FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy

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1 FIN 413 Corporate Finance Capital Structure, Taxes, and Bankruptcy Evgeny Lyandres Fall

2 Relaxing the M-M Assumptions E D T Interest payments to bondholders are deductible for tax purposes while payments to equityholders are not. V (levered firm) = V(unlevered firm) + PV(tax shields) 2

3 3

4 Consider the following income statements Income Statements Firm U Firm L EBIT $1000 $1000 Interest payments at 8% $0 $80 Pretax income $1000 $920 Taxes $340 $312.8 Net shareholders income $660 $607.2 Total net income $660 $687.2 Interest tax shield $0 $27.2 4

5 The tax bill of L is $T C r D D less than that of U This is the tax shield provided by the debt of L The value of this tax shield is PV tax shield = Tax rate * Return on Debt * Amount borrowed Return on Debt We thus have: V L = V U + T C D or V(levered firm) = V(unlevered firm) + PV(tax shields) 5

6 According to this analysis, all firms should be 100% debt-financed Two reasons can explain the difference between empirical evidence and this argument - personal taxes - bankruptcy costs 6

7 Taxes and Bankruptcy Costs D E T Bankruptcy Costs V (levered firm) = The optimal capital structure balances the gains from lower taxes with the increased expected costs of bankruptcy. 7

8 U.S. bankruptcy code Chapter 7 bankruptcy - Absolute priority Chapter 11 bankruptcy - Debtholders and equityholders get new claims instead of the old ones - Reorganization plan 8

9 Costs of bankruptcy Direct costs - Management time - Legal expenses and advisors fees - Court costs Indirect costs - Conflicts of interests between equityholders and debtholders (agency problems) 9

10 Trade-off between tax shield and cost of financial distress Market Value PV Tax Shields PV of costs of financial distress Value if all equity financed Debt Ratio Optimal Debt Ratio Value of the firm = Value of all equity financed + PV tax shield - PV costs of financial distress 10

11 Bankruptcy Costs Jerry Warner examined bankruptcies of 11 railroads to estimate the costs of bankruptcy The bankruptcy proceedings typical lasted many years. The average was 13 years, and the longest was 23 years On average, these firms spent approximately $2M on the bankruptcy proceedings 11

12 Bankruptcy Costs Several academic studies have examined the direct costs of bankruptcy: BC = T t= 0 BC V 0 BC V 5 BC t = $2M = 5.3% = 1.4% BC E( ) V 5 is even lower 12

13 Taxes and bankruptcy Costs Merton Miller - A case of horse and rabbit s stew - Analysis so far ignores personal taxes and the effect of the equilibrium in the bond market 13

14 Miller's Debt and Taxes Both corporations and individuals pay taxes. When corporations pay interest on debt, they reduce their own taxes, but increase the taxes of individuals. Ultimately, the corporation must bear all of the taxes associated with its activities either directly, or indirectly through higher required rates of return on the securities that it issues. 14

15 Miller's Debt and Taxes D E T Personal Taxes Increase the amount of debt in the capital structure until the marginal corporate tax saving is equal to the marginal personal tax cost. 15

16 The Tax Advantage of Debt Financing After-tax cash flow from $1 of interest After-tax cash flow from $1 of equity income (1-Tb) (1-Tc) (1-Te) Net savings from $1 of interest: T* = (1-Tb) - (1-Tc) (1-Te) 16

17 17

18 Return on debt 10% After-corporate tax return on riskless equity 8% Investor A B Tax rate on equity 20% 20% Marginal tax rate on income 40% 20% Net return on equity 6.4% 6.4% Net return on debt 6% 8% 18

19 DeAngelo and Masulis Debt and Taxes As corporations increase their debt, they reduce the probability that they will pay the highest marginal tax rate and be able to fully utilize all tax credits and deductions. Default Zero taxes, deductions not fully utilized Positive taxes, tax credits not fully utilized Taxes paid at the highest marginal rate Income 19

20 DeAngelo and Masulis Debt and Taxes Comparative statics for optimal leverage Non-interest tax shields Bankruptcy costs Corporate marginal tax rate Personal marginal tax rate 20

21 DeAngelo and Masulis Debt and Taxes Holding other things constant, the logic of the model is sound, and provides useful information However, large industrial firms typically have many non-interest deductions (depreciation), large tax credit (investment tax credit), and also high leverage What s wrong with DeAngelo/ Masulis story? 21

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