Advanced Corporate
Finance FINA 7330
Capital Structure Issues and Financing Lecture 07 and 08 Fall, 2010
The Theories of Capital Structure
Irrelevance Static Tradeoff
Pecking Order
The Irrelevance Theorem
Perfect Capital Market Setting No Taxes No Contracting Costs Costs of Financial Distress Agency Costs No Information Costs
Irrelevance Theorem
ASSETS PVA PVGO $1,000,000 2,000,000 LIABILITIES DEBT EQUITY TOTAL 0 3,000,000 $3,000,000
TOTAL $3,000,000
Irrelevance Theorem
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000
PVGO
2,000,000
EQUITY 1,400,000
TOTAL $3,000,000
TOTAL $3,000,000
Tax Implications ( tax rate of 30%)
ASSETS PVA PVGO $1,000,000 2,000,000 DEBT
LIABILITIES
- PV of Tax Liability 900,000
EQUITY
2,100,000
TOTAL
$2,100,000
TOTAL
$2,100,000
Tax Implications
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000
PVGO
2,000,000
Less: PV of Tax Liability 420,000
EQUITY
___________
TOTAL
$2,580,000
TOTAL
$2,580,000
Tax Implications
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000
PVGO
2,000,000
Less: PV of Tax Liability 420,000
EQUITY
980,000
TOTAL
$2,580,000
TOTAL
$2,580,000
Stockholders Wealth
Originally: $2,100,000 in Equity Interest Now: 980,000 in Equity Interest $1,600,000 in Cash 2,580,000 Total Stockholders Wealth. Notice that Stockholders wealth increased by an amount equal to the Present Value of the Tax Shield on Debt.
The Static Tradeoff Theory
Benefits versus Costs of Leverage. Benefits Costs Taxes Financial Distress Resolution of Agency Costs Agency Costs Bondholder/Stockholder Manager/Stockholder Bankruptcy Costs Direct and Indirect Information Costs
The Impact of Taxes on the Capital Structure Decisions
Firm Value =
S Operating Cash Flow (t) (1+ro)t
= Market Value of the Firms Liabilities (Including Equity)
Let OCF(t) = Operating Cash Flow at time t
With Taxes
Firm Value for an equity financed firm = S OCF(t) - Tax on operations (1+ro)t
= Market Value of the Firm = Market Value of Equity = V(u) We call this the Value of the Unlevered Stream (Firm), or the Asset Value of the Firm)
Example
Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = Before Tax Operating Cash Flow - Tax Before Tax Operating Cash Flow = (1000-500) = 500 Tax = T*(1000-500-300) .32*200 = 64 Thus V(u) = (500 64)/r = 436/.1 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow
Example
Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = (1000-500) -.32*(1000-500-300) {EBIT(1-t) + Depreciation} = (1000-500-300)*.68 + 300 = 136 + 300 = 436 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow
Leverage Effects
Now suppose the firm issues 2000 worth of perpetual debt, paying interest at 5%. Then interest will be: INT = .05*2000 = $100
Now lets consider the interest deductions
Cash Revenue $1000 Cash Expense 500 Depreciation 300 Interest 100 Tax Rate (t) = 32% CF = (1000-500) -.32*(1000-500-300 -100) = = 500 - 32 = 468 Or: = ATOCF + t*INT = 436 + 32 = 468
Now Discount
CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT ro rB V = V(u) + t*B
Now Discount
CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT ro rB V = V(u) + t*B = 4,360 + .32 * 2,000 = $5,000
Value of Debt and Equity
Value of firm = $5,000 Value of Debt = $2,000 Value of Equity = $3,000 B/V = .4 E/V = .6
With Taxes
In general, V(L) = V(u) Plus Present Value of Tax Shield on Debt. V(L) = V(u) + (Corp. Tax Rate) * Debt, in the special case when debt is thought of as perpetual, or is selling at par.
Graphically
Firm Value (V)
V(u)
Debt
Recall: Cost of Capital In the absence of taxes
rS = ro + (ro-rB)B/S
WACC = ro
rB
Cost of Capital (After Tax)
rE = ro + (ro-rB)(1-t)B/S
rd
Weighted Average Cost of Capital
WACC is the discount rate we use to discount the firms after tax Operating Cash Flow: (ATOCF)
So in the example we just had: WACC = ro(1-T(B/V) ) = 8.72% = rE(E/V) + (1-T)rB(B/V), and rE = .10 + (.10-.05)(1-.32)(.6) = 12.27% WACC = .1227*.6 + .68*.05*.4 = 8.72% = .07362 +.0136 = 8.72%
Firm Value and the Tax Shield on Debt
Notice that the value of the firm is simply the ATOCF discounted by the WACC! The greater is the amount of debt issued, the lower is the WACC, and thus the higher is the value of the firm. By assumption, the ATOCF is unaffected by the firms capital structure.
Static Tradeoff Theorem
Costs of Financial Distress
Potential Bankruptcy Costs Underinvestment Risk Shifting Agency Costs
General Approach
Assume:
No Taxes Single period Cost of Capital = 10%
Perfect Capital Market
Widgets International Good State
Bad State
Pure Equity 11 million 2.2 million Probability of each state is 50% Stockholders Wealth V = $6 million E = $6 million
Bond and Stock Valuation
Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million. What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (rB) is 5% Then the value is B = E{Cash Flows}/1.05
Debt valuation
What is the Yield to Maturity? (YTM) What is the Expected Return?
This will require some work
Perfect Capital Markets
Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%) Widgets International Good State Bad State Expected
Total 11 million Debt 4.2 million Equity 6.8 million Stockholders Wealth V = $6 million B = 3.2/(1.05) = $3.05 E = $6 - $3.05 = $2.95 2.2 million 2.2 million 0 6.6 3.2 3.4
IF The Value of the Firm remains unchanged
Valuation of Equity
If the value of the firm is independent of capital structure, rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:
E = 3.4/1.1517 =
???
Finally What is Stockholders Wealth?
Valuation of Equity
If the value of the firm is independent of capital structure, rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:
E = 3.4/1.1517 =
2.96 (2.95 really, without rounding)
Finally What is Stockholders Wealth?
Debt Valuation
Yield to Maturity Coupon rate Expected (required) return to Bonds
Bankruptcy Costs
Widgets International Good State Bad State
Pure Equity 11 million Probability of each state is 50% Stockholders Wealth V = $6 million E = $6 million 2.2 million
Direct Bankruptcy Costs
Typically amounts to 2% to 5% of the distressed value of the firm Widgets International
Again assume the same leverage of a bond promising to pay 4.4 million
Good State
Total 11 million Bankruptcy cost
Bad (Default)
2.2 million 0.1 million
Net
11 million
2.1 million
Impact of Bankruptcy Costs
Good State
Total 11 million Bankruptcy cost
Bad (Default)
2.2 million 0.1 million
Net 11 million 2.1 million Value 5.95 million Debt 3 million Equity 2.95 million Thus stockholders wealth declines by $50,000 (SHW = 2.95 + 3 = 5.95 not 6) Notice that it is the stockholders that pays the expected bankruptcy costs.
