Corporate Finance

Lecture 17

INTRODUCTION TO CAPITAL STRUCTURE (continued)

Ronald F. Singer

FINA 4330

Fall, 2010

The Irrelevance Theorem

• Perfect Capital Market Setting

• No Taxes

• No Contracting Costs

• Costs of Financial Distress

• Agency Costs

• No Information Costs

Irrelevance Theorem

• ASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

• LIABILITIES

DEBT 0

EQUITY 3,000,000

TOTAL $3,000,000

Irrelevance TheoremASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 1,600,000

EQUITY 1,400,000

TOTAL $3,000,000

The Static Tradeoff Theory

• Benefits versus Costs of Leverage. • Benefits Costs Taxes Financial Distress Resolution of Agency Costs

Agency Costs Bondholder/StockholderManager/Stockholder

Bankruptcy CostsDirect and Indirect

Information Costs

Tax Implications

ASSETS

PVA $1,000,000

PVGO 2,000,000

- PV of Tax Liability 900,000

TOTAL $2,100,000

LIABILITIES

DEBT 0

EQUITY 2,100,000

TOTAL $2,100,000

Tax Implications (Suppose T = 30%)

ASSETS

PVA $1,000,000

PVGO 2,000,000

Less: PV of Tax Liability 420,0000

TOTAL $2,580,000

LIABILITIES

DEBT 1,600,000

EQUITY 980,000

TOTAL $2,580,000

Stockholders’ Wealth

• Originally: $2,100,000 in Equity Interest

• Now: 980,000 in Equity Interest

$1,600,000 in Cash

2,580,000 Total Stockholders’ Wealth increased by

480,000 = the reduction of taxes.

Firm Value Assuming Perfect Capital Markets except for Taxes

• Notice what happens, the (after tax) FCF increases due to the tax benefit from the interest deduction on debt. In particular,

FCF = Before Tax FCF – Tax

Tax = T (Earnings) = T (Rev-Exp-Interest)

= (Rev-Exp)(T) – (Int)(T)

So FCF = FCF(1-T) + Interest(T)

The Tax Benefit

• So we can divide the After Tax Free Cash Flow into two separate Cash Flows:

• Cash Flow from operations FCF*(1-T) = The Free Cash Flow (after Tax)

that would be generated if there were no debt in the capital structure

Interest*(T) = The reduction of tax due to the Tax shield on interest.

Example

• Suppose that the firm’s cash flows looked as follows:– Revenue $20 million– Cash Expense $10 million – Interest $2 million – Depreciation $3 million – Change in WC 0

Calculation of Unlevered Cash Flow

1. That is, how much (after tax) would be generated if there were no interest payments

2. “Net Operating Income” (NOI)= (Rev-Cash Expense – Depreciation)

= $7 millionTax @ 30 % = $2.1 millionAfter Tax Operating Cash Flow

NOI – Tax + Depreciation $7 - 2.1 + 3 = 7.9 Million

The Interest Tax Shield

• Notice we can find the amount of the tax shield by considering how much tax saving there is for each dollar of interest. In particular The Tax Shield = T * Interest = (.3) * 2 million

= 0.6 million

PV of Cash Flow:

• V = (Y)(1-T) + T (Interest) (1+ro)t (1+rB) t

= V(u) + PV of Tax Shield

With Taxes

V = V(u) Plus Present Value of Tax Shield on Debt.

V= V(u) + (Corp. Tax Rate) * Debt

In the special case when debt is thought of as perpetual.

Graphically

Firm Value (V)

V = V(u) + Tc*B

V(u)

Debt

Cost of Capital

WACC = ro

rs = ro + (ro -rB)B/S

rB

Cost of Capital (After Tax)

WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V)

rs = ro + (ro-rB)(1-T)B/S

rB

The two ways of representing firm value

V = V (u) + T * B

V = Y(1-T) (1+WACC)t

Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)

Static Tradeoff Theorem

• Costs of Financial Distress (“Contracting Costs”)– Potential Bankruptcy Costs– Underinvestment – Risk Shifting – Agency Costs

• Assume:• Not Taxes• Risk neutrality• Single period• Interest rate = 0%

Example of Underinvestment

ASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment

ASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment

ASSETS

PVA $1,000,000 (Cash = 600,000) (Real Assets = 400,000)PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment Make a Div Payment rather than

investASSETS

PVA $400,000

(Real Assets = 400,000)PVGO 2,000,000

TOTAL $2,400,000

LIABILITIES

DEBT 2,250,000

EQUITY 1 50,000

TOTAL $2,400,000

Risk Shifting

• Suppose the firm has value that will look like the following:

»Value in Good State = $4,500,000»Value in Bad State = 1,500,000»With equal probability »Promised payment to the Bondholder: $3,500,000

What is the value of the equity and the debt?

Investment Opportunity

• Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are:

$5,000,000 in good state

500,000 in bad state:

What is the NPV of the project, value of the debt and value of the equity?

Costs of Financial Distress

V = V(u) + PV of Tax Shield

Firm Value

Debt LevelOptimal Debt Level

Pecking Order Hypothesis

• Costly Information

• Conclusion – Firm has an ordering under which they will

Finance• First, use internal funds• Next least risky security

Intuition

• Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it?

• Now suppose you believe the firm is overvalued

Pecking Order theory

• So you have a dominating way of getting capital – Internal Financing – Risk free debt– Risky debt– Equity

In general, the more “debt like” a security is, the more you want to issue it.

So the announcement effect

• If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm.

• Therefore the firm will never issue equity if it can avoid it.

• Thus pecking order.