Corporate Finance Lecture 9

outline Signaling Agency cost of equity Capital budgeting with debt

Integration of Tax Effects and Financial Distress Costs Value of firm (V) Value of firm under MM with corporate taxes and debt Present value of tax shield on debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt Debt (B) B* Optimal amount of debt

Signaling The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. Investors view debt as a signal of firm value. A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.

Agency Cost of Equity Agency cost of equity is caused by the conflict between the manager and the shareholders. Shirking: The manager will work harder for the firm if he is one of the owners than if he is just an employee. The manager will work harder for the firm if he owns a large proportion of the firm than if he only owns a small percentage. Perquisite The manager has the incentive to obtain more perquisite if he owns a smaller proportion of the firm. Overinvestment: The manager is likely to make bad investments when he owns less of the firm.

Reducing Agency Cost of Equity Free cash flow hypothesis: The manager’s opportunity to obtain more perquisite comes from free cash flow of the firm. Dividend payouts reduce the ability of managers to pursue wasteful activities. Debt also reduces the ability of managers to pursue wasteful activities.

Integration of Tax Effects and Financial Distress Costs and Agency Costs Value of firm (V) Value of firm under MM with corporate taxes and debt Present value of tax shield on debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt Agency Cost of Equity Agency Cost of Debt Debt (B) B* Optimal amount of debt

The Pecking-Order Theory Asymmetric information between the manager and outside investors The Pecking Order: Internal funding Bank loan Issue debt Issue equity

The Pecking-Order Theory vs. the Trade-off Theory Target D/E ratio no yes Debt as a signal of the firm bad good Financial slack High-growth firms will have lower debt ratios than low-growth firms. 100% debt financing is sub-optimal.

How Firms Establish Capital Structure Most Corporations Have Low Debt-Asset Ratios. Changes in Financial Leverage Affect Firm Value. There are Differences in Capital Structure Across Industries. There is evidence that firms behave as if they had a target Debt to Equity ratio.

Factors in Target D/E Ratio Taxes Types of Assets Uncertainty of Operating Income Pecking Order and Financial Slack

Capital budgeting with debt Adjusted Present Value Approach Flows to Equity Approach Weighted Average Cost of Capital Method

Adjusted Present Value APV = NPV + NPVF The value of a project to the firm can be thought of as the value of the project to an unlevered firm (NPV) plus the present value of the financing side effects (NPVF): There are four side effects of financing: The Tax Subsidy to Debt The Costs of Issuing New Securities The Costs of Financial Distress Subsidies to Debt Financing

APV Example The unlevered cost of equity is r0 = 10%: Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: –$1,000 $125 $250 $375 $500 0 1 2 3 4 The unlevered cost of equity is r0 = 10%: The project would be rejected by an all-equity firm: NPV < 0.

APV Example (continued) Now, imagine that the firm finances the project with $600 of debt at rB = 8%. Pearson’s tax rate is 40%, so they have an interest tax shield worth TCBrB = .40×$600×.08 = $19.20 each year. The net present value of the project under leverage is: APV = NPV + NPV debt tax shield So, Pearson should accept the project with debt.