B40.2302 Class #8

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

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B40.2302 Class #8

BM6 chapters 16.5-16.8,18.1-18.3,18.5,19 16.5-16.8: Dividend relevance under taxes etc. 18.1-18.3, 18.5: Capital structure relevance under

taxes and financial distress 19: Valuation under financing effects

Based on slides created by Matthew Will Modified 10/31/2001 by Jeffrey Wurgler

The Dividend Controversy

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 16.5-16.8



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Topics Covered

Views on dividend relevance

The “Rightists” (dividends increase value) The “Radical Left” (dividends decrease value) The “Middle-of-the-Roaders” (little or no effect)


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Dividends Increase Value

A “rightist” (high-payout) view

… the considered and continuous verdict of the stock market is overwhelmingly in favor of liberal dividends as against niggardly ones…

Benjamin Graham and David Dodd

Security Analysis (1951) (1st ed. 1934)


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Rightist argument: M&M ignore risk Dividends are cash in hand, but capital gains are not “Bird in hand versus bird in bush” So isn’t the dividend to be preferred?

Questionable argument Declaring high dividend makes (residual) capital gain component

more risky, overall risk to shareholders does not change Can get dividend-like “bird in hand” whenever you like, just by

selling some of your stock M&M assume efficient capital market: $1 in dividend would

otherwise be capitalized at $1 in share price. So long as this is true, the “bird in hand” argument is invalid. If this is not true (as Graham and Dodd imply), argument is valid.


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Rightist argument: There are “clienteles” that prefer dividends Some financial institutions cannot hold stocks that do not have established

dividend records Trusts and endowments may be discouraged from spending capital gains

(which may be viewed as “principal”) but allowed to spend dividends (may be viewed as “income”)

Retirees(?)/Small investors(?) may prefer to spend from their AT&T dividend checks rather than sell a few shares every month. (Reduces transaction costs, inconvenience)

Corporations pay corporate income tax on only 30% of dividends they receive, but 100% of capital gains.

The demand of these “dividend clienteles” may increase the price of a dividend-paying stock

But… Unclear whether any particular firm can benefit by increasing dividends.

There may already be enough high-dividend stocks to choose from.


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Rightist argument: Dividends can’t be wasted Investors may not trust managers to invest retained

earnings wisely Firms that refuse to pay out cash may sell at a discount

Comments In this case dividend decision is tied to investment decision May have particular merit in countries with poor corporate

governance systems


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Dividends Decrease Value

Leftist (low-payout) argument: Taxes If dividends are taxed more heavily than capital

gains, investors dislike dividends. Firms should pay low dividend, retain cash or

repurchase shares Investors should require higher pre-tax return on

dividend-paying stocks (i.e, dividend-paying stocks sell at a discount price)


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Dividends decrease value

0.101000.10100(%) return of rateAfter tax

66.9)17.15()83.510(1050.2)50.120(taxes)-gain cap(div

incomeTax After Total17.183.5.202.5012.50.2020% @ Gain Cap onTax

00.510.50050% @ div onTax

4.161005.12100(%) return of ratePretax

5.8312.50gain Capital

96.67100pricestock sToday'

112.50112.50payoffpretax Total

100Dividend

102.50112.50price sNext year'dividend) (high

BFirm

dividend) (no

A Firm

96.679.66

10010

96.6715.83

10012.5

Effect of investor taxes (50% dividend, 20% capital gain) on share prices and returns


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1998 Marginal Income Tax Brackets

Income Bracket

Marginal Tax Rate Single Married (joint return)

15% $0 - $25,350 $0 - $42,35028 25,351 - 61,400 42,351 - 102,30031 61,401 - 128,100 102,301 - 155,95036 128,101 - 278,450 155,951 - 278,450

39.6 over 278,450 over 278,450

• Dividends are taxed at the personal income rate• Capital gains are, for most investors, taxed at 28%• High-tax-bracket investors therefore still prefer capital gains


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Empirical evidence on dividends, prices, returns:

• Mixed.

• Generally a positive relationship between dividend yield and pre-tax returns, as predicted by “leftists”

• But statistically unreliable


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Middle of the road

Maybe M&M conclusion of irrelevance is right even when some of the assumptions are relaxed:

• High- or low-payout clienteles may exist, but they are already satisfied, so no firm can increase its value by changing dividends

• This “middle of the road” view argues that dividends have little or no effect on value

How Much Should a Firm Borrow?


Slides by


Chapter 18.1-18.3, 18.5©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill


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Topics Covered

Corporate Taxes Corporate and Personal Taxes Costs of Financial Distress

Financial distress games

The “trade-off theory” of capital structure


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Corporate Taxes

Main advantage of debt in U.S.:

Corporations can deduct interest Whereas retained earnings and dividends are

taxed at the corporate level Thus, more cash left for investors if firm

uses debt finance


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Corporate Taxes

U L

EBIT 1,000 1,000

Interest Pmt 0 80

Pretax Income 1,000 920

Tax @ Tc= 35% 350 322

Net Income to shhs $650 $598

Net to bhhs 80

Total to investors 650 678

Interest tax shield (.35*interest) 28

Example – Firm U is unlevered, firm L is levered. Firms have same investment policy (so same operating cash flows).


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Corporate Taxes

PV of Tax Shield =D x rD x Tc

rD

= D x Tc

Example (D = 1000, rD =.10, Tc=.35):

Yearly savings = 1000 x (.10) x (.35) = $35

PV Perpetual Tax Shield @ 10% = 35 / .10 = 1000*.35 = $350

What is present value of tax shield?• If the same savings occur every year, value as a perpetuity• If the savings are as risky as the debt, discount at cost of debt• Under these assumptions:


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Corporate TaxesTaxes don’t change the total size of the pretax “pizza.” But now the government gets a slice. Government’s slice is smaller (and investors’ slices are bigger)

when debt is used.

M&M proposition I with corporate taxes:

Firm Value = Value of All Equity Firm

+ PV(Tax Shield)

… and in special case where debt is permanent …

Firm Value = Value of All Equity Firm + Tc*D


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Corporate Taxes

So why not 100% debt, then, or close to it?

Maybe looking at corporate and personal taxation will uncover a personal tax disadvantage to borrowing (to offset the corporate tax advantage)

Or, maybe firms that borrow incur other costs – such as costs of financial distress – that offset interest tax shield


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Corporate and Personal TaxesTC Corporate tax rate

TP Personal tax rate on interest income

TPE Personal tax rate on Equity income (= TP if all equity

income comes in form of cash dividends, but < TP if comes as capital gains, << if they are deferred)

---------------------------------------------------------------------------$1 in operating income paid as interest:

= $(1 – TP) to bondholder (escapes corporate tax)

$1 in operating income paid as equity income:

= $(1 – TPE)*(1 – TC) (hit by corporate tax, then personal tax)


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Corporate and Personal Taxes

Relative Tax Advantage of Debt over Equity

1-TP

(1-TPE)*(1-TC)

RA > 1 Debt

RA < 1 Equity

Tax advantage

=


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Example 1 Interest Equity income

Income before tax 1.00 1.00

Corp taxes Tc=.35 0.00 0.35

To investor 1.00 0.65

Pers. taxes TP =.40, TPE=.10 0.40 0.065

Income after all taxes 0.60 0.585

RA = 1.025 Advantage: Debt (barely)



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Example 2 Interest Equity income

RA = 0.923 Advantage: Equity


Income before tax 1.00 1.00

Corp taxes Tc=.35 0.00 0.35

To investor 1.00 0.65

Pers. taxes TP =.40, TPE= 0 0.40 0.00

Income after all taxes 0.60 0.65


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Corporate and Personal TaxesSo then … equity or debt? Merton Miller’s argument: Suppose TPE = 0 and TP varies across investors. Then

• Economy-wide tax-minimizing mix of debt and equity depends on distribution of personal tax rates

• But there still may be are no tax gains left for individual firms to get by varying their own leverage

- “Low-tax” investors already hold all the bonds they want- If “marginal investor” has high tax rate, may be no tax gain left from issuing debt to him!- Current tax law still seems to favor borrowing, though (TPE not as low as Miller assumed)


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Costs of Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions on the brink of bankruptcy.

Firm value = Value of All Equity Firm

+ PV(Tax Shield)

- PV(Costs of Financial Distress)


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Trade-off Theory

Debt ratio

Mar

ket V

alue

Value ifAll Equity

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt


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Bankruptcy is not costly in itself; bankruptcy costs are the cost of using this legal mechanism

Bankruptcy costs and costs of financial distress are borne by shareholders Creditors foresee the costs and foresee that they will pay

them if default occurs For this, they demand higher interest rates in advance This reduces the present market value of shares


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Direct costs (legal, administrative fees) Manville (1982, asbestos): $200m on fees Eastern Airlines (1989): $114m on fees On average, direct costs = 3% of book assets, or 20% of

market equity in year prior to bankruptcy

Indirect costs Customers may stray if firm may not be around, suppliers

may be unwilling to give much effort to firm’s account, good employees hard to attract …

Hard to measure, but probably large


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US bankruptcy procedures

Chapter 11

Aims to rehabilitate firm; protect value of assets while reorganization plan is worked out; used more by large, public companies

Chapter 7

Aims to dismember firm; assets are auctioned and creditors paid off (usually) according to seniority; used more by small companies


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Financial distress may be costly even without formal bankruptcy

When a firm is in trouble, both shareholders and bondholders want it to recover, but otherwise their interests may conflict

Shareholders may pursue self-interest rather than the usual objective of maximizing overall market value

Shareholders may play “games” at creditors’ expense These games can reduce overall value


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

Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total value

Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total value

Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total value

Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total value


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Game #1: Risk shifting

Circular File Company may invest $10 as follows:

y)probabilit (90% $0

$10Invest

y)probabilit (10% $120

Next Year PayoffsPossibleNow

Suppose NPV of the project is (-$2). What is the effect on the market values?


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Firm value falls by $2 But equity gains $3 (say)

Circular File Company (Market Values - post project)Net W.C. 10 20 Bonds outstandingFixed assets 18 8 Common stockTotal assets 28 28 Total liabilities



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Game #2: Refusing to contribute equity capital

Suppose NPV = $5 project (costs 10 new equity, returns 15)

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

Shareholders will therefore resist the project




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Other games

Cash In and Run

Playing for Time

Bait and Switch


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Trade-off theory redux

Trade-off theory argues that optimal debt ratios vary from firm to firm PV (tax shields) vary

• Depends on level and risk of taxable income

PV (costs of financial distress) vary• Tangible assets lose least value in distress

• So can take on more debt

So trade-off theory may explain why different firms have different capital structures

Financing and Valuation


Slides by


Chapter 19



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Topics Covered

After-Tax WACC Using WACC: Tricks of the Trade Adjusting WACC when risks change Adjusted Present Value (APV)


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After Tax WACC

The tax shield of interest reduces the after-tax weighted-average cost of capital.

The amount of the reduction depends on Tc

Note WACC < r (our previous “opportunity cost of capital”)

V

Er

V

DTcrWACC ED )1(


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After Tax WACC

So WACC incorporates the tax advantages of debt financing in lower discount rate

Note that all variables in WACC refer to whole firm So after-tax WACC gives right discount rate only for new

projects that are just like the firm’s “average” Would need to be adjusted for projects whose acceptance

would cause a change in the firm’s overall debt ratio (we’ll show how later)

Would need to be adjusted for safer or riskier projects (we won’t show how)


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After Tax WACC

Example - Sangria Corporation

The firm has a marginal tax rate Tc of 35%. The cost of equity is 14.6% and the pretax cost of debt is 8%. Given the following market value balance sheets, what is the after tax WACC?


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After Tax WACCExample - Sangria Corporation - continued

Balance Sheet (Market Value, millions)Assets 125 50 Debt (D)

75 Equity (E)Total assets 125 125 Firm value (V)

Balance Sheet (Market Value, millions)Assets 125 50 Debt (D)

75 Equity (E)Total assets 125 125 Firm value (V)

Given: Tc=35%, rE=.146, rD=.08, and the market value balance sheet:


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Debt ratio = (D/V) = 50/125 = .4

Equity ratio = (E/V) = 75/125 = .6

Plug and chug to solve for WACC …

V

Er

V

DTcrWACC ED )1( = .1084


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How to use the WACC of 10.84%?

Suppose company has following investment opportunity: can invest in an ice-crushing machine with perpetual, pretax cash flows of $2.085 million per year.

Given an initial investment of $12.5 million, and assuming that firm will finance it without changing its current debt ratio, what is the value of the opportunity?


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After Tax WACCExample - Sangria Corporation - continuedThe company would like to invest in a perpetual ice-crushing machine with cash flows of $2.085 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

Cash FlowsPretax cash flow 2.085Tax @ 35% 0.730After-tax cash flow $1.355 million

Cash FlowsPretax cash flow 2.085Tax @ 35% 0.730After-tax cash flow $1.355 million


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After Tax WACC

Example - Sangria Corporation – contd.

Discount after-tax cash flow (not accounting for debt tax shield) at after-tax WACC. I.e., calculate taxes as if company were all-equity financed.

Value of debt tax shield is already being counted in the after-tax WACC!

01084.

355.15.12

NPV

01084.

355.15.12

NPV


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After Tax WACC

Interim review:After-tax WACC methodology is one way to calculate value when interest is tax-deductible

Required assumptions:1. Project’s business risks are same as firm average

2. Project supports the same fraction of D/V as overall firm


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WACC Tricks of the Trade

What about other forms of financing?

Preferred stock (P) and other forms of financing are easily included

In this case, V = D + P + E

V

Er

V

Pr

V

DTcrWACC EPD )1(


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How do you get the inputs?

Can use stock market data to estimate rE

rD , debt and equity ratios usually easy … … Unless the debt is junk. If default risk is high,

promised yield overstates true cost, true expected return

No easy solution. (Try sensitivity analysis, see if your choice makes a difference.)


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Some common mistakes

“My firm could borrow 90% of project cost if I want. So D/V=.9, E/V=.1. My firm’s cost of debt is 8%, and cost of equity is 15%. When I discount at WACC = .08*(1-.35)*.9+.15*.1=6.2%, project looks great!”

Mistakes: Formula doesn’t apply if project isn’t same as firm. E.g. if firm isn’t already

90% debt financed, can’t use formula without making adjustment. Even if firm was going to lever up to 90% debt, its cost of capital would not

decline to 6.2%. The increased leverage would increase the cost of debt and the cost of equity, too.

V

Er

V

DTcrWACC ED )1(


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WACC for U.S. oil industry

0

5

10

15

20

25

30Cost of Equity

WACC

Treasury Rate

Per

cent

(no

min

al)


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WACC(y?) adjustments

What if project is not financed at same D/E proportions as firm?

• Can’t just plow ahead with regular WACC. Need to adjust.

• Three-step process:

1. Calculate opportunity cost of capital using firm debt ratio

r = rD(D/V) + rE (E/V)

2. Estimate project cost of debt rD at project debt-equity ratio, and then use this and r to calculate project cost of equity rE

rE = r + (r - rD)(D/E)

3. Recalculate WACC at project rD , rE , debt ratio


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WACC(y?) adjustments

Sangria contd.

What if project supports 20% D/V, not 40% D/V like overall firm?

1. Calculate opportunity cost of capital using firm debt ratio

r = rD(D/V) + rE (E/V) = .08(.4) + .146(.6) = .12

2. Estimate project cost of debt rD at project debt-equity ratio, and then use this and r to calculate project cost of equity rE

rE = r + (r - rD)(D/E) = .12 + (.12-.08)(.25) = .13

• Notes: assumed rD stays at 8%; D/V =.20 D/E = .25

3. Recalculate WACC at project rD , rE , debt ratio

WACC = .08(1-.35)(.2) + .13(.8) = .1140 (vs. .1084 orig.)


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Adjusted Present Value

APV is second way to incorporate tax advantages of debt WACC messes around with discount rate, while APV explicitly

adjusts the cash flows and present values.

APV = base-case NPV

+ PV(Financing effects)

“Base case” = All-equity NPV. “Financing effects” = costs/benefits due to financing

(interest tax shields, security issue costs)


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Example (financing effect = issue cost):

Project A has a base-case NPV of $150,000. But in order to finance the project we must issue stock, which costs $200,000 in fees.

Project NPV = 150,000Stock issue cost = -200,000APV - 50,000

APV < 0 don’t do it



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Example (financing effect = tax shield):

Project B has a base-case NPV of -$100,000. If financed with debt, however, it adds a tax shield with a PV of $140,000.

Project NPV = -100,000PV(tax shield) = 140,000APV 40,000

APV > 0 do it (but wouldn’t do it if all-equity)



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After-Tax WACC vs. APV

With consistent assumptions, get same answer.

WACC assumes constant debt ratio , but then don’t have to value tax shield explicitly

APV lets tax shields vary over time , but have to calculate them yourself . APV more flexible: can handle other financing

effects besides interest tax shields

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B40.2302 Class #8