Chapter 15Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
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Debt Policy
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Topics Covered
Debt and Value in a Tax Free EconomyCapital Structure and Corporate TaxesCost of Financial DistressExplaining Financial Choices
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Value and Capital Structure
Assets Liabilities and Stockholder’s Equity
Value of cash flows from firm’s real assets and operations
Market value of debt
Market value of equity
Value of Firm Value of Firm
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Average Book Debt Ratios
Industry Debt RatioSoftware and programming 0.06 Semiconductors 0.09 Communications equipment 0.13 Biotech 0.28 Retail 0.34 Hotels and motels 0.37 Chemical manufacturing 0.53 Airlines 0.59 Electric utilities 0.60 Real estate operations 0.62 Beverages (alcohol) 0.63 -------------------------------------- --------Average for US Companies 0.51
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M&M (Debt Policy Doesn’t Matter)
Modigliani & MillerWhen there are no taxes and capital markets
function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company.
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M&M (Debt Policy Doesn’t Matter)
Assumptions
By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities
Capital structure does not affect cash flows e.g...No taxesNo bankruptcy costsNo effect on management incentives
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Example - River Cruises - All Equity Financed
17.5%12.5%7.5% shares on Return
1.751.25$.75shareper Earnings
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
million 1 $Shares of ValueMarket
$10shareper Price
100,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
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Example
cont.
50% debt
25%15%5% shares on Return
2.501.50$.50shareper Earnings
125,00075,000$25,000earningsEquity
50,00050,000$50,000Interest
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
500,000 $debt of ueMarket val
500,000 $Shares of ValueMarket
$10shareper Price
50,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
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Example - River Cruises - All Equity Financed
- Debt replicated by investors
25%15%5% investment$10 on Return
2.501.50$.50investment on earningsNet
1.001.00$1.0010% @Interest :LESS
3.502.50$1.50shares twoon Earnings
BoomExpectedSlump
Economy theof State Outcome
M&M (Debt Policy Doesn’t Matter)
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Example - River Cruises – Firm debt at 50%
- Investor can unwrap debt
17.5%12.5%7.5% investment$10 on Return
3.502.50$1.50investmenton earningsNet
1.001.00$1.0010% @Interest :PLUS
2.501.50$0.50share oneon Earnings
BoomExpectedSlump
Economy theof State Outcome
M&M (Debt Policy Doesn’t Matter)
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Operating Risk (business risk) – Risk in the firm’s operating income.
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.
C.S. & Corporate Taxes
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Cost of Capital
)( debtassetsassetsequity rrE
Drr
ED
Er
ED
DrTWACC c equitydebt)1(
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r
DV
rD
rE
MM’s Proposition II (w/fixed interest rate)
rA
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Includes Bankruptcy Risk
r
DV
rD
rE
MM’s Proposition II (w/risky debt)
rA
Risk free debt Risky debt
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r
DV
rD
rE
WACC
Weighted Average Cost of Capital
WACC with no bankruptcy risk
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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 $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
C.S. & Corporate Taxes
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C.S. & Corporate TaxesExample - You own all the equity of Space Babies Diaper Co. The company
has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
4,5506,500FlowCash Net
2,4503,50035% @ Taxes
7,00010,000IncomePretax
3,0000PmtInterest
10,00010,000EBIT
Debt 1/2Equity All
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C.S. & Corporate Taxes
Total Cash Flow
All Equity = 6,500
*1/2 Debt = 7,550*1/2 Debt = 7,550
(4,550 + 3,000)
Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
4,5506,500FlowCash Net
2,4503,50035% @ Taxes
7,00010,000IncomePretax
3,0000PmtInterest
10,00010,000EBIT
Debt 1/2Equity All
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 10,000 x (.06) x (.35) = $210
PV of 210 perpetuity = 210 / .06 = $3,500
PV Tax Shield = D x Tc = 10,000 x .35 = $3,500
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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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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 Slack
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Web Resources
http://finance.yahoo.com
http://moneycentral.msn.com
http://edgarscan.pwcglobal.com
www.bankruptcydata.com
www.abiworld.org
www.bankrupt.com
www.turnaround.org
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