corporate finance lecture 17 introduction to capital structure (continued) ronald f. singer fina...

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

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

• LIABILITIES

DEBT 0

EQUITY 3,000,000

TOTAL $3,000,000

Irrelevance TheoremASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 1,600,000

EQUITY 1,400,000

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/StockholderManager/Stockholder

Bankruptcy CostsDirect and Indirect

Information Costs

Tax Implications

ASSETS

PVA $1,000,000

PVGO 2,000,000

- PV of Tax Liability 900,000

TOTAL $2,100,000

LIABILITIES

DEBT 0

EQUITY 2,100,000

TOTAL $2,100,000

Tax Implications (Suppose T = 30%)

ASSETS

PVA $1,000,000

PVGO 2,000,000

Less: PV of Tax Liability 420,0000

TOTAL $2,580,000

LIABILITIES

DEBT 1,600,000

EQUITY 980,000

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 millionTax @ 30 % = $2.1 millionAfter 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 = (Y)(1-T) + T (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)

V = V(u) + Tc*B

V(u)

Debt

Cost of Capital

WACC = ro

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

rB

Cost of Capital (After Tax)

WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V)

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

rB

The two ways of representing firm value

V = V (u) + T * B

V = Y(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 $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment

ASSETS

PVA $1,000,000

PVGO 2,000,000

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment

ASSETS

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

TOTAL $3,000,000

LIABILITIES

DEBT 2,500,000

EQUITY 500,000

TOTAL $3,000,000

Example of Underinvestment Make a Div Payment rather than

investASSETS

PVA $400,000

(Real Assets = 400,000)PVGO 2,000,000

TOTAL $2,400,000

LIABILITIES

DEBT 2,250,000

EQUITY 1 50,000

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?

Costs of Financial Distress

V = V(u) + PV of Tax Shield

Firm Value

Debt LevelOptimal 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.