1. How MUCH Should A CORPORATION BORROW?18
How MUCH Should A CORPORATION BORROW?
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. TABLE 18.1 RATIOS OF DEBT TO DEBT-PLUS-Equity FOR NONFINANCIAL BUSINESSes
Ratios of debt to debt-plus-equity for sample of nonfinancial businesses, 2010
Note: Debt to total capital ratio = D/(D + E), where D and E are book values of long-term debt and equity.

3. TABLE 18.2 TaX-DEDUCTIBLE INTEREST
The tax deductibility of interest increases the total income that can be paid out to bondholders and stockholders
This shows that the interest tax shield for the year is $28. The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.

4. 18-1 CORPORATE TAXES
This example is the same as in the book. PV of tax shield = 28/0.08 = $350 = (0.35)(1000).
This assumes permanent debt.

5. 18-1 CORPORATE TAXES Examples
You own all equity of Space Babies Diaper Co.
Company has no debt
Company has annual cash flow of $900,000 before interest and taxes
Corporate tax rate is 35%
You have the option to exchange 1/2 of your equity position for 5% bonds with face value of $2,000,000
Should you do this and why?
Here is an example of leveraging on the personal account.

6. 18-1 CORPORATE TAXES Example Continued Total Cash Flow
All equity = 585
*1/2 debt = 620
( )
With 50% debt, the net cash flow to the equity is $585 (in thousands). There is a reduction in taxes by $35 (in thousands). Total cash flow to the holder of equity and debt is $620 (in thousands). $35 (in thousands) is the tax saving through interest expense deduction.
The total cash flow with all equity is $585,000.
The total cash flow with 50% debt is $620,000.
The difference of $35,000 is the tax savings.

7. 18-1 CORPORATE TAXES
Tax benefit per year is $35 (in thousands). Assuming that this benefit will occur through perpetuity, the present value of the tax shield is 35/0.05 = $700 (in thousands). The same result is obtained by using the formula (D)(Tc) = (2,000,000)(0.35) = $700,000.

8. Table 18.3 Market value balance sheets
Table 18.3 Normal and expanded market value balance sheets.

9. TABLE 18.4a Simplified balance sheets johnson & johnson, October 2011
This is the balance sheet for Johnson & Johnson as of October 2011.

10. Table 18.4b balance sheets johnson & johnson
This is the Johnson & Johnson balance sheet with $1 billion debt for equity swap.

11. 18-1 corporate taxes Example All-equity value = 585/.05 = 11,700,000
PV tax shield = 700,000
Firm value of ½ debt = $12,400,000
The increase in the value of the firm due to the debt is the present value of the tax shield.
Firm value = value of an equivalent all-equity firm + PV of tax shield.
All-equity value = 585/0.05 = $11,700,000.
PV of tax shield is $700,000.
Firm Value with ½ debt is 11,700, ,000 = $12,400,000.

12. Figure 18.1 Capital structure determines payout
The diagram shows how personal taxes affect the payoffs to bondholders and stockholders.

13. 18-2 corporate and personal taxes
Relative Advantage Formula (RAF)
Debt vs. equity
RAF > 1 = debt
RAF < 1 = equity
If we consider corporate taxes, we should also consider personal taxes, as we have a two-tier tax system in the U.S. The relative advantage formula (RAF): (1 − TP)/[(1 − TPE) (1 − TC)] shows the effect of considering personal taxes. The relative advantage of debt depends on the differential personal tax rate. If TPE = TP, then the value of the tax shield is (Tc)(D), same as before, without personal taxes. For RAF>1 debt, is advantageous. For RAF<1, equity is advantageous.

14. 18-2 corporate and personal taxes
Example
For example where RAF>1. RAF = (1 − 0.35) / [(1 − ) (1 − 0.35)] =
Debt is advantageous in this case.

15. 18-2 corporate and personal taxes
Another Example
Another numerical example where RAF>1. RAF = (1 − 0.35)/[(1 − 0.105)(1 − 0.35)] = Debt is advantageous in this case. If debt is advantageous, then why is 100% debt not used?

16. 18-2 corporate and personal taxes
RAF and Debt versus Equity Preference
RAF =
Why are companies not all debt ?
RAF = (1 − 0.33)/[(1 − 0.16)(1 − 0.35)] = 1.23.
If debt is advantageous, then why is 100% debt not used?

17. 18-3 costs of financial distress
Costs of financial distress; this is another breakdown of the value of a firm.

18. Figure 18.2 FIRM value
Firm value is true if all-equity-financed plus PV tax shield minus PV costs of financial distress
Figure 18.2: The graph illustrates the way to understand the true value of a firm.

19. 18-3 costs of financial distress
Capital Structure r
Bond Yield
Bond yield rate increases with D/E ratio as shown graphically. According to the traditional view, as the debt-equity ratio increases, the interest rate on debt increases because of an increase in the probability of default (bankruptcy risk). Remember that in the MM world, there is no default. D
Structure of Bond Yield Rates E

20. 18-3 costs of financial distress
Traditional View of WACC Without Taxes D V rE r rD
Includes Bankruptcy Risk
This shows the weighted-average cost of capital WACC vs. D/V, which is the debt ratio. This includes bankruptcy.

21. 18-3 costs of financial distress
Cost of Financial Distress
Costs arising from bankruptcy or distorted business decisions before bankruptcy
Market Value Equals Value If:
All-equity financed
+ PV tax shield
− PV costs of financial distress
At higher levels of debt, costs of financial distress have to be considered. Financial distress occurs when promises to creditors are broken or honored with difficulty. Financial distress includes failure to pay interest or principal or both. Formally, financial distress is defined as events preceding and including bankruptcy, such as violation of a loan or bond contract. Financial distress has both direct and indirect costs. The market value of a firm when bankruptcy costs are considered:
Market value = value if all equity financed + PV tax shield – PV costs of financial distress

22. 18-3 costs of financial distress
Debt
Market Value of the Firm
Value of
unlevered
firm
PV of interest
tax shields
Costs of
financial distress
Value of levered firm
Optimal amount
of debt
Maximum value of firm
The trade-off between the tax benefits and the costs of distress determines optimal capital structure. PV(tax shield) initially increases as a firm borrows more. PV(cost of financial distress) is small and the value of the firm increases with more borrowing. At higher levels of debt, PV(cost of financial distress) dominates and the firm value diminishes. The manager should choose the debt ratio that maximizes the firm value.

23. Figure 18.3 Comparison of limited and unlimited liability
This frame shows the advantages of limited liability to shareholders. The value of the option is positive. Shareholders hold the option to obtain the rights to the assets by paying off debt. Limited liability gives the stockholders a right to default.

24. Figure 18.4 payout to ace limited security holders
Here there is a $200 bankruptcy cost in the event of default. The graph is the total payoff to security holders (bondholders and stockholders).

25. 18-3 costs of financial distress
Circular File company has $50 of one-year debt
Circular File Company has $50 of one-year debt as reflected in the balance sheet.

26. 18-3 costs of financial distress
Circular File Company has $50 of one-year debt
Here is the balance sheet in market values—firm is in financial distress. The reason the equity has any value is because of the one-year time period it has before the bond requires payment. Shareholders control investment and operating strategy.
Why does equity have any value?
Shareholder option to obtain rights to assets
by paying $50 debt

27. 18-3 costs of financial distress
Circular File Company invests $10
Risk shifting: The firm can invest $10 and can have a payoff of $120 (10% probability); or a payoff of $0 (90% probability). This is a very risky project that would normally be rejected as it has a negative NPV (–$2). [It assumes a discount rate of 50% for the project.] This is a high-risk investment, but it gives the shareholders a small chance to get out of bankruptcy if the project is successful and pays $120.
Assume NPV of project is (=$2)
What is effect on market values?

28. 18-3 costs of financial distress
Circular File Company Value, Post-Project
Firm value falls by $2
Equityholder gains $3
Even though the firm value falls by $2, the equityholders gain $3 in value because the bond value has fallen by $5. The $10 that could have been used to pay the bond has been replaced by a risky project worth only $8. So they accept the project. This is called risk shifting. The bond value drops by $5. This game is played at the expense of the bondholders. Stockholders, when faced with bankruptcy, might be tempted to take high-risk projects, even with negative NPVs, in an effort to avoid bankruptcy. This is an error of omission, as normally firms would not accept such a high-risk project with negative NPV.

29. 18-3 costs of financial distress
Circular File Company Value
Assumes safe project with NPV = $5
Firm value rises and lack of potential payoff for shareholders causes decrease in equity value
Here is an opportunity to invest in a safe project (NPV = +$5) by investing $10. The value of the bond increases by $8. The value of the firm increases by $15. The value of equity increases by only $7. Therefore, shareholders will reject this project. Conflicts of interest may lead to errors of omission, as normally firms would accept such a project. Here shareholders are refusing to contribute equity capital.

30. 18-3 costs of financial distress
Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch
These are three more games that shareholders play when in financial distress.
Cash in and run: Pay cash dividends (large if possible).
Playing the time: Delay settlement.
Bait and switch: Issue large amounts of debt.
These problems can be minimized through bond covenants. At higher levels of debt, the risk of bankruptcy outweighs the advantages of debt.

31. 18-3 Costs of financial distress
Henrietta Ketchup has two possible investment projects
Example 18.1 Consider the case of Henrietta Ketchup, a budding entrepreneur with two possible investment projects that offer payoff detailed in the table.

32. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Trade-Off Theory
Theory that capital structure is based on trade- off between tax savings and distress costs of debt
Pecking-Order Theory
Theory stating firms prefer to issue debt over equity if internal finances are insufficient
These are two theories that try to reconcile theory and practice. A firm’s capital structure decision is a trade-off between interest tax shields and the costs of financial distress. The above results are consistent with the assertion that managers have more information than investors, or informational asymmetry. Pecking-order theory states that firms prefer to issue debt to rather than equity if internally generated funds are insufficient.

33. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Trade-Off Theory and Prices
Stock-for-debt exchange offers results in stock price falling
Inversely, debt-for-stock exchange offers results in stock price rising
Issuing common stock drives down stock prices, whereas repurchases increase stock prices
Issuing straight debt has small negative impact
According to trade-off theory, stock-for-debt exchange offer results in a fall in stock price.
Debt-for-stock exchange offer results in an increase in stock price. Issuing common stock drives down stock prices; repurchase increases stock prices. Issuing straight debt has a small negative impact.

34. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Issues and Stock Prices
Why do security issues affect stock prices when demand for firm’s securities should be flat?
Any firm is drop in bucket
Plenty of close substitutes
Large debt issues do not significantly depress stock price
Security exchange offers should not affect stock prices. This leads us to the pecking-order theory.

35. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Pecking-Order Theory
Firms prefer internal finance
Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends
The pecking-order theory explains why firms prefer internal finance.

36. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Pecking-Order Theory
Internally generated cash flows sometimes more than capital expenditures, other times not
Due to dividend policies, plus fluctuations in profitability and investment opportunities
If more, firm pays off debt or invests in marketable securities
If less, firm first draws down cash balance or sells marketable securities
What a firm will do if its internal cash flow is more than the capital expenditures and what the firm does if it is not.

37. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Pecking-Order Theory
If external finances are required, firms issue the safest security first
They start with debt then possibly hybrid securities, such as convertible bonds, then equity as a last resort
What a firm will do if external finances are required.

38. 18-4 PECKING ORDER OF FINANCIAL CHOICES
Pecking-Order Theory
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
The implications of this theory are:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is needed, debt is better.