Modigliani-Miller with only corporate taxes:

Transcription

1 Moigliani-Miller with only corporate taxes: V L V U N tc interest * j j1 1i If there is constant, infinitely-live ebt: V V t D L U c j This means: Share value increases linearly with ebt: Debt an Share Value MM with only corp. tax 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 share price ebt 1 t r( L) ru ( ) ru ( ) r D e c E WACC FCF WACC as D V( L) E Chapter 8 slies page 1

2 Problems: Descriptive what happens when I increase ebt/equity ratio Not normative Maybe MM mae a mistake? NPV ( ebt) ebt N j1 t c * interest N j1 1i ( )* interest j j c ebt j 1i 1i If, on the other han, we iscounte at the after-tax ebt rate: N ( tc)* interest j ebt NPV ( ebt) ebt 1 j j ( t ) i ( t ) i c j c N N Chapter 8 slies page 2

3 However: So if iniviuals are not taxe, then the interest rate i is the correct iscount rate: I.e.: N interesti ebt principal ebt value N j j i i Chapter 8 slies page 3

4 For the future (Miller moel) Suppose interest is taxe at rate t : Then ebt principal N j1 interest 1marginal bonh. IRR marginal bonholer's IRR i ebt principal 1marginal bonh. IRR i j N Chapter 8 slies page 4

5 Other possibilities: Costs of financial istress ( bankruptcy costs ) V V t D PV ( future costs of financial istress) L U c as popularly written: V V t D PV ( Bankruptcy Costs) L U c 6,000 COST OF FINANCIAL DISTRESS a schematic representation 5,000 4,000 3,000 MM without costs of financial istress, V(L) = V(U) + DT MM with costs of financial istress, V(L) = V(U)+DT-PV(BC) 2,000 1,000 0 unlevere value of firm, V(U) 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Optimal ebt level Chapter 8 slies page 5

6 Problem: Where are the bankruptcy costs? Miller: Terminal events of bankruptcy Costly monitoring of covenants Costs of ebt refinancing Costs of business isruption We utifully acknowlege these well-known costs of ebt finance, but we were har put at the time to see how they coul overweigh the tax savings of up to 50 cents per ollar of ebt that our moel implie. Not only i there seem to be potentially large amounts of corporate taxes to be save by converting equity capital to tax-euctible interest ebt capital, but there appeare to be ways of oing so that avoie, or at least rastically reuce, the seconary costs of high-ebt capital structures. Hybri securities, such as income bons uner which euctible interest payments coul be mae in the goo years, but passe or eferre in the ba years without precipitating a technical efault. Source: Merton Miller, The Moigliani-Miller Propositions after Thirty Years, Journal of Economic Perspectives, Fall Chapter 8 slies page 6

7 Option-like costs Line of thought: In levere firm, equity-holers own a put option on the assets. Puts increase in value when the unerlying security gets more risky. Thus: Trae-off between tax-benefits of leverage an increase riskiness of assets Chapter 8 slies page 7

8 Associate line of thought: Debt gives shareholers more negotiating power. Both of these theories (bankruptcy costs/option costs): Clearly true to some extent Har to quantify Har to translate to normative recommenations Difficult to see that they offset the tremenous tax avantage of MM (currently, t c 40%, formerly t c 50%). Chapter 8 slies page 8

9 Miller s Debt an Taxes Moel V L V U j 1 i N t t t interest * j1 c e j where: t c is the corporate tax rate t e is the marginal tax rate on equity earnings of the marginal equity purchaser t is the marginal tax rate on ebt earnings (i.e., interest) of the marginal ebt purchaser Chapter 8 slies page 9

10 Before we o the theory, some examples: Suppose t 40%, t 0%, t 0%. Then c e ( ) ( )*( ) 1( )* 1 t 40% c e c c i.e.:!"!! #. Suppose: t 40%, t 39%, t 36%. Then c e ( ) ( )*( ) ( 139%) ( 140%) *( 136%) c e 22. 6% Suppose: t 40%, t 39%, t 0%. Then c e ( ) ( )*( ) ( 139%) ( 140%) *( 10%) c e 1% Suppose: t 50%, t 70%, t 28%. Then c e ( ) ( )*( ) ( 170%) ( 150%) *( 128%) c e 19% ( DuPont capital structure case ) Question: What s the marginal tax rate of the marginal equity holer on equity earnings? Chapter 8 slies page 10

11 For Valuation Purposes Suppose: t 40%, t 39%, t 10%. Then c e ( ) ( )*( ) 7% c e Is this enough to convince me that capital structure is important given: Uncertainty about iscount rates Uncertainty about terminal values Uncertainty about taxes? Uncertainty about uncertainty? Chapter 8 slies page 11

12 Miller Moel Theory At corporate level: Avantage of corporate ebt is its taxeuctibility. At personal level: Equity income taxe at generally lower rate: capital gains exclusions postponability of taxation: IRAs, etc. tax evasion on iviens (Germany) Debt income taxe at higher rate: more ifficult to avoi/postpone ifferent clienteles from equity hence ifferent marginal tax rates. Chapter 8 slies page 12

13 Net avantage of ebt over equity: c e Discount rate for this net avantage: 1 t (the marginal rate of the marginal purchaser of ebt). i Chapter 8 slies page 13

14 Avantages an isavantages of Miller moel: Avantages: Takes into account more complex taxation arrangements Can explain variety of ebt/equity structures Disavantages: Tax arbitrage not a stanar efficient markets theory requires short-selling constraints Difficult to calculate the appropriate tax rates Chapter 8 slies page 14

15 Are there ebt/equity norms or clustering in inustries as might be suggeste by Moigliani- Miller? Auto Inustry Debt/Equity Ratios 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% Chrysler Daimler- Benz For General Motors Hona Navistar Nissan Paccar Toyota Volvo Debt/Equity Debt/Equity Ratios in Publishing Reaer's Digest Playboy National Eucation Mereith McGraw-Hill Houghton M ifflin Harlan Harcourt General Graphic Inust ries Golen Books Dun & Brastree Donnelley Deluxe Bowne & Co. Banta 0.00% 20.00% 40.00% 60.00% 80.00% % % Chapter 8 slies page 15

16 Hotel & Gaming Debt/Equity Ratios Station Casinos Showboat Rio Hotel & Casino M irage Resorts Marriott Int'l Marcus Corp. MGM Gran La Quinta Jackpot Enterprises Int'l Game Tech. ITT Hilt on Harrah's Circus-Circus Aztar (Ramaa) 0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200% Debt/Equity Ratios for REITs 300% 250% 200% 150% 100% 50% 0% Chapter 8 slies page 16

17 Debt/Equity Ratios in Foo 200% 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Chapter 8 slies page 17

18 Debt/Equity Ratios in Electronics Inustry 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Note: All ata from Value Line, Debt/Equity ratio efine as: Value Line' s reporte " Total Debt" # shares* current share price Chapter 8 slies page 18

19 Debt/Equity--Summary Data 140% 120% 100% 80% 60% average st. ev. 40% 20% 0% Electronics Publishing Toys Foo Processing Hotels&Gaming REIT Auto Chapter 8 slies page 19

20 Miller Moel Infinitely-Live Debt Assumptions: Firm maintains constant ebt level D interest t = i*d Then the Miller formula for V L becomes: V L V U V U V U V U N j j1 1i N 1 1 c1 e j j1 1i 1 1 c1 e i ce t t t * interest c e j t t t ** i D t t t ** i D DV TD U Chapter 8 slies page 20

21 Values of T? These are the cases consiere previously. Recall that: T c e. MM with only corporate taxes: t 40%, t 0%, t 0% T = 0.4. c e Suppose: t 40%, t 39%, t 36%. T = c e Suppose: t 40%, t 39%, t 0%. T = c e Suppose: t 50%, t 70%, t 28%. T = -0.2 c e ( DuPont capital structure case ) Suppose: t 40%, t 39%, t 10%. T = c e Chapter 8 slies page 21

22 Miller s Debt an Taxes : Miller s ultimate claim: REASONING Who invests in equity? For same risk class an expecte return, iniviuals with high personal tax rates. Since t e < t. Who invests in bons? Iniviuals with low personal tax rates (all other things being equal). Denoting by r equity the return on a typical equity security an by r ebt the return on a typical ebt security (same risk, return), in equilibrium, at the margin: 1 1 r t r t r r equity e ebt equity ebt e Chapter 8 slies page 22

23 If T > 0, corporations will issue more ebt to raise value will raise interest i pai on ebt will attract investors to bons who have higher personal tax rates t e an t. This increase in interest i makes ebt relatively more attractive, an it raises the marginal tax rate t in the numerator of T. Looking at the previous expression: 1 t r r equity ebt 1 te stays must increases same ecrease The effect on T: T c e e 1 c t 1 T e ( Note: because from previous formula ) t 1 e In equilibrium (you guesse it!): T = 0. Chapter 8 slies page 23

24 SUPPOSE MILLER IS RIGHT an T = 0 V V T* DV, L U U c e since T 0 WACC = r(u) ( ) ( ) 1 1 r L ru ru T r t e c ru ( ) ru ( ) r c D E D E * notice that the first line is always true, even if T 0. * notice that this formula agrees with the same formula for MM with only t c. WACC is the IRR of the FCFs necessary to give V(U). VU ( ) t1 FCFt 1WACC t 0 Chapter 8 slies page 24

25 Note that in all cases the WACC is the IRR of the FCFs necessary to give V(L): V( L) t1 FCFt 1WACC t 0 Note that none of this is trivial. For example:!"! (We iscuss this an other computational topics in Chapter 9.) Chapter 8 slies page 25

26 MILLER an CAPM Calculating the cost of equity in CAPM, using the Miller moel: equity ebt1 cequity m, equity ebt1 c Er rf t Er rf t equity where Cov return Cov return equity 2 equity, return equity market portfolio, return equity market portfolio ( this is the " regular" ) 2 m, equity equity market portfolio Calculating the cost of ebt in CAPM, using the Miller moel: 1 E r rf E r rf t where ebt ebt ebt ebt m, equity ebt c Cov return ebt, return equity market portfolio equity market portfolio ( note that the ebt beta is calculate with respect to an equity market portfolio) 2 Chapter 8 slies page 26

27 Calculating the WACC in CAPM, using the Miller moel: 1 1 WACC rf t E r rf t where ebt c assets m, equity ebt c E D DE DE assets equity ebt c PROOF OF CAPM Recall that: r equity r ebt 1 t 1 t 1. If Miller is correct an T = 0, then T so that we can write: c e e r r 1 t. equity ebt c 0 c e, Chapter 8 slies page 27

28 2. This means that for a zero asset, E zero equity, r *( ) equity Ezero ebtr, ebt *( ) rfebt ( ) ( ) Ezero equity, requity rf ebt rf ebt c Thus the intercept for the SMLs is: 3. Write the equity SML as: ebt SML intercept rf ebt equity SML intercept rf e ebt equity ebt c equity m Er rf Er? Since the expecte return of an asset with equity = 1 must be E(r m ), it follows that? = rf ebt (1-t c ). 4. From the principle that r r t 1, take E(r equity ebt c ebt ) as it woul be calculate by the equity SML an ivie by (1-t c ): Er ebt 1 1 c Covr, r ebt c m, equity rf t E r rf t rf ebt c ebt m ebt c ebt c Var rm, equity Cov r, r ebt m, equity rf Er rf t ebt Var r m, equity c e 1 m ebt c c 1 Er rf t m ebt c Chapter 8 slies page 28