Chapter 16 Debt Policy

Size: px

Start display at page:

Download "Chapter 16 Debt Policy"

Tyrone Page
5 years ago
Views:

Chapter 16 Debt Policy Konan Chan Financial Management, Fall 2018 Topic Covered Capital structure decision Leverage effect Capital structure theory MM (no taxes) MM (with taxes) Trade-off Pecking

capital structure choice Understand the basic components of the bankruptcy process Choosing a Capital Structure What is the primary goal of financial managers?

1 Chapter 16 Debt Policy Konan Chan Financial Management, Fall 2018 Topic Covered Capital structure decision Leverage effect Capital structure theory MM (no taxes) MM (with taxes) Trade-off Pecking order Financial Management Konan Chan 2 Key Concepts and Skills Understand the effect of financial leverage on cash flows and the cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process Choosing a Capital Structure 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 16-3 Financial Management Konan Chan 4 Leverage Effect Example Example Financial Management Konan Chan 5 Financial Management Konan Chan 6

2 Leverage Effect When increase financial leverage by more debt Let s ignore tax here for simplicity In good year, we have more left-over after paying interests; in bad year, we have less left-over ROE changes from 6%-20% to 2%-30% range EPS changes from $.6-$2 to $.2-$3 range The variability in both ROE and EPS increases when financial leverage is increased EPS and EBIT Financial Management Konan Chan 7 Financial Management Konan Chan 8 Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures If expected EBIT > break-even, leverage is good If expected EBIT < break-even, leverage is bad EBIT/500,000 = (EBIT-250,000)/250,000 EBIT = 2* EBIT 500,000 EBIT = 500,000; EPS = 500,000/500,000 = 1 Capital Structure Theory MM theory Assume no bankruptcy cost Case I: no tax Case II: with corporate tax (no personal tax) Trade-off theory Pecking order theory Financial Management Konan Chan 9 Financial Management Konan Chan 10 Homemade Leverage Current Capital Structure Proposed Capital Structure Investor borrows $500 and Investor buys $250 worth of uses $500 of her own to buy stock (25 shares) and $250 worth 100 shares of stock of bonds paying 10%. Payoffs: Payoffs: Recession: 100(0.60) -.1(500) Recession: 25(.20) +.1(250) = = $10 $30 Expected: 100(1.30) -.1(500) Expected: 25(1.60) +.1(250) = = $80 $65 Expansion: 100(2.00) -.1(500) Expansion: 25(3.00) +.1(250) = = $150 $100 Mirrors the payoffs from Mirrors the payoffs from purchasing 50 shares from the purchasing 50 shares under the firm under the proposed capital current capital structure structure Financial Management Konan Chan 11 MM Theory (no tax) The original MM theory assumes no taxes, and no bankruptcy costs Capital structure does not affect cash flows It is the same firm value whether or not the firm or individual borrows Therefore, the market value of a company does not depend on its capital structure Financial Management Konan Chan 12

MM Propositions (no tax) MM proposition I Capital structure does NOT affect firm value or WACC WACC keeps the same for any debt ratio MM proposition II Given proposition I, WACC keeps the same WACC =

3 MM Propositions (no tax) MM proposition I Capital structure does NOT affect firm value or WACC WACC keeps the same for any debt ratio MM proposition II Given proposition I, WACC keeps the same WACC = R D (D/V) + R E (E/V) = R A = R U R E = R A + (D/E)(R A - R D ) = R U + (D/E)(R U - R D ) the expected return on equity increases with the debt-equity ratio Business and Financial Risk R E = R A + (D/E)(R A - R D ) R A is the cost of the firm s business risk, i.e., the risk of the firm s assets (R A R D )(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 leverage Financial Management Konan Chan 13 Financial Management Konan Chan 14 MM Theory (no tax) Financial Management Konan Chan 15 Example: MM w/o Tax Suppose required return on assets = 16%, cost of debt = 10%, debt/assets = 45% What is the cost of equity? R E = 16% + (16% - 10%)(.45/.55) = 20.91% Suppose the cost of equity is 25%, what is the debt-to-equity ratio? What is equity/assets? 25% = 16% + (16% - 10%)(D/E) D/E = (25% - 16%) / (16% - 10%) = 1.5 E/V = 1 / 2.5 = 40% Financial Management Konan Chan 16 Interest Tax Shield Consider two firms with 40% tax rate: A has no debt, B has $5000 debt with 10% interest rate Company A B EBIT Interest Expense Pre-tax income Taxes (40%) Net Income B saves 200 of taxes due to debt, making CF B ( ) > CF A (600) by 200 (Debt*R D *T C =5000*.1 *.4) This tax savings is tax shield Financial Management Konan Chan 17 Cash Flows with Leverage Financial Management Konan Chan 18

MM Theory with Taxes If tax shield is perpetual, PV of tax shield = D * R D * T C / R D = T C * D Value of levered firm (V L ) = unlevered firm value (V U ) + PV of tax shield = EBIT(1- T C ) / R U +

19 Proof: Cost of equity This slide, requested by some students, shows how we can derive MM proposition II with tax Total cash flow each year = E (R E ) + D (R D ) = V U ( R U )+ T C D (R D ) (assume

4 MM Theory with Taxes If tax shield is perpetual, PV of tax shield = D * R D * T C / R D = T C * D Value of levered firm (V L ) = unlevered firm value (V U ) + PV of tax shield = EBIT(1- T C ) / R U + T C * D More debt is better, because the interest deduction generates extra value (save tax) R A = (E/V)R E + (D/V)(R D )(1-T C ) R E = R U + (R U R D )(D/E)(1-T C ) Financial Management Konan Chan 19 Proof: Cost of equity This slide, requested by some students, shows how we can derive MM proposition II with tax Total cash flow each year = E (R E ) + D (R D ) = V U ( R U )+ T C D (R D ) (assume perpetual CFs) So, R E = [V U ( R U )+ T C D (R D ) - D (R D ) ]/E Since V U = V T C * D = (D + E) T C * D R E = [E + (1 T C )D](R U /E) R D (1-T C ) (D/E) R E = R U +(R U R D ) (1-T C ) (D/E) Financial Management Konan Chan 20 MM Theory (with Corp. tax) Financial Management Konan Chan 21 Financial Management Konan Chan 22 Example - MM with Tax Suppose EBIT is 25 million, tax rate 35%, debt $75 million, cost of debt 9%, unlevered cost of capital 12% V U = 25(1-.35) /.12 = $ million V L = (.35) = $ million E = = $86.67 million R E = 12% + (12%-9%)(75/86.67)(1-.35) = 13.69% R A = (86.67/161.67)(13.69%) + (75/161.67)(9%)(1-.35) R A = 10.05% Example - MM with Tax 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? R E = 12% + (12% - 9%)(1)(1-.35) = 13.95% What will happen to the weighted average cost of capital? R A =.5(13.95%) +.5(9%)(1-.35) = 9.9% Financial Management Konan Chan 23 Financial Management Konan Chan 24

MM in Reality and Trade-off In reality, no firm takes the extreme step of using 100% debt financing as implied by MM with tax MM ignored the costs of bankruptcy in their analysis of MM with taxes By

5 MM in Reality and Trade-off In reality, no firm takes the extreme step of using 100% debt financing as implied by MM with tax MM ignored the costs of bankruptcy in their analysis of MM with taxes By including the cost of bankruptcy, there is a tradeoff between the benefits of debt financing (tax shields) against costs of debt financing (increased risk of bankruptcy) Firm value = unlevered firm value + PV tax shield - PV of financial distress costs Financial Management Konan Chan 25 Bankruptcy Costs Direct costs Legal and administrative costs Bondholders lose benefits Indirect costs Lost sales, managerial efforts, no incentives to work Larger than direct costs, but difficult to measure Costs of financial distress Costs arising from bankruptcy or distorted business decisions before bankruptcy Financial Management Konan Chan 26 Trade-off Theory Financial Management Konan Chan 27 Financial Management Konan Chan 28 Optimal Capital Structure MM w/o tax no taxes or bankruptcy costs No optimal capital structure MM with tax w/ corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Trade-off w/ corporate taxes and bankruptcy costs Exists an optimal capital structure Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs Financial Management Konan Chan 29 Managerial Recommendations The tax benefit is only important if the firm has a large tax liability Firms with huge loss will get little tax shield value The greater the risk of financial distress, the less debt will be optimal for the firm Firms with more intangible assets or unstable EBITs should use less debt Financial Management Konan Chan 30

Pecking Order and Signaling Asymmetric Information - managers have different and better information about the firm s prospects than investors do The action that firms announce to raise capital sends

6 Pecking Order and Signaling Asymmetric Information - managers have different and better information about the firm s prospects than investors do The action that firms announce to raise capital sends a signal about the firm s future prospects New stock issue = bad signal, firms are selling overvalued stock New Debt issue = better signal, because the information asymmetry is not as severe as equity Financial Management Konan Chan 31 Pecking Order Theory Theory Firms prefer to use internally generated funds When needs external financing is necessary, debt is the primary way to get financing Equity is the last resort to finance projects Implications No target (optimal) capital structure Profitable firms borrow less Financial slack (cash reserve or the extent to access financial markets) is valuable Financial Management Konan Chan 32 Financial Choices 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 Management Konan Chan 33 Financial Management Konan Chan 34 Observed Capital Structure Capital structure differs by industries Lowest levels of debt Drugs with 7.8% debt Computers with 9.1% debt Highest levels of debt Airlines with 64% debt Utilities with 49% debt Financial Management Konan Chan 35 Bankruptcy Process Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978 Trustee takes over assets, sells them and distributes the proceeds according to absolute priority rule (APR), which defines the priority of claims Reorganization Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors Financial Management Konan Chan 36

7 Ethics Issues Suppose managers of a firm know that the company is approaching financial distress. Should the managers borrow from creditors and issue a large one-time dividend to shareholders? How might creditors control this potential transfer of wealth? Quick Quiz Explain the effect of leverage on EPS and ROE What is the break-even EBIT, and how do we compute it? How do we determine the optimal capital structure? What is the optimal capital structure in the three cases that were discussed in this chapter? What is the difference between liquidation and reorganization? Financial Management Konan Chan 37 Financial Management Konan Chan 38

Capital Structure. Capital Structure. Konan Chan. Corporate Finance, Leverage effect Capital structure stories. Capital structure patterns

Capital Structure. Capital Structure. Konan Chan. Corporate Finance, Leverage effect Capital structure stories. Capital structure patterns Capital Structure, 2018 Konan Chan Capital Structure Leverage effect Capital structure stories MM theory Trade-off theory Free cash flow theory Pecking order theory Market timing Capital structure patterns