8c how much should firms borrow compatibility mode

M&M and TaxesNORMAL BALANCE SHEET MARKET VALUES Asset value =PV of after-tax cash flows Total assets Debt Equity Total liabilities and equity By reducing the governments claim on the fir

How Much Should a Firm Borrow?

Brealey, Myers, Partington and Robinson

Topics Covered

 Capital structure policy when market is not

perfect:

 Trade-off Theory

 Pecking Order Theory of Financial Choices

Debt Tax Shields

Debt Tax Shields

 Interest payments are tax deductible.

 This is very good news under a classical tax

system, but less good under an imputation

system, but less good under an imputation

system.

less franking credits for investors.

 For the time being we will concentrate on the

firm’s tax position only.

Value of Tax Shield

Income Statement of Firm U Income Statement of Firm L Earnings before interest and taxes $1,000 $1,000.00

Interest paid to bondholders 0 80.00

Consider firm U (Unlevered) and firm L (Levered).

L is identical to U, except that L has borrowed $1,000 at 8%.

Interest paid to bondholders 0 80.00

Tax at 36 percent 360 331.20

Net income to shareholders $640 $588.80

Total income to both bondholders

Value of Tax Shield

What is the value of $28.80 in perpetuity? If the tax shield has the same risk as the debt then the value is: 28.80/ 0.8 =$360

M&M and Taxes

NORMAL BALANCE SHEET (MARKET VALUES)

Asset value

=(PV of after-tax cash flows)

Total assets

Debt Equity Total liabilities and equity

By reducing the governments claim on the firm more of the pre-tax value becomes after tax value.

Total assets Total liabilities and equity

EXPANDED BALANCE SHEET (MARKET VALUES)

Pretax asset value

=(PV of pretax cash flows)

Total pretax assets

Debt Government’s claim (PV of future taxes)

Equity Total liabilities and equity

V L = V U + PV (tax shield) = T c D if debt

is permanent

A Problem with M&M

 Firm value is maximised with 100% debt.

 Possible ways out of this difficulty:

corporate tax advantage.

deduction is risky.

offset the debt tax benefit.

CIT and PIT

Debt and Taxes (Personal & Corp.)

Paid as interest Paid as equity

Operating Income

Income (no tax) $1.00 $1.00 MM (no tax) V L = V U

Corporate tax None T C

Income after corp' tax $1.00 $1.00 - T C MM (corporate tax) V L = V U + T C D

=

)1(

)1

)(

1(1Miller

P

PE C

U L

T

T T

D V V

Debt and Taxes (Personal & Corp.)

Relative Advantage Formula

T PE can effectively be less than T P because part the return comes as capital gains, or because of imputation tax credits.

Relative Advantage Formula

( Debt vs Equity )

Debt and Taxes (Personal & Corp.)

Relative Advantage Formula (RAF) Debt over Equity

Debt and Taxes (Personal & Corp.)

Two special cases: 100% dividend payout So T PE = T P under a classical tax system

>1

Relative tax advantage to debt (classical)

= )

1 )(

1 (

) 1

(

c E

)(

1 (

) 1

(

c E

)(

1

Example 1

Interest Equity

Income Income before tax $1.00 $1.00

Classical tax system with T PE less than T P

Income before tax

less corporate tax at T t = 46

Income after corporate tax

less tax at T P = 47 and T PE = 07

Income after all taxes

$1.00 _0 1.00 .47 $ 53

$1.00 .46 .54 038

Example 2

Interest Equity Income Income before tax

less corporate tax at T c = 36

Income after corporate tax

$1.00 _0 1.00

$1.00 .36

Imputation tax system with 100% dividend payout and full use of franking credits.

Income after corporate tax

add corporate tax refunded as imputation

credits

less tax at T P = 47 and T PE = 47 1

Income after all taxes

1.00 0 _.47

$ 53

.36 _.47

$ 53

1

1444 444 4442 2 2444 444 4443 3

Advantage to debt = $ 0.00

$1.00 .36

Imputation tax system with less than 100% dividend payout and less than full use of franking credits.

less corporate tax at T c = 36

Income after corporate tax

add corporate tax refunded as imputation

$ 53

.36 64 108 216

$ 532

1

1444 444 4442 2 2444 444 4443 3

Advantage to equity = $.002

Miller’s Debt and Taxes

=

) 1

(

) 1

)(

1

( 1

p

pE

C U

L

T

T

T D

V V

Relative tax advantage to Equity Which is expected to be less than 1 under classical taxes expected to be less than 1 under classical taxes

Assume T PE = 0, and a classical tax system

As long as the corporate tax rates exceed T c, there is an incentive to issue more debt, which can initially besold to tax exempt investors (T P = 0)

Miller’s Debt and Taxes

What Happens as More Debt is Issued?

 When the tax exempt investors appetite for

debt is satiated, firms must sell debt to taxable investors.

 But taxable investors prefer equity (T = 0)

 But taxable investors prefer equity (T PE = 0)

so firms have to gross up the interest rate to offset the investor’s increased tax on interest.

 This process stops when T P = T C and interest

rates have been grossed up by 1/(1-T C ) exactly offsetting the debt tax shield.

Miller’s Model and Imputation

Miller’s Model and Imputation

 If firms payout a fraction δ of their income

and retain (1- δ) then the income to shareholders is:

−

−

−

− +

=

) 1

(

)]

1 )(

1 )[(

1 ( )]

1 ( )

C p

U L

T

T T

T

T D

V

Financial Distress

Financial Distress

Costs of Financial Distress - Costs arising from

bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

PV(Costs of financial distress)

Value of levered firm Maximum value of firm

firm

Optimal amount

of debt

Conflicts of Interest

Circular File Company has $50 of 1-year debt.

Circular File Company (Book Values)

Total assets 100 100 Total liabilities

Conflicts of Interest

Circular File Company has $50 of 1-year debt.

Circular File Company (Market Values)

 Why does the equity have any value ?

 Shareholders have an option they can obtain the

rights to the assets by paying off the $50 debt.

Total assets 30 30 Total liabilities

Conflicts of Interest

Circular File Company has may invest $10 as follows.

Next Year Payoffs

Possible Now

y) probabilit (90%

$0

$10 Invest

y) probabilit (10%

$120

 Assume the NPV of the project is (-$2).

What is the effect on the market values?

Conflicts of Interest

Circular File Company value (post project)

Circular File Company (Market Values)

 Firm value falls by $2, but equity holder gains $3

Total assets 28 28 Total liabilities

Conflicts of Interest

Circular File Company value (assumes a safe project with NPV = $5)

Circular File Company (Market Values)

 While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.

Total assets 45 45 Total liabilities

Other Financial Distress Games

Trade-off Theory

Trade-off Theory - Theory that capital structure is

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

E.g Firms with tangible assets and high profits should use more debt

should use more debt Explains similarity of debt ratios by industry, but not why profitable firms use less debt.

r E

WACC (traditional view)

Assuming r E is insensitive to moderate levels of D/E BUT sensitive to high levels of D/E

D E

r D

WACC

Optimum D/V

Pecking Order Theory

 Pecking Order Theory - Theory stating that

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

Issues and Share Prices

 Why do security issues affect share price? The

demand for a firm’s securities ought to be flat

 Any firm is a drop in the bucket.

 Plenty of close substitutes.

 Plenty of close substitutes.

 Large debt issues don’t significantly depress

the share price.

 But the evidence is that share price falls in

response to a rights issue

Pecking Order Theory

Consider the following story:

The announcement of a share issue drives down the share price because investors believe managers are more likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can be raised without sending adverse signals.

If external finance is required, firms issue debt first and

equity as a last resort.

The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Some Implications:

 Internal equity may be better than external

equity.

 Financial slack is valuable.

 Financial slack is valuable.

 If external capital is required, debt is better

(There is less room for difference in opinions about what debt is worth).

One Final Benefit of Debt

 Shareholders worry about managers

mis-using free cash flow.

 Using more debt reduces the available free

cash flow.

cash flow.

 It also forces managers to work harder and

run a tighter ship