LIMITS TO THE USE OF DEBT

Personal Taxes

• The cash flows to investors are typically taxed twice. Once at the corporate level and then investors are taxed again when they receive their interest or dividend payment.

• For individuals: Interest payments received from debt have been taxed as ordinary

income.

Equity investors also must pay taxes on dividends and capital gains.

• The price individuals will pay for a security depends upon the cash flows after all taxes have been paid.

After-Tax Investor Cash Flows Resulting from $1 Received by Debt Holders

Considering Personal Taxes in the Interest Tax Shield

• In general, every $1 received after taxes by debt holders from interest payments costs equity holders $(1 − *) on an after-tax basis, where: Effective Tax Advantage of Debt:

• When there are no personal taxes on debt income (i = 0) or when the personal tax rates on debt and equity income are the same (i = e ), the formula reduces to * = c.

• When equity income is taxed less heavily (e is less than i ), then * (.15) is less than c (.34).

(1 ) (1 ) (1 ) (1 ) (1 ) 1

(1 ) (1 )i c e c e

i i

Valuing the Interest Tax Shield with Personal Taxes

• With personal taxes and permanent debt, the value of the firm with leverage becomes

If * is less than c, the benefit of leverage is reduced in the presence of personal taxes.

L UV V D

Limits to the Tax Benefit of Debt

• The optimal level of leverage from a tax saving perspective is where interest equals EBIT. At the optimal level of leverage, the firm shields all of

its taxable income and it does not have any tax-disadvantaged excess interest.

• However, it is unlikely that a firm can predict its future EBIT precisely. If there is uncertainty regarding EBIT, there is a risk

that interest will exceed EBIT. As a result, the expected tax savings for high levels of interest falls, reducing the optimal level of the interest payment.

The Low Leverage Puzzle

• It would appear that firms, on average, are under-leveraged. However, it is hard to accept that most firms are acting suboptimally. In reality, there is more to the capital structure story

than discussed so far.

• A key item missing from the analysis thus far is that increasing the level of debt increases the probability of bankruptcy.

• If bankruptcy is costly, the expected costs offset the tax advantages of debt financing.

The Costs of Bankruptcy and Financial Distress

• With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt, rather bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors. In reality, bankruptcy is rarely simple and

straightforward. It is often a long and complicated process that imposes both direct and indirect costs on the firm and its investors.

Direct Costs of Bankruptcy

• The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive. Costly outside experts are often hired by the firm to

assist with the bankruptcy process.

Creditors also incur costs during bankruptcy.

The direct costs of bankruptcy average about 3% to 4% of the pre-bankruptcy market value of total assets.• Workouts and pre-packaged bankruptcies may help reduce

these small costs as well.

Indirect Costs of Financial Distress

• While the indirect costs of bankruptcy are difficult to measure accurately, they are often much larger than the direct costs. Loss of Customers

Loss of Suppliers

Loss of Employees

Loss of Management’s Time

Fire Sale of Assets

Delayed Liquidation

Costs to Creditors

It is estimated that the potential loss due to financial distress (or the threat of distress) is 10% to 20% of firm value

The Tradeoff Theory

• The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.

• According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the expected tax savings from debt, less the present value of the expected financial distress costs.

(Interest Tax Shield) (Financial Distress Costs)L UV V PV PV

Optimal Leverage

• For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield.

• As the level of debt increases, the probability of default increases. As the level of debt increases, the costs of financial

distress increase, ultimately reducing the value of the levered firm.

The rate at which the costs and benefits change are different across firms.

Optimal Leverage with Taxes and Financial Distress Costs

Optimal Leverage

• The tradeoff theory states that firms should set their leverage to the level at which firm value is maximized. At this point, the tax savings that result from increasing

leverage are perfectly offset by the increased probability of incurring the costs of financial distress.

The tradeoff theory helps explain why firms choose debt levels that are too low to fully exploit the interest tax shield (due to financial distress costs)

And helps explain differences in the use of leverage across industries (due to differences in the magnitude of distress costs and the volatility of cash flows)

Exploiting Debt Holders: The Agency Costs of Leverage

• Agency Costs Costs that arise when there are conflicts of interest

between the firm’s stakeholders

• Management will generally make decisions that increase the value of the firm’s equity. However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm.

Over-Investment

• Big Trouble Corp. (BTC) owes its creditors $5 million, due in six months.

• BTC has liquidated its assets because it could not operate profitably. Its remaining asset is $1 million cash.

• Big Bill, the lone shareholder and general manager is considering two possible investments. (1) Buy six month T-bills to earn 3% interest. (2) Go to Vegas and wager the entire $1 million on a

single spin of the roulette wheel.• Why might Bill consider the second “investment”?• Would he have considered it in the absence of

high leverage?

Under-Investment

• Slight Trouble Corp. (STC) has a small but significant chance of bankruptcy in the next few years. Its debt is trading below par.

• Managers are evaluating an investment project that will cost $1 million to undertake. The alternative is to pay $1 million out as dividends.

• While the NPV of the project is positive it may be that the shareholders are better off with the dividend than if the project is taken.

• The reason is that while shareholders pay all the costs of the project, they will have to share its value with bondholders, the added value will raise bond prices as well as stock prices.

Disciplinary Power of Debt

• “On the other hand” as economists are fond of saying, debt can be a disciplinary device. It is well recognized that an owner works harder and

makes better decisions than an employee. This was an often cited justification for the LBO wave of

the mid 80’s and early 90’s.• Similarly, one of the most contentious issues between

managers and shareholders is the payout of excess cash. Consider Hollinger International and Conrad Black’s behavior. Debt allows manager to commit to the payout in a way

that cannot be accomplished with a dividend policy.

Agency Costs and the Tradeoff Theory

• The value of the levered firm can be thought of as being given by:

(Interest Tax Shield) (Financial Distress Costs)

(Agency Costs of Debt)+ (Agency Benefits of Debt)

L UV V PV PV

PV PV

Debt-to-Value Ratio [D / (E + D)] for Select Industries

Asymmetric Information and Capital Structure

• Asymmetric Information A situation in which parties have different information

• For example, when managers have superior information to investors regarding the firm’s future cash flows

Allows for a signaling role for leverage

Issuing Equity and Adverse Selection

• Adverse Selection The idea that when the buyers and sellers have

different information, the average quality of assets in the market will differ from the average quality overall

• Lemons Principle When a seller has private information about the value

of a good, buyers will discount the price they are willing to pay due to adverse selection.

Implications for Equity Issuance

• The lemons principle directly implies that: The stock price declines on the announcement of an

equity issue.

The stock price tends to rise prior to the announcement of an equity issue.

Firms tend to issue equity when information symmetries are minimized, such as immediately after earnings announcements.

• Leads to a “Pecking Order” for incremental financing choices.

PAYOUT POLICY

Historical View

• Illustrated by the arguments of Gordon (1959) - more dividends means more value.

• Follows from the discounted dividend approach to valuing a firm:

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tt

t

r

DV

Historical View

• Gordon argued that retained earnings rather than paying current dividends makes the cash flow stream for the shareholder riskier.

• This would increase the cost of capital.• The future dividend stream would presumably be

higher due to the investment of retained earnings (+NPV).

• However, he argued the first effect would be the dominant one.

• Now called the “bird in the hand fallacy.”

Along Came M&M

• Basic Point: Firm value is determined by its investment policy, net dividends are simply the residual of earnings after investment. Cash flow identity:

Earnings + Net new financing = Investment + Dividends

• Dividend Irrelevance• In perfect capital markets, holding fixed the investment

policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the current share price.

Dividend Irrelevance Example

• Consider the case of Ralph Inc. Currently (time 0) Ralph Inc. is expected to survive another

year in business (till time 1). At which time the firm will liquidate and all value will be distributed to claimants.

The firm is presently all equity financed with 50,000 shares outstanding. The cash flow of the firm is risk free and it is common knowledge that Ralph Inc. will receive $1 million immediately and another $1 million at time 1.

The current dividend policy is for Ralph Inc. to payout its entire cash flow as dividends as it is received. So $20 per share, now and at time 1.

The risk free rate in the economy is 5%. And the firm has no positive NPV projects available.

Dividend Irrelevance Example

• Ralph, the CEO of Ralph Inc. is convinced that an alternative dividend policy would increase the current stock price.

• The current value of the firm and the price per share is: V0 = Div0 + Div1/(1.05) = $1m + $1m/(1.05)

= $1,952,380.95 or P0 = $39.05 per share.

• The share price will drop to $19.05 after the time 0 dividend is paid (P1) but our focus in on today’s price (P0).

• Ralph wants you to evaluate the impact on the current stock price of an increase or a decrease of the current dividend of $2 per share.

Dividend Irrelevance Example

• $2 per share dividend increase: A $2 per share dividend requires $1,100,000 in total so the

firm must raise $100,000 to accomplish this policy change. The firm can issue risk free bonds to raise $100,000 today

they must promise to repay $105,000 (5% risk free rate) in one year.

This will leave only $895,000 in total dividends, or $17.90 per share, for the existing shareholders at time 0.

The time zero stock price will then be: P0 = $22 + $17.90/(1.05) = $39.05 (??). The price will drop to $39.05 - $22 = $17.05 when the time 0 dividend is paid.

Dividend Irrelevance Example

• $2 per share dividend decrease: With an $18 per share dividend today this leaves an

extra $100,000 in cash within the firm. Because the firm has no positive NPV projects it does

the next best thing and makes a zero NPV investment, buying t-bills.

With a risk free rate of 5%, the t-bills will return $105,000 at time 1. This implies a total dividend of $1,105,000 or $22.10 per share at time 1.

The current stock price is: P0 = $18 + $22.10/(1.05) = $39.05

Again, the stock price will drop (by $18 per share) after the dividend is paid.

Dividend Irrelevance Example

• What made this example work? Two things were critical:

1. We fixed the cash the firm will receive and assumed they had no positive NPV projects. This is simply an extreme version of the assumption that the dividend policy will not alter the investment policy of the firm.

2. We assumed no taxes or transactions costs. Several were not:

• The one year time frame.• The risk free cash flows.• The fact that the firm was all equity financed to begin with.

Dividend Irrelevance Example

• The insight this example is supposed to bring to you is that under the irrelevance assumptions a change in dividend policy results in the company simply moving money across time.

• Using the capital markets (so the NPV is zero) ensures that no value is created or destroyed by such action. Thus the current stock price is not changed.

• Viewed another way, moving money across time is exactly what the capital markets allow individual investors to do on their own. Therefore, a change in dividend policy doesn’t do anything for the investors they can’t do themselves. Again no price change is the result.

Empirical Observation 1

• Five empirical observations have shaped the academic study of dividend policy.

• Corporations typically payout a significant percentage of their after-tax profits as dividends. Examination of dividend payouts over time shows that on

average firms paid out between 40% and 50% of their profits.• This confirms that the dividend decision is indeed an important

financing decision! Recently, a smaller percentage of all firms are paying

dividends. Seems in part due to there being a lot of new firms (who traditionally don’t pay dividends) and in part to the fact that fewer firms of all types are paying dividends. Some evidence suggests that firms are beginning to substitute repurchases for dividends.

Empirical Observation 2

• Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid 1980’s.

• This is despite the fact that in many years dividends have been taxed at the individual level at a rate that is twice as high as capital gains were taxed. Before 1984 repurchases amounted to between 2% and

11% of corporate earnings. Since 1984 they have accounted for between 30% and 40% and have been on the rise.• It is interesting to note that in the mid 80’s the other major

form of payout from the corporate sector, M&A activity, also dramatically increased.

The Changing Composition of Payouts

Empirical Observation 3

• Individuals in high tax brackets receive large amounts of dividends and pay large taxes on these dividends. That they choose to do so was labeled the “Dividend

Puzzle” by Fisher Black. Study by Peterson, Peterson, & Ang (1985) showed

that individuals received $33 B in dividends in 1979 (2/3rds of total paid) and the marginal tax rate paid on the dividends was 40% (versus 20% on capital gains).

More recently, 1996, individual investors held 54% of all stocks by market value yet received only 35% of all dividends paid indicating that individuals tend to hold low dividend paying stocks but still receive significant amounts of dividends.

Empirical Observation 4

• Corporations smooth dividends. Lintner in a survey of companies noted that:

• Firms are primarily concerned with the stability of their dividends.

• Changes in earnings are the most important determinant of changes in dividends.

Dividend changes lag earnings changes.• Dividend policy is set first then the investment and financing

decisions are made, taking dividends as given. Firms with many valuable investment projects are likely to set a

low target payout ratio and those with few a higher target.

GM: 1985–2008

Empirical Observation 5

• There are positive stock price reactions to unexpected dividend increases and big negative reactions to unexpected dividend decreases. Pettit(1972), Charest(1978), Aharony & Swary(1980). Consistent with asymmetric information models (dividends

relay information) and with incomplete contracting models (dividends solve agency problems).

Inconsistent with the existence of a large tax differential (or at least the tax effects are swamped by other effects).