Advanced Corporate

Finance FINA 7330

Capital Structure Issues and Financing Lecture 07 and 08 Fall, 2010

The Theories of Capital Structure

Irrelevance Static Tradeoff
Pecking Order

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 PVGO $1,000,000 2,000,000 LIABILITIES DEBT EQUITY TOTAL 0 3,000,000 $3,000,000

TOTAL $3,000,000

Irrelevance Theorem
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000

PVGO

2,000,000

EQUITY 1,400,000
TOTAL $3,000,000

TOTAL $3,000,000

Tax Implications ( tax rate of 30%)

ASSETS PVA PVGO $1,000,000 2,000,000 DEBT

LIABILITIES

- PV of Tax Liability 900,000

EQUITY

2,100,000

TOTAL

$2,100,000

TOTAL

$2,100,000

Tax Implications
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000

PVGO

2,000,000

Less: PV of Tax Liability 420,000

EQUITY

___________

TOTAL

$2,580,000

TOTAL

$2,580,000

Tax Implications
ASSETS PVA $1,000,000 LIABILITIES DEBT 1,600,000

PVGO

2,000,000

Less: PV of Tax Liability 420,000

EQUITY

980,000

TOTAL

$2,580,000

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. Notice that Stockholders wealth increased by an amount equal to the Present Value of the Tax Shield on Debt.

The Static Tradeoff Theory

Benefits versus Costs of Leverage. Benefits Costs Taxes Financial Distress Resolution of Agency Costs Agency Costs Bondholder/Stockholder Manager/Stockholder Bankruptcy Costs Direct and Indirect Information Costs

The Impact of Taxes on the Capital Structure Decisions

Firm Value =

S Operating Cash Flow (t) (1+ro)t

= Market Value of the Firms Liabilities (Including Equity)

Let OCF(t) = Operating Cash Flow at time t

With Taxes
Firm Value for an equity financed firm = S OCF(t) - Tax on operations (1+ro)t

= Market Value of the Firm = Market Value of Equity = V(u) We call this the Value of the Unlevered Stream (Firm), or the Asset Value of the Firm)

Example
Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = Before Tax Operating Cash Flow - Tax Before Tax Operating Cash Flow = (1000-500) = 500 Tax = T*(1000-500-300) .32*200 = 64 Thus V(u) = (500 64)/r = 436/.1 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow

Example
Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = (1000-500) -.32*(1000-500-300) {EBIT(1-t) + Depreciation} = (1000-500-300)*.68 + 300 = 136 + 300 = 436 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow

Leverage Effects
Now suppose the firm issues 2000 worth of perpetual debt, paying interest at 5%. Then interest will be: INT = .05*2000 = $100

Now lets consider the interest deductions

Cash Revenue $1000 Cash Expense 500 Depreciation 300 Interest 100 Tax Rate (t) = 32% CF = (1000-500) -.32*(1000-500-300 -100) = = 500 - 32 = 468 Or: = ATOCF + t*INT = 436 + 32 = 468

Now Discount
CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT ro rB V = V(u) + t*B

Now Discount
CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT ro rB V = V(u) + t*B = 4,360 + .32 * 2,000 = $5,000

Value of Debt and Equity

Value of firm = $5,000 Value of Debt = $2,000 Value of Equity = $3,000 B/V = .4 E/V = .6

With Taxes
In general, V(L) = V(u) Plus Present Value of Tax Shield on Debt. V(L) = V(u) + (Corp. Tax Rate) * Debt, in the special case when debt is thought of as perpetual, or is selling at par.

Graphically
Firm Value (V)

V(u)

Debt

Recall: Cost of Capital In the absence of taxes

rS = ro + (ro-rB)B/S

WACC = ro

rB

Cost of Capital (After Tax)

rE = ro + (ro-rB)(1-t)B/S

rd

Weighted Average Cost of Capital

WACC is the discount rate we use to discount the firms after tax Operating Cash Flow: (ATOCF)

So in the example we just had: WACC = ro(1-T(B/V) ) = 8.72% = rE(E/V) + (1-T)rB(B/V), and rE = .10 + (.10-.05)(1-.32)(.6) = 12.27% WACC = .1227*.6 + .68*.05*.4 = 8.72% = .07362 +.0136 = 8.72%

Firm Value and the Tax Shield on Debt

Notice that the value of the firm is simply the ATOCF discounted by the WACC! The greater is the amount of debt issued, the lower is the WACC, and thus the higher is the value of the firm. By assumption, the ATOCF is unaffected by the firms capital structure.

Static Tradeoff Theorem

Costs of Financial Distress
Potential Bankruptcy Costs Underinvestment Risk Shifting Agency Costs

General Approach
Assume:
No Taxes Single period Cost of Capital = 10%

Perfect Capital Market

Widgets International Good State

Bad State

Pure Equity 11 million 2.2 million Probability of each state is 50% Stockholders Wealth V = $6 million E = $6 million

Bond and Stock Valuation

Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million. What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (rB) is 5% Then the value is B = E{Cash Flows}/1.05

Debt valuation
What is the Yield to Maturity? (YTM) What is the Expected Return?
This will require some work

Perfect Capital Markets

Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%) Widgets International Good State Bad State Expected
Total 11 million Debt 4.2 million Equity 6.8 million Stockholders Wealth V = $6 million B = 3.2/(1.05) = $3.05 E = $6 - $3.05 = $2.95 2.2 million 2.2 million 0 6.6 3.2 3.4

IF The Value of the Firm remains unchanged

Valuation of Equity
If the value of the firm is independent of capital structure, rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:

E = 3.4/1.1517 =

???

Finally What is Stockholders Wealth?

Valuation of Equity
If the value of the firm is independent of capital structure, rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:

E = 3.4/1.1517 =

2.96 (2.95 really, without rounding)

Finally What is Stockholders Wealth?

Debt Valuation
Yield to Maturity Coupon rate Expected (required) return to Bonds

Bankruptcy Costs
Widgets International Good State Bad State
Pure Equity 11 million Probability of each state is 50% Stockholders Wealth V = $6 million E = $6 million 2.2 million

Direct Bankruptcy Costs

Typically amounts to 2% to 5% of the distressed value of the firm Widgets International
Again assume the same leverage of a bond promising to pay 4.4 million

Good State
Total 11 million Bankruptcy cost

Bad (Default)
2.2 million 0.1 million

Net

11 million

2.1 million

Impact of Bankruptcy Costs

Good State
Total 11 million Bankruptcy cost

Bad (Default)
2.2 million 0.1 million

Net 11 million 2.1 million Value 5.95 million Debt 3 million Equity 2.95 million Thus stockholders wealth declines by $50,000 (SHW = 2.95 + 3 = 5.95 not 6) Notice that it is the stockholders that pays the expected bankruptcy costs.