JEM034 Corporate Finance Winter Semester 2017/2018 Lecture #9 Olga Bychkova
Topics Covered Today Does debt policy matter? (chapter 17 in BMA) How much should a corporation borrow? (chapter 18 in BMA)
Debt Policy: Topics Covered Financial Leverage in a Competitive Tax Free Environment Financial Risk and Expected Returns The Weighted Average Cost of Capital A Final Word on After Tax WACC
Modigliani & Miller: Debt Policy Doesn t Matter When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.
Modigliani & Miller: Key Assumptions No taxes No bankruptcy costs No effect on management incentives/no agency costs No assymetric information Existence of efficient market
Example: Macbeth Spot Removers (All Equity Financed)
Example: Macbeth Spot Removers (50% Debt)
Borrowing and EPS at Macbeth Borrowing increases Macbeth s EPS when operating income is greater than $1,000 and reduces EPS when operating income is less than $1,000. Expected EPS rises from $1.5 to $2.
Example: Macbeth Spot Removers (All Equity Financed + Debt Replicated by Investors) As long as investors can borrow or lend on their own account on the same terms as the firm, they can undo the effect of any changes in the firm s capital structure.
No Magic in Financial Leverage Modigliani & Miller s Proposition 1 If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. The total value of the firm is independent of the debt ratio.
Leverage and Returns Expected return on assets = r A = expected operating income market value of all securities In perfect capital markets the company s borrowing decision does not affect either the firm s operating income or the total market value of its securities. Therefore, the borrowing decision also does not affect the expected return on the firm s assets r A. r A = r D D D + E + r E E D + E r E = r A + (r A r D ) D E
Leverage and Returns Modigliani & Miller s Proposition 2 The expected rate of return on the common stock of a levered firm increases in proportion to the debt equity ratio ( D /E), expressed in market values; the rate of increase depends on the spread between r A, the expected rate of return on a portfolio of all the firm s securities, and r D, the expected return on the debt.
Example: Macbeth Spot Removers All Equity Financed: r E = r A = 50% Debt: expected operating income market value of all securities = 1, 500 10, 000 = 0.15 r E = r A + (r A r D ) D E = 0.15 + (0.15 0.1)5, 000 5, 000 = 0.2
Leverage and Risk Financial leverage increases the risk of Macbeth shares. A $1,000 drop in operating income reduces earnings per share by $1 with all equity financing, but by $2 with 50% debt.
Modigliani & Miller s Proposition 2 The expected return on equity r E increases linearly with the debt equity ratio so long as debt is risk free. But if leverage increases the risk of the debt, debtholders demand a higher return on the debt. This causes the rate of increase in r E to slow down.
WACC (Traditional View) Traditionalists say that borrowing at first increases r E more slowly than Modigliani & Miller predict but that r E shoots up with excessive borrowing. If so, the weighted average cost of capital can be minimized if you use just the right amount of debt.
After Tax WACC (Reminder) The tax benefit from interest expense deductibility must be included in the cost of funds. This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate. After Tax WACC = (1 T c )r D D D + E + r E E D + E
Debt Policy: Problem 19, Chapter 17 of BMA Textbook Archimedes Levers is financed by a mixture of debt and equity. You have the following information about its cost of capital: Can you fill in the blanks?
Debt Policy: Problem 19, Chapter 17 of BMA Textbook We begin with r E and the capital asset pricing model: r E = r f + β E (r m r f ) = 10% + 1.5(18% 10%) = 22%. Similarly for debt: r D = r f + β D (r m r f ) β D = r D r f 12% 10% = r m r f 18% 10% = 0.25. Also, we know that: r A = r D D V + r E E V To solve for β A, use the following: β A = β D D V + β E E V = 12% 0.5 + 22% (1 0.5) = 17%. = 0.25 0.5 + 1.5 (1 0.5) = 0.875.
Debt Policy: Problem 20, Chapter 17 of BMA Textbook Suppose now that Archimedes repurchases debt and issues equity so that D /V = 0.3. The reduced borrowing causes r D to fall to 11%. How do the other variables change? We know from Proposition I that the value of the firm will not change. Also, because the expected operating income is unaffected by changes in leverage, the firm s overall cost of capital will not change. In other words, r A remains equal to 17% and β A remains equal to 0.875. However, risk and, hence, the expected return for equity and for debt, will change.
Debt Policy: Problem 20, Chapter 17 of BMA Textbook We know that r D is 11%, so that, for debt: r D = r f + β D (r m r f ) β D = r D r f 11% 10% = r m r f 18% 10% = 0.125. For equity: r A = r D D V +r E E V r E = r A r D D/V E/V = 17% 11% 0.3 1 0.3 = 19.6%. Also: r E = r f + β E (r m r f ) β E = r E r f r m r f = 19.6% 10% 18% 10% = 1.2.
Corporate Borrowing: Topics Covered Corporate Taxes Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices
Capital Structure & Corporate Taxes 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.
Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.
Capital Structure & Corporate Taxes PV (tax shield) = 28 0.08 = $350 Interest payment = return on debt amount borrowed = r D D PV (tax shield) = corporate tax rate interest payment expected return on debt = T cr D D r D = T c D =
Capital Structure & Corporate Taxes Example You own all the equity of Space Babies Diaper Co. The company has no debt. The company s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35%. You have the option to exchange 1 /2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? All Equity 1/2 Debt EBIT $900,000 $900,000 Interest Payment 0 $100,000 Pretax Income $900,000 $800,000 Tax at 35% $315,000 $280,000 Net Cash Flow $585,000 $520,000 Total Cash Flow $585,000 $620,000 (All Equity + 1 /2 Debt)
Capital Structure & Corporate Taxes Or directly: PV (tax shield) = T cr D D r D = T c D Tax benefit = 0.35 0.05 2, 000, 000 = $35, 000 PV of $35, 000 in perpetuity = 35, 000 0.05 = $700, 000 PV (tax shield) = 0.35 2, 000, 000 = $700, 000
Capital Structure & Corporate Taxes Firm Value = Value of All Equity Firm + PV (Tax Shield) All Equity Value = 585 = $11, 700, 000 0.05 PV (Tax Shield) = $700, 000 Firm Value with 1 /2 Debt = $12, 400, 000
Corporate Borrowing: Problem 12, Chapter 18 of BMA Textbook Compute the present value of interest tax shields generated by these three debt issues. Consider corporate taxes only. The marginal tax rate is T c = 0.35. (a) A $1,000, one year loan at 8%. PV (tax shield) = T cr D D 0.35 0.08 1, 000 = = $25.93 1 + r D 1.08 (b) A five year loan of $1,000 at 8%. Assume no principal is repaid until maturity. PV (tax shield) = (c) A $1,000 perpetuity at 7%. 0.35 0.08 1, 000 0.08 ( 1 1 ) 1.08 5 = $111.8 PV (tax shield) = T c D = 0.35 1, 000 = $350
Financial Distress Costs of Financial Distress Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV (Tax Shield) PV (Costs of Financial Distress)
Financial Distress
Default Payoff Scenarios If the two firms asset values are less than $1,000, Ace Limited stockholders default and its bondholders take over the assets. Ace Unlimited stockholders keep the assets, but they must reach into their own pockets to pay off its bondholders. The total payoff to both stockholders and bondholders is the same for the two firms.
Ace Limited Example Total payoff to Ace Limited security holders. There is a $200 bankruptcy cost in the event of default (shaded area).
Conflicts of Interest Circular File Company has $50 of 1 year debt. 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.
Conflicts of Interest Circular File Company has $10 cash and may invest them as follows: Assume the NPV of the project is $2. What is the effect on the market values? Firm value falls by $2, but equity holder gains $3.
Conflicts of Interest Assume there is a relatively safe asset costing $10 with a present value of $15 and NPV = $5. While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.
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.
Pecking Order Theory Consider the following story: The announcement of a stock issue drives down the stock 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. If external capital is required, debt is better (there is less room for difference in opinions about what debt is worth).
Corporate Borrowing: Problem 18, Chapter 18 of BMA Textbook Who gains and who loses from the following maneuvers? (a) Circular scrapes up $5 in cash and pays a cash dividend. Stockholders win. Bond value falls since the value of assets securing the bond has fallen.
Corporate Borrowing: Problem 18, Chapter 18 of BMA Textbook (b) Circular halts operations, sells its fixed assets, and converts net working capital into $20 cash. Unfortunately the fixed assets fetch only $6 on the secondhand market. The $26 cash is invested in Treasury bills. Bondholder wins if we assume the cash is left invested in Treasury bills. The bondholder is sure to get $26 plus interest. Stock value is zero because there is no chance that the firm value can rise above $50.
Corporate Borrowing: Problem 18, Chapter 18 of BMA Textbook (c) Circular encounters an acceptable investment opportunity, NPV = 0, requiring an investment of $10. The firm borrows to finance the project. The new debt has the same security, seniority, etc., as the old. The bondholders lose. The firm adds assets worth $10 and debt worth $10. This would increase Circular s debt ratio, leaving the old bondholders more exposed. The old bondholders loss is the stockholders gain.
Corporate Borrowing: Problem 18, Chapter 18 of BMA Textbook (d) Suppose that the new project has NPV = $2 and is financed by an issue of preferred stock. Both bondholders and stockholders win. They share the (net) increase in firm value. The bondholders position is not eroded by the issue of a junior security. (We assume that the preferred does not lead to still more game playing and that the new investment does not make the firm s assets safer or riskier.) (e) The lenders agree to extend the maturity of their loan from one year to two in order to give Circular a chance to recover. Bondholders lose because they are at risk for a longer time. Stockholders win.