Texaco by Texas courts because of Texaco’s interference with Pennzoil’s effort to acquire the assets of Getty Oil Co.

 Texaco filed for Chapter 11 reorganization in attempt to shield the equity shareholders

from this onerous non-marketed claim.

 An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help”.

 Who bears the burden of these agency costs?

 While managers may have motive to partake in perquisites, they also need opportunity Free cash flow provides this opportunity

 The free cash flow hypothesis says that an increase in

dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities

 The free cash flow hypothesis also argues that an increase

in debt will reduce the ability of managers to pursue wasteful

Free Cash Flow Hypothesis

The Pecking-Order Theory

 Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient

 Rule 1

 Use internal financing first.

 Rule 2

 Issue debt next, equity last.

 The pecking-order theory is at odds with the off theory:

trade- There is no target D/E ratio

 Profitable firms use less debt

Companies like financial slack

Growth and the Debt-Equity

Personal Taxes: The Miller

Model

 The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:

B T

T

T V

V

B

S

C U

( )

1

( 1

Where:

TS = personal tax rate on equity income

TB = personal tax rate on bond income

Personal Taxes: The Miller

Model (cont.)

B T

T

T V

V

B

S

C U

( )

1

( 1

 In the case where TB = TS, we return to M&M with only corporate tax:

B T

V

VL  U  C

Effect of Financial Leverage on Firm

Value with Both Corporate and

V L =V U when (1-T B ) = (1-T C )×(1-T S)

B T

T

T V

V

B

S

C U

( ) 1

( 1

Integration of Personal and Corporate

Tax Effects and Financial Distress Costs

and Agency Costs

Value of firm (V)

Present value of tax shield on debt

Present value of financial distress costs Value of firm under

MM with corporate taxes and debt

V L = V U + T C B

V = Actual value of firm

V U = Value of firm with no debt

Maximum

firm value

V L < V U + T C B when T S < T B but (1-T B ) > (1-T C )×(1-T S)

Agency Cost of Equity Agency Cost of Debt

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

How Firms Establish Capital Structure

 Most Corporations Have Low Debt-Asset Ratios.

 Changes in Financial Leverage Affect Firm Value.

 Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes

 Another interpretation is that firms signal good news when they lever up

 There are Differences in Capital Structure Across Industries.

 There is evidence that firms behave as if they had

a target Debt to Equity ratio.

Observed Capital Structure

 Capital structure does differ by industries

 Differences according to Cost of Capital 2000

Yearbook by Ibbotson Associates, Inc.

 Lowest levels of debt

 Drugs with 2.75% debt

 Computers with 6.91% debt

 Highest levels of debt

 Steel with 55.84% debt

 Department stores with 50.53% debt

Work the Web Example

 You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Yahoo Marketguide

 Click on the web surfer to go to the site

 Choose a company and get a quote

 Choose ratio comparisons

Factors in Target D/E Ratio

 Taxes

 If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt

 Types of Assets

 The costs of financial distress depend on the types of

assets the firm has

 Uncertainty of Operating Income

 Even without debt, firms with uncertain operating income have high probability of experiencing financial distress

 Pecking Order and Financial Slack

 Theory stating that firms prefer to issue debt rather than

Example, continued

a What is the value of EXES Company?

VU = SU = (EBIT)/r0 = $3,000/.2 = $15,000

b The president of EXES has decided that

shareholders would be better off if the company had equal proportions of debt and equity He proposes to issue $7,500 of debt at an interest rate of 10% He will use the proceeds to

repurchase 500 shares of common stock.

Example, continued.

i What will the new value of the firm be?

Since we are in a world with no taxes:

Example, continued

c Suppose the president’s proposal is implemented.

i What is the required rate of return on equity?

rS = r0 +(B/S)(r0-rB) = 20+(7500/7500)(.20-.10) = 0.30

= 30%

ii What is the firm’s overall required return?

Example, continued

d. Suppose the corporate tax rate is 40%.

i What is the value of the firm?

VU = SU = (EBIT) (1- TC) / r0

= $3000(1-.4)/.2 = $9,000

VL= VU +TC B =$9,000+ 40*$7,500 = $12,000

Example, continued.

ii. Does the presence of taxes increase or decrease

the value of the firm?

 Taxes decrease the value of the firm because the

government becomes a claimant on the firm’s assets

iii. How does the presence of bankruptcy costs change

the effect of taxes on the value of the firm?

 They will further lower the value of the firm.

Example, continued.

ii. Under the Miller model, what will happen to

the value of the firm as the tax on interest income rises? (TB=55%)

Summary and Conclusions

 Costs of financial distress cause firms to

restrain their issuance of debt.

 Direct costs

 Lawyers’ and accountants’ fees

 Indirect Costs

 Impaired ability to conduct business

 Incentives to take on risky projects

 Incentives to underinvest

 Incentive to milk the property

 Three techniques to reduce these costs are:

 Protective covenants

Summary and Conclusions

 Because costs of financial distress can be

reduced but not eliminated, firms will not

finance entirely with debt.

Value of firm (V)

Present value of tax shield on debt

Present value of financial distress costs

Value of firm under

MM with corporate taxes and debt

V L = V U + T C B

V = Actual value of firm

V U = Value of firm with no debt

Maximum

firm value

Summary and Conclusions

 If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset In fact, the corporate

advantage to debt is eliminated if (1-T C ) × (1-T S ) = (1-T B)

Value of firm (V)

Present value of tax shield on debt

Present value of financial distress costs Value of firm underMM with corporate

taxes and debt

V L = V U + T C B

V = Actual value of firm

V U = Value of firm with no debt

Maximum

firm value V L < V U + T C B when T S < T B

but (1-T B ) > (1-T C )×(1-T S)

Summary and Conclusions

 Debt-to-equity ratios vary across industries.

 Factors in Target D/E Ratio

 Uncertainty of Operating Income

 Even without debt, firms with uncertain operating income have high probability of experiencing financial

The Bottom Line

the nature and degree of market imperfections.

 Some market imperfections are important:

corporate and personal taxes, agency costs, and other costs of financial distress

firms

 A safe strategy is to stay close to the industry

average since these firms represent the survivors.