EMBA in Management & Finance. Corporate Finance. Eric Jondeau

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1 EMBA in Management & Finance Corporate Finance

2 EMBA in Management & Finance Lecture 4: Capital Structure Limits to the Use of Debt

3 Outline 1. Costs of Financial Distress 2. Description of Costs 3. Can Costs of Debt Be Reduced? 4. Integration of Tax Effects and Financial Distress Costs 5. The Pecking-Order Theory 6. Growth and the Debt-Equity Ratio 7. Personal Taxes 8. How Firms Establish Capital Structure 9. Summary and Conclusions EMBA 3/29

4 1. Costs of Financial Distress Bankruptcy risk versus bankruptcy cost. The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the costs associated with bankruptcy. It is the stockholders who bear these costs. EMBA 4/29

5 2. Description of Costs Direct Costs Legal and administrative costs (tend to be a small percentage of firm value). Indirect Costs Impaired ability to conduct business (e.g., lost sales) Agency Costs Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish strategy 3: Milking the property EMBA 5/29

6 Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 $200 Fixed Asset $400 $0 Equity $300 $0 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? The bondholders get $200. The shareholders get nothing. EMBA 6/29

7 Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm s cash). Required return is 50%. Expected CF from the Gamble = $1, $0 = $100 $100 NPV= $200 + = $ EMBA 7/29

8 Selfish Strategy 1: Take Large Risks Expected CF from the Gamble To Bondholders = $ $0 = $30 To Stockholders = ($1000 $300) $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble: PV of Stocks With the Gamble: $30 $20 = 1.5 $70 $47 = 1.5 Selfish Stockholders Accept Negative NPV Project with Large Risks. EMBA 8/29

9 Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project. Required return is 10% Should we accept or reject? $350 NPV= $300 + = $ EMBA 9/29

10 Selfish Strategy 2: Underinvestment Expected CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project: PV of Stocks With the Project: $ $300 = 1.1 $50 $54.55 = $ Selfish Stockholders Forego Positive NPV Project. EMBA 10/29

11 Selfish Strategy 3: Milking the Property Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. Such tactics often violate bond indentures. Increase perquisites to shareholders and/or management EMBA 11/29

12 3. Can Costs of Debt Be Reduced? Protective Covenants Debt Consolidation: If we minimize the number of parties, contracting costs fall. EMBA 12/29

13 Protective Covenants Agreements to protect bondholders Negative covenant: Thou shalt not: Pay dividends beyond specified amount. Sell more senior debt & amount of new debt is limited. Refund existing bond issue with new bonds paying lower interest rate. Buy another company s bonds. Positive covenant: Thou shall: Use proceeds from sale of assets for other assets. Allow redemption in event of merger or spin-off. Maintain good condition of assets. Provide audited financial information. EMBA 13/29

14 4. Integration of Tax Effects and Financial Distress Costs There is a trade-off between the tax advantage of debt and the costs of financial distress. It is difficult to express this with a precise and rigorous formula. EMBA 14/29

15 Integration of Tax Effects and Financial Distress Costs Value of firm (V) Present value of tax shield on debt V L = V U + τ C B Value of firm under MM with corporate taxes and debt Maximum firm value Present value of financial distress costs V = Actual value of firm V U = Value of firm with no debt 0 B * Optimal amount of debt Debt (B) EMBA 15/29

16 The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy lawyers, respectively. V T = S + B + G + L B L S G The essence of the MM intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie. EMBA 16/29

17 5. The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1: Use internal financing first. Rule 2: Issue debt next, equity last. The pecking-order Theory is at odds with the trade-off theory: There is no target D/E ratio. Profitable firms use less debt. Companies like financial flexibility EMBA 17/29

18 6. Growth and the Debt-Equity Ratio Growth implies significant equity financing, even in a world with low bankruptcy costs. Thus, high-growth firms will have lower debt ratios than low-growth firms. Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal. EMBA 18/29

19 7. Personal Taxes: The Miller Model The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: where: (1 τ C )(1 τ S ) VL = VU + 1 B (1 τ B ) τ S = personal tax rate on equity income τ B = personal tax rate on bond income τ C = corporate tax rate EMBA 19/29

20 Personal Taxes: The Miller Model Shareholders in a levered firm receive Bondholders receive ( EBIT r B) (1 τ ) (1 τ ) r B (1 τ ) B C S Total cash flow to all stakeholders: ( EBIT r B) (1 τ ) (1 τ ) + r B (1 τ ) B C S B B B B This can be rewritten as EBIT (1 τ C ) (1 τ S ) + rb B (1 τ B ) 1 (1 τ C ) (1 τ S ) (1 τ B ) EMBA 20/29

21 Personal Taxes: The Miller Model Total cash flow to all stakeholders in the levered firm: EBIT (1 τ C ) (1 τ S ) + rb B (1 τ B ) 1 (1 τ C ) (1 τ S ) (1 τ B ) The first term is the cash flow of an unlevered firm after all taxes. Its value = V U. The value of the sum of these two terms must be V L so that A bond is worth B. It promises to pay r B B (1 τ B ) after taxes. Thus the value of the second term is: (1 τ C ) (1 τ S ) 1 B 1 τ B (1 τc)(1 τs) VL = VU + 1 B (1 τb) EMBA 21/29

22 Personal Taxes: The Miller Model Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: (1 τc )(1 τ S ) VL = VU + 1 B (1 τ B ) In the case where τ B = τ s, we return to MM with only corporate tax: VL = VU +τ CB EMBA 22/29

23 Effect on Financial Leverage on Firm Value with Different Taxes Value of firm (V) (1 τc )(1 τ S ) VL = VU + 1 B (1 τ B ) V L = V U + τ C B when τ S =τ B V L < V U + τ C B when τ S < τ B but (1 τ B ) > (1 τ C ) (1 τ S ) V U V L =V U when (1 τ B ) = (1 τ C ) (1 τ S ) V L < V U when (1 τ B ) < (1 τ C ) (1 τ S ) Debt (B) EMBA 23/29

24 Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Value of firm (V) Maximum firm value Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + τ C B V L < V U + τ C B when τ S < τ B but (1 τ B ) > (1 τ C ) (1 τ S ) V U = Value of firm with no debt V = Actual value of firm Agency Cost of Equity Agency Cost of Debt 0 B* Optimal amount of debt Debt (B) EMBA 24/29

25 8. How Firms Establish Capital Structure Most corporations have low Debt-Asset ratios. Changes in financial leverage affect firm value. Stock price increases with increases in leverage and viceversa; this is consistent with MM with taxes. Another interpretation is that firms signal good news when they lever up. There are differences in capital structure across industries. There is evidence that firms behave as if they had a target Debt to Equity ratio. EMBA 25/29

26 How Firms Establish Capital Structure Capital structure ratios for selected US nonfinancial firms: Debt as % of market value of Equity + Debt (5-year averages) High Leverage Hotel and lodging Building construction Paper Air transport Low Leverage Computers Apparel Drugs Biological products EMBA 26/29

27 Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. EMBA 27/29

28 9. Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of debt. Direct costs Lawyers and accountants fees Indirect Costs Impaired ability to conduct business Incentives to take on risky projects Incentives to underinvest Incentive to milk the property Three techniques to reduce these costs are: Protective covenants Repurchase of debt prior to bankruptcy Consolidation of debt EMBA 28/29

29 Summary and Conclusions Debt-to-equity ratios vary across industries. Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. EMBA 29/29

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