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Intermediate

Corporate
Finance
F305
Capital Structure
Theories and Evidence – Imperfect World I

Professor:
Burcu Esmer 1
Outline
What if the markets are not perfect?
• Valuation by parts
• Relax assumption 1: corporate tax
• Interest tax shield (Market value of balance sheet)
• Relax assumption 2: bankruptcy costs
• Relax assumption 3: agency problems

• If capital structure changes, what happens to the


cost of equity?
• Equity beta of levered firm contains two parts
• Unlevered asset beta
• “De-lever” vs. “Re-lever”

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Overview of our approach
• Objectives:
• To examine the costs and benefits of leverage in an imperfect
world
• To understand how leverage influences value

• Approach: “Valuation by parts”


• Value of levered firm = Value of unlevered firm
+ Net value added by debt
• Note:
• Value of unlevered firm is obtained by discounting FCFs (and
Terminal Value) at the unlevered firm’s cost of capital, Ru
• Value added by debt is not same as value of debt

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Why do we need valuation by part?
• Traditionally, we discount the FCFs (and terminal value)
at the levered firm’s WACC to get firm value.

 Rd  1  T 
E D
WACC   Re 
V V

• where Re is the levered firm’s cost of equity

• This direct method is difficult to handle when the leverage


changes:
• FCF does not change with leverage
• …but WACC does
• Unfortunately, it is difficult (not impossible) to figure out WACC after
change in leverage

• Valuation by parts makes it easier for us to see the


change in value due to change in leverage
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Market Imperfection I: Corporate -Taxes
• Interest is a tax-deductible expense, while dividends are
not
• So with taxes, there is a relative advantage to using debt (or, a
disadvantage to using equity)
• How do we value this?
• Interest expense = Rd x D
• Interest tax shield = Rd x D x Tc
• Suppose interest tax shield is a perpetuity, then:

R DT
Value added by debt  dR c  DT
d c

• Example: a firm has a perpetual debt $1,000, and the tax rate is 35%, then the
PV of interest tax shield is $1,000×35%=$350

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M&M Proposition 1 (with corporate
taxes)
• The value of the levered firm is equal to the
value of the unlevered firm plus the present
value of the debt tax shield

VL  VU  D  Tc
• The value of the firm is linearly increasing in
debt
• The optimal strategy? Maximize the usage of
debt… finance 100% (or 99.9999%) of the firm’s
capital needs with debt
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M&M Prop 1 with Corporate
Taxes
VL
V

PV(Tax Shield)

VU

*
Optimal D E  D/E 7
M&M with corporate taxes…
• Let V(L) and V(U) denote the values of the levered and
unlevered firms, respectively. Then:

V L   V U   Tc D
This formula is
difficult to derive;
Take it as given

Re  Ru  Ru  Rd 1  Tc 
D
E
E D
WACC   Re   R d (1  T )
V V c
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M&M Prop 2 with Corporate
Taxes
D
withouttaxes :rE  ru  (ru  rD )
E
%
D
rE  ru  (ru  rD )(1  Tc )
E

WACCL
rD(1-Tc)
without taxes : rD

*
Optimal D E  ! D/E 9
Example I: MM with taxes
• Dividend Airlines expects to generate an EBIT of
$153.85, in perpetuity (i.e., dividend payout
=1). Tax rate is 35%. Unlevered cost of capital is
20%.
• Questions:
• What is the firm value if it takes on $200 of debt at
10% interest?
• Ignore depreciation, NWC, capex
• What is equity value?
• What’s the cost of equity?
• What’s WACC?

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Answer key to example I

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Re and Corporate Taxes
• Corporate taxes reduce the financial risk of the firm
Re  Ru 
D
E
 
Ru  Rd 1  Tc 

• We can also express this in terms of s:


 e  u 
D
E
 
u   d 1  Tc 

( Because CAPM: Re = Rf + βe(Rm–Rf) )

• With corporate taxes, as the firm’s capital structure changes,


both cost of equity (Re) and WACC will change
• Note the crucial difference: Without taxes, in the MM world, WACC
always remained the same
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Beta with Taxes
• If we consider taxes, the relationship between the
equity beta and asset beta is altered in the
expected manner

D
 E   u  (  u   D )(1  Tc )
E
Beta on the equity Beta if firm were all
of a firm with equity (Unlevered)
leverage a.k.a. Asset beta
(the Levered firm)

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“Business” + “Financial” risk
assuming debt beta=0 (it is very common)

 D
BE  Bu 1  (1  t ) 
 E
D
 Bu  Bu (1  t )
E
Business Risk
Financial Risk

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Example II
• A firm has a debt to equity ratio of 2/3. Its cost of equity is
15.2%, cost of debt is 4%, and tax rate is 35%. Assume that
the risk-free rate is 4%, and market risk premium is 8%.

• Suppose the firm repurchases stock and finances the


repurchase with debt, causing its debt to equity ratio to
change to 3/2:
• Compute the firm’s new equity beta and new cost of equity?
• What is the firm’s WACC before and after the change in capital
structure?

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Solution steps
• First “de-lever” to obtain unlevered asset beta
using the current capital structure
• If betas are not given, derive using CAPM
• Next, lever it up to the target leverage ratio to
determine the new equity beta
• Calculate the new expected return on equity
• Using CAPM
• Then, calculate the new WACC under the target
leverage ratio

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Answer key to Example II

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Answer key to Example II cont.

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M&M Summary
(No Bankruptcy)
• Proposition 1: Firm value (and shareholder value)
increases with debt

VL  VU  D  Tc
• Proposition 2: The cost of equity is increasing in debt-to-
equity, and the firm cost of equity is decreasing in debt-
to-equity

WACCL<WACCU
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Summary of the story so far
• In the MM world with taxes, as leverage increases:
• Cost of Re increases, but the increase is less
than in the perfect MM world
• WACC decreases, so firm value increases
• The reason firm value increases is because higher
the debt, higher is the interest tax shield
• Key assumption: No bankruptcy risk
• Therefore, WACC = Ru only if the firm has zero debt.
• So optimal capital structure is to have 100% debt

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Have we found a money
machine?
• If we can do this for the first million in debt
financing, what about the tenth million? The
twentieth? The fiftieth?
• Can we reduce our investment to almost nothing
and make all of this cash?
• Obviously not… we aren’t picking up some aspect
of reality
• Possibilities:
• More complex corporate and personal tax system
• Other costs of debt… bankruptcy? Agency costs?

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Market Imperfection II: Bankruptcy
Costs
• Let’s now add in the possibility of bankruptcy
• Debt increases the probability of financial distress and
bankruptcy
• Bankruptcy has costs
• Other assumptions about perfect market remain
unchanged

• Now we are taking both corporate taxes and


bankruptcy into account
• We could also take personal taxes into account by
changing our present value of tax shield calculation,
but let’s leave that out for simplicity’s sake

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Remember:
Advantages of Debt
• Reduces agency costs (Jensen, 1986)
• Debt creates obligations for firm
• A portion of cash from operations must go
toward repaying debt
• Management is less likely to overinvest and be
an “empire-builder”
• Tax shield created by interest expense
• After-tax cost of debt is low compared to
alternative forms of financing

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Disadvantages of Debt
• Lack of future financing flexibility
• Debt can lock a firm into a particular
capital structure for a long period of time
• Lack of flexibility for using firm cash flows
• Agency cost (between lenders and owners)
• Bankruptcy Costs

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Market Imperfection II: Bankruptcy Costs
• Debt can put pressure on the firm’s finances during bad
times (“financial distress”)
• because interest and principal payments (unlike dividend payments)
are legal obligations

• Bankruptcy: Legal transfer of ownership of firm’s assets to


debtholders in the event of a default
• Think of it as an extreme form of financial distress

• Two forms of bankruptcy in US:


• Chapter 11 (reorganization): Firm gets temporary respite from
creditors so that it can reorganize
• Chapter 7 (liquidation)

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Bankruptcy Costs of Debt
• The expected cost has two components
• Probability of Bankruptcy
• Dollar Cost of Bankruptcy (direct and indirect costs)

Expected Bankruptcy Cost  Probabilit y of Bankruptcy


* Cost of Bankruptcy
• Example: If the estimated bankruptcy cost is $500 (mil), and the
probability of bankruptcy is 5%, then the expected bankruptcy cost is $500
×5% = $25 (mil)

• All else equal, the greater the bankruptcy cost and/or the
probability of bankruptcy implicit in the operating cash
flows of the firm, the less debt the firm can afford to use
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1. Probability of Bankruptcy
• Likelihood a firm’s CF will be insufficient to meet its
promised debt obligations (interest and principal)
• Probability is a function of
• Size of operating cash flow (CF) relative to size of debt
obligations
• Higher operating CF can support more debt
• Higher operating CF implies lower probability of default
• Variance in operating CF
• More stable CF implies a lower default probability
• More volatile CF implies a higher default probability

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2. Bankruptcy Costs
• There are both direct and indirect costs to bankruptcy (ultimately,
borne by shareholders)
• Direct costs: Legal and administrative
• Although large in absolute terms, usually not very big in proportion to
total value
• only 1% of market value 7 years prior (Warner (1977))
• In Macy’s 1992 Chapter 11 bankruptcy, at least $100 million (2 to 3 percent
of Macy’s value)
• Real Example: Orange County
• Indirect costs: Due to disruption of normal activities
• Lost sales, change in customer behavior
• Change in supplier behavior, like requiring up-front cash
payment for raw materials
• Difficulty obtaining new capital (higher cost)
• Firm could lose precious human capital
• Note: These can occur even before bankruptcy, when the firm
is in financial distress
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e.g. of Direct Cost of Bankruptcy
Lawyers Set to Profit on Lehman
Weil Gotshal Asks Bankruptcy Court to Approve Record Quarterly Payout of $55 Million
By ASHBY JONES

Lehman Brothers Holdings Inc., which set a record as the largest company to file for bankruptcy
protection, is on course to yield one of the biggest bonanzas for lawyers.

New York-based Weil, Gotshal & Manges LLP earlier this week asked a federal bankruptcy judge in New
York to sign off on a $55.1 million payment for its work representing Lehman.

That marks the biggest quarterly fee request made by lawyers representing a bankrupt company,
according to Lynn LoPucki, a law professor at the University of California, Los Angeles, who runs a
bankruptcy-fee database. Mr. LoPucki estimates that Weil stands to bring in more than $200 million in fees
by the end of the case. That would exceed the next-highest debtor counsel fee, the $159 million that Weil
earned during the Enron bankruptcy.

Note: The lead lawyer is claiming 759 hours of work at $950 /hour for the 3 month period!
That means he claims he worked the equivalent of 7 days a week and 8.3333 hours a day
for the entire 90 days.

Enron spent total cost of $750m on legal and accounting fees!


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Indirect Costs of Financial Distress
• While the indirect costs are difficult to measure accurately,
they are often much larger than the direct costs of
bankruptcy.
• Loss of Customers (e.g. Distressed airlines)
• Loss of Suppliers (e.g. Swiss Air)
• Loss of Employees
• Loss of Receivables (e.g. Enron)
• Fire Sale of Assets (study shows firms in distress sell their aircraft
15%-40% cheaper)
• Inefficient Liquidation (Eastern Airlines lost more than 50% of value
during banktruptcy)
• Costs to Creditors (e.g. Lehman – domino effect)
• It is estimated that the potential loss due to financial distress
is 10% to 20% of firm value (Andrade and Kaplan, 1998)

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Indirect Costs of Bankruptcy
• The indirect costs of bankruptcy are higher for firms
that sell or produce:
• Long life durable goods that require replacement parts
• Cars: Renault, Daewoo
• Goods/services for which quality is an important attribute
• Airlines: Delta, US Air, United
• Products whose value depends on complementary products
supplied by other companies
• Computers: Apple vs Windows
• Products that require continuous service and support
• Copiers: Xerox
• High proportion of intangibles
• Tangible assets like land, machinery etc. can be liquidated/
redeployed easily.
• Intangible assets like human capital, brand value, R&D
capabilities is lost in the event of bankruptcy

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Bankruptcy Cost
• We talked about bankruptcy cost previously
• Bankruptcy Cost = Bankruptcy Dollar Cost *
Probability of Bankruptcy
• The dollar cost of bankruptcy depends largely on
firm operations, not so much on capital structure
• The probability of bankruptcy is heavily dependent
on capital structure
• Increasing debt-to-equity implies higher probability of
bankruptcy
• Therefore, bankruptcy cost is increasing in debt-to-
equity 32
Implications of
Bankruptcy Costs of Debt
• Implications for optimal capital structure:
• Firms with more volatile CF should have less debt
• Tech and Biotech firms
• A firm can hold more debt if it can match the CF of debt
and investments
• Commodity companies
• Firms protected by an external entity will tend to borrow
more
• Banks: FDIC
• Fannie Mae, Freddie Mac: Federal government
• Firms with illiquid assets tend to have less debt
• Assets cannot easily be separated from the business
• Firms producing assets requiring long-term service and
support tend to have less debt
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M&M Proposition 1 with Corporate Taxes
and Bankruptcy Costs
VL  VU  PV ( tax shield)-PV(expected bankruptcy costs)
 VL  VU  D  Tc  PV(expected bankruptcy costs)

• The only difference from our previous equation is the


subtraction of the present value of expected
bankruptcy costs
• Since the probability of bankruptcy is increasing in
debt-to-equity, the PV of expected bankruptcy costs is
also increasing in debt-to-equity
• There is a trade-off between the tax advantage of
debt and the costs of financial distress.
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M&M Prop 1 with Corporate
Taxes and Bankruptcy Costs
V PV(Exp Bankruptcy Costs)

PV(Tax Shield)
VL

VU

*
Optimal D D/E
E 35
Bankruptcy Costs and WACC
• In the perfect MM world, as leverage increases:
• Only Re increases, Rd is unchanged
• Overall, WACC and firm value are unchanged

• What happens when bankruptcy costs are the only


imperfection introduced into the MM world?
• As leverage increases:
• Rd increases due to higher expected bankruptcy costs
• Re also increases (just as in MM world)
• Overall, WACC also increases, and firm value falls

• Why does firm value fall?


• bankruptcy costs cause value added by debt to be negative

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M&M Prop 2 with Corporate
Taxes and Bankruptcy Costs
At first, increasing
D/E decreases
% rE WACC b/c tax
advantage
outweighs the
increase in the
WACCL probability of
bankruptcy. But at
rD(1-t) some point, the
probability of
bankruptcy
increases enough
to outweigh tax
* benefit.
Optimal D E
D/E
(min imizes WACC)
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Optimal Leverage
(with bankruptcy costs and taxes)
• Corporate taxes and bankruptcy costs impact firm
value differently
• Bankruptcy costs lower firm value
• Interest tax shield increases firm value
• In a world with both bankruptcy costs and taxes, as
the firm adds debt:
• Firm value increases if PV of interest tax shield exceeds PV
of expected bankruptcy costs
• Firm value decreases if PV of interest tax shield is less
than PV of expected bankruptcy costs

• Optimal leverage is that leverage beyond which


costs of debt exceed its benefits
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