16- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Chapter 16 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Debt Policy

16- 2 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Debt and Value in a Tax Free Economy  Capital Structure and Corporate Taxes  Cost of Financial Distress  Explaining Financial Choices  Bankruptcy Procedures

16- 3 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Value and Capital Structure AssetsLiabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm

16- 4 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved M&M (Debt Policy Doesn’t Matter)  Modigliani & Miller  When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company.

16- 5 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved M&M (Debt Policy Doesn’t Matter) Assumptions  Capital structure does not affect cash flows e.g...  No taxes  No bankruptcy costs  No effect on management incentives

16- 6 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved M&M (Debt Policy Doesn’t Matter) Borrowing increases EPS for River Cruises

16- 7 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved River Cruise’s “Value Pie”

16- 8 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Operating Risk (business risk) – Risk in the firm’s operating income. Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. C.S. & Corporate Taxes

16- 9 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Cost of Capital

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved r DVDV rDrD rErE MM’s Proposition II (w/fixed interest rate) rArA

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Includes Bankruptcy Risk r DVDV rDrD rErE MM’s Proposition II (w/risky debt) rArA Risk free debtRisky debt

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved r DVDV rDrD rErE WACC Weighted Average Cost of Capital WACC with no bankruptcy risk

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders. C.S. & Corporate Taxes

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders. C.S. & Corporate Taxes Total Cash Flow All Equity = 81,250 *1/2 Debt = 98,750 (48, ,000)

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why? C.S. & Corporate Taxes

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why? C.S. & Corporate Taxes

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved C.S. & Corporate Taxes Total Cash Flow All Equity = 6,500 *1/2 Debt = 7,550 (4, ,000) Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000. Should you do this and why?

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Capital Structure PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 50,000 x (.06) x (.35) = $1,050 PV of 1,050 perpetuity = 1,050 /.06 = $17,500 PV Tax Shield = D x Tc = 50,000 x.35 = $17,500

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Financial Distress Debt Market Value of The Firm Value of all equity financed firm PV of interest tax shields PV costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Financial Slack