How Much Should a Corporation Borrow?

Topics Covered Corporate Taxes Corporate and Personal Taxes Cost of Financial Distress The Pecking Order of Financial Choices 2 2 2 2 3 2

Industry Debt Levels Ratios of debt to debt-plus-equity for sample of nonfinancial businesses, 2010 Note: Debt-to-total capital ratio = D/(D + E), where D and E are book values of long-term debt and equity.

Tax-Deductible Interest The tax deductibility of interest increases the total income that can be paid out to bondholders and stockholders This shows that the interest tax shield for the year is $28. The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.

Capital Structure & Corporate Taxes

Capital Structure & Corporate Taxes Example You own all the equity of Space Babies Diaper Co. the company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35%. You have the option to exchange half of your equity position for 5% bonds with face value of $2,000,000. Should you do this and why? Here is an example of leveraging on the personal account.

Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange half of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? Total Cash Flow All equity = 585 *1/2 Debt = 620 (520 + 100)

Capital Structure & Corporate Taxes PV of tax shield = D× 𝑟 𝐷 ×𝑇 𝑐 𝑟 𝐷 =𝐷× 𝑇 𝑐 Example: Tax benefit = 2,000,000× .05 × .35 =$35,000 PV of $35,000 in perpetuity = 35,000 .05 =$700,000 or PV of tax shield = $2,000,000 × .35 = $700,000

Capital Structure & Corporate Taxes Firm value = value of all equity firm + PV tax shield Example All equity value = 585 .05 =11,700,000 PV tax shield = 700,000 Firm value with 50% debt = $12,400,000

Market Value Balance Sheets Table 18.3 Normal and expanded market value balance sheets.

Capital Structure & Corporate Taxes Johnson & Johnson Balance Sheet September 2014 (figures in $millions)

Capital Structure & Corporate Taxes Johnson & Johnson Balance Sheet September 2014 (figures in $millions) (w/ $10 billion Debt for Equity Swap)

C.S. & Taxes (Personal & Corp) Operating Income ($1.00) Or paid out as equity income Paid out as interest Corporate Tax None Tc Income after corp taxes $1.00 $1.00 – Tc Personal taxes Tp TpE (1.00-Tc) Income after all taxes $1.00 – Tp $1.00 − Tc − TpE(1.00 − Tc) =(1.00 − TpE)(1.00 − Tc) To bondholders To stockholders

C.S. & Taxes (Personal & Corp) Relative Advantage Formula ( Debt vs. Equity ) Advantage RAF > 1 Debt RAF < 1 Equity

C.S. & Taxes (Personal & Corp) Example

C.S. & Taxes (Personal & Corp) Another Example

C.S. & Taxes (Personal & Corp) Today’s RAF & Debt vs. Equity preference RAF= 1−.33 (1−.15)(1−.35) =1.21 Why are companies not all debt?

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

Financial Distress Maximum value of firm Market value of the firm Debt unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm

Default Payoff Scenarios

Ace Limited Example Total payoff to Ace Limited security holders. There is a $200 bankruptcy cost in the event of default (shaded area).

Conflicts of Interest Circular File Company has $50 of 1-year debt

Conflicts of Interest Circular File Company has $50 of one-year debt Why does the equity have any value? Shareholders have an option—they can obtain the rights to the assets by paying off the $50 debt.

Conflicts of Interest Circular File Company may invest $10 as follows Assume the NPV of the project is -$2. What is the effect on the market values?

Conflicts of Interest Circular File Company value (post project) Firm value falls by $2, but equity holder gains $3

Conflicts of Interest Circular File Company value (assumes a safe project with NPV = $5) While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.

Financial Distress Games Cash In and Run Playing for Time Bait and Switch

Ms. Ketchup Faces Credit Rationing Henrietta Ketchup has two possible investment projects Example 18.1 Consider the case of Henrietta Ketchup, a budding entrepreneur with two possible investment projects that offer payoff detailed in the table.

The Pecking Order of Financing Choices Trade-Off Theory Theory that capital structure is based on trade- off between tax savings and distress costs of debt Pecking-Order Theory Theory stating firms prefer to issue debt over equity if internal finances are insufficient These are two theories that try to reconcile theory and practice. A firm’s capital structure decision is a trade-off between interest tax shields and the costs of financial distress. The above results are consistent with the assertion that managers have more information than investors, or informational asymmetry. Pecking-order theory states that firms prefer to issue debt to rather than equity if internally generated funds are insufficient.

Asymmetric Information 1. Stock-for-debt exchange offers Stock price falls Debt-for-stock exchange offers Stock price rises 2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact.

Issues and Stock Prices Why do security issues affect stock price? The demand for a firm’s securities ought to be flat. Any firm is a drop in the bucket. Plenty of close substitutes. Large debt issues don’t significantly depress the stock price.

Pecking Order Theory Consider the following story: The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory Some Implications: Internal equity may be better than external equity Financial slack is valuable If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).

Implications of the Pecking Order Firms prefer internal finance Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends Internally generated cash flows is sometimes more than capital expenditures, other times not Due to dividend policies, plus fluctuations in profitability and investment opportunities If more, firm pays off debt or invests in marketable securities If less, firm first draws down cash balance or sells marketable securities If external finances are required, firms issue the safest security first They start with debt then possibly hybrid securities, such as convertible bonds, then equity as a last resort The pecking-order theory explains why firms prefer internal finance.

The Pecking Order - Evidence Size. Large firms tend to have higher debt ratios. Tangible assets. Firms with high ratios of fixed assets to total assets have higher debt ratios. Profitability. More profitable firms have lower debt ratios. Market to book. Firms with higher ratios of market-to-book value have lower debt ratios The implications of this theory are: Internal equity may be better than external equity. Financial slack is valuable. If external capital is needed, debt is better.