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									 Financial Management
             Lecture 9 (Ch.17)
Capital Structure: Limits to the Use of Debt
        Lecturer: Sheng-Syan Chen
          College of Management
        National Taiwan University


                                               1
     Key Concepts and Skills
l Description  of costs of financial distress
l Protective covenants
l Integration of tax effects and financial
  distress costs
l Effect of agency costs of equity
l Effect of growth




                                                2
    Part 1 :Costs of financial distress
l   The MM model with corporate taxes
    leads to the conclusion that one can
    always increase firm value by increasing
    leverage, implying that firms should use
    maximum debt.
l   This is inconsistent with the real world,
    where firms generally employ only
    moderate amounts of debt.
ÞThe MM model doesn’t consider the costs
 of financial distress (CFD).
                                                3
l   Debt provides tax befits to the firm, but
    debt also puts pressure on the firm
    because interest & principal payments are
    obligations.

l   If these obligations are not met, the firm
    may risk some sort of financial distress.

l   The ultimate distress is bankruptcy,
    where ownership of the firm's assets is
    legally transferred from the stockholders
    to the bondholders.
                                                 4
l These debt obligations are fundamentally
  different from stock obligations.
l While stockholders like & expect
  dividends, they are not legally entitled to
  dividends in the way bondholders are
  legally entitled to interest & principal
  payments.
l The following simple example illustrates
  that stockholders are hurt by CFD.
l Taxes are ignored to focus only on the
  costs of debt.

                                                5
              Example
lThe  Knight Corporation plans to be in
 business for one more year.
lIt forecasts a cash flow of either $100 or $50
 in the coming year, each occurring with 50%
 probability.
lThe firm has no other assets.
lPreviously issued debt requires payments of
 $49 of interest & principal.
lThe Day Corporation has identical cash flow
 prospects but has $60 of interest & principal.   6
7
lNote  that if Day Corporation is in a
 recession, the bondholders are owed by
 $60, but the firm has only $50 in cash.
lSincethe firm has no other assets, the
 bondholders can not be satisfied in full.
lIfthe bankruptcy occurs, the bondholders
 will receive all of the firm’s cash, and the
 stockholders will receive nothing.
lNotethat the stockholders do not have to
 come out with the additional $10 (= 60 - 50)
 because of limited liability.
                                                8
lFor   simplicity, we assume that:
 lBondholders and stockholders are risk-neutral.
 lthe interest rate is 10%.



Þ Cash flows to stockholders and
  bondholders are to be discounted at 10%
  (i.e. rS = rB = 10%) since risk-neutral
  investors do not demand compensation
  for bearing risk.



                                                   9
10
lNote that the 2 firms have the same value,
 even though Day runs the risk of bankruptcy.

lAlso note that although the promised
 payment of principal & interest is $60, the
 Day’s bondholders are willing to pay only
 $50.

lHence, their promised return or yield is: 20%
 (= $60/$50 - 1).

                                                 11
lDay’s example is not realistic because it
 ignores CFD.
lIfin a recession cash flow is only $50,
 bondholders will be informed that they will
 not be paid in full. These bondholders are
 likely to hire lawyers to negotiate or even to
 sue the company. Similarly, the firm is
 likely to hire lawyers to defend itself. Further
 costs will be incurred if the case gets to a
 bankruptcy court.
lThesefees are always paid before the
 bondholders get paid. We assume that
 bankruptcy costs total $15.

                                                12
13
lThe value of the firm is now $61.36, an amount
 below the $68.18 figure calculated earlier.
lBy comparing Day's value in a world with no
 bankruptcy costs to Day's value in a world with
 these costs, we conclude that the possibility of
 bankruptcy has a negative effect on the value of
 the firm.
lHowever,  it is not the risk of bankruptcy itself
 that lowers value.
lRather it is the costs associated with bankruptcy
 that lower value.

                                                     14
lBecause the bondholders are aware that they
 would receive little in a recession, they pay a
 low price. Their promised return is 39% (=
 $60/$43.18 - 1).

lNote:
 l   It is the stockholders who bear these future
     bankruptcy costs.

 l   To see this, imagine that Day was originally all
     equity. The stockholders want the firm to issue
     debt with a promised payment of $60 and use the
     proceeds to pay a dividend.
                                                        15
lIfthere were no bankruptcy costs,
 bondholders would pay $50 to purchase the
 debt, and hence a dividend of $50 could be
 paid to stockholders.

lHowever,  if bankruptcy costs exist,
 bondholders would only pay $43.18 for the
 debt, and hence only a dividend of $43.18
 could be paid to the stockholders.
lBecause  the dividend is less when
 bankruptcy costs exist, the stockholders are
 hurt by bankruptcy costs.
                                                16
     Description of costs of financial
                 distress
l Direct   Costs
 l Legal, accounting and administrative expenses
   add to the total bill.
 l The direct costs of financial distress is about 3%

   of the market value of the firm.




                                                    17
l Indirect    Costs
  l   Impaired ability to conduct business
        Key employees jump ship.

        Bankruptcy hampers conduct with customers.
             Sales are lost because of both fear of impaired service
              and loss of trust.
             Customers seek more stable suppliers.

        Suppliers may refuse to ship without cash on
         delivery.

        Lenders demand higher interest rates or even
         refuse to extend credit.



                                                                        18
l Agency Costs of Debt:
  l When a firm has debt, conflicts of interest arise between
    stockholders & bondholders.
  l   Because of this, stockholders are tempted to pursue selfish
      strategies to hurt the bondholders & help themselves.
  l   These conflicts of interest, which are magnified when financial
      distress is incurred, impose agency costs on the firm which lower
      the market value of the whole firm.

l Three  kinds of selfish strategies that stockholders
  use to hurt the bondholders and help themselves:
  l   Selfish Strategy 1: Incentive to take large risks
  l   Selfish Strategy 2: Incentive toward underinvestment
  l   Selfish Strategy 3: Milking the property




                                                                      19
     Selfish investment strategy 1:
      Incentive to take large risks
lA   levered firm is considering 2 mutually
  exclusive projects, a low-risk one & a
  high-risk one.
l The firm has promised to pay bondholders
  $100. Shareholders will obtain the
  difference between the total payoff and
  the amount paid to the bondholders; i.e.
  the bondholders have the prior claim on
  the payoffs, and the shareholders have the
  residual claim.

                                           20
l Thecash flows for the entire firm if the
 low-risk project is taken can be described
 as:




l The expected value of the firm is $150 ( =
 0.5 ´ $100 + 0.5 ´ $200).


                                               21
l Now suppose that another riskier project
 can be substituted for the low-risk project.
 The payoffs & probabilities are as
 follows:




l Note  that if a recession hits, the firm will
 fall into bankruptcy and the bondholders
 receive only $50.
                                                  22
l The  expected value of the firm is $145 ( =
  0.5 ´ $50 + 0.5 ´ $240), which is lower than
  the expected value of the firm with the low-
  risk project. Thus, the low-risk project
  would he accepted if the firm were all-equity.
l However, the expected value of the stock is
  $70 (= 0.5 ´ $0 + 0.5 ´ $140) with the high-
  risk project, but only $50 (= 0.5 ´ $0 + 0.5 ´
  $100) with the low-risk project. Given the
  firm’s present levered state, stockholders will
  select the high-risk project, even though the
  high-risk project has a lower NPV.
                                                23
l The   key

 l   Relative to the low-risk project, the high-risk
     project increases firm value in a boom and
     decreases firm value in a recession.

 l   The increase in value in a boom is captured by
     the stockholders, because the bondholders are
     paid in full (they receive $100) regardless of
     which project is accepted.



                                                       24
l Conversely,   the drop in value in a
  recession is lost by the bondholders,
  because they are paid in full with the low-
  risk project but receive only $50 with the
  high-risk one.
l The stockholders will receive nothing in a
  recession anyway, whether the high-risk
  or low-risk project is selected.
l Thus, stockholders expropriate value from
  the bondholders by selecting high-risk
  projects.

                                            25
   Selfish investment strategy 2:
 Incentive toward underinvestment
l Stockholders  of a firm with a significant
  probability of bankruptcy often find that
  new investment helps the bondholders at
  the stockholders' expense.
l Consider a firm with $4,000 of principal
  & interest payments due at the end of the
  year.
l The firm's cash flows are presented in the
  left-hand side of Table 17.1.
                                               26
The firm will be pulled into bankruptcy by a
recession because its cash flows will be only
$2,400 in that state.
                                                27
l The  firm invests in a new project by raising
  new equity.
l The project costs $1,000 and brings in
  $1,700 in either state, implying a positive net
  present value (NPV).
l Clearly it would be accepted in an all-equity
  firm.
l However, the project hurts the stockholders
  of the levered firm.



                                                28
l Imagine  the old stockholders contribute
  the $1,000 themselves.
l The expected value of the stockholders'
  interest without the project is $500 (= 0.5
  ´ $1,000 + 0.5 ´ $0).
l The expected value with the project is
  $1,400 (= 0.5 ´ $2,700 + 0.5 ´ $100).
l The stockholders' interest rises by only
  $900 (= $1,400 - $500) while costing
  $1,000.

                                                29
l The   key
 l   The stockholders contribute the full $1,000
     investment, but the stockholders and
     bondholders share the benefits.

 l   The stockholders take the entire gain if boom
     times occur.

 l   Conversely, the bondholders reap most of the
     cash flow from the project in a recession.



                                                     30
   Selfish investment strategy 3:
        Milking the property
l Another strategy is to pay out extra
 dividends or other distributions (e.g.
 increase perks to management) in times of
 financial distress, leaving less in the firm
 for the bondholders.




                                            31
  Summary of selfish strategies
l The  above distortions occur only when
  there is a probability of bankruptcy or
  financial distress.
l Because the distortions are related to
  financial distress, we have included them
  in indirect costs of financial distress.
l Itis ultimately the stockholders who pays for
  the cost of selfish investment strategies.


                                              32
l Rational  bondholders know that, when
  financial distress is imminent, they cannot
  expect help from stockholders.
l Rather, stockholders are likely to choose
  investment strategies that reduce the value
  of the bonds.
l Bondholders protect themselves
  accordingly by raising the interest rate
  that they require on the bonds.
l Because the stockholders must pay these
  high rates, they ultimately bear the costs
  of selfish strategies.

                                            33
Can Costs of Debt Be Reduced?
l Protective   Covenants
 l Negative Covenant
 l Positive Covenant

l Consolidation   of Debt




                                34
       Protective Covenants
lBecause  the stockholders must pay
 higher interest rates as insurance
 against their own selfish strategies,
 they frequently make agreements with
 bondholders in hopes of lower rates.
lThese agreements, called protective
 covenants, are incorporated as part of
 the loan document (or indenture)
 between stockholders and bondholders.

                                          35
l Two    types:
 l   Negative covenants: limit or prohibit actions
     that the company may take.
      Limitations are placed on the amount of cash
       dividends a company may pay.
      The firm may not pledge any of its assets to other
       lenders.
      The firm may not merge with another firm.
      The firm may not sell or lease its major assets
       without approval by the lender.
      The firm may not issue additional long-term debt.




                                                            36
l Positive   covenants:
    l specify an action that the company agrees to
      take or a condition the company must abide by.
    l The company agrees to maintain its net
      working capital (= current assets - current
      liabilities) at a minimum level.
    l The company must furnish periodic financial
      statements to the lender.
l    Firms that violate the covenants are in
    technical default, which means that
    debtholders can demand repayment even if
    the firm has not missed an interest payment.

                                                       37
l Bond covenants, even if they reduce
 flexibility, should reduce the CFD,
 ultimately increasing the value of the firm.
 Thus, stockholders are likely to favor all
 reasonable covenants.

l Notethat covenants can not solve all the
 incentive problems.
l Some of the incentive problems would be
 especially difficult to eliminate with
 contractual provisions.

 e.g. it is unlikely to include debt covenants
      that prevent firms from turning down
      positive NPV projects.
                                                 38
             Debt Consolidation
l Thehigh bankruptcy costs are alleviated by
 proper arrangement of bondholders and
 stockholders.
 l   One, at most a few, lenders can shoulder the
     entire debt.
      Negotiating costs are minimized.
 l   Bondholders can purchase stock as well.
      Stockholders and debtholders are not pitted against
       each other because they are not separate entities.


                                                             39
Integration of Tax Effects and CFD
          (See Figure 17.1)
l Thediagonal straight line represents the
 value of the firm in a world without CFD.
l The Ç-shaped curve represents the value
 of the firm with CFD.
l The Ç-shaped curve rises as the firm
 moves from all-equity to a small amount
 of debt. Here, the present value (PV) of
 the CFD is minimal because the
 probability of distress is so small.
                                             40
41
l However,   as more and more debt is
  added, the PV of CFD rises at an
  increasing rate.
l At point B*, the increase in the PV of
  CFD from an additional dollar of debt
  equals the increase in the PV of the tax
  shield.
l This  is the debt level maximizing the
  value of the firm; i.e., B* is the optimal
  amount of debt.
l CFD increase faster than the tax shield
  beyond this point, implying a reduction
  in firm value from further leverage.
                                               42
43
l The weighted average cost of capital
 (rWACC) goes down as debt is added to the
 capital structure.

 After reaching B*, rWACC goes up.
 The optimal amount of debt also produces
 the lowest weighted average cost of
 capital.
lA  firm's capital structure decisions can be
 thought of as a trade-off between the tax
 benefits of debt and the costs of financial
 distress.
                                                44
    Changes in financial leverage
         affect firm value
l Figure  17.3 shows the stock price behavior
  of firms that change their proportions of debt
  and equity via exchange offers (i.e. one class
  of securities is exchanged for another) on
  stock prices.
l The solid line in the figure indicates that a
  stock price rises substantially on the date
  when an exchange offer increasing leverage
  (i.e. debt-for-stock offer) is announced.
  (This announcement date is referred to in the
  figure as date 0.)
                                                   45
46
l Conversely, the dotted line in the figure
 indicates that stock price falls substantially
 when an offer decreasing leverage (i.e. stock-
 for-debt offer) is announced.

l Thus, the market infers from an increase in
 debt that the firm is better off, leading to a
 stock price rise.

l Conclusions:
 l   Stock price increases from increased leverage and
     stock price decreases from decreased leverage are
     consistent with a tax benefit from debt.

                                                         47
l   The results are also consistent with the notion
    that firms "signal" things about themselves
    when they announce major leverage changes.

l   Adding debt can be a signal of high future
    cash flows and high value.




                                                      48
Effect of Agency Costs of Equity
lA   potential agency conflict between
  stockholders and managers arises whenever
  the manager of a firm owns less than 100%
  of the firm’s common stock.
l If a firm is solely owned and managed by a
  single individual, that person will take action
  to increase his own welfare.

l If the owner-manager relinquishes a portion
  of his ownership by selling some of the
  firm’s stock to outsiders, a potential conflict
  of interest arises.

                                                    49
    example, the owner-manager may
l For
 now be more likely to:
 l   lead a more relaxed life and not work as hard
     to maximize shareholder wealth, because less
     of this wealth will go to him.

 l   consume more perquisites (i.e. executive
     fringe benefits such as luxurious offices, use
     of corporate planes, personal assistants,
     generous retirement plans, etc.), because part
     of those costs will now fall on the outside
     stockholders.


                                                      50
     on capital-budgeting projects with
l take
 negative NPVs.

l Managerial   salaries generally rise with
 firm size.

l When  an unprofitable project is accepted,
 the loss in stock value to a manager with
 only a small equity interest may be less
 than the increase in salary.

                                               51
l Thus, as the firm issues more new equity
 that dilutes the owner-manager’s equity
 holdings, the owner-manager will likely
 increase leisure time, work-related
 perquisites, and unprofitable investments.

 These 3 items are called agency costs of
 equity.




                                              52
l It is ultimately the owner-manager who
  bears the burden of these agency costs.
l Knowing that the owner-manager will take
  action to increase his own welfare, new
  stockholders will pay only a low price for
  the stock.
l Thus, the owner-manager has an incentive
  to reduce these agency costs by allowing
  monitoring by new stockholders.
l However, it at most reduces (but cannot
  eliminate) the agency costs of equity.
                                               53
l Effectof agency costs of equity on debt-
 equity financing:

 When debt is substituted for equity:
  Change in the value of the firm
 = tax shield on debt
  - increase in CFD
  + reduction in the agency costs of equity
ÞThe optimal debt-equity ratio would be
 higher in a world with agency costs of
 equity than in a world without these costs.

                                               54
 Free Cash Flow (FCF) Hypothesis
lWe  might expect to see more wasteful
 activity in a firm with a capacity to generate
 large cash flows than in one with a capacity
 to generate only small cash flows.
lSince dividends leave the firm, they reduce
 FCF.
lThus, an increase in dividends should
 benefit the stockholders by reducing the
 ability of managers to pursue wasteful
 activities.
                                              55
l Since principal & interest also leave the
  firm, debt reduces FCF flow as well.
l However, principal & interest should have
  a greater effect than dividends have on the
  free-spending ways of managers, because
  bankruptcy will occur if the firm is unable
  to make future debt payments. (In
  contrast, the firm has no legal obligation
  to pay dividends).
l Because of this, a shift from equity to debt
  will boost the firm’s value. Thus, the FCF
  hypothesis provides another reason for
  firms to issue debt.
                                             56
Part 2: Asymmetric Information
l So  far we assume that investors & managers
  have exactly the same information about a
  firm’s prospect¾this is called symmetric
  information.
l However, the managers of a company have
  access to information about the expected
  future earnings & cash flows of the firm that
  is not available to outside investors.
l That is, managers often have better
  information than outside investors.
l This is called asymmetric information.

                                                  57
l Managers   try to maximize the value for
  current stockholders (including managers), not
  new ones.
l If managers know that the firm has excellent
  prospects (but investors don’t know),
  managers won’t want to issue new shares
  since the current stockholders (including
  managers) have to share the benefits with the
  new stockholders.
l In this case, managers will raise any required
  new capital by other means, including using
  debt.
l Thus, debt issues are regarded as good news
  by investors.
                                               58
l If managers know that the firm’s future looks bad
  (but investors don’t know), managers will want to
  issue new shares since the new stockholders will
  share the losses with the current stockholders
  (including managers).
l The conclusion is that firms with good prospects
  prefer to finance with debt, whereas firms with
  poor prospects like to finance with stock.
l Thus, investors will take a stock offering to be a
  signal of bad news, so stock prices tend to decline
  when new issues are announced.
l As a result, new equity financings are relatively
  expensive.
                                                   59
     The Pecking–Order Theory
l Based on repeated observations of how
  corporations actually raise funds over years.
l Firms prefer internal equity (i.e. retained
  earnings) to external financing because:
 l there are no flotation costs associated with the use
   of internal equity;
 l internal financing avoids the discipline and

   monitoring that occurs when new securities are
   sold publicly.
 =>Rule1: Use Internal Financing

                                                          60
l Iffunding requirements exceed retained
  earnings, debt issues are preferred to
  equity issues because:
  l debt poses lower risk on the investor than
    equity and lower cost on the firm;
  l because of asymmetric information, when

    overpriced firm tends to issue equity, the
    investor will infer the firm is the most
    overprice, causing the stock to fall more than
    is deserved;
  l the stock market tends to react negatively to

    announcements of new common stock
    offerings.
  =>Rule 2 : Issue Safe Securities First
                                                     61
        Summary & implications:
l The pecking-order theory is at odds with
 the tradeoff theory:
 l    Profitable firms use less debt
      If firms prefer retained earnings over external
       financing, they may use less debt than is
       implied by taxes & financial distress costs.
      This is particularly true for highly profitable
       firms where retained earnings are likely to
       exceed financing requirements.



                                                         62
l   There is no target D/E ratio
     There’s no well-defined target debt-equity mix,
      because there’re 2 kinds of equity, internal and
      external, one at the top of the pecking order and
      one at the bottom.
     Rather, the debt ratio varies as capital
      expenditures and retained earnings change, in
      other words, each firm chooses its leverage
      ratio based on financing needs.
     By contrast, in trade-off model, the optimal
      amount of leverage occurs where the marginal
      benefit of debt equals the marginal cost of debt.

                                                      63
l Companies    like financial slack.
    Firms will hoard cash during good times to
     avoid the need to finance externally during bad
     times.
    They may also use low debt levels during
     good times so that during bad times (or when
     great opportunities arise) they can borrow
     needed funds if internal funds are not available.




                                                    64
Financing Decisions by U.S.
Nonfinancial Corporations




                              65
66
67
           Effect of Growth
l No-growth:
 l Imagine a world of perfect certainty where a
   firm has EBIT of $100 per year.
 l In addition, the firm has issued $1,000 of debt

   at an interest rate of 10%, implying interest
   payments of $100 per year.
 l The firm has issued just enough debt so that

   all EBIT is paid out as interest.



                                                     68
l The   cash flows to the firm are:




l The firm will pay no taxes.
l The equity is worthless because stockholders
  receive no cash flows.
l Since debt is worth $1,000, the firm is also
  valued at $1,000.
l The debt-to-firm-value ratio is 100%
  (= $1,000/$1,000).

                                             69
lGrowth:
 l   Now imagine another firm that also has EBIT of
     $100 at year 1 but is growing at 5% per year.
 l   To eliminate taxes, this firm also wants to issue
     enough debt so that interest equals EBIT. Interest
     rate is always 10%.

 l   Since EBIT is growing at 5% per year, interest
     must also grow at this rate. This is achieved by
     increasing debt by 5% per year. The new debt is
     used to buy back shares of stock.




                                                        70
71
l Now,   what is the value of the firm?
l Recall the MM model with corporate
  taxes:
 If EBIT and interest are constant over
  time,
 the total annual cash flows available to the
 firm’s investors are:




                                                72
l Now, both EBIT and interest grow at 5% per
 year perpetually:




                                               73
Þ The value of equity at date 0 is $1,000
   (= the value of the firm at date 0
      - the value of debt at date 0
    = $2,000 - $1,000)
lThat is, equity has value even when taxable
income is zero.

lActually, the equityholders are receiving
cash flow each period, since new debt is used
to buy back stock.


                                                74
Þ The debt-to-firm-value ratio is 50% (=
 $1,000/$2,000).

lConclusion:
 lNo-growth: debt-to-firm-value ratio is 100%
 lGrowth: debt-to-firm-value ratio is 50%

lThat is, growth implies significant equity
 financing.
lImplication:
  High-growth firms will have lower debt
 ratios than low-growth firms.

                                                75
        Part 3: Personal Taxes
l Reproduce  the Water Products example:
 The company has a corporate tax rate, TC,
 of 35% and expected EBIT of $1 million
 each year. Its entire earnings after taxes
 are paid out as dividends.

l The firm is considering 2 alternative
 capital structures:
 Plan I: no debt.
 Plan II: B = $4,000,000 and rB = 10%.
                                              76
77
l Now  we assume that dividends & interest
 are both taxed at the same personal tax
 rate, 30%.




                                             78
      taxes paid at both corporate &
l Total
 personal levels are:




                                       79
l Totalcash flow to all investors after
  personal taxes is greater under plan II.
l This must be the case because:
 l   total cash flow was higher when personal taxes
     were ignored
 l   all cash flows (both interest and dividends)
     are taxed at the same personal tax rate.

 Þ Debt increases the value of the firm.



                                                      80
l Now  suppose that the effective personal tax
 rate on distributions to stockholders is 10%
 and the personal tax rate on interest is 50%.




                                                 81
      taxes paid at both corporate &
l Total
 personal levels are:




                                       82
l In   this scenario, the total cash flows are
    higher under plan I than under plan II.

Þ The value of the firm will be higher under
   plan I than under plan II.

l    The increase in corporate taxes under the
    all-equity plan is more than offset by the
    decrease in personal taxes.


                                                 83
l Conclusion:
 l    Interest receives a tax deduction at the
     corporate level.

 l   Dividend may be taxed at a lower rate than
     interest at the personal level.

 l   The above examples illustrate that total tax at
     all levels may either increase or decrease with
     debt, depending on the tax rates in effect.



                                                       84
   Valuation under corporate and
  personal taxes: The Miller model
TC : corporate tax rate
TB : personal tax rate on income from debt
TS : personal tax rate on income from stock
VL : value of a levered firm
VU: value of an unlevered firm
B : value of debt
r0 : cost of capital for an all-equity firm
      (Since the unlevered firm uses no debt, r0
       also denotes the unlevered firm’s cost of
       equity.)
                                                   85
Note: The Miller model does not consider
      financial distress costs.

                                       86
                    Implications
     T S:
l TB =
Þ VL = VU + TCB (MM with corporate taxes)
Þ Firms should use debt financing as much as
  possible.

l (1   - TC)(1 - TS) > (1 - TB):
Þ VL < V U
Þ Firms should not use any debt financing.

                                             87
l (1   - TC)(1 - TS) = (1 - TB): (Þ TS < TB)

  Þ VL = VU (MM without corporate taxes)
(i.e. the tax advantage of debt to the firm is
      exactly offset by the personal tax
      advantage of equity.)

 Þ The value of the firm doesn’t depend on
   its financial structure.



                                                 88
l   (1 - TC)(1 - TS) < (1 - TB) and TS < TB:
    Þ VU < VL < VU + TCB.
     (e.g. TC = 34%, TS = 20%, TB = 28%.
           Þ VL = VU + 0.27B < VU + 0.34B.)
    Þ Personal taxes offset some of the benefits
      of corporate debt, so the gain from
      leverage (0.27B) is less than that implied
      by MM with corporate taxes (0.34B).
l   Note VL is still positively related to B (i.e.
    firms should use debt financing as much as
    possible.)

                                                     89
lEffect of financial leverage on firm
 value with both corporate and personal taxes




                                                90
               Example
l The personal tax rate on stock income is
 12%, and the personal tax rate on interest
 is 28%.

l AcmeIndustries anticipates a perpetual
 EBIT of $100,000 per year and faces a
 35% corporate tax rate.



                                              91
l Acme   currently has an all-equity structure.
 Investors (i.e. stockholders) demand a 15%
 return after corporate taxes; i.e. they
 demand a 13.2% (= 15% ´ (1 - 12%)) return
 after both corporate and personal taxes.
 Therefore, stockholders will discount the
 earnings stream after both corporate and
 personal taxes at 13.2%.

l Acme   is considering borrowing $120,000 at
 10%.

                                                  92
93
Þ Gain from leverage = $24,677 < TCB
  = 35% ´ 120,000 = $42,000.

l Now, suppose that the personal tax rate on
 stock income is 18%, and the personal tax
 rate on interest is 50%.




                                               94
Þ V L < V U.

l Thisoccurs because the personal tax rate
 on interest is much higher than that on
 stock income.

l Thatis, the reduction in corporate taxes
 from leverage is more than offset by the
 increase in taxes from leverage at the
 personal level.
                                             95
How Firms Establish Capital Structure:
   Evidence from the Real World
 l Most     corporations have low Debt-Asset
  ratios.
   l   Figure 17.4 shows in recent years debt-to-total
       -value ratios of firms (using book value) in
       several countries.

   l   In all of the countries, firms have debt-to-total
       -value ratios considerably less than 100%.

   l   There must be limits to the amount of debt
       corporations can issue.
                                                       96
97
98
99
100
lA   number of firms use no debt.
l There are differences in the capital
  structures of different industries.
  l Table 17.3 shows that debt ratios tend to be
    very low in high growth industries with ample
    future investment opportunities such as the
    drugs & electronics industries.
  l This is true even when the need for external
    financing is great.
  l Industries with large investments in tangible
    assets, such as building construction, tend to
    have leverage.


                                                 101
102
l   Most corporations employ target debt-equity
    ratios.(Figure 17.5 shows that the great majority of the
    firms use targets, though the strictness of the targets
    varies across companies.)
l   Only 19% of the firms avoid target ratios.




                                                               103
      How should establish target
         debt-equity ratios
l Taxes:


 l   Firms can deduct interest for tax purposes to
     the extent of their profits before interest.

 l   Thus, highly profitable firms are more likely
     to have larger debt ratios than less profitable
     firms.


                                                       104
l Types   of Assets:

 l The costs of financial distress depend on the
   types of assets that the firm has.
 l E.g. If a firm has a large investment in land,
   buildings, and other tangible assets, it will have
   smaller costs of financial distress than a firm
   with a large investment in research and
   development (R&D).
 l R&D typically has less resale value than land;
   thus, most of its value disappears in financial
   distress.

Þ Firms with more tangible assets use more debt
  whereas firms with more intangible assets use
  less debt.
                                                    105
l Uncertainty    of operating Income:

 l   Firms with more uncertainty of operating
     income should use less debt since they have
     greater probability of experiencing financial
     distress.




                                                     106

								
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