Corporate Finance Lecture 17 CAPITAL STRUCTURE: Limits to Debt Ronald F. Singer FINA 4330 Fall, 2010

The Irrelevance Theorem Perfect Capital Market Setting No Taxes No Contracting Costs Costs of Financial Distress Agency Costs No Information Costs

Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT0 EQUITY3,000,000 TOTAL$3,000,000

Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT1,600,000 EQUITY1,400,000 TOTAL$3,000,000

The Static Tradeoff Theory Benefits versus Costs of Leverage. BenefitsCosts Taxes Financial Distress Resolution of Agency Costs Agency CostsBondholder/Stockholder Manager/Stockholder Bankruptcy Costs Direct and Indirect Information Costs

Tax Implications ASSETS PVA $1,000,000 PVGO 2,000,000 - PV of Tax Liability 900,000 TOTAL $2,100,000 LIABILITIES DEBT 0 EQUITY2,100,000 TOTAL$2,100,000

Tax Implications (Suppose T = 30%) ASSETS PVA $1,000,000 PVGO 2,000,000 Less: PV of Tax Liability 420,0000 TOTAL $2,580,000 LIABILITIES DEBT 1,600,000 EQUITY 980,000 TOTAL$2,580,000

Stockholders’ Wealth Originally: $2,100,000 in Equity Interest Now: 980,000 in Equity Interest $1,600,000 in Cash 2,580,000 Total Stockholders’ Wealth increased by 480,000 = the reduction of taxes.

Firm Value Assuming Perfect Capital Markets except for Taxes Notice what happens, the (after tax) FCF increases due to the tax benefit from the interest deduction on debt. In particular, FCF = Before Tax FCF – Tax Tax = T (Earnings) = T (Rev-Exp-Interest) = (Rev-Exp)(T) – (Int)(T) So FCF = FCF(1-T) + Interest(T)

The Tax Benefit So we can divide the After Tax Free Cash Flow into two separate Cash Flows: Cash Flow from operations FCF*(1-T) = The Free Cash Flow (after Tax) that would be generated if there were no debt in the capital structure Interest*(T) = The reduction of tax due to the Tax shield on interest.

Example Suppose that the firm’s cash flows looked as follows: –Revenue $20 million –Cash Expense $10 million –Interest $2 million –Depreciation $3 million –Change in WC 0

Calculation of Unlevered Cash Flow 1.That is, how much (after tax) would be generated if there were no interest payments 2.“Net Operating Income” (NOI)= (Rev-Cash Expense – Depreciation) = $7 million 30 % = $2.1 million After Tax Operating Cash Flow NOI – Tax + Depreciation $ = 7.9 Million

The Interest Tax Shield Notice we can find the amount of the tax shield by considering how much tax saving there is for each dollar of interest. In particular The Tax Shield = T * Interest = (.3) * 2 million = 0.6 million

PV of Cash Flow: V =  (Y)(1-T) +  T (Interest) (1+r o ) t (1+r B ) t = V(u) + PV of Tax Shield

With Taxes V = V(u) Plus Present Value of Tax Shield on Debt. V= V(u) + (Corp. Tax Rate) * Debt In the special case when debt is thought of as perpetual.

Graphically Firm Value (V) V = V(u) + Tc*B V(u) Debt