miller channels model
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Miller Channels Model. Tax-class clienteles, equilibrium, and capital structure. Review item. Explain why an increase in leverage doesn’t affect the value of a firm in a world without taxes or threat of bankruptcy. Answer. - PowerPoint PPT PresentationTRANSCRIPT
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Miller Channels Model
Tax-class clienteles,
equilibrium,
and capital structure.
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Review item
Explain why an increase in leverage doesn’t affect the value of a firm in a world without taxes or threat of bankruptcy.
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Answer
Homemade leverage gives the investor the same effects as leverage in the firm.
Homemade leverage is costless. Therefore investors won’t pay extra for
leverage in the firm.
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Recapitulation
Started with VU = VL
Corporate taxes Financial distress
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B
Value, VL
Vu
V L = V u
+ T CB
Value of the firm
Cost ofFinancialDistress
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Indirect costs of financial distress
Lost sales, delayed collection, slow deliveries.
Managers take large risks. Investors won’t support good projects. Equity “milks the property.”
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Against-the-Wall MartAssets BV MV Liabilities BV MV
Cash 200 200 LT bonds 300 ?
Fixed Asset 400 0 Equity 300 ?
Total 600 200 Total 600 200
What happens if the firm is liquidated today?
LT Bonds = 200.
Equity = 0.
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Managers take bad risksCost = $200 (all the firm’s cash)
The gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Required return is 50%
Expected CF from the gamble = $1000 x 0.10 + $0 = $100
NPV = - $200 + $100 / 1.5 = -$133 BAD PROJECT
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Equity accepts the bad risk Expected CF to debt (bondholders)
= 300 x 0.10 + 0 = 30 Expected CF to equity (shareholders)
= (1000 - 300) x 0.10 + 0 = 70
PV of bonds without the gamble = 200 PV of stocks without the gamble = 0
PV of bonds with the gamble = $30 / 1.5 = $20 PV of stocks with the gamble = $70 / 1.5 = $47
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The market won’t invest in good projects.
Government sponsored project t=0 t=1-300 +350
Required return is 10% NPV = -$300 + $350 / 1.1 = $18.18 GOOD PROJECT But … the firm only has $200 now.
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Equity passes, debt passes
• New bondholders contribute the 100 by buying more bonds. They are owed 100 or ¼ of the firm’s debt.
• When the firm gets 350, the new bondholders collect ¼*350 = 87.5. They lose.
• New shareholders contribute the 100:They get 50 / 1.1 - 100 = -54.55
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Summary of failure to contribute
Neither new equity nor new debt will contribute. Markets fail.
Note: old debt would contribute if it could do so in a coordinated manner. There is an externality element.
One purpose of bankruptcy is to coordinate the interests of debt.
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Milking the PropertyLiquidating dividends ...are often illegal …or restricted by bond indenture.Other tactics to siphon money.Perks, compensation to
management.Sweetheart deals with shell
companies
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Optimal Debt and Value
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL=VU+TCB=
V=Actual value of firm
VU=Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
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The final word on capital structure
Miller channels model. Restores MMI with important
differences
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What's been left out so far?
Investor taxes. Supply and demand.
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Financial officers as marketers … or arbitragers.
They package EBIT into either the debt channel or the equity channel,
depending on which has more value.
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Taxes in the debt channel
Only TB, investor tax rate on bond income
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Taxes in the equity channel
TC the corporate tax rate
TS investor tax rate on stock income
Stock income is partially or largely tax shielded: unrealized capital gains net capital gains
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Channels$ of operatingcash flows
TB
TC
TS
1-TB (1-TC)(1-TS)
Corporatetaxes
Personaltaxes
Debtchannel Equity
channel
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Clienteles for the channels
Dependent on tax rates which differ among investors
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Clienteles for the debt channel
1-TB > (1-TC)(1-TS)
Low income investors (Low TB and TS )
Pension funds (TB = TS = 0)
IRA's (low TB, TS, because deferred)
Non profit organizations
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Clienteles for the equity channel
1-TB < (1-TC)(1-TS)
High income investors (high TB, low TS )
Corporations (low TS on dividends)
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Equilibrium of demand
The debt clientele demands debt. The equity clientele demands equity. But at what prices?
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Value asequity
Value asDebt
Operating C.F.’s ofthe whole economy
D of InstitutionsD of ric
h investors
V* = 1/RB V* = 1/RS
as equityasdebt
Miller: Tax-class clienteles
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Meaning of the Miller channels model.
Economy-wide debt-equity ratio is determinate.
For each firm, debt-equity ratio does not affect value.
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Tax reform and leveraged buyouts in the late 1980's
Tax reform of 1986 Raised TC, which favors bonds
Raised TS, which also favors bonds
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Value asequity
Value asdebt
Operating C.F.’s ofthe whole economy
tax reform
increaseddebt
...
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Increase in demand for bonds
Raises economy-wide debt Rewards debt-for-equity swaps and leveraged buyouts.
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Value asequity
Value asdebt
Operating C.F.’s ofthe whole economy
...
tax cut
increasedequity
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Summary
Value is unaffected by leverage,
except when tax laws have changed
or something else affects the demands of clienteles.
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Review item
In a world with corporate taxes, VL=VU+TCB. Why?
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Answer: Present value of tax shield
Debt and other assets are perpetuities. Let rB be the market rate for the bonds.
Interest payments of BrB each year generate a tax shield of TCBrB
Present value of this perpetuity is found by dividing by rB. Result is TCB.
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