2Topics Covered Corporate Taxes Corporate and Personal Taxes Cost of Financial DistressPecking Order of Financial Choices222232
3Capital 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.
4Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.
6Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s 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?
7Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s 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 FlowAll Equity = 585*1/2 Debt = 620( )
8Capital Structure & Corporate Taxes D x rD x TcrDPV of Tax Shield =(assume perpetuity)= D x TcExample:Tax benefit = 2,000,000 x (.05) x (.35) = $35,000PV of $35,000 in perpetuity = 35,000 / .05 = $700,000PV Tax Shield = $2,000,000 x .35 = $700,000
9Capital Structure & Corporate Taxes Firm Value = Value of All Equity Firm + PV Tax ShieldExampleAll Equity Value = 585 / .05 = 11,700,000PV Tax Shield = ,000Firm Value with 1/2 Debt = $12,400,000
10Capital Structure & Corporate Taxes Merck Balance Sheet, December (figures in $millions)
11Capital Structure & Corporate Taxes Merck Balance Sheet, December 2008 (figures in $millions)(w/ $1 billion Debt for Equity Swap)
12C.S. & Taxes (Personal & Corp) Operating Income ($1.00)Or paid out as equity incomePaid out as interestCorporate TaxNoneTcIncome after Corp Taxes$1.00$1.00 – TcPersonal Taxes .TpTpE (1.00-Tc)Income after All Taxes$1.00 – Tp$1.00–Tc-TpE (1.00-Tc) =(1.00-TpE)(1.00-Tc)To bondholders To stockholders
16C.S. & Taxes (Personal & Corp) Today’s RAF & Debt vs Equity preference.1-.33= 1.23RAF =(1-.16) (1-.35)Why are companies not all debt?
17Capital StructureStructure of Bond Yield RatesrBondYieldDE
18WACC w/o taxes (traditional view) Includes Bankruptcy RiskrEWACCrDDV
19Financial DistressCosts of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
20Financial DistressCosts 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
21Financial Distress Maximum value of firm Costs of financial distress Market Value of The FirmPV of interesttax shieldsValue of levered firmValue ofunleveredfirmOptimal amountof debtDebt
23Ace Limited ExampleTotal payoff to Ace Limited security holders. There is a $200 bankruptcy cost in the event of default (shaded area).
24Conflicts of InterestCircular File Company has $50 of 1-year debt.
25Conflicts of Interest Circular File Company has $50 of 1-year debt. 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.
26Conflicts of InterestCircular File Company has may invest $10 as follows.Assume the NPV of the project is (-$2).What is the effect on the market values?
27Conflicts of Interest Circular File Company value (post project) Firm value falls by $2, but equity holder gains $3
28Conflicts of InterestCircular File Company value (assumes a safe project with NPV = $5)While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.
29Financial Distress Games Cash In and RunPlaying for TimeBait and Switch
30Financial ChoicesTrade-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.
31Trade 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.
32Issues and Stock Prices Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.Any firm is a drop in the bucket.Plenty of close substitutes.Large debt issues don’t significantly depress the stock price.
33Pecking 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.
34Pecking 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).
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