INTRODUCTION TO CAPITAL STRUCTURE (continued) Corporate Finance Lecture 17 and 20 INTRODUCTION TO CAPITAL STRUCTURE (continued) Ronald F. Singer FINA 4330 Fall, 2010

The Irrelevance Theorem Perfect Capital Market Setting No Taxes No Contracting Costs Costs of Financial Distress Agency Costs No Information Costs

Irrelevance Theorem LIABILITIES ASSETS DEBT 0 PVA $1,000,000 EQUITY 3,000,000 TOTAL $3,000,000 ASSETS PVA $1,000,000 PVGO 2,000,000 TOTAL $3,000,000

Irrelevance Theorem ASSETS LIABILITIES PVA $1,000,000 DEBT 1,600,000 PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 1,600,000 EQUITY 1,400,000 TOTAL $3,000,000

The Static Tradeoff Theory Benefits versus Costs of Leverage. Benefits Costs Taxes Financial Distress Resolution of Agency Costs Agency Costs Bondholder/Stockholder Manager/Stockholder Bankruptcy Costs Direct and Indirect Information Costs

Tax Implications LIABILITIES ASSETS PVA $1,000,000 DEBT 0 EQUITY 2,100,000 TOTAL $2,100,000 ASSETS PVA $1,000,000 PVGO 2,000,000 - PV of Tax Liability 900,000 TOTAL $2,100,000

Tax Implications (Suppose T = 30%) ASSETS PVA $1,000,000 PVGO 2,000,000 Less: PV of Tax Liability 420,0000 TOTAL $2,580,000 LIABILITIES DEBT 1,600,000 EQUITY 980,000 TOTAL $2,580,000

Stockholders’ Wealth Originally: $2,100,000 in Equity Interest Now: 980,000 in Equity Interest $1,600,000 in Cash 2,580,000 Total Stockholders’ Wealth increased by 480,000 = the reduction of taxes.

Firm Value Assuming Perfect Capital Markets except for Taxes Notice what happens, the (after tax) FCF increases due to the tax benefit from the interest deduction on debt. In particular, FCF = Before Tax FCF – Tax Tax = T (Earnings) = T (Rev-Exp-Interest) = (Rev-Exp)(T) – (Int)(T) So FCF = FCF(1-T) + Interest(T)

The Tax Benefit So we can divide the After Tax Free Cash Flow into two separate Cash Flows: Cash Flow from operations FCF*(1-T) = The Free Cash Flow (after Tax) that would be generated if there were no debt in the capital structure Interest*(T) = The reduction of tax due to the Tax shield on interest.

Example Suppose that the firm’s cash flows looked as follows: Revenue $20 million Cash Expense $10 million Interest $2 million Depreciation $3 million Change in WC 0

Calculation of Unlevered Cash Flow That is, how much (after tax) would be generated if there were no interest payments “Net Operating Income” (NOI)= (Rev-Cash Expense – Depreciation) = $7 million Tax @ 30 % = $2.1 million After Tax Operating Cash Flow NOI – Tax + Depreciation $7 - 2.1 + 3 = 7.9 Million

The Interest Tax Shield Notice we can find the amount of the tax shield by considering how much tax saving there is for each dollar of interest. In particular The Tax Shield = T * Interest = (.3) * 2 million = 0.6 million

PV of Cash Flow: V = S(Y)(1-T) + ST (Interest) (1+ro)t (1+rB) t = V(u) + PV of Tax Shield

With Taxes V = V(u) Plus Present Value of Tax Shield on Debt. V= V(u) + (Corp. Tax Rate) * Debt In the special case when debt is thought of as perpetual.

Graphically Firm Value (V) V = V(u) + Tc*B V(u) Debt

Cost of Capital rs = ro + (ro -rB)B/S WACC = ro r rB

Cost of Capital (After Tax) rs = ro + (ro-rB)(1-T)B/S r WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V) rB

The two ways of representing firm value V = V (u) + T The two ways of representing firm value V = V (u) + T * B V = SY(1-T) (1+WACC)t Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)

Static Tradeoff Theorem Costs of Financial Distress (“Contracting Costs”) Potential Bankruptcy Costs Underinvestment Risk Shifting Agency Costs Assume: Not Taxes Risk neutrality Single period Interest rate = 0%

Example of Underinvestment ASSETS PVA $1,000,000 PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment ASSETS PVA $1,000,000 PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment ASSETS PVA $1,000,000 (Cash = 600,000) (Real Assets = 400,000) PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment Make a Div Payment rather than invest ASSETS PVA $400,000 (Real Assets = 400,000) PVGO 2,000,000 TOTAL $2,400,000 LIABILITIES DEBT 2,250,000 EQUITY 1 50,000 TOTAL $2,400,000

Risk Shifting Suppose the firm has value that will look like the following: Value in Good State = $4,500,000 Value in Bad State = 1,500,000 With equal probability Promised payment to the Bondholder: $3,500,000 What is the value of the equity and the debt?

Investment Opportunity Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are: $5,000,000 in good state 500,000 in bad state: What is the NPV of the project, value of the debt and value of the equity?

Firm Value Costs of Financial Distress V = V(u) + PV of Tax Shield Debt Level Optimal Debt Level

Pecking Order Hypothesis Costly Information Conclusion Firm has an ordering under which they will Finance First, use internal funds Next least risky security

Intuition Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it? Now suppose you believe the firm is overvalued

Pecking Order theory So you have a dominating way of getting capital Internal Financing Risk free debt Risky debt Equity In general, the more “debt like” a security is, the more you want to issue it.

So the announcement effect If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm. Therefore the firm will never issue equity if it can avoid it. Thus pecking order.