chapter 18 how much should firm borrow
TRANSCRIPT
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How Much Should a Firm
Borrow?
Principles of
Corporate
Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Slides by
Matthew Will
Chapter 18
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. ll rights
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Topics Covered
Corporate Taxes and Value
Corporate and Personal Taxes
Cost of Financial istress
Pec!in" #rder of Financial Choices
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. ll rights
Financial Risk $ %is! to shareholders resultin" from
the use of de&t'
Financial evera!e $ (ncrease in the varia&ilit) of
shareholder returns that comes from the use of de&t'"nterest Ta# Shield$ Tax savin"s resultin" from
deducti&ilit) of interest pa)ments'
C.S. $ Corporate Ta#es
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. ll rights
%#a&ple $ *ou own all the e+uit) of Space Ba&ies
iaper Co'' The compan) has no de&t' The
compan),s annual cash flow is -./000/ &efore
interest and taxes' The corporate tax rate is 102'*ou have the option to exchan"e .34 of )our e+uit)
position for .02 &onds with a face value of -./000'
Should )ou do this and wh)?
C.S. $ Corporate Ta#es
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. ll rights
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Preta In!"me 1,000 #00
Taes $ 40% 400 3&0
'et (as) *l"+ $600 $540
C.S. $ Corporate Ta#es
%#a&ple $ *ou own all the e+uit) of Space Ba&ies iaper Co'' The
compan) has no de&t' The compan),s annual cash flow is -./000/ &efore interest and taxes' The corporate tax rate is 102' *ou have theoption to exchan"e .34 of )our e+uit) position for .02 &onds with aface value of -./000'
Should )ou do this and wh)?
All
Equity
EBIT 1,000
Interest Pmt 0
Preta In!"me 1,000
Taes $ 40% 400
'et (as) *l"+ $600
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All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Preta In!"me 1,000 #00
Taes $ 40% 400 3&0
'et (as) *l"+ $600 $540
C.S. $ Corporate Ta#es
%#a&ple $ *ou own all the e+uit) of Space Ba&ies iaper Co'' The
compan) has no de&t' The compan),s annual cash flow is -./000/
&efore interest and taxes' The corporate tax rate is 102' *ou have the
option to exchan"e .34 of )our e+uit) position for .02 &onds with a
face value of -./000'
Should )ou do this and wh)?
T"tal (as) *l"+
All Equity = 600
*1/2 Debt = 640 *1/2 Debt = 640
(540 + 100)
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Capital Str'ct're
PV of Tax Shield 5
6assume perpetuit)7 D x r D x Tc
r D
= D x Tc
Example:Tax benefit = 1000 x (10) x (40) = !40
"# $f 40 perpetuity = 40 % 10 = !400
"# Tax &'iel = D x Tc = 1000 x 4 = !400
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Capital Str'ct're
Firm Value 5Value of 8ll E+uit) Firm 9 PV Tax Shield
Example
All Equity #alue = 600 % 10 = 6000
"# Tax &'iel = 400
*irm #alue it' 1%, Debt = !6400
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C.S. $ Ta#es ()ersonal $ Corp*
elati.e A.antae *"rmula
Debt .s Equity
1-TP1-TPE 1-T(
A* 1 Debt
A* 1 Equity
A.antae
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Eamle 1All Debt All Equity
In!"me BT(P 1600 1600
less T(764& 0600 064&
In!"me BTP 1600 0654
Taes TP 765 TPE70 0650 0600
Ater Ta In!"me 0650 0654
A* 7 6#2& A.antae Equity
C.S. $ Ta#es ()ersonal $ Corp*
In!"me BT(P 1600
less T(764& 0600
In!"me BTP 1600
Taes TP 765 TPE70 0650
Ater Ta In!"me 0650
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Eamle 2 All Debt All Equity
In!"me BT(P 1600 1600
less T(7634 0600 0634
In!"me BTP 1600 06&&
Taes TP 7628 TPE7621 0628 0613#
Ater Ta In!"me 062 06521
A* 7 16381 A.antae Debt
C.S. $ Ta#es ()ersonal $ Corp*
In!"me BT(P 1600
less T(7634 0600
In!"me BTP 1600
Taes TP 7628 TPE7621 0628
Ater Ta In!"me 062
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Toda),s %8F : e&t vs E+uit) preference'
1-..
(1-16) (1-.5)= 1,./A* =
C.S. $ Ta#es ()ersonal $ Corp*
'y are c$mpanie n$t all ebt2
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Capital Str'ct're
9tru!ture " B"n :iel ates
D
E
B"n
:iel
r
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;ei)te A.erae ("st " (aitalit'$ut taxe (traiti$nal 3ie)
r
D#
r D
r Enclue anruptcy /i
;A((
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Financial +istress
Costs o, Financial +istress $ Costs arisin" from &an!ruptc) or distorted &usiness decisions &efore
&an!ruptc)'
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Financial +istress
Costs o, Financial +istress $ Costs arisin" from &an!ruptc) or distorted &usiness decisions &efore
&an!ruptc)'
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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Financial +istress
e&t
M a r ! e t V a l u e o f T h e F i r m
Value of unlevered
firm
PV of interest
tax shields
Costs of financial distress
Value of levered firm
#ptimal amountof de&t
Maximum value of firm
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Con,licts o, "nterest
Circular File Co!any has "#$ of %-year de&t'
Circular File Company (Book alue!"
7et 8 ,0 50 $n $uttanin9*ixe aet 0 50 8$mm$n t$c
T$tal aet 100 100 T$tal liabilitie
Circular File Company (Book alue!"
7et 8 ,0 50 $n $uttanin9*ixe aet 0 50 8$mm$n t$c
T$tal aet 100 100 T$tal liabilitie
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Con,licts o, "nterest
Circular File Co!any has "#$ of %-year de&t'
;h) does the e+uit) have an) value ? Shareholders have an option $$ the) can o&tain the
ri"hts to the assets &) pa)in" off the -
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Con,licts o, "nterest
Circular File Co!any has ay in(est "%$ as follo)s'
)7 pro&a&ilit6=02-0
-.0(nvest
)7 pro&a&ilit6.02-.40 >ext *ear Pa)offsPossi&le >ow
8ssume the >PV of the proect is 6$-47'
;hat is the effect on the mar!et values?
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Con,licts o, "nterest
Circular File Co!any (alue *!ost !roect,
Firm value falls &) -4/ &ut e+uit) holder "ains -@
Circular File Company (#arket alue!"7et 8 10 ,0 $n $uttanin9
*ixe aet 1 8$mm$n t$c
T$tal aet , , T$tal liabilitie
Circular File Company (#arket alue!"7et 8 10 ,0 $n $uttanin9
*ixe aet 1 8$mm$n t$c
T$tal aet , , T$tal liabilitie
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Con,licts o, "nterest
Circular File Co!any (alue *assues a safe !roect)ith PV = "#,
;hile firm value rises/ the lac! of a hi"h potential pa)off for
shareholders causes a decrease in e+uit) value'
Circular File Company (#arket alue!"7et 8 ,0 .. $n $uttanin9
*ixe aet ,5 1, 8$mm$n t$c
T$tal aet 45 45 T$tal liabilitie
Circular File Company (#arket alue!"7et 8 ,0 .. $n $uttanin9
*ixe aet ,5 1, 8$mm$n t$c
T$tal aet 45 45 T$tal liabilitie
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Financial +istress -a&es
Cash "n and R'n
)layin! ,or Ti&e
Bait and Switch
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Financial Choices
Tradeo,, Theory $ Theor) that capital structure is &ased on a trade$off &etween tax savin"s and distress
costs of de&t'
)eckin! /rder Theory $ Theor) statin" that firms
prefer to issue de&t rather than e+uit) if internal
finance is insufficient'
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Trade /,, Theory $ )rices
1. Stock,ordebt Stock price
e#chan!e o,,ers ,alls
+ebt,orstock Stock price
e#chan!e o,,ers rises
0. "ss'in! co&&on stock drives down stock prices
rep'rchase increases stock prices.
2. "ss'in! strai!ht debt has a s&all ne!ative
i&pact.
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"ss'es and Stock )rices
Why do sec'rity iss'es a,,ect stock price3 Thede&and ,or a ,ir&4s sec'rities o'!ht to be ,lat.
Any ,ir& is a drop in the b'cket.
)lenty o, close s'bstit'tes.
ar!e debt iss'es don4t si!ni,icantly depressthe stock price.
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)eckin! /rder Theory
Consider the follo)in. story/
The anno'nce&ent o, a stock iss'e drives down the stock price
beca'se investors believe &ana!ers are &ore likely to iss'e when
shares are overpriced.
There,ore ,ir&s pre,er internal ,inance since ,'nds can be
raised witho't sendin! adverse si!nals.
", e#ternal ,inance is re5'ired6 ,ir&s iss'e debt ,irst ande5'ity as a
last resort.
The &ost pro,itable ,ir&s borrow less not beca'se they have lower
tar!et debt ratios b't beca'se they don7t need e#ternal ,inance.
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M G Hill/I i
)eckin! /rder Theory
Soe 0!lications/
"nternal e5'ity &ay be better than e#ternal
e5'ity.
Financial slack is val'able.
", e#ternal capital is re5'ired6 debt is better.
(There is less roo& ,or di,,erence in opinions
abo't what debt is worth*.