Bankruptcy Tax Outline Nyu by jtv15100

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									Session 7: Capital Structure

   C15.0008 Corporate Finance
            Topics
                  Outline
• Distress costs
• Agency conflicts
• Finding the optimal capital structure
     Financial Distress Costs
• Direct costs
  – Lawyers, accountants, consultants fees
  – Forced asset sales
• Indirect costs
  – Wasted time and energy
  – Deterioration of reputation and customer,
    supplier, and employee relationships
• Total ~10-20% of firm value
           Agency Conflicts
• Bondholders vs. stockholders (managers)
  – Occur when debt is risky
  – Stockholders control the firm
• Management vs. stockholders
  – Occur when corporate governance system
    does not work perfectly
  – Managers can misuse the firms assets
       Stockholder Incentives
• Take risk, i.e., undertake high risk
  (possibly negative NPV) projects
• Under-invest, i.e., reject positive NPV
  projects that require equity investment
• Pay dividends, i.e., distribute wealth to
  shareholders
              Agency Costs
Since the market is smart, bondholders anticipate
future actions and demand protection up front
• Bond covenants (restrict the actions of
managers and may reduce value)
• Higher promised payments
• These are all costs to the firm
       Valuation Implications
VL = VU + PV(tax shield)
     - PV(financial distress costs)
     - PV(agency costs)
Financial distress and agency costs
(bondholder vs. stockholder) increase as the
amount of debt increases.
Optimal capital structure trades off the tax
benefits of debt with financial distress and
agency costs.
A Graphical Interpretation

   V
                  Financial distress and
                  agency costs

               Tax benefits
   VU


               B/S
  Agency conflict demonstrated
• Firm with 30 million debt to be repaid in 1
  year, liquidated after a year
• Assets to pay off 35 million after 1 year
  (for certain). Risk free rate = 10%
• Asset value = 31.81, Debt value = 27.27.
  Hence equity value = 4.54
   Risky negative NPV project
• NPV of project = -2 million
• Project changes the distribution of cash-
  flows. Cash-flows could either be 100
  million or 10 million after 1 year
• New PV of firm = 31.81 – 2 = 29.81 million
             Equity Pay-off
                          65


         S


                          0


• H = 0.72
• B = 6.56
• Equity value = 14.96 : It increased, even
  though firm value decreased!
Finding the Optimal Capital Structure

• Comparison with other firms
• Maximize firm value
  – WACC approach
    V =  UCFt/(1+rWACC)t
  – APV approach
    VL = VU + PV(tax shield) - PV(financial
    distress costs)
  – Binomial approach
        The WACC Approach
             V =  UCFt/(1+rWACC)t
 UCF = EBIT(1-T) + depreciation – capex – nwc
• Calculate WACC at various debt levels
  – rB from debt rating via interest coverage and leverage
    ratios
  – rS from Prop. II
    rS = r0 + (1- TC)(B/S)(r0 - rB)
  – WACC = (B/(S+B)) rB(1-T)+(S/(S+B)) rS
• Adjust expected cash flows for financial distress
  costs
Example
    Interest Coverage, Ratings and
               Spreads
 Interest Coverage
   >           <     Rating   Spread
                                       Large manufacturing
              0.20     D      14.00%   companies
   0.2        0.65     C      12.70%
  0.65        0.80    CC      11.50%
   0.8        1.25    CCC     10.00%
  1.25        1.50     B-     8.00%
   1.5        1.75     B      6.50%
  1.75        2.00    B+      4.75%
    2         2.50    BB      3.50%
   2.5        3.00    BBB     2.25%
    3         4.25     A-     2.00%
  4.25        5.50     A      1.80%
   5.5        6.50    A+      1.50%
   6.5        8.50    AA      1.00%
  8.50               AAA      0.75%
Source: http://www.stern.nyu.edu/~adamodar/
        Issues with the WACC
              Approach
• How big is the cash flow adjustment?

• You get a tax shield on interest expenses only
  as long as you are making a profit and are
  paying taxes.

• Financial distress costs and tax shields have
  option like pay-offs.
                 The APV Approach
VL = VU + PV(tax shield) - PV(financial distress costs)
•   PV(tax shield) = t [TC(interest expense)t] / (1+ rB)t
     – The expected tax rate decreases as debt increases
•   PV(financial distress costs) =
    Prob * PV(financial distress costs | financial distress)
     – The probability increases as the debt rating declines
     – Cost are usually estimated as a percentage of pre-distress firm
        value (~10-20%)
•   Financial distress costs and tax shields have option like payoffs
    Ratings and Default Risk
Rating    Default Risk           Rating      Prob
AAA           0.01%              AAA       0.03%
AA            0.28%              AA        0.55%
A+            0.40%              A         0.78%
A             0.53%              BBB       9.33%
A-            1.41%              BB       20.03%
BBB           2.30%              B        38.19%
BB           12.20%              CCC      54.88%
B+           19.28%
B            26.36%           Source: Altman, 1971-2002
B-           32.50%
CCC          46.61%
CC           52.50%
C               60%
D               75%

Source: http://www.stern.nyu.edu/~adamodar/
Time Series of Default Rates

                 14.00%
                 12.00%
                 10.00%
  Default Rate




                 8.00%
                 6.00%
                 4.00%
                 2.00%
                 0.00%
                       71
                       73
                       75
                       77
                       79
                       81
                       83
                       85

                       87
                       89
                       91
                       93
                       95
                       97
                       99
                       01
                    19
                    19
                    19
                    19
                    19
                    19
                    19
                    19

                    19
                    19
                    19
                    19
                    19
                    19
                    19
                    20
                           Year




 % of high yield bonds defaulting in a given year
        The Binomial Approach
Firm:
• Single remaining cash flow in 1 year
   EBIT $10 million or $2 million (prob. 50%)
   no salvage value
• Corporate tax rate: T=40%
• Unlevered required return: r0=10%
• In the event of bankruptcy
   – Financial distress costs are 15% of VU
   – Pay taxes, financial distress costs, residual goes to
     bondholders
            The Unlevered Firm
VU = S
Liquidating dividend is only cash flow
Value via DCF


                             EBIT(1-T)=10(1-0.4)=6

[0.5(6)+0.5(1.2)]/1.1=3.27

                             EBIT(1-T)=2(1-0.4)=1.2
            The Levered Firm
• $2 million amount of (risky) 1-year debt
• Promised interest rate = 56.65% (rf=2%)
• Promised payment (at maturity)
  2(1+56.65%)=3.13
  – Solvent for high EBIT
    Payment to bondholders: 3.13
  – Bankrupt for low EBIT
    Payment to bondholders:
    EBIT-taxes-financial distress costs =
    EBIT-(EBIT-int.exp.)T-0.15VU =
    2-[2-2(56.65%)]0.4-0.15(3.27) = 1.16
                 Debt Value

Replicate using the unlevered firm (rf=2%)
             6                     3.13
3.27                   B
              1.2                  1.16

H=0.41, B*=-0.656, B=2 (trading at
par!!)
                 Equity Value

Replicate using the unlevered firm (rf=2%)
             6
3.27
              1.2
             (EBIT-56.65%(B))(1-T)-B=3.32
  S
              0
H=0.69, B*=0.814, S=1.45         rS=14.49%
                 Firm Value
VU = S = 3.27
VL = S + B = 1.45 + 2 =3.45
VL = VU + PV(tax shield) - PV(f.d. costs) ?

The tax shield is risk-less (even though the debt is
risky):
PV(tax shield) = [56.65%(2)(0.4)/1.02]
                = 0.444
       Financial Distress Costs

Replicate using the unlevered firm (rf=2%)
             6                     0
3.27                   FD
              1.2                  0.491

H = -0.102, B* = -0.602, FD = 0.267

VL = VU + PV(tax shield) - PV(f.d. costs)
   = 3.27 + 0.444 - 0.267 = 3.45
            Assignments
• Chapter 18
• Problems 18.6,18.14, 18.16
• Problem set 3 due in 1 week

								
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