1. Chapter SeventeenCapital Structure: Limits to the Use of Debt
2. 17- Chapter Outline 17.1 Costs of Financial Distress 17.2 Description of Costs 17.3 Can Costs of Debt Be Reduced? 17.4 Integration of Tax Effects and Financial Distress Costs 17.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 17.6 Signaling 17.7 The Pecking-Order Theory 17.8 Growth and the Debt-Equity Ratio 17.9 Personal Taxes 17.10 How Firms Establish Capital Structure 17.11 Summary and Conclusions McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
4. 17- 17.1 Costs of Financial Distress • Bankruptcy risk versus bankruptcy cost. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
5. 17- 17.1 Costs of Financial Distress • Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
6. 17- 17.1 Costs of Financial Distress • Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
7. 17- 17.1 Costs of Financial Distress • Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. • Rather it is the costs associated with bankruptcy. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
8. 17- 17.1 Costs of Financial Distress • Bankruptcy risk versus bankruptcy cost. • The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. • Rather it is the costs associated with bankruptcy. • It is the stockholders who bear these costs. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
10. 17- 17.1 Costs of Financial Distress • The bondholders are willing to pay less for the Day bonds due to the cost of bankruptcy. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
11. 17- 17.1 Costs of Financial Distress • The bondholders are willing to pay less for the Day bonds due to the cost of bankruptcy. • They can make a realistic assessment in this case because they know of the bankruptcy costs and can demand the higher return (through a lower purchase cost). McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
12. 17- 17.1 Costs of Financial Distress • The bondholders are willing to pay less for the Day bonds due to the cost of bankruptcy. • They can make a realistic assessment in this case because they know of the bankruptcy costs and can demand the higher return (through a lower purchase cost). • Of course, they get this return only if their assessment is correct about the risks and costs. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
14. 17- 17.2 Description of Costs • Direct Costs – Legal and administrative costs (tend to be a small percentage of firm value). McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
15. 17- 17.2 Description of Costs • Direct Costs – Legal and administrative costs (tend to be a small percentage of firm value). • Indirect Costs – Impaired ability to conduct business (e.g., lost sales) – Agency Costs • Selfish Strategy 1: Incentive to take large risks • Selfish Strategy 2: Incentive toward underinvestment • Selfish Strategy 3: Milking the property McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
16. 17- Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
17. 17- Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. Note: owning preferred shares provides no more protection here than owning common shares. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
18. 17- Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 $200 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. Note: owning preferred shares provides no more protection here than owning common shares. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
19. 17- Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 $200 Fixed Asset $400 $0 Equity $300 $0 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. Note: owning preferred shares provides no more protection here than owning common shares. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
20. 17- Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 10% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
21. 17- Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 10% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 $100 NPV = –$200 + (1.10) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
22. 17- Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 10% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 $100 NPV = –$200 + (1.10) NPV = –$133 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
23. 17- Remember… • Bondholders have nothing to gain here and much to lose by taking on a negative NPV project. • Stockholders (who are currently getting nothing) may gain, but have really no downside risk here. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
24. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
25. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
26. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
27. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
28. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
29. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
30. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0 • PV of Bonds With the Gamble = $30 / 1.1 = $27 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
31. 17- Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble – To Bondholders = $300 × 0.10 + $0 = $30 – To Stockholders = ($1000 - $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0 • PV of Bonds With the Gamble = $30 / 1.1 = $27 • PV of Stocks With the Gamble = $70 / 1.1 = $64 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
33. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
34. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
35. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project • Required return is 10% McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
36. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project • Required return is 10% McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
37. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project • Required return is 10% • McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
38. 17- Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project • Required return is 10% • • Should we accept the project? McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
40. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
41. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
42. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
43. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 • PV of Stocks Without the Project = $0 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
44. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 • PV of Stocks Without the Project = $0 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
45. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 • PV of Stocks Without the Project = $0 • PV of Bonds With the Project = $300 / 1.1 = $272.73 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
46. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 • PV of Stocks Without the Project = $0 • PV of Bonds With the Project = $300 / 1.1 = $272.73 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
47. 17- Selfish Stockholders Forego Positive NPV Project • Expected CF from the government sponsored project: – To Bondholder = $300 – To Stockholder = ($350 - $300) = $50 • PV of Bonds Without the Project = $200 • PV of Stocks Without the Project = $0 • PV of Bonds With the Project = $300 / 1.1 = $272.73 • PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
48. 17- Remember… • Bondholders have something to gain here and something to lose (as usual) by taking on a positive NPV project. They are currently getting $200 but could get more. • Stockholders (who are currently getting nothing) won’t lose any additional money, so they have really no upside here, so they forego the positive NPV project.. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
50. 17- Selfish Strategy 3: Milking the Property • Liquidating dividends – Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent , with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
51. 17- Selfish Strategy 3: Milking the Property • Liquidating dividends – Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent , with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures. • Increase perquisites to shareholders and/or management McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
52. 17- Selfish Strategy 3: Milking the Property • Liquidating dividends – Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent , with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures. • Increase perquisites to shareholders and/or management McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
53. 17- Selfish Strategy 3: Milking the Property • Liquidating dividends – Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent , with nothing for the bondholders, but plenty for the former shareholders. – Such tactics often violate bond indentures. • Increase perquisites to shareholders and/or management http://www.globenewswire.com/newsroom/ news.html?d=144442 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
54. 17- 17.3 Can Costs of Debt Be Reduced? McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
55. 17- 17.3 Can Costs of Debt Be Reduced? • Protective Covenants McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
56. 17- 17.3 Can Costs of Debt Be Reduced? • Protective Covenants • Debt Consolidation : – If we minimize the number of parties, contracting costs fall. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
59. 17- Protective Covenants • Agreements to protect bondholders • Negative covenant: Thou shalt NOT: – Pay dividends beyond specified amount. – Sell more senior debt & amount of new debt is limited. – Refund existing bond issue with new bonds paying lower interest rate. – Buy another company’s bonds. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
60. 17- Protective Covenants • Agreements to protect bondholders • Negative covenant: Thou shalt NOT: – Pay dividends beyond specified amount. – Sell more senior debt & amount of new debt is limited. – Refund existing bond issue with new bonds paying lower interest rate. – Buy another company’s bonds. • Positive covenant: Thou shall: – Use proceeds from sale of assets for other assets. – Allow redemption in event of merger or spinoff . – Maintain good condition of assets. – Provide audited financial information. – Segregate and maintain specific assets as security for debt. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
61. 17- 17.4 Integration of Tax Effects and Financial Distress Costs McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
62. 17- 17.4 Integration of Tax Effects and Financial Distress Costs • There is a trade-off between the tax advantage of debt and the costs of financial distress. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
63. 17- 17.4 Integration of Tax Effects and Financial Distress Costs • There is a trade-off between the tax advantage of debt and the costs of financial distress. • It is difficult to express this with a precise and rigorous formula. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
64. 17- Integration of Tax Effects and Financial Distress Costs Value of firm under Value of firm (V) MM with corporate Present value of tax taxes and debt shield on debt VL = VU + TCB Maximum Present value of firm value financial distress costs V = Actual value of firm VU = Value of firm with no debt The tax shield increases the value of the levered ﬁrm. Financial distress costs lower the value of the levered ﬁrm. The two offsetting factors produce an optimal amount of debt at B*. 0 Debt (B) B* Optimal amount of debt McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
65. 17- The Pie Model Revisited • Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. • Let G and L stand for payments to the government and bankruptcy lawyers, respectively. • VT = S + B + G + L S B L G • The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
66. 17- 17.5 Signaling • The firm’s capital structure is optimized where marginal subsidy to debt = the marginal cost. • Investors view debt as a signal of firm value. – Firms with low anticipated profits will take on a low level of debt. – Firms with high anticipated profits will take on high levels of debt. • A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
67. 17- 17.5 Signaling • In situations where stock can be exchanged for debt or vice versa, stock prices go up where leverage is increased and go down when leverage is decreased. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
68. 17- 17.6 Shirking, Perquisites , and Bad Investments: The Agency Cost of Equity • An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.” • Who bears the burden of these agency costs? • While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. • The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. • The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
69. 17- 17.6 Shirking, Perquisites, and Bad Investments: The Agency Cost of Equity • If a large stock issue is floated, then a manager is more likely to take advantage of the fact that their ownership is diluted and get more perques as well as work less hard. • There is incentive to get bigger through taking on projects (even if they are negative NPV) because salaries are higher in larger companies. • The increase in salary will more than offset the loss in the managers’ equity positions. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
70. 17- 17.7 The Pecking-Order Theory • Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. – Rule 1 • Use internal financing first. – Rule 2 • Issue debt next, equity last. • The pecking-order theory is at odds with the trade-off theory: – There is no target D/E ratio. – Profitable firms use less debt. – Companies like financial slack McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
71. 17- 17.7 The Pecking-Order Theory • Managers issue equity when it is overvalued. • Managers issue debt when the equity is undervalued. • This leads the market to make assumptions about which way the price of equity should move. – If equity is issued, they will wait for the price to approach the intrinsic value. – Managers may also issue debt when they think it is overvalued (when the company is doing well) • Leads to confusion and cynicism with debt and equity issues. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
72. 17- 17.7 The Pecking-Order Theory • So, if the public is cynical , they may view all issues as overvalued and wait to see if the stock or bonds reach intrinsic value. • This is why projects are financed out of retained earnings if possible. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
73. 17- 17.8 Growth and the Debt-Equity Ratio • Growth implies significant equity financing, even in a world with low bankruptcy costs. • There is a trade-off with debt tax shield and financial distress costs. • Thus, high-growth firms will have lower debt ratios than low-growth firms. • Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal . McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
74. 17- Example pg 493 EBIT = 100 issued debt = 1000, interest = 10% No Growth Value = 100/0.1 = 1000 (all debt) D/V=1000/1000=100% => no equity g = 5% Growth = 100/(r-g)=100/(0.1-0.05)=2000 V=S+B V=1000+1000 D/V=0.5 Thus, the growth firm does not have 100% debt. High-growth ﬁrms will have lower debt ratios than low-growth ﬁrms This is sub-optimal. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
75. 17- 17.9 Personal Taxes: The Miller Model • The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: Where: TS = personal tax rate on equity income TB = personal tax rate on bond income TC = corporate tax rate McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
76. 17- Personal Taxes: The Miller Model The derivation is straightforward: McGraw-Hill Ryerson Continued… © 2005 McGraw–Hill Ryerson Limited
77. 17- Personal Taxes: The Miller Model (cont.) The total cash flow to all stakeholders in the levered firm is: The first term is the cash A bond is worth B. It promises to flow of an unlevered firm pay rBB×(1- TB) after taxes. Thus after all taxes. the value of the second term is: Its value = VU. The value of the sum of these two terms must be VL McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
78. 17- Personal Taxes: The Miller Model (cont.) • Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: • In the case where TB = TS, we return to M&M with only corporate tax: McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
79. 17- Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes Value of firm (V) VL = VU+TCB when TS =TB VL < VU + TCB when TS < TB but (1-TB) > (1-TC)×(1-TS) VU VL =VU when (1-TB) = (1-TC)×(1-TS) VL < VU when (1-TB) < (1-TC)×(1-TS) Debt (B) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
80. 17- Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Present value of Value of firm (V) financial distress costs Value of firm under MM with corporate taxes and debt Present value of tax shield on debt VL = VU + TCB Maximum VL < VU + TCB firm value when TS < TB but (1-TB) > (1-TC)×(1-TS) VU = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt 0 Debt (B) B* Optimal amount of debt McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
81. 17- One model of optimal debt levels McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
82. 17- One model of optimal debt levels • Suppose we can make the following assumptions: – XYZ has an unlevered value of $100 million – The corporate tax rate is 35%. Ignore personal taxes – If the firm goes bankrupt, the present value of the costs associated with the distress are expected to be 30% of the value of the firm. – The probability of default is estimated to be the square of the debt to value ratio. (So if the debt to value ratio is 50%, there is a 25% chance of default) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
83. 17- One model of optimal debt levels • Suppose we can make the following assumptions: – XYZ has an unlevered value of $100 million – The corporate tax rate is 35%. Ignore personal taxes – If the firm goes bankrupt, the present value of the costs associated with the distress are expected to be 30% of the value of the firm. – The probability of default is estimated to be the square of the debt to value ratio. (So if the debt to value ratio is 50%, there is a 25% chance of default) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
84. 17- One model of optimal debt levels • Suppose we can make the following assumptions: – XYZ has an unlevered value of $100 million – The corporate tax rate is 35%. Ignore personal taxes – If the firm goes bankrupt, the present value of the costs associated with the distress are expected to be 30% of the value of the firm. – The probability of default is estimated to be the square of the debt to value ratio. (So if the debt to value ratio is 50%, there is a 25% chance of default) What is the optimal debt level for XYZ? McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
85. 17- One model of optimal debt levels • Recall that VL = VU + TCB - PVFDC • Where PVFDC is the Present Value of the Financial Distress Costs. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
86. 17- 17.10 How Firms Establish Capital Structure • Most Corporations Have Low Debt-Asset Ratios. • Changes in Financial Leverage Affect Firm Value. – Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes. – Another interpretation is that firms signal good news when they lever up. • There are Differences in Capital Structure Across Industries. • There is Evidence that Firms Behave as If They had a Target Debt-to-Equity ratio. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
87. 17- Factors in Target D/E Ratio • Taxes if Tc > Tb, => adv. to debt – If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. • Types of Assets – The costs of financial distress depend on the types of assets the firm has. • Uncertainty of Operating Income – Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. • Pecking Order and Financial Slack – Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
88. 17- 17.11 Summary and Conclusions • Costs of financial distress cause firms to restrain their issuance of debt. – Direct costs • Lawyers’ and accountants’ fees – Indirect Costs • Impaired ability to conduct business • Incentives to take on risky projects • Incentives to underinvest • Incentive to milk the property • Three techniques to reduce these costs are: – Protective covenants – Repurchase of debt prior to bankruptcy – Consolidation of debt McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
89. 17- 17.11 Summary and Conclusions • Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt. Value of firm (V) Value of firm under Present value of tax MM with corporate shield on debt taxes and debt VL = VU + TCB Maximum Present value of firm value financial distress costs V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) B* Optimal amount of debt McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
90. 17- 17.11 Summary and Conclusions • If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB) Present value of Value of firm (V) financial distress costs Value of firm under MM with corporate Present value of tax taxes and debt shield on debt VL = VU + TCB Maximum VL < VU + TCB when TS < TB firm value but (1-TB) > (1-TC)×(1-TS) VU = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt 0 Debt (B) B* McGraw-Hill Ryerson Optimal amount of debt © 2005 McGraw–Hill Ryerson Limited
91. 17- 17.11 Summary and Conclusions • Debt-to-equity ratios vary across industries. • Factors in target D/E ratio – Taxes • If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. – Types of Assets • The costs of financial distress depend on the types of assets the firm has. – Uncertainty of Operating Income • Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
92. 17- Appendix 17B The Miller Model and the Graduated Income Tax • In our previous discussion, we assumed that all investors share a single personal income tax on interest income. • Consistent with the real world, Miller’s model allows for the real world case where tax rates differ across individuals. • In Canada, federal tax rates for individuals are 0, 15.5, 22, 26, and 29-percent, depending on their income. • Other entities, such as pension funds and universities, are tax exempt. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
93. 17- The Miller Model and the Graduated Income Tax: Example • Consider an economy with: TC = 40%, TS = 0, rS = 10%, individual tax rates range between 0 and 50-percent, and all individuals are risk neutral. • ABC corp. is considering a $1 million issue of debt. • The after-corporate-tax cost of debt for ABC is: (1 - TC)rB, and its cost of equity is rS . • The maximum interest rate that ABC can pay on its debt and still prefer issuing debt to issuing equity, is given by setting: (1 - TC)rB = rS . Or the break-even rate is given by: McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
94. 17- The Miller Model and the Graduated Income Tax: Example (continued) • Tax-exempt investors will be indifferent between purchasing ABC’s stocks or ABC’s bonds yielding also 10-percent. • If ABC is the only firm issuing debt, it can pay an interest rate greater or equal to 10-percent, and well below its break- even rate of 16.67-percent. • Noticing this advantage, other firms are likely to issue debt. • However, since the number of tax-exempt individuals is limited, such new debt issues must pay interest high enough to attract individuals in higher brackets. • For these individuals, the tax rate that applies to debt is greater than that applies to equity (0-percent). McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
95. 17- The Miller Model and the Graduated Income Tax: Example (continued) • Thus, tax-exempt individuals will only buy debt if its yield is greater than that of equity (10%). • An individual in the 15% tax bracket, will be indifferent between debt and equity if rB = 11.765%, because 0.11765×(1-0.15) = 10%. • Since 11.765% is less than the break-even rate of 16.67%, firms still gain from issuing debt to individuals in the 15% tax bracket. • For individuals in the 40% tax bracket, the after-tax return from a bond paying 16.67% is 0.1667×(1-0.4) = 10%. • Thus, individuals in a tax bracket that equals the corporate tax rate (40%), will be indifferent between debt and equity. • In equilibrium, firms will issue enough debt so these individuals will hold debt. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
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