Chapter 18 Principles of Corporate Finance Eighth Edition How Much Should a Firm Borrow? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,

Chapter 18

Principles of

Corporate FinanceEighth Edition

How Much Should a Firm Borrow?

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Topics Covered

Corporate Taxes and ValueCorporate and Personal TaxesCost of Financial DistressPecking Order of Financial Choices


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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


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Income Statement of

Firm U

Income Statement of

Firm L

Earnings before interest and taxes $1,000 $1,000Interest paid to bondholders - 80 Pretax income 1,000 920 Tax at 35% 350 322 Net income to stockholders 650 598

Total income to both bondholders and stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.


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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?



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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?

($ 1,000 s) All Equity

EBIT 900Interest Pmt 0Pretax Income 900Taxes @ 35% 315Net Cash Flow 585

1/2 Debt

900100800280520

Total Cash Flow

All Equity = 585

*1/2 Debt = 620*1/2 Debt = 620

(520 + 100)


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PV of Tax Shield = (assume perpetuity) D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 2,000,000 x (.05) x (.35) = $35,000

PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

PV Tax Shield = $2,000,000 x .35 = $700,000


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Firm Value =

Value of All Equity Firm + PV Tax Shield

Example

All Equity Value = 585 / .05 = 11,700,000

PV Tax Shield = 700,000

Firm Value with 1/2 Debt = $12,400,000


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Net working capital 10,752 7,144 Long-term debt21,460 Other long-term liabilities

Long-term assets 86,900 69,048 EquityTotal assets 97,652 97,652 Total value

Net working capital 10,752 7,144 Long-term debtPV interest tax shield 2,500 21,460 Other long-term liabilitiesLong-term assests 283,373 268,021 EquityTotal assets 296,625 296,625 Total value

Book values

Market values

Pfizer Balance Sheet, March 2004 (figures in $millions)


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Pfizer Balance Sheet, March 2004 (figures in $millions)

(w/ $1 billion Debt for Equity Swap)

Net working capital 10,752 8,144 Long-term debt21,460 Other long-term liabilities

Long-term assets 86,900 68,048 EquityTotal assets 97,652 97,652 Total value

Net working capital 10,752 8,144 Long-term debtPV interest tax shield 2,850 21,460 Other long-term liabilitiesLong-term assests 283,373 267,371 EquityTotal assets 296,975 296,975 Total value

Book values

Market values


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C.S. & Taxes (Personal & Corp)

Relative Advantage Formula

( Debt vs Equity )

1-Tp

(1-TpE) (1-Tc)

RAF > 1 Debt

RAF < 1 Equity

Advantage


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Corporate Tax

Income after Corp Taxes

$1.00

Tp

$1.00 – Tp

Personal Taxes .

Income after All Taxes

$1.00–Tc-TpE (1.00-Tc) =(1.00-TpE)(1.00-Tc)

TpE (1.00-Tc)

$1.00 – Tc

TcNone

To bondholders To stockholders

Operating Income ($1.00)

Paid out as interest

Or paid out as equity income


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Example


Interest Equity Income

Income before tax $1 $1

Less corporate tax at Tc =.35 0 0.35

Income after corporate tax 1 0.65

Personal tax at Tp = .35 and Tpe = .105 0.35 0.068

Income after all taxes $0.675 $0.582

Advantage to debt= $ .068


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Today’s RAF & Debt vs Equity preference.

1-.33

(1-.16) (1-.35)= 1.23RAF =


Why are companies not all debt?


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Capital Structure

Structure of Bond Yield Rates

D

E

Bond

Yield

r


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Weighted Average Cost of Capitalwithout taxes (traditional view)

r

DV

rD

rE

Includes Bankruptcy Risk

WACC


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Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.


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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


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Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm


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Conflicts of Interest

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 liabilities

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


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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.

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



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Circular File Company has may invest $10 as follows.

y)probabilit (90% $0

$10Invest

y)probabilit (10% $120

Next Year PayoffsPossibleNow

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


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Circular File Company value (post project)

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




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

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




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Financial Distress Games

Cash In and Run

Playing for Time

Bait and Switch


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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.


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Trade Off Theory & Prices

1. Stock-for-debt Stock price

exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices; repurchase increases stock prices.

3. Issuing straight debt has a small negative impact.


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Issues and Stock Prices

Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.

Any firm is a drop in the bucket.

Plenty of close substitutes.

Large debt issues don’t significantly depress the stock price.


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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.


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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).

Documents

Chapter 18 Principles of Corporate Finance Eighth Edition How Much Should a Firm Borrow? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,