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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

cost of equity?

• Equity beta of levered firm contains two parts

• Unlevered asset beta

• “De-lever” vs. “Re-lever”

2

Overview of our approach

• Objectives:

• To examine the costs and benefits of leverage in an imperfect

world

• To understand how leverage influences value

• 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

3

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

changes:

• FCF does not change with leverage

• …but WACC does

• Unfortunately, it is difficult (not impossible) to figure out WACC after

change in leverage

change in value due to change in leverage

4

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

5

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

6

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

8

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?

10

Answer key to example I

11

Re and Corporate Taxes

• Corporate taxes reduce the financial risk of the firm

Re Ru

D

E

Ru Rd 1 Tc

e u

D

E

u d 1 Tc

both cost of equity (Re) and WACC will change

• Note the crucial difference: Without taxes, in the MM world, WACC

always remained the same

12

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)

13

“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

14

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%.

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?

15

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

16

Answer key to Example II

17

Answer key to Example II cont.

18

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

19

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

20

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?

21

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

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

22

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

23

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

24

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

debtholders in the event of a default

• Think of it as an extreme form of financial distress

• Chapter 11 (reorganization): Firm gets temporary respite from

creditors so that it can reorganize

• Chapter 7 (liquidation)

25

Bankruptcy Costs of Debt

• The expected cost has two components

• Probability of Bankruptcy

• Dollar Cost of Bankruptcy (direct and indirect costs)

* 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

26

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

27

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

28

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.

29

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)

30

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

31

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

33

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)

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.

34

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

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

• bankruptcy costs cause value added by debt to be negative

36

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)

37

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

costs of debt exceed its benefits

38

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