corporate finance lecture 17 introduction to capital structure (continued) ronald f. singer
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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. ASSETS - PowerPoint PPT PresentationTRANSCRIPT
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.