Presentation on theme: "Capital Structure: Limits to the Use of Debt"— Presentation transcript:
1 Capital Structure: Limits to the Use of Debt Chapter 16
2 MM Proposition I with taxes: VL = VU + TC B It implies that firm should maximize its value by borrowing an infinite amount.In RealityHowever, as the debt/equity ratio rises, the probability that the firm could not be able to pay the interest and principal to bondholders increases.In principal, a firm is in bankruptcy when the value of its assets equals the value of the debt.When this occurs, the value of equity is zero and the shareholders turn over control of the firm to the bondholders.In a perfect world, there are no costs associated with this transfer of ownership. In the real world, it is expensive to go bankruptcy.the value of its assets equals the value of the debt can found in the B/S model.
3 Costs of Bankruptcy Direct Bankruptcy Costs Indirect Bankruptcy Costs Legal and administrative costs (e.g. lawyers, accounting, expert witnesses)Indirect Bankruptcy CostsThe difficulties of running a business that is experiencing financial distress.Since shareholders and bondholders are different groups. In the financial distress, shareholders may engage inSelfish strategy 1: Incentive to take large risksSelfish strategy 2: Incentive toward under-investmentSelfish Strategy 3: Milking the propertyThe above three Selfish strategies are called as ‘agency cost of equity’.Because of the expenses directly associated with bankruptcy, bondholders won’t get all that they are owed.The difference between financial distress and bankruptcy is that the first have financial crisis, but the second actually applied for bankruptcy. The firms with financial distress are not necessarily go to bankruptcy. Example, AIR CANADA.Until the firm is legally bankrupt, the shareholders control it. Since the shareholders can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing. In contrast, bondholders have a very strong incentives to seek bankruptcy to protect their interests and keep shareholders away from further dissipating the assets of the firm.Selfish strategy 1: If S.H succeed, the shareholders is the big winnerIf not succeed, the shareholder is no worse off.Selfish Strategy 3: S/H remove as much as possible from the firm and leave less for B/Hfor example (liquidating dividend, or Increase perks to owners/management)
4 Integration of Tax Effects and Financial Distress Costs Tax effects: A firm borrows because the valuable interest tax shieldFinancial Distress Costs: A firm can not borrow an infinite amount because of bankruptcy riskAt a relative low debt level, the benefit from debt outweighs the costAt a relative high debt level, the cost from debt outweighs the benefitIt suggests that an optimal capital structure exists somewhere between these extremes.The Value of a levered firm:VL = VU + TC B – PV [expected costs of financial distress]Conclusion:The firm should borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.Do an example in BOB Question
5 The Optimal Capital Structure and the Value of the Firm Value of the firm (VL )VL = VU + TC BPresent value of tax shield on debtFinancial distress costsMaximum firm value VL*Actual firm valueVUVU = Value of firm with no debtTotal Debt (B)(B/S) *Optimal Leverage Ratio
6 The Optimal Capital Structure and the Cost of Capital WACC = (S/V) rS + (B/V) rB (1-TC) +Premium for Costs of Financial DistressCost of capital (%)rSrUrUWACCMinimum cost of capitalThe capital Structure that maximizes the value of the firm is also the one that minimizes the cost of capital. The WACC line declines at first. This occurs because the after tax cost of debt is initially cheaper than equity, so the overall cost of capital declines. At some point, the fact that debt is cheaper than equity is more than offset by the financial distress costs and a further increase in debt actually increases the WACC.rB (1 – TC)WACC*Debt/equity ratio (B/S)(B/S) *Optimal Leverage Ratio
7 Personal Taxes: The Miller Model The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:Where:TS = personal tax rate on dividends.TB = personal tax rate on interests.TC = corporate tax rateNote: Both personal taxes and corporate taxes are included. Assuming the cash flows in perpetuity. Bankruptcy costs and agency costs are ignored.
8 Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes 1Value of firm (V)2VU3See BOB notes.4Debt (B)
9 Example:Nortel anticipates a perpetual pretax earning stream of $100,000 and faces a 45% corporate tax rate. Investors discount the earning after corporate taxes at 15 percent. The personal tax rate on dividend is 30% and the personal tax rate on interest is 47%. Nortel currently has an all equity capital structure but is considering borrowing $120,000 at 10%. Calculate the value of the levered Nortel firm.Answer: The value of the all equity firm is:Vu =____The value of the levered firm is: VL = ______For first calculation, we could have said tat investors discount the earning stream after both corporate and personal taxes.