1Valuation with Leverage

Lecture 13

Class 12: Summary

The required return on debt is lower than the required return on equity: Debt is senior

Modigliani-Miller (M&M) irrelevance results. Under perfect capital markets:

1. Leverage by itself does not increase firm value1. Leverage (debt financing) increases the risk of equity2. The benefit of debts lower cost is exactly offset by the higher equity cost

of capital (higher equity risk)2. The WACC is unaffected by financing

M&M: the capital structure benchmark M&M: focus on the key source of value Cash flows, cash flows, cash flows!

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2Beyond M&M

Capital structure decisions seem to matter. Evidence: Stock prices react to financing decisions

Increase if firms: increase leverage Decrease if firms: decrease leverage

Corporations spend resources on capital structure design Ex. Investment banking fees

Managers are reluctant to change them: Tell a CFO that debt policy does not matter

M&M does not predict any patterns for capital structure But, capital structure shows lots of patterns

Across time for a given firm: life cycle Across industries: different asset or cash-flow characteristics Across countries: different institutional factors

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4

MM relied on perfect or frictionless capital markets MM: any capital structure is as good as any other!

Thus, capital structure must matter due to some market imperfection that affects cash-flows/value Corporate income taxes Bankruptcy costs Agency costs (incentives) Differences in information Security mispricing

Corporate income taxes: Can leverage be used to reduce the corporate income taxes that

the firm must pay, and thereby increase its value for investors?

Leverage and Taxes

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Interest expenses deducted before tax

The Corporate Income Tax

Income Statement2010 2011 2012 2013 2014

Sales Revenues 4,405 4,669 4,985 5,347 5,747Cost of Goods Sold -2,908 -3,059 -3,240 -3,448 -3,679

SG&A Expenses -705 -747 -797 -856 -920Depreciation -132 -140 -149 -160 -172

Operating Income 660 724 799 883 976Other Income 13 10 15 20 24

EBIT 673 734 814 903 1,000Interest Expense -65 -65 -80 -100 -100

Income Before Tax 608 669 734 803 900Taxes (35%) -213 -234 -257 -281 -315Net Income 395 435 477 522 585

No corresponding deduction for dividends or share repurchases

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Gain from Leverage

With vs. Without Leverage (2014)

What is the benefit? Total income to all investors:

All equity firm = $650 Levered firm = 100 + 585 = $685

Gain from leverage = 685 650 = $35 Tax savings = 350 315 = $35

All Equity Firm Levered Firm

EBIT $1000 $1000

Interest Paid to Debt Holders $0 $100

Pre-Tax Income $1000 $900

Tax at 35% $350 $315

Net Income to Equity $650 $585

$100

$585

Levered Firm

$650

All Equity Firm

$685

(debt)

(equity)

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The Interest Tax Shield

Debt gives the firm an interest tax shield which reduces taxes each year:

Tax reduction = Corporate Tax Rate Interest Payments This tax shield:

Reduces the taxes paid by the firm Increases the net-of tax cash-flows available to both debt and equity Increases the value of the firm:

PV(future interest tax shields) = Tc PV(future interest payments)Tc : corporate tax rate

Value of the Interest Tax Shield

Special and simplest case: Firm increases debt by D permanently: perpetually rolled over Each period, the tax shield is = Tc D rD. Given that D is permanent, the

present value of tax shields is:

Gain from leverage: V(Levered Firm) = V(Unlevered) + Tc D Change in value: V(Levered Firm) = 1 + Tc D

V(Unlevered) V(Unlev) Are these effects meaningful?

If Tc= 35%: for D / V(Unlev)= 20%, firm value increases by about 7% for D / V(Unlev)= 50%, firm value increases by about 17.5%

Bottom line: debt tax shields matter! What happens if a competent CEO does not want to lever up?

8Offer !!!! Do it! or someone will do it for you!Call

DTr

rDTITSPV cD

Dc )(

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Weighted Average Cost of Capital

The After-Tax Cost of Debt Each $1 of interest paid gives the firm a $0.35 tax benefit Net after-tax cost of paying $1 in interest is only $0.65! Effective after-tax interest rate on debt = rD (1 Tc)

Pretax WACC:

WACC with Taxes:

WACC E DE Dr r r

D E D E

(1 )WACC E D CE Dr r r T

D E D E

ur

u C DDr T r

D E

Unchanged by leverage ratio

Decreasing with leverage

u-unlevered

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Weighted Average Cost of Capital

0%

5%

10%

15%

20%

25%

30%

35%

40%

0% 20% 40% 60% 80% 100%% Debt-to-Value Ratio D/(E+D)

Equity Cost of Capital rE

Debt Cost of Capital rD

After-Tax Debt Cost of Capital rD(1c)

WACC with taxes

pretax WACC

611

2/5/2015

For years, RadioShack the retailer that helped bring personal computers to the masses outlasted untold predictions that it would buckle in the face of bigger rivals and online competitors. But its clock has finally run out. RadioShack which listed $1.2 billion in assets and nearly $1.4 billion in total debt could still survive in a much smaller form.

Mexico

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713

Optimal Leverage

Fact: firms dont fully exploit the interest tax shield What is the tradeoff?

Interest/EBIT

0

10

20

30

40

50

60

1975 1980 1985 1990 1995 2000 2005 2010

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Direct and indirect costs of financial distress

If debt tax savings are so large what limits debt use?

Direct bankruptcy costs: Cost of the legal proceedings around reorganization or liquidation Any costs directly related to the event of bankruptcy:

Legal fees Accounting fees Advisory fees

Indirect costs of financial distress: Loss of (or damage to) intangibles, such as brands Difficulty retaining valuable employees Difficulty of maintaining relationships with customers and suppliers Distortions to investment behavior when firm is close to default Distortions to managers incentives when firm is close to default

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Example cost of financial distress: GM

This idea that you just go into Chapter 11 and hang around for three months and agree to reduce your debt obligations and don't pay your retirees, this is a fantasy. Most people will stop buying the cars of a bankrupt company.

Rick Wagoner (Source: Reuters, Nov 16, 2008)

Trade-Off theory of capital structure

Firms trade off tax benefits of debt against bankruptcy and financial distress costs

Optimal leverage ratio is determined by: a. The value and probability of using tax shields, and b. The costs and probability of financial distress

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Characteristic EffectonOptimalLeverageProfitability Positive

Nondebttaxshields(eg.Depreciation) NegativeTangibilityofassets Positive

Volatilityofcashflows NegativeSize Positive

Indirectcostsoffinancialdistress* Negative*Customerconfidence,laborforcemightleave,supplierswon'tship,etc)

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Tradeoff Theory

Optimal leverage balances tax advantages and direct and indirect bankruptcy costs

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Valuation with Leverage

Main methods for valuing a firm or project with leverage

WACC: Weighted Average Cost of Capital Method: this class Cash Flows: Unlevered Free Cash Flow Discount Rate: WACC (after tax) using constant leverage ratio Determines: Enterprise Value

APV: Adjusted Present Value Method (Corporate finance class, etc.) Cash Flows: Unlevered Free Cash Flow

Interest Tax Shield Discount Rates: Unlevered (Asset) Cost of Capital

Tax Shield Cost of Capital Determines: Enterprise Value

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Example: Diptron Incs expansion

A manufacturer of electronic switches is evaluating an expansion: $60 million expansion Expected to increase its FCF by $7.5 m the first year, with 4% growth thereafter Diptrons tax rate is 40% The debt-equity ratio is 1/3 or D/(D+E)=25% The equity cost of capital is 14.33%, and its cost of debt is 5% (pre-tax)

Questions:1. What is the WACC?2. What is the NPV of this project?3. How large are the expected tax savings from using debt financing?

Solution

Unlevered Cost of Capital: Diptrons pre-tax WACC:

NPV without leverage

Tax savings:

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WACC Method: Assumptions

Assumptions: Risk: Expansion has similar risk to the rest of the firm Leverage: Diptron D/E = D/E project today and in the future

How much debt will Diptron use to fund the expansion? Capital structure = 75% equity + 25% debt (market value)

25% $60 million investment = $15 million25% $40 million inc. in mkt value = $10 millionTotal new debt = $25 million

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Adjusted Present Value (APV) Method

Unlevered Cost of Capital: Diptrons pre-tax WACC:

rUnlevered = (E/V) rE + (D/V) rD = 75% 14.3333% + 25% 5.0%= 12%

NPV without leverage

NPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million

Interest Tax Shield

First Year: $25 million 5% 40% = $0.5 million PV(Int Tax Shield) = 0.5/(12% - 4%) = $6.25 million

Adjusted Present Value

APV = NPVU + PV(Int Tax Shield) = 33.75 + 6.25 = $40 million

Increases by 4%/yr

Same risk as project

U-unlevered

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Alternative Leverage Policies

Suppose Diptron will not maintain a fixed D/E ratio Instead Diptron plans to:

Borrow $60 million initially Repay $60 million after 2 years

NPV without leverageNPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million

Interest Tax Shield

APV (at 5%) = 33.75 + 2.23 = $35.98 million

Sum Year1 Year2Interest 3,000 3,000

Interesttaxshield 1,200 1,200PresentvalueITS(at12%) 2,028 1,071 957PresentvalueITS(at5%) 2,231 1,143 1,088

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Valuation Methods in Practice

WACC is the most common method Easiest to apply when the project has a constant target D/E ratio Implicitly assumes that the debt tax savings are as risky as the

projects cash flows Important note:

Many firms calculate a single firm-wide WACC and apply it to all new projects: that is typically wrong!

Only valid if all projects have: (a) same target D/E as the firm and (b) similar business risk

APV is useful if the leverage ratio (D/E) is not constant Easiest to apply when future debt levels are known Easy to use a different (lower) discount rate for the debt tax

savings Easy to adjust for other costs or benefits of debt

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Big picture

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Belgium: Notional Interest Deduction

Since 2006, firms receive a tax deduction based on the book value of equity (deduction=Equity*rD) Level the financing playing field

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Source: Panier, Perez-Gonzalez and Villanueva (2014)

30%

32%

34%

36%

38%

40%

42%

44%

2002 2003 2004 2005 2006 2007 2008 2009

Percentages

Equitytoassetsratio

PreReform PostReform

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Summary

M&M: capital structure affects value if D,E affect cash flows Corporate income taxes: Interest payments are tax-deductible. Debt financing can increase the net-of-tax cash flows and hence value M&M intuition holds

Trade-off theory of capital structure. Firms choose an optimal level of debt financing that balances: 1. The tax benefit of using debt financing (tax-shield) against2. The costs of financial distress (ex. bankruptcy costs)

Valuation methods to capture the effect of debt tax shields on firm value: WACC: discount FCFs using the weighted average of after-tax debt costs and

equity costs Adjusted Present Value (APV). Two steps:

1. Value projects as if 100% equity financed: FCFs & all-equity cost of capital2. Add the present value of the tax shield of debt: using the expected interest

tax shield and the tax shield cost of capital