Firm financing in perfect markets Firm financing in imperfect markets (TAXES)

Capital structure: Mix of debt (D) and equity (E) WACC vs IRR
𝐷
•
𝐸
= Mkt Value of Debt (Can use book value unless firm is in • IRR= WACC => NPV = 0
financial distress); ALWAYS use mkt value of Equity • IRR>WACC => NPV > 0
•
𝐷
• IRR<WACC -> NPV < 0
𝐸+𝐷
𝐷
• ; This is mostly greater because book value
𝑇𝑜𝑡𝑎𝑙 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 Capital structures matter because equity and debt are taxed
is less than market value differently. The tax shield on interest payments creates
incentives to use debt.
• Debt increases firm value by reducing tax burden,
• Interest tax shield: interest payment*tax = rDDTC
• Imp: All benefits of tax shield go to equity investors.
MM Proposition – I : VALUE
• VU = V L = D + E
• Assumptions: No info asymmetry or agency cost, no
distortion(tax), Investors can do what firm can do
• Hence, as per MM I - VU = VL => NPVFS = 0
• Financing choice has no impact on value
• If the value of levered an unlevered firms don’t match, there will MM Proposition – I with Taxes
be an arbitrage opportunity and ultimately they will be same. • Value of levered firm is greater than unlevered firm because of tax
• Leverage recapitalization: firm uses borrowed funds to pay a shield => = VL = VU + PV (rDDTC)
large special dividend or repurchase a significant number of • WACC with taxes:
outstanding shares.
• IMP: In perfect market, open market repurchase will not change •
Effective cost
share price. of debt
reduces to rD*(1-Tc)
MM Proposition – II : Cost of Capital Valuing Tax Shields
• WACC: rate at which you discount FCFs of a levered firm. The • Fixed debt: same risk as the debt hence discount at r D PV
minimum required rate of return such that FCF meets both equity (rDDTC) = rDDTC/ rD = TcD
and debt obligations. • Dynamic debt: same risk as underlying firm so discount at rU (Pre
𝐸 𝐷
WACC = rE + rD tax wacc)
𝐸+𝐷 𝐸+𝐷
Two methods: APV (use with fixed debt) and WACC (use with
• VL = E(X)/ 1+ WACC = D + E dynamic debt)
• Under perfect markets, capital structure (D/E) won’t affect firm’s APV: VL = VU + PV (rDDTC)
cost of capital => WACCL = WACCU = rU • Estimate FCFs as if all equity finance. Discount the FCFs at PRE
• When you increase debt (cuz its cheaper), you make equity TAX WACC and get VU
costlier. This means that increasing debt is same as leveraging • Value tax shield at appropriate discount rate( depending of type of
equity. Both effects offset each other and WACC is same. debt)
• IMP: Capital structure won’t change WACC. • Add both
Important formulas: WACC
• Cost of capital for levered firm’s equity • Estimate FCFs as if all equity financed. Discount FCFs at AFTER
rE = rU + D/E (rU – rD) TAX WACC
• Increasing D/V ratio => cost of equity rises, cost of debt doesn’t Remember: CAN ONLY USE ONE METHOD. USING BOTH
change but will increase after one point, WACC is the same WILL LEAD TO DOUBLE COUNTING AND OVER
• Unlevered beta: risk w/o leverage ESTIMATION.
• Mostly levered beta is greater than unlevered beta (opposite can To remember: When you announce potential debt, equity
happen) immediately rises to reflect the future expectations. Also called
efficient market hypothesis. Eg: Equity is 300 mn. You announce
debt of 100 mn with 35% tax rate. Investors expect a tax shield of
35 mn hence equity immediately becomes 335 mn.
Deviations:
• Theoretically, all firms should have 0 debt in cases of losses since
no taxes are paid and hence no tax shield.
• And have a Interest = EBIT with positive profit to have 0 tax
payments.
Pitfalls:
• In reality this will never happen, the ratio of Interest/EBIT is
• “Debt is better cuz cheaper”: No. Increasing debt make equity
mostly around 50% or so.
riskier, and hence WACC remains unchanged for the firm.
• Reason: There are other cost to debts – personal taxes, asymmetry
• “Debt is better cuz EPS increase”: No. EPS increase won’t matter
etc also play a role.
if MV is the same which is what happens in this case.
• Remember: Debt varies across industries. High growth firms have
• “Debt better cuz avoid equity dilution”: No. Share price remains
low debts. Utilities have high debt.
same because both # of shareholders and cash increases. As long
as firm sells at fair price no gain or loss associated with equity
issue.
Firm financing in imperfect markets – Part 2 Information asymmetry: Managers know more than
Bankruptcy costs shareholders. Using debt to signal prospective information.
• Financial distress: difficulty in meeting debt obligations. Won’t • How to signal? Needs to be costly signal for people to find it
always lead to a default. truly credible. Alternative: Issue more debt – people believe
• Default: Failing to make payment (interest of principal) on debt you won’t raise debt unless you are confident about paying
• Economic distress: reduction in value of project of firms. it, else there can be default. Market value goes up.
Economic value of firm declines because present value of future • Opposite case in Equity: Lemons problem. You may issue an
cash flows goes down. This may lead to financial distress for a
equity, but due to lemon problem people will assume you are
levered firm.
• EV decline is orthogonal to debt. What happens is if you have debt
over-valued your equity and hence mkt value will go down.
EV decline can lead to default. • Self-selection: over-valued firm will issue equity.
Default in perfect markets: • For new investment, on avg you will issue debt not equity
• MM irrelevance holds with financial distress and default. Capital • In case of info asymmetry, pecking order in choosing
structure is irrelevant as long as financial distress doesn’t alter total financing: RE, Debt, Hybrid, Equity (in order)
cash flows of the firm. o Depends how informationally sensitive
• In MM world, no cost to bankruptcy. In real world there is.
Bankruptcy and leverage
• Bankruptcy costs depend on probability of going bankrupt and
direct and indirect costs of bankruptcy
• Deadweight costs: costs that don’t create value for form, takes
away value from all investors. Direct – legal, court etc. Indirect –
reputation, loss of employees, fire-sale of assets, predatory pricing
by competitors, wasted management time.
Trade off theory of capital structure
• Firms balance tax advantage of debt with financial distress
• VL = VU + PV(Tax shield) – PV(Bankruptcy cost)
• Implication: firms will always aim to revert to their target leverage
ratio in case shocks shift it.
Agency Conflicts
• Conflict due to separation of cash flow rights and control
rights; shareholders can take decisions on behalf of debt
holders (at their expense also) and -vely impact firm value
• Conflict: Shareholders take away wealth from bondholers.
Forgo +ve NPV – underinvestment – debt overhang
• Don’t take a +ve NPV project because the upside of project
is divided between debt and equity holders.
• Debt holders may not invest due to information asymmetry
• Equity holders look at their NPV above project NPV
• Happens often for firms with a lot +ve NPV projects (high
growth – tech firms)
Take up -ve NPV – overinvestment – risk shifting & asset
substitution (more common)
• Firms take on risky investments since the worse that can
happen to equity holders is they get 0 return which may
already be happening due to excessive debt
• Hence, they take risky investments at the cost of the debt
holders value – risk borne by debt holders
• Debt holder are smart – can see these tendencies of the
shareholder and hence dd greater interest rates. Higher
interest rates mean NPV cut off is higher now => you miss
out on increasing firm value => equity decline=>
shareholders bear the cost.
Reducing agency cost
• Debt covenants: Control rights with debtors. Control what
firm can do under certain conditions eg: CFs go below 10%,
can’t take new investment. Reduces management flexibility.
Costly for firms with multiple investment opportunities and
with risky cash flows.
• Debt Maturity: Borrow short term – low risk of default.
Entrenched managers – Managerial excesses: Inefficient
investment (nepotism, buying random fancy stuff), unnecessary
diversification for ego boosts. Keep more debt, less for manager t0o
waste. =>SH-Manager conflict: more debt. SH-Bondholder
conflict: less debt
Other solutions: Incentive compensation, corporate governance,