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.
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