CORPORATION FINANCE I
CORPORATION FINANCE I FIN 3322
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Date Created: 10/22/15
Chapter 18 How much should a rm borrow Read 181 quickly skim 182 read 183 read 184 In Chapter 17 we learned that with a certain set of unrealistic assumptions a firm39s value and investors39 opportunities are determined by the asset side of the firm39s balance sheet ie the firm s capital budgeting decisions and not by the particular mix of securities that a firm uses to finance those assets ie the firm s capital structure decision This chapter discusses how real world assumptions change these conclusions Preview we will conclude contrary to Chapter 13 and 17 that firms should not view all financing choices as equivalent 1 Interest rates Transaction Costs review of the discussion toward the end of Chapter 17 The assumptions outlined at the beginning of Chapter 17 specifically assume that investors have the same opportunities to borrow and lend money that fir39m39s have and can do so at the same interest rate These assumptions also state that there are no transaction costs associated with executing arbitrage transactions However corporations can often borrow money at a lower interest rate than individuals and transaction costs are not zero This might allow two firms with the exact same assets managed in exactly the same way to have different market values if they have different capital structures The text argues that even with this capital market imperfection firm value should not be affected by capital structure choice for example see pages 459 7 461 and in particular the last two paragraphs in section 173 The reasoning is simple For example assume that a firm can increase its value over and above the value of another firm with the exact same assets managed in exactly the same way by issuing debt and buying back some of its stock Although it may have been beneficial for the first set of firms to issue debt the demand among investors for these highlylevered firms will quickly be satisfied as other firms also try to take advantage of this opportunity Once demand is satisfied additional firms cannot increase their value by issuing more debt The same reasoning would apply to issuing other more exotic securities 2 Corporate Income Taxes Cash Flow Effects ModiglianiMiller 1963 In the US corporations are subject to a corporate income tax Interest payments to bondholders are tax deductible but dividend or capital gain payments to stockholders are not tax deductible Therefore the corporation can lower its corporate income tax liability by using debt financing rather than equity financing This gives a cash flow advantage to debt financing Example Firm U has assets that produce cash flows of 225 45 or 30 per year in perpetuity 13 chance of each cash flow Thus the expected cash flow from Firm US assets is 100 per year in perpetuity Assume that there is no difference between Firm U s cash flow and its taxable income Therefore since Firm U has no debt and no interest payments its taxable income is expected to be 100 per year With a corporate income tax rate of 34 Te 34 the income tax liability is expected to be 34 per year and the aftertax cash flow per year available to stockholders is expected to be 100 34 66 Summary for Firm U Optimistic Middle Pessimistic Expected Total cash flow from assets Bondholders interest Taxable income Government taxes 39 39 dividends Firm L has the exact same assets as Firm U managed in exactly the same way but has 600 of perpetual permanent riskfree debt with a 5 interest rate 30 interest payment per year What does it mean to have perpetual permanent debt of 600 On average Firm L will have 100 30 70 of taxable income per year This means that it expects to pay only 2380 of income tax per year and the yearly expected aftertax cash flow to its stockholders 4620 Summary for Firm L Optimistic Middle Pessimistic Expected Total cash flow from assets Bondholders interest Taxable income Government taxes 39 39 39 39 dividends Summary of Expected Cash Flows Firm U Firm L Bondholders Stockholders Government Total Both firms distribute the entire 100 expected cash flow generated by the assets However Firm L provides more cash flow to its owners bondholders and stockholders and less money to the government This additional expected cash flow 30 4620 66 1020 is equal to the extra cash flow generated by the reduction of income taxes the difference between 34 and 2380 The following is the formula for calculating the expected cash flows for Firm L CFL CFU tax shield cash flows CFU GDrDTc 3 Corporate Income Taxes Valuation Effects ModiglianiMller 1963 Use all of the Chapter 17 assumptions except now assume that there is a corporate income tax with a deduction for interest payments This reduction of tax liability through the use of debt financing will result in an increase in firm value Therefore if two firms have the exact same assets managed in exactly the same way but one firm uses no debt financing and the other firm uses some debt financing the levered firm will be more valuable Example The value ofFii39m U using a 10 discount rate see Chapter 17 notes is 66 010 660 The decrease in value from 1000 Chapter 17 to 660 is caused by the corporate income tax liability Therefore any reduction of the corporate income tax liability should increase firm value Logically if the corporate tax liability could be reduced to zero in all possible states then the firm value should be restored to 1000 Firm L has the same exact assets as Firm U managed in the same way that Firm U manages its assets These assets produce the same expected cash flows as Firm U with the same risk plus an extra 1020 CDrDTc Therefore VL VU PV of a perpetuity of cash flows expected to be equal to DrDTc Assuming the corporate income tax rate for the firm will remain at 34 forever this additional cash flow is just as risky as the firm39s debt VL VU 03rnTc rD VL VU CDXTc VL Where does the increase in rm value come from The 204 increase in value from 660 to 864 represents a subsidy from the government for using a particular type of financing Government subsidy if equity financing used 0 Government subsidy if debt financing used CDTc Implication of this equation Each dollar of debt increases firm value by 1Tc Theoretically firms should increase the amount of debt to the point that the expected tax liability per year is reduced to zero In the example given above this could potentially increase the firm value to 1000 the Chapter 17 value Another implication The NPV of debt financing is no longer equal to the NPV of equity financing If debt financing is used to finance a project instead of equity financing the government will provide a subsidy to the firm that increases firm value Comment about tax law Tax law might prevent a firm from totally eliminating corporate income tax liability through the use of debt One nal point In the above discussion we assume that the firm will always maintain a fixed amount of debt 600 in the above example that the firm can always fully use the tax deduction from the interest payments e g they have at least 30 of income that can be sheltered by the 30 of interest expense and that the marginal income tax rate always stays at the same rate 34 in the above example Changes to these assumptions change the conclusions For example the tax benefit will be lower if the firm s marginal income tax rate ie tax bracket was lower In the extreme a firm with large tax deductions from other sources e g large depreciation deductions may not see any tax benefit from debt if these tax deductions reduce current and future taxable income to zero Conclusion 7 Firm U should issue debt using the proceeds of the debt issue to repurchase stock or use the proceeds to pay a dividend to the stockholders The reduction in tax liability will increase firm value and increase the wealth of stockholders VU EU 660 VL DL EL 600 264 864 Total wealth of stockholders in Firm L 264 stock value 600 cash 864 4 Personal Income Taxes Miller 1977 DeAngelo and Masulis 1980 Even though there is a corporate tax advantage to debt there a personal tax disadvantage Individuals pay a higher tax on income earned from bond ownership interest income than from stock ownership dividends and capital gains Capital gains on stocks held for a long period of time are taxed at relatively low rates a maximum of 15 and are only taxed when the stock is sold There has recently been a decrease in the personal tax rate on dividends The top tax rate on dividend income is now also 15 This is a further benefit to individuals who purchase equity instead of debt Therefore there is a personal tax disadvantage to debt financing that can offset a portion of the corporate tax advantage to debt Thus the tax advantage to debt is probably less than CDTc So it is likely that VL gt VU VL lt VU CDXTc This very complicated subject discussed in detail in section 182 of the text will not be discussed further For the rest of the notes we will ignore the personal tax disadvantage of debt But in the real world firms need to take this into account when making capital structure decisions 5 Bankruptcy and agency costs are two additional disadvantages to debt financing that work to further offset the corporate tax advantage to debt A Bankruptcy Costs high debt levels imply a high probability of bankruptcy This means a high probability of incurring bankruptcy costs In bankruptcy the ownership and control of the firm is transferred from stockholders to bondholders Bankruptcy costs include the direct costs of transferring this ownership and control as well as indirect costs The combination of direct and indirect costs can be substantial Direct costs Lawyers39 fees accountants39 fees trustee39s fees court fees administrative expenses etc As noted in the textbook Eastern Airlines spent 1 14 million in professions fees with their bankruptcy A total of 514 million has already been spent on the Enron bankruptcy as of November 2003 and it s expected that the direct bankruptcy costs will top 1 billion See httpwwwcbccastories20031114enron 031114 for a more indepth description The above article points out that there are three dozen law firms and several consulting and accounting firms working on the Enron bankruptcy Indirect costs Managements time spent on the bankruptcy lost revenues inefficient investment strategies losing your best employees to your competitors etc Indirect costs can be much larger than direct costs An increase in debt financing will probably mean lower income tax liabilities but will also mean a higher probability of bankruptcy Thus the PV of the expected tax benefits needs to be offset with the PV of the expected bankruptcy costs PV Expected Bankruptcy Costs PV Probability of Bankruptcy x Estimated Bankruptcy Costs B Agency Costs Jensen and Meckling 1976 Managers of firms with a lot of debt sometimes quotplay gamesquot that reduce firm value creating quotdebt agency costs Allequity firms do not have debt agency costs Firms can reduce their debt agency costs by reducing the amount of debt The book describes the types of valuereducing games that managers can play and the impact of these games on firm in pages 481486 One of the value reducing games described in the book is Cash in and run on page 484 MV of Assets 20 assets each with a PV of 5 100 MV of Liabilities owe 150 99 MV of Equity 1 Why is the market value ofthe debt 99 if the firm owes 150 What would happen if the firm sold one of its assets for 4 and paid this as a cash dividend to stockholders MV of Assets 95 MV of Liabilities owe 150 MV of Equity What are the costs of this game Negative NPV of abandonment Bad reputation making it harder to borrow money at a reasonable interest in the future Monitoring expenses in the attempt by bondholders to prevent these games Why wouldn t stockholders do this game with less debt For example what if the firm had no debt 6 The tradeoff theory 0 l V The tradeoff theory of capital structure states that a firm will weigh the tax advantage to debt against the costs of debt bankruptcy and agency costs VL VU GDTC PV Expected Bankruptcy Costs PV Expected Agency Costs Note 7 this formula continues to ignore the personal tax disadvantage to debt Taking into account the personal tax disadvantage to debt will further reduce the value of Firm Graphically Generalizations 7 Under the tradeoff theory first will evaluate two factors 1 High bankruptcy or agency costs will induce firms to have less debt For some types of firms or industries bankruptcy and debt agency costs for a given level of debt are relatively low For others these costs are high Firms with higher bankruptcy and debt agency costs will probably want to have less debt thereby reducing the chances of incurring these costs See pages 487490 of the text Here Brealey Myers and Allen argue that bankruptcy and debt agency costs are relatively low for real estate firms and high for hightech firms This could explain why real estate firms have a lot of debt and hightech firms have very little debt N V Highly profitable firms will have more debt and firms with low profits will have less debt Here the theory starts to break down Highly profitable firms often have little debt and vice versa It doesn t seem likely that bankruptcy and agency costs could be so high so as to cause an extremely profitable firm to have little debt or so low to cause a lowprofit firm to have little debt The PeckingOrder Theory Akerlof 1970 Myers 1984 Myers and Majluf 1984 provides an alternative theory of capital structure If managers and investors use the same information then capital structure decisions should be based on factors such as tax liability corporate and personal bankruptcy costs and agency costs However consider a situation in which management have superior information about the true value of the firm s securities and can use this superior information to decide which type of security to issue to finance a project For instance what happens if the firm can issue either riskfree debt always correctly valued by investors or equity which could be under or overvalued by investors Assume a firm needs to raise 60 to finance a project Case A 50 chance Stock overvalued by 20 insiders know it is worth 40 outsiders think it is worth 60 Case B 50 chance Stock undervalued by 20 insiders know it is worth 80 outsiders think it is worth 60 At these prices management can benefit existing stockholders Issuing stock in Case 7 Issuing debt which is always correctly valued in Case 7 Outside investors initially don t know whether the stock is under or overvalued However an announcement of a stock issue immediately indicates Case Therefore the issue price for the stock is Is there an advantage to a stock issue at this price Under this line of reasoning investors will suspect that any attempt to issue stock instead of correctlyvalued debt is an attempt to issue overvalued stock and they will reduce the amount they are willing to pay for the stock accordingly If managers are still willing to issue stock at this lower price it must still be overvalued resulting in a further lowering in stock price 7 see footnote 31 page 491 Thus stock issues should be rare at least for firms that could issue debt and announcements of stock issues should result in a stock price decrease The peckingorder theory fits this story and hence outlines the order of financing sources that firms would use to finance projects in light of the fact that investors incorrectly price securities According to the peckingorder theory I Firms have a preference for internal cash With internal cash a firm does not need to issue a new security to finance a project They can instead use the cash Therefore the problem of undervaluation or overvaluation does not present itself I Dividends tend to be sticky That is they don t change much from yeartoyear Because of this firms adapt their dividend payout policy to match their investment opportunities at least in the longrun Thus firms with a lot of investment opportunities will pay lower dividends while firms with fewer investment opportunities can pay out higher dividends Since investment opportunities don t occur at an even rate sometimes the firm will have money left over after making investments in projects and paying dividends Other times they will have a shortfall When they have excess cash they will store it in marketable securities eg Treasury Bills Therefore the firm would sell these securities to raise the cash to finance projects in future years when there is a shortfall Instead of storing excess cash in marketable securities another possibility is to pay off debt when you have excess cash This enables you to reborrow if you need the cash in the future I If the firm needs to raise funds by issuing a new security to outside investors ie they have used up all of their storedup cash they will first issue the securities that are least likely to be incorrectly priced ie least likely to be undervalued or overvalued before they issue other securities Therefore they will issue riskfree debt first then riskydebt then convertible debt and finally common stoc The pecking order theory explains why profitable firms have little debt 7 they have a lot of internally generated cash to finance projects It also explains why less profitable firms have a lot of debt 7 they don t have much internally generated cash and therefore use the next best choice on the pecking order 7 debt A word of caution The peckingorder theory implies that firms will try to build up financial slack eg cash marketable securities borrowing capacity etc to use to fund future projects However managers might be tempted to waste this cash on perks that do not enhance firm value Selected quiz questions from Chapter 18 of the textbook 181c 182 185 186 187a 188 189 1810 Chapter 18 Review Questions 7 You only need to know the basics of quottransaction costs and quotpersonal taxesquot explanations for capital structure the first and fourth points discussed in the Chapter 18 notes 1 Assuming interest payments are deductible by corporations be able to calculate cash flows paid to bondholders and stockholders at various levels of debt What is the market value of the corporation at these various levels of debt If interest payments are deductible by a corporation what type of capital structure will a corporation use 2 What are some examples of bankruptcy costs What is the difference between direct and indirect bankruptcy costs How is the probability of bankruptcy in uenced by the amount of debt in the firm Remember that high amounts of debt could also result in high debt agency costs What types of firms have high or low bankruptcy andor debt agency costs What type of capital structure should a firm want to have if it has high or low bankruptcy and debt agency costs How does firm profitability affect a firm s capital structure decision under the tradeoff theory Be able to graphically solve for the optimal capital structure using the tradeoff model 9 Assume that managers have more precise information about firm value than outside investors According to the quotpeckingorder theory which financing sources will they use first second third and last to finance a project Why Why is common stock used only as a last resort Why is a firm39s dividend policy an important part of the pecking order theory What is financial slack Why is it valuable to store up financial slack What are the problems of storing up financial slack O hapter 18 Practice Problems i Refer back to the Chapter 17 practice problems In those problems we worked with ABC Inc and XYZ Inc Here are the assumptions we used The assets of ABC Inc produce a perpetual stream of 150 expected cash flows The beta of these cash flows is 56 With a riskfree interest rate of 5 and a marketrisk premium of 84 the appropriate discount rate for these cash flows using the CAPM is 12 This implies that the assets of ABC Inc are worth 1250 Since ABC Inc is all equity then the beta for the equity is also 56 the required rate of return for the equity is 12 and the market value of the equity is 1250 XYZ Inc has the exact same assets as ABC Inc managed in exactly the same way as ABC Inc manages its assets However XYZ Inc has 900 of perpetual permanent default riskfree debt 5 interest rate and stock with a current market value of 350 Both companies have a 100 dividend payout ratio Now continue to use the Chapter 17 assumptions and assume the financial markets are in equilibrium however assume that corporate interest payments are tax deductible and that both corporations are in the 34 tax bracket I What are the total expected cash flows to the owners ofthe two firms ABC Inc 150 1 034 99 Bonc zolders ofXYZ expect to receive 45 stockholders ofXYZInc expect to receive 150 451 034 6930 Total expectedpayments to owners ofXYZ 11430 What are the income tax payments for the two firms ABC Inc 51 XYZInc 35 70 What is the market value of ABC Inc stock using a 12 required rate of return 825 What is the market value ofXYZ Inc stock and debt Stock 231 Debt 900 Total 1131 Assume that XYZ Inc wants to issue more debt and plans to pay the proceeds of the debt issue to their stockholders as a dividend Ignoring bankruptcy costs and other costs of debt what is the maximum value of XYZ Inc if it can totally eliminate their income tax liability in all future years through the interest expense deduction 1250
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