How Much Should a Firm Borrow. Effect of tax shields. Capital Structure Theory. Capital Structure & Corporate Taxes

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1 How Much Should a Fim Boow Chapte 19 Capital Stuctue & Copoate Taxes Financial Risk - Risk to shaeholdes esulting fom the use of debt. Financial Leveage - Incease in the vaiability of shaeholde etuns that comes fom the use of debt. Inteest Tax Shield- Tax savings esulting fom deductibility of inteest payments. Effect of tax shields A fim boows 8%. If they ae in the 35% tax backet, they can save: 1,000(.08) = $80 (.35) = $28 a yea in taxes (ove a fim with no debt). The pesent value of this: 28 PV (tax shield) = = $ Inteest payment = etun on debt X amount boowed = copoate tax ate X inteest payment PV (tax shield) = expected etun on debt TC ( ) = = TC Asymmetic Infomation and Signaling Manages know the fim s futue pospects bette than investos. Manages would not issue additional equity if they thought the cuent stock pice was less than the tue value of the stock (given thei inside infomation). Hence, investos often peceive an additional issuance of stock as a negative signal, and the stock pice falls. Capital Stuctue Theoy MM theoy Zeo taxes (chapte 18) Copoate taxes Copoate and pesonal taxes Tade-off theoy Pecking ode 1

2 MM Result: Copoate Taxes MM show that the total CF to Fim L s investos is equal to the total CF to Fim U s investo plus an additional amount due to inteest deductibility. MM then show that: V L = V U + T Value of fim = value if all equity-financed + T c If T=40%, then evey dolla of debt adds 40 cents of exta value to fim. MM elationship. between value and debt when copoate taxes ae consideed. Value of Fim, V 0 T V L V U ebt Unde MM with copoate taxes, the fim s value inceases continuously as moe and moe debt is used. MM elationship between capital costs and leveage when copoate taxes ae consideed. Cost of Capital (%) WACC d (1 - T) ebt/value Ratio (%) s Mille s Theoy: Copoate and Pesonal Taxes Pesonal taxes lessen the advantage of copoate debt: Copoate taxes favo debt financing since copoations can deduct inteest expenses. Pesonal taxes favo equity financing, since no gain is epoted until stock is sold, and long-tem gains ae taxed at a lowe ate. C.S. & Taxes (Pesonal & Cop) [When pesonal taxes ae intoduced the fim should ty and educe all taxes pesonal and copoate] Relative Advantage Fomula ( ebt vs Equity ) RAF > 1 RAF < 1 1-Tp (1-TpE) (1-Tc) Advantage ebt Equity Conclusions with Pesonal Taxes Use of debt financing emains advantageous, but benefits ae less than unde only copoate taxes. Fims should still use 100% debt. Note: Howeve, Mille agued that in equilibium, the tax ates of maginal investos would adjust until thee was no advantage to debt. 2

3 SO??? Why don t fims use 100% debt??? Capital Stuctue Stuctue of Bond Yield Rates Bond Yield E WACC w/o taxes (taditional view) Financial istess Includes Bankuptcy Risk E Costs of Financial istess - Costs aising fom bankuptcy o distoted business decisions befoe bankuptcy. WACC Maket Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial istess V Maket Value of The Fim Financial istess Maximum value of fim Value of unleveed fim PV of inteest tax shields ebt Optimal amount of debt Costs of financial distess Value of leveed fim Tade-off Theoy Tade-off Theoy - Theoy that capital stuctue is based on a tade-off between tax savings and distess costs of debt. MM theoy ignoes bankuptcy (financial distess) costs, which incease as moe leveage is used. At low leveage levels, tax benefits outweigh bankuptcy costs. At high levels, bankuptcy costs outweigh tax benefits. An optimal capital stuctue exists that balances these costs and benefits. 3

4 Tade Off Theoy & Pices 1. Stock-fo-debt Stock pice exchange offes falls ebt-fo-stock exchange offes Stock pice ises 2. Issuing common stock dives down stock pices; epuchase inceases stock pices. 3. Issuing staight debt has a small negative impact. Pecking Ode Theoy Pecking Ode Theoy - Theoy stating that fims pefe to issue debt athe than equity if intenal finance is insufficient. Fims use intenally geneated funds fist, because thee ae no flotation costs o negative signals. MM assumed that investos and manages have the same infomation. But, manages often have bette infomation. Thus, they would: Sell stock if stock is ovevalued. Sell bonds if stock is undevalued. Investos undestand this, so view new stock sales as a negative signal. If moe funds ae needed, fims then issue debt because it has lowe flotation costs than equity and not negative signals. If moe funds ae needed, fims then issue equity. Implications of Pecking Ode Theoy Some Implications: Intenal equity may be bette than extenal equity. Financial slack is valuable. If extenal capital is equied, debt is bette. (Thee is less oom fo diffeence in opinions about what debt is woth). ebt Financing and Agency Costs One agency poblem is that manages can use copoate funds fo non-value maximizing puposes. The use of financial leveage: Bonds fee cash flow. Foces discipline on manages to avoid peks and non-value adding acquisitions. A second agency poblem is the potential fo undeinvestment. ebt inceases isk of financial distess. Theefoe, manages may avoid isky pojects even if they have positive NPVs. Empiical Evidence Tax benefits ae impotant $1 debt adds about $0.10 to value. Suppots Mille model with pesonal taxes. Bankuptcies ae costly costs can be up to 10% to 20% of fim value. Afte big stock pice un ups, debt atio falls, but fims tend to issue equity instead of debt. Inconsistent with tade-off model. Inconsistent with pecking ode. Many fims, especially those with gowth options and asymmetic infomation poblems, tend to maintain excess boowing capacity. Implications fo Manages Avoid financial distess costs by maintaining excess boowing capacity, especially if the fim has: Volatile sales High opeating leveage Many potential investment oppotunities If manage has asymmetic infomation egading fim s futue pospects, then avoid issuing equity if actual pospects ae bette than the maket peceives. Always conside the impact of capital stuctue choices on lendes and ating agencies attitudes 4

5 What does capital stuctue theoy pescibe fo copoate manages? MM, No Taxes: Capital stuctue is ielevant--no impact on value o WACC. MM, Copoate Taxes: Value inceases, so fims should use (almost) 100% debt financing. Mille, Pesonal Taxes: Value inceases, but less than unde MM, so again fims should use (almost) 100% debt financing. o fims follow the ecommendations of capital stuctue theoy? Fims don t follow MM/Mille to 100% debt. ebt atios aveage about 40%. Howeve, debt atios did incease afte MM. Many think debt atios wee too low, and MM led to changes in financial policies. 5