1. Corporate Finance
Lecture 9

2. outline
Signaling
Agency cost of equity
Capital budgeting with debt

3. 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

4. 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.

5. 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.

6. 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.

7. 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

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

9. 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.

10. 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.

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

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

13. 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

14. 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 $ $ $ $500
The unlevered cost of equity is r0 = 10%:
The project would be rejected by an all-equity firm: NPV < 0.

15. 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.