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Corporate Finance
Lecture 17
INTRODUCTION TO CAPITAL STRUCTURE (continued)
Ronald F. Singer
FINA 4330
Fall, 2010
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 $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
• LIABILITIES
DEBT 0
EQUITY 3,000,000
TOTAL $3,000,000
Irrelevance TheoremASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 1,600,000
EQUITY 1,400,000
TOTAL $3,000,000
The Static Tradeoff Theory
• Benefits versus Costs of Leverage. • Benefits Costs Taxes Financial Distress Resolution of Agency Costs
Agency Costs Bondholder/StockholderManager/Stockholder
Bankruptcy CostsDirect and Indirect
Information Costs
Tax Implications
ASSETS
PVA $1,000,000
PVGO 2,000,000
- PV of Tax Liability 900,000
TOTAL $2,100,000
LIABILITIES
DEBT 0
EQUITY 2,100,000
TOTAL $2,100,000
Tax Implications (Suppose T = 30%)
ASSETS
PVA $1,000,000
PVGO 2,000,000
Less: PV of Tax Liability 420,0000
TOTAL $2,580,000
LIABILITIES
DEBT 1,600,000
EQUITY 980,000
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 increased by
480,000 = the reduction of taxes.
Firm Value Assuming Perfect Capital Markets except for Taxes
• Notice what happens, the (after tax) FCF increases due to the tax benefit from the interest deduction on debt. In particular,
FCF = Before Tax FCF – Tax
Tax = T (Earnings) = T (Rev-Exp-Interest)
= (Rev-Exp)(T) – (Int)(T)
So FCF = FCF(1-T) + Interest(T)
The Tax Benefit
• So we can divide the After Tax Free Cash Flow into two separate Cash Flows:
• Cash Flow from operations FCF*(1-T) = The Free Cash Flow (after Tax)
that would be generated if there were no debt in the capital structure
Interest*(T) = The reduction of tax due to the Tax shield on interest.
Example
• Suppose that the firm’s cash flows looked as follows:– Revenue $20 million– Cash Expense $10 million – Interest $2 million – Depreciation $3 million – Change in WC 0
Calculation of Unlevered Cash Flow
1. That is, how much (after tax) would be generated if there were no interest payments
2. “Net Operating Income” (NOI)= (Rev-Cash Expense – Depreciation)
= $7 millionTax @ 30 % = $2.1 millionAfter Tax Operating Cash Flow
NOI – Tax + Depreciation $7 - 2.1 + 3 = 7.9 Million
The Interest Tax Shield
• Notice we can find the amount of the tax shield by considering how much tax saving there is for each dollar of interest. In particular The Tax Shield = T * Interest = (.3) * 2 million
= 0.6 million
PV of Cash Flow:
• V = (Y)(1-T) + T (Interest) (1+ro)t (1+rB) t
= V(u) + PV of Tax Shield
With Taxes
V = V(u) Plus Present Value of Tax Shield on Debt.
V= V(u) + (Corp. Tax Rate) * Debt
In the special case when debt is thought of as perpetual.
Graphically
Firm Value (V)
V = V(u) + Tc*B
V(u)
Debt
Cost of Capital
WACC = ro
rs = ro + (ro -rB)B/S
rB
Cost of Capital (After Tax)
WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V)
rs = ro + (ro-rB)(1-T)B/S
rB
The two ways of representing firm value
V = V (u) + T * B
V = Y(1-T) (1+WACC)t
Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)
Static Tradeoff Theorem
• Costs of Financial Distress (“Contracting Costs”)– Potential Bankruptcy Costs– Underinvestment – Risk Shifting – Agency Costs
• Assume:• Not Taxes• Risk neutrality• Single period• Interest rate = 0%
Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment
ASSETS
PVA $1,000,000 (Cash = 600,000) (Real Assets = 400,000)PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment Make a Div Payment rather than
investASSETS
PVA $400,000
(Real Assets = 400,000)PVGO 2,000,000
TOTAL $2,400,000
LIABILITIES
DEBT 2,250,000
EQUITY 1 50,000
TOTAL $2,400,000
Risk Shifting
• Suppose the firm has value that will look like the following:
»Value in Good State = $4,500,000»Value in Bad State = 1,500,000»With equal probability »Promised payment to the Bondholder: $3,500,000
What is the value of the equity and the debt?
Investment Opportunity
• Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are:
$5,000,000 in good state
500,000 in bad state:
What is the NPV of the project, value of the debt and value of the equity?
Costs of Financial Distress
V = V(u) + PV of Tax Shield
Firm Value
Debt LevelOptimal Debt Level
Pecking Order Hypothesis
• Costly Information
• Conclusion – Firm has an ordering under which they will
Finance• First, use internal funds• Next least risky security
Intuition
• Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it?
• Now suppose you believe the firm is overvalued
Pecking Order theory
• So you have a dominating way of getting capital – Internal Financing – Risk free debt– Risky debt– Equity
In general, the more “debt like” a security is, the more you want to issue it.
So the announcement effect
• If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm.
• Therefore the firm will never issue equity if it can avoid it.
• Thus pecking order.
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