Docstoc

Lecture 17 - Introduction to Capital Structure

Document Sample
Lecture 17 - Introduction to Capital Structure Powered By Docstoc
					    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                • LIABILITIES


  PVA      $1,000,000   DEBT      0


  PVGO     2,000,000    EQUITY    3,000,000

  TOTAL $3,000,000      TOTAL     $3,000,000
         Irrelevance Theorem
ASSETS                 LIABILITIES

 PVA      $1,000,000     DEBT   1,600,000

 PVGO     2,000,000      EQUITY 1,400,000


 TOTAL $3,000,000        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/Stockholder
                      Manager/Stockholder
                  Bankruptcy Costs
                      Direct and
                      Indirect
                    Information Costs
               Tax Implications
                                LIABILITIES
ASSETS

PVA             $1,000,000

PVGO             2,000,000      DEBT          0


- PV of Tax Liability 900,000   EQUITY        2,100,000


                                TOTAL         $2,100,000
TOTAL          $2,100,000
               Tax Implications
             (Suppose T = 30%)

ASSETS                         LIABILITIES

PVA            $1,000,000      DEBT          1,600,000


PVGO             2,000,000

Less:
PV of Tax Liability 420,0000   EQUITY          980,000


TOTAL         $2,580,000       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 million
   Tax @ 30 % = $2.1 million
   After 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=   S(Y)(1-T) +    ST (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)

                             T c*B
                     )   +
                 V(u
            V=




  V(u)




                                     Debt
    Cost of Capital

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




              WACC = ro
r



                           rB
Cost of Capital (After Tax)

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




 r
               WACC = r (1-T(D
                         0        /v))
               = rs(S/V) + r (1-T
                            B     ) (B/V)


                                rB
The two ways of representing firm
             value

         V = V (u) + T * B

            V = SY(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                  LIABILITIES

PVA        $1,000,000   DEBT          2,500,000


PVGO        2,000,000   EQUITY          500,000


                        TOTAL         $3,000,000
TOTAL     $3,000,000
  Example of Underinvestment
ASSETS                 LIABILITIES

PVA      $1,000,000    DEBT          2,500,000


PVGO       2,000,000   EQUITY          500,000


                       TOTAL         $3,000,000
TOTAL    $3,000,000
  Example of Underinvestment
ASSETS                   LIABILITIES

PVA          $1,000,000    DEBT        2,500,000
          (Cash = 600,000)
   (Real Assets = 400,000)
PVGO         2,000,000     EQUITY        500,000


                         TOTAL         $3,000,000
TOTAL       $3,000,000
 Example of Underinvestment
Make a Div Payment rather than
            invest
ASSETS                   LIABILITIES

PVA          $400,000    DEBT          2,250,000

   (Real Assets = 400,000)
PVGO         2,000,000     EQUITY        1 50,000


                         TOTAL         $2,400,000
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?
Firm Value


                                                     ld                Costs of
                                                S hie
                                        a   x                          Financial
                                     fT                                Distress
                              P Vo
                      )   +
                  V(u
             V=




                                                                     Debt Level
                                                Optimal 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.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:0
posted:7/19/2013
language:Latin
pages:31