You are on page 1of 35

Chapter 18

Principles of
Corporate Finance
Tenth Edition

How Much Should


a Corporation
Borrow?
Slides by
Matthew Will

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Topics Covered
Corporate Taxes
Corporate and Personal Taxes
Cost of Financial Distress
Pecking Order of Financial Choices

18-2

Capital Structure & Corporate Taxes


Financial Risk - Risk to shareholders resulting from
the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

18-3

Capital Structure & Corporate Taxes


The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.

18-4

Capital Structure & Corporate Taxes


28
$350
.08
Interest payment return on debt X amount borrowed
PV (tax shield)

rD D

rcorporate tax rate X interest payment


expected return on debt
T (r D)
C D
TC D
rD

PV (tax shield)

18-5

Capital Structure & Corporate Taxes


Example - You own all the equity of Space Babies
Diaper Co. The company has no debt. The
companys annual cash flow is $900,000 before
interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your equity
position for 5% bonds with a face value of
$2,000,000.
Should you do this and why?

18-6

Capital Structure & Corporate Taxes


Example - You own all the equity of Space Babies Diaper Co. The company
has no debt. The companys annual cash flow is $900,000 before interest
and taxes. The corporate tax rate is 35% You have the option to exchange
1/2 of your equity position for 5% bonds with a face value of $2,000,000.
Should you do this and why?

Total Cash Flow


All Equity = 585

*1/2 Debt = 620


(520 + 100)

18-7

Capital Structure & Corporate Taxes


PV of Tax Shield =
(assume perpetuity)

D x rD x Tc

= D x Tc

rD
Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

PV Tax Shield = $2,000,000 x .35 = $700,000

18-8

Capital Structure & Corporate Taxes


Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield =

700,000

Firm Value with 1/2 Debt = $12,400,000

18-9

Capital Structure & Corporate Taxes


Merck Balance Sheet, December 2008
(figures in $millions)

18-10

Capital Structure & Corporate Taxes


Merck Balance Sheet, December 2008 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)

18-11

C.S. & Taxes (Personal & Corp)


Operating Income ($1.00)
Or paid out as
equity income

Paid out as
interest
Corporate Tax

None

Tc

Income after
Corp Taxes

$1.00

$1.00 Tc

Personal Taxes .

Tp

TpE (1.00-Tc)

Income after All


Taxes

$1.00 Tp

$1.00Tc-TpE (1.00-Tc)
=(1.00-TpE)(1.00-Tc)

To bondholders

To stockholders

18-12

C.S. & Taxes (Personal & Corp)


Relative Advantage Formula
( Debt vs Equity )
1-Tp
(1-TpE) (1-Tc)
Advantage
RAF > 1

Debt

RAF < 1

Equity

18-13

C.S. & Taxes (Personal & Corp)


Example

18-14

C.S. & Taxes (Personal & Corp)


Another Example

18-15

C.S. & Taxes (Personal & Corp)


Todays RAF & Debt vs Equity preference.

RAF =

1-.33
(1-.16) (1-.35)

= 1.23

Why are companies not all debt?

18-16

18-17

Capital Structure
Structure of Bond Yield Rates
r

Bond
Yield

D
E

WACC w/o taxes (traditional view)


r

Includes Bankruptcy Risk

rE

WACC

rD
D
V

18-18

Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

18-19

Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
Market Value =

Value if all Equity Financed


+ PV Tax Shield
- PV Costs of Financial Distress

18-20

Financial Distress

Market Value of The Firm

Maximum value of firm


Costs of
financial distress
PV of interest
tax shields

Value of
unlevered
firm

Debt

Optimal amount
of debt

Value of levered firm

18-21

Default Payoff Scenarios

18-22

Ace Limited Example


Total payoff to Ace Limited security holders. There is a $200
bankruptcy cost in the event of default (shaded area).

18-23

Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular
Circular File
FileCompany
Company(Book
(BookValues)
Values)
Net
20
50
NetW.C.
W.C.
20
50
Fixed
80
50
Fixedassets
assets
80
50
Total
100
100
Totalassets
assets
100
100

Bonds
Bondsoutstanding
outstanding
Common
Commonstock
stock
Total
Totalliabilities
liabilities

18-24

Conflicts of Interest
Circular File Company has $50 of 1-year debt.

Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
20
25
Bonds
NetW.C.
W.C.
20
25
Bondsoutstanding
outstanding
Fixed
10
55
Common
Fixedassets
assets
10
Commonstock
stock
Total
30
30
Total
Totalassets
assets
30
30
Totalliabilities
liabilities

Why does the equity have any value ?


Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.

18-25

Conflicts of Interest
Circular File Company has may invest $10 as
follows.

Now

Possible Payoffs Next Year


$120 (10% probability)

Invest $10
$0 (90% probability)
Assume the NPV of the project is (-$2).
What is the effect on the market values?

18-26

Conflicts of Interest
Circular File Company value (post project)

Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
10
20
Bonds
NetW.C.
W.C.
10
20
Bondsoutstanding
outstanding
Fixed
18
88
Common
Fixedassets
assets
18
Commonstock
stock
Total
28
28
Total
Totalassets
assets
28
28
Totalliabilities
liabilities

Firm value falls by $2, but equity holder gains $3

18-27

Conflicts of Interest
Circular File Company value (assumes a safe project
with NPV = $5)

Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
20
33
Bonds
NetW.C.
W.C.
20
33
Bondsoutstanding
outstanding
Fixed
25
12
Common
Fixedassets
assets
25
12
Commonstock
stock
Total
45
45
Total
Totalassets
assets
45
45
Totalliabilities
liabilities

While firm value rises, the lack of a high potential payoff for
shareholders causes a decrease in equity value.

18-28

Financial Distress Games


Cash In and Run
Playing for Time
Bait and Switch

18-29

Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.

18-30

Trade Off Theory & Prices


1. Stock-for-debt

Stock price

exchange offers

falls

Debt-for-stock

Stock price

exchange offers

rises

2. Issuing common stock drives down stock prices;


repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.

18-31

Issues and Stock Prices


Why do security issues affect stock price?
The demand for a firms securities ought to be
flat.

Any firm is a drop in the bucket.


Plenty of close substitutes.
Large debt issues dont significantly depress
the stock price.

18-32

Pecking Order Theory


Consider the following story:
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.
Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.
If external finance is required, firms issue debt first and
equity as a last resort.
The most profitable firms borrow less not because they have lower
target debt ratios but because they don't need external finance.

18-33

Pecking Order Theory


Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).

18-34

Web Resources
Click to access web sites
Internet connection required
http://astro.temple.edu/~tub06197/Wk1Myers1984.pdf

18-35