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Capital Structure: Limits to the Use of Debt

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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 Reality However, 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 Costs The difficulties of running a business that is experiencing financial distress. Since shareholders and bondholders are different groups. In the financial distress, shareholders may engage in Selfish strategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward under-investment Selfish Strategy 3: Milking the property The 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 winner If 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/H for 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 shield Financial Distress Costs: A firm can not borrow an infinite amount because of bankruptcy risk At a relative low debt level, the benefit from debt outweighs the cost At a relative high debt level, the cost from debt outweighs the benefit It 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 B Present value of tax shield on debt Financial distress costs Maximum firm value VL* Actual firm value VU VU = Value of firm with no debt Total 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 Distress Cost of capital (%) rS rU rU WACC Minimum cost of capital The 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 rate Note: 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
1 Value of firm (V) 2 VU 3 See BOB notes. 4 Debt (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.

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