Corporate Finance
Lecture 17 and 20
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
• LIABILITIES
• ASSETS
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
PVGO
2,000,000
EQUITY 1,400,000
TOTAL $3,000,000
1,600,000
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
PVGO
$1,000,000
2,000,000
- PV of Tax Liability 900,000
TOTAL
$2,100,000
DEBT
0
EQUITY
2,100,000
TOTAL
$2,100,000
Tax Implications
(Suppose T = 30%)
ASSETS
PVA
PVGO
LIABILITIES
$1,000,000
DEBT
1,600,000
2,000,000
Less:
PV of Tax Liability 420,0000
EQUITY
TOTAL
TOTAL
$2,580,000
980,000
$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
– Cash Expense
– Interest
– Depreciation
– Change in WC
$20 million
$10 million
$2 million
$3 million
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) +
(1+ro)t
=
V(u)
ST (Interest)
(1+rB) t
+
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)
V(u)
Debt
Cost of Capital
rs = ro + (ro -rB)B/S
r
WACC = ro
rB
Cost of Capital (After Tax)
r
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
PVA
PVGO
TOTAL
LIABILITIES
$1,000,000
2,000,000
$3,000,000
DEBT
EQUITY
TOTAL
2,500,000
500,000
$3,000,000
Example of Underinvestment
ASSETS
PVA
PVGO
TOTAL
LIABILITIES
$1,000,000
2,000,000
$3,000,000
DEBT
EQUITY
TOTAL
2,500,000
500,000
$3,000,000
Example of Underinvestment
ASSETS
LIABILITIES
PVA
$1,000,000
DEBT
(Cash = 600,000)
(Real Assets = 400,000)
EQUITY
PVGO
2,000,000
TOTAL
$3,000,000
TOTAL
2,500,000
500,000
$3,000,000
Example of Underinvestment
Make a Div Payment rather than
invest
ASSETS
PVA
LIABILITIES
$400,000
DEBT
(Real Assets = 400,000)
EQUITY
PVGO
2,000,000
TOTAL
$2,400,000
TOTAL
2,250,000
1 50,000
$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
Costs of
Financial
Distress
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.