18-2 Topics CoveredCorporate TaxesCorporate and Personal TaxesCost of Financial DistressPecking Order of Financial Choices
18-3Capital Structure & Corporate TaxesFinancial 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.
18-4Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders. Income Income Statement of Statement of Firm U Firm L Earnings before interest and taxes $1,000 $1,000 Interest 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
18-5Capital Structure & Corporate Taxes 28 PV (tax shield) $350 .08 Interest payment return on debt X amount borrowed rD D rcorporatetax rate X interest payment PV (tax shield) expected return on debt TC (rD D) TC D rD
18-6Capital Structure & Corporate TaxesExample - 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?
18-7 Capital Structure & Corporate TaxesExample - 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 1/2 Debt Total Cash FlowEBIT 900 900 All Equity = 585Interest Pmt 0 100Pretax Income 900 800 *1/2 Debt = 620Taxes @ 35% 315 280 (520 + 100)Net Cash Flow 585 520
18-8Capital Structure & Corporate Taxes PV of Tax Shield = D x rD x Tc = D x Tc (assume perpetuity) rDExample:Tax benefit = 2,000,000 x (.05) x (.35) = $35,000PV of $35,000 in perpetuity = 35,000 / .05 = $700,000PV Tax Shield = $2,000,000 x .35 = $700,000
18-9 Capital Structure & Corporate TaxesFirm 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
18-10Capital Structure & Corporate Taxes Merck Balance Sheet, December 2008 (figures in $millions) Book values Net working capital 4,986.2 3,943.3 Long-term debt 10,175.4 Other long-term liabilities Long-term assets 27,890.8 18,758.3 Equity Total assets 32,877.0 32,877.0 Total value Market values Net working capital 4,986.2 3,943.3 Long-term debt PV interest tax shield 1,380.2 10,175.4 Other long-term liabilities Long-term assests 72,680.6 64,928.3 Equity Total assets 79,047.0 79,047.0 Total value
18-11Capital Structure & Corporate Taxes Merck Balance Sheet, December 2008 (figures in $millions) (w/ $1 billion Debt for Equity Swap) Book values Net working capital 4,986.2 4,943.3 Long-term debt 10,175.4 Other long-term liabilities Long-term assets 27,890.8 17,758.3 Equity Total assets 32,877.0 32,877.0 Total value Market values Net working capital 4,986.2 4,943.3 Long-term debt PV interest tax shield 1,730.2 10,175.4 Other long-term liabilities Long-term assests 72,680.6 64,278.3 Equity Total assets 79,397.0 79,397.0 Total value
18-12 C.S. & Taxes (Personal & Corp) Operating Income ($1.00) Paid out as Or paid out as interest equity income Corporate Tax None Tc Income after $1.00 $1.00 – Tc Corp TaxesPersonal Taxes . Tp TpE (1.00-Tc)Income after All $1.00 – Tp $1.00–Tc-TpE (1.00-Tc) Taxes =(1.00-TpE)(1.00-Tc) To bondholders To stockholders
18-14 C.S. & Taxes (Personal & Corp)Example Interest Equity Income Income before tax $1 $1 Less corporate tax at Tc =.35 0 0.35 Income after corpotare tax 1 0.65 Personal tax at Tp = .35 and TpE = .125 0.35 0.081 Income after all taxes $0.650 $0.569 Advantage to debt= $ .081
18-15 C.S. & Taxes (Personal & Corp)Another Example Interest Equity Income Income before tax $1 $1 Less corporate tax at Tc =.35 0 0.35 Income after corpotare 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
18-16 C.S. & Taxes (Personal & Corp)Today’s RAF & Debt vs Equity preference. 1-.33 RAF = = 1.23 (1-.16) (1-.35) Why are companies not all debt?
18-17 Capital Structure Structure of Bond Yield Rates rBondYield D E
18-18WACC w/o taxes (traditional view) r Includes Bankruptcy Risk rE WACCrD D V
18-19 Financial DistressCosts of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
18-20 Financial DistressCosts 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
18-21 Financial Distress Maximum value of firm Costs of financial distressMarket Value of The Firm PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt
18-23 Ace Limited ExampleTotal payoff to Ace Limited security holders. There is a $200bankruptcy cost in the event of default (shaded area).
18-24 Conflicts of InterestCircular 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
18-25 Conflicts of Interest Circular File Company has $50 of 1-year debt. Circular File Company (Market Values) Net W.C. 20 25 Bonds outstanding Fixed assets 10 5 Common stock Total assets 30 30 Total liabilities 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.
18-26 Conflicts of Interest Circular File Company has may invest $10 as follows. Now Possible PayoffsNext Year $120 (10% probabilit y)Invest $10 $0 (90% probabilit y) Assume the NPV of the project is (-$2). What is the effect on the market values?
18-27 Conflicts of Interest Circular File Company value (post project) Circular File Company (Market Values) Net W.C. 10 20 Bonds outstanding Fixed assets 18 8 Common stock Total assets 28 28 Total liabilities Firm value falls by $2, but equity holder gains $3
18-28 Conflicts of Interest Circular File Company value (assumes a safe project with NPV = $5) Circular File Company (Market Values) Net W.C. 20 33 Bonds outstanding Fixed assets 25 12 Common stock Total assets 45 45 Total liabilities While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.
18-29 Financial Distress GamesCash In and RunPlaying for TimeBait and Switch
18-30 Financial ChoicesTrade-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.
18-31 Trade Off Theory & Prices1. Stock-for-debt Stock price exchange offers falls Debt-for-stock Stock price exchange offers rises2. Issuing common stock drives down stock prices; repurchase increases stock prices.3. Issuing straight debt has a small negative impact.
18-32 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.
18-33 Pecking Order TheoryConsider 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 andequity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they dont need external finance.
18-34 Pecking Order TheorySome 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).
18-35 Web ResourcesClick to access web sitesInternet connection required http://astro.temple.edu/~tub06197/Wk1Myers1984.pdf