16- 1 mcgraw hill/irwin copyright © 2009 by the mcgraw-hill companies, inc. all rights reserved...
TRANSCRIPT
16- 1
McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Fundamentals of Corporate
Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
Slides by
Matthew Will
Chapter 16
McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Debt Policy
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Topics Covered
Debt and Value in a Tax Free Economy Capital Structure and Corporate Taxes Cost of Financial Distress Explaining Financial Choices Bankruptcy Procedures
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Value and Capital Structure
Assets Liabilities and Stockholder’s Equity
Value of cash flows from firm’s real assets and operations
Market value of debt
Market value of equity
Value of Firm Value of Firm
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Average Book Debt Ratios
Industry Debt RatioInternet information 0.07 Biotech 0.12 Communications equipment 0.19 Semiconductors 0.21 Oil exploration 0.29 Aerospace defense 0.32 Beverages (alcohol) 0.36 Consumer appiances 0.40 Hotels and motels 0.53 Gas utilities 0.53 Airlines 0.73
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M&M (Debt Policy Doesn’t Matter)
Modigliani & Miller When there are no taxes and capital markets
function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company.
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M&M (Debt Policy Doesn’t Matter)
Assumptions
By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities
Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives
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Example - River Cruises - All Equity Financed
17.5%12.5%7.5% shares on Return
1.751.25$.75shareper Earnings
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
million 1 $Shares of ValueMarket
$10shareper Price
100,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
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Example
cont.
50% debt
25%15%5% shares on Return
2.501.50$.50shareper Earnings
125,00075,000$25,000earningsEquity
50,00050,000$50,000Interest
175,000125,000$75,000Income Operating
BoomExpectedSlump
Economy theof State Outcome
500,000 $debt of ueMarket val
500,000 $Shares of ValueMarket
$10shareper Price
50,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
16- 9
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M&M (Debt Policy Doesn’t Matter)
Borrowing increases EPS for River Cruises
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Example - River Cruises - All Equity Financed
- Debt replicated by investors
25%15%5% investment$10 on Return
2.501.50$.50investment on earningsNet
1.001.00$1.0010% @Interest :LESS
3.502.50$1.50shares twoon Earnings
BoomExpectedSlump
Economy theof State Outcome
M&M (Debt Policy Doesn’t Matter)
16- 11
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Example - River Cruises – Firm debt at 50%
- Investor can unwrap debt
17.5%12.5%7.5% investment$10 on Return
3.502.50$1.50investmenton earningsNet
1.001.00$1.0010% @Interest :PLUS
2.501.50$0.50share oneon Earnings
BoomExpectedSlump
Economy theof State Outcome
M&M (Debt Policy Doesn’t Matter)
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River Cruise’s “Value Pie”
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Operating Risk (business risk) – Risk in the firm’s operating income.
Financial Risk - Risk to shareholders resulting from the use of debt.
Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.
Interest Tax Shield- Tax savings resulting from deductibility of interest payments.
C.S. & Corporate Taxes
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Cost of Capital
)( debtassetsassetsequity rrE
Drr
ED
Er
ED
DrTWACC c equitydebt)1(
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r
DV
rD
rE
MM’s Proposition II (w/fixed interest rate)
rA
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Includes Bankruptcy Risk
r
DV
rD
rE
MM’s Proposition II (w/risky debt)
rA
Risk free debt Risky debt
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r
DV
rD
rE
WACC
Weighted Average Cost of Capital
WACC with no bankruptcy risk
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River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders.
48,75081,250FlowCash Net
26,25043,75035% @ Taxes
75,000125,000IncomePretax
50,0000PmtInterest
125,000125,000EBIT
Debt 1/2Equity All
C.S. & Corporate Taxes
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River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders.
48,75081,250FlowCash Net
26,25043,75035% @ Taxes
75,000125,000IncomePretax
50,0000PmtInterest
125,000125,000EBIT
Debt 1/2Equity All
C.S. & Corporate Taxes
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Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
C.S. & Corporate Taxes
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Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
4,5506,500FlowCash Net
2,4503,50035% @ Taxes
7,00010,000IncomePretax
3,0000PmtInterest
10,00010,000EBIT
Debt 1/2Equity All
C.S. & Corporate Taxes
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C.S. & Corporate Taxes
Total Cash Flow
All Equity = 6,500
*1/2 Debt = 7,550*1/2 Debt = 7,550
(4,550 + 3,000)
Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.
Should you do this and why?
4,5506,500FlowCash Net
2,4503,50035% @ Taxes
7,00010,000IncomePretax
3,0000PmtInterest
10,00010,000EBIT
Debt 1/2Equity All
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Capital Structure
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 50,000 x (.06) x (.35) = $1,050
PV of 1,050 perpetuity = 1,050 / .06 = $17,500
PV Tax Shield = D x Tc = 50,000 x .35 = $17,500
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Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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Financial Distress
Debt
Mar
ket V
alue
of
The
Fir
m
Value of all equity financed
firm
PV of interesttax shields
PV costs offinancial distress
Value of levered firm
Optimal amount of debt
Maximum value of firm
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Financing Games
The First Game: Bet the Bank’s Money
The Second Game: Don’t Bet Your Own Money
These games demonstrate an inherent conflict between shareholders and bondholders.
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Financial Choices
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
Financial Slack
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