Lecture 6: Debt Policy Changing a firm’s capital structure should not affect its value to shareholders. This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm. Chapter 16 Outline Does Borrowing Affect Value? MM’s Proposition I How Borrowing Affects EPS How Borrowing Affects Risk and Return Debt and the Cost of Equity MM’s Proposition II Debt and Taxes Tax Shields and Shareholders’ Equity Taxes and WACC Costs of Financial Distress Costs of Bankruptcy Financial Distress Without Bankruptcy Explaining Financial Choices Financial Slack

Does Borrowing Affect Value? A company’s choice of capital structure does not increase the value of the firm. Capital Structure – The mix of long-term debt and equity financing. On the balance sheet, the value of the cash flows on the left determines the value of the firm, and therefore determines the values on the right. If the firm alters its capital structure, overall value should not change. Capital Structure – The mix of long-term debt and equity financing. On the balance sheet, the value of the cash flows on the left determines the value of the firm, and therefore determines the values on the right. If the firm alters its capital structure, overall value should not change.

MM’s Irrelevance Proposition The value of a firm does not depend on its capital structure. If this holds, can financial managers increase the value of the firm by changing the mix of securities used to finance the company? Note: This proposition assumes well functioning capital markets and no taxes. MM’s Proposition I – The value of a firm is unaffected by its capital structure.

MM’s Irrelevance Proposition Assumptions of MM’s argument: “Well functioning” capital markets Efficient capital markets No taxes (therefore no distortion) Ignore costs of financial distress

MM’s Irrelevance Proposition Example: An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value? Restructuring – Process of changing the firm’s capital structure without changing its real assets. Note: In the example above, since the value of the firm is the same in both situations, common shareholders are no better or worse off in either. Shares still trade at $10 each Overall value of equity falls to $6,000,000 but shareholders also receive $4,000,000. Before Restructuring:   Restructuring – Process of changing the firm’s capital structure without changing its real assets. Note: In the example above, since the value of the firm is the same in both situations, common shareholders are no better or worse off in either. Shares still trade at $10 each Overall value of equity falls to $6,000,000 but shareholders also receive $4,000,000.   After Restructuring:      

How Borrowing Affects EPS Ceteris paribus, borrowing will increase earnings per share. However, this isn’t a source of value to shareholders. Shareholders can easily replicate a firm’s borrowing on their own if they choose. As long as investors can borrow or lend on their own account on the same terms as the firm, they are not going to pay more for a firm that borrows on their behalf. The value of the firm after the restructuring must be the same as before. As long as investors can borrow or lend on their own account on the same terms as the firm, they are not going to pay more for a firm that borrows on their behalf. The value of the firm after the restructuring must be the same as before.

How Borrowing Affects Risk and Return Debt financing does not affect the operating risk of the firm. Operating Risk – Risk in firm’s operating income. Financial Risk – Risk to shareholders resulting from the use of debt. Ex: with only half the equity to absorb the same amount of operating risk, risk per share must double. Financial Leverage – Debt financing to amplify the effects of changes in operating income on the returns to stockholders. Debt financing does affect the financial risk of the firm. Debt financing doesn’t affect the operating risk of the firm. Operating Risk – Risk in firm’s operating income. Debt financing does affect the financial risk of the firm. Financial Risk – Risk to shareholders resulting from the use of debt. Ex: with only half the equity to absorb the same amount of operating risk, risk per share must double. Financial Leverage – Debt financing to amplify the effects of changes in operating income on the returns to stockholders.

How Borrowing Affects Risk and Return The circles on the left assume “River Cruises” has no debt. The circles on the right reflect a proposed restructuring that splits firm value 50-50. Shareholders get more than 50% of expected operating income, but only because they bear additional financial risk. The circles on the left assume “River Cruises” has no debt. The circles on the right reflect a proposed restructuring that splits firm value 50-50. Shareholders get more than 50% of expected operating income, but only because they bear additional financial risk.

Debt and the Cost of Equity       MM’s Proposition II – The required rate of return on equity increases as the firm’s debt-equity ratio increases.

Debt and the Cost of Equity: Example What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 30% of assets?      

MM’s Proposition II Debt increases financial risk and causes shareholders to demand higher rates of return. MM’s Proposition II – The required rate of return on equity increases as the firm’s debt-equity ratio increases. Once the implicit cost of debt is recognized, debt is no cheaper than equity. The return that investors require on their assets is unaffected by the firm’s borrowing decision. MM’s Proposition II – The required rate of return on equity increases as the firm’s debt-equity ratio increases. Once the implicit cost of debt is recognized, debt is no cheaper than equity. The return that investors require on their assets is unaffected by the firm’s borrowing decision.

Debt and Taxes Debt financing advantage: the interest that a firm pays on debt is tax deductible. Interest tax shield – Tax savings resulting from deductibility of interest payments. Interest tax shield:   Interest tax shield – Tax savings resulting from deductibility of interest payments.  

Perpetual Tax Shield If the tax shield is perpetual, then:     Interest tax shield – Tax savings resulting from deductibility of interest payments. Interest tax shield – Tax savings resulting from deductibility of interest payments.

Perpetual Tax Shield: Example What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $12 million at an interest rate of 4% and a tax rate of 35%?    

Tax Shield and Shareholders’ Equity When accounting for taxes, borrowing increases firm value and shareholders’ wealth.  

Taxes and WACC Recall that the WACC takes into account the required after-tax rate of return  

Taxes and WACC: Example What is the expected rate of return to shareholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?      

Costs of Financial Distress Investors factor the potential for future distress into their assessment of current value. Overall Market Value = Value if all equity financed + PV tax shield – PV costs of financial distress Costs of Financial Distress – Cost arising from bankruptcy or distorted business decisions before bankruptcy. Trade-off Theory – Debt levels are chosen to balance interest tax shields against the costs of financial distress. At some point, additional borrowing causes the probability of financial distress to increase rapidly and the potential costs of distress begin to take a substantial bite out of firm value. Costs of Financial Distress – Cost arising from bankruptcy or distorted business decisions before bankruptcy. Trade-off Theory – Debt levels are chosen to balance interest tax shields against the costs of financial distress. At some point, additional borrowing causes the probability of financial distress to increase rapidly and the potential costs of distress begin to take a substantial bite out of firm value.

Bankruptcy Costs If there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of all court expenses. Bankruptcy costs vary with different types of assets. Some assets, like good commercial real estate, can pass through bankruptcy and reorganization largely unscathed. The greatest losses are from intangible assets that are linked to the continuing prosperity of the firm. Bankruptcy costs vary with different types of assets. Some assets, like good commercial real estate, can pass through bankruptcy and reorganization largely unscathed. The greatest losses are from intangible assets that are linked to the continuing prosperity of the firm.

Financial Distress Without Bankruptcy Even if a firm narrowly escapes bankruptcy, this does not mean that costs of financial distress are avoided. Stockholders may be tempted to play games at the expense of creditors Betting the Bank’s Money Not Betting Your Own Money In times of financial distress, stockholders are tempted to forsake the usual objective of maximizing the overall market value of the firm and to pursue narrower self-interest instead. The games that they are tempted to play add to the costs of financial distress. If the probability of default is high, managers and stockholders will be tempted to take on excessively risky projects. To reassure lenders that the firm plans to pay their debts, they often agree to loan covenants. Loan covenant – Agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan. Loan Covenant: Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.

Explaining Financing Choices The Trade-off Theory Debt levels are chosen to balance interest tax shields against the costs of financial distress. A Pecking Order Theory: Firms prefer to issue debt rather than equity if internal finance is insufficient. Trade-off Theory – Debt levels are chosen to balance interest tax shields against the costs of financial distress. Pecking order theory – Firms prefer to issue debt rather than equity if internal finance is insufficient.

Financial Slack Financial Slack: Ready access to cash or debt financing. Financial managers usually place a very high value on having financial slack. Financial Slack – Ready access to cash or debt financing.

Two Faces of Financial Slack Benefits Long run value rests more on capital investment and operating decisions than on financing. Most valuable to firms with positive-NPV growth opportunities Drawbacks Too much financial slack may lead to lazy management. Managers may try to increase their own perks or engage in empire-building. Benefits: Long run value rests more on capital investment and operating decision than on financing. Therefore financing should be quickly available. Most valuable to firms with positive- NPV growth opportunities. Drawbacks: Too much financial slack may lead to lazy management. Managers may try to increase their own perks or engage in empire-building.