How Much Should a Firm Borrow? Student Presentations Why M & M Does Not Hold Corporate Taxes Personal Taxes Financial Distress Pecking Order of Financing Choices

Corporate Taxes Debt provides a tax shield Interest is tax deductible Government’s share of income declines Value of bondholders’ and stockholders’ share increases

Present Value of Tax Shield If debt is assumed to be a perpetuity

Table 18.1: Comparison of Unlevered Firm and Levered Firm with $1000 of Debt at 8%

1 year $1,000,000 loan at 8% A) $25,926 B) $28,000 C) $35,000 Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue: 1 year $1,000,000 loan at 8% A) $25,926 B) $28,000 C) $35,000 D) $350,000 E) None of the above

$1,000,000 perpetuity loan at 8% A) $28,000 B) $80,000 C) $324,074 Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue: $1,000,000 perpetuity loan at 8% A) $28,000 B) $80,000 C) $324,074 D) $350,000 E) None of the above

Claims on Firm Bondholders: Debt Government: Taxes Equityholders: Remainder of firm value

M&M and Taxes Value of firm = Value of all-equity-financed firm + PV(tax shield)

Pfizer Balance Sheet 2004 and Adjusted for $1 billion Debt for Equity Trade ACTUAL ADJUSTED

What’s Wrong with Pfizer’s CFO? Should also consider personal taxes Cost of financial distress

Corporate and Personal Taxes Relative tax advantage of debt vs. equity If the relative advantage is > 1, debt is preferred If the relative advantage is < 1, equity is preferred

Example – Advantage to Debt Assume dividends are 40% of earnings Each dollar of earnings generates $0.40 in dividends and $0.60 in capital gains Marginal investor is in the 35% tax bracket on interest and 15% on dividends and capital gains Deferral of capital gains reduces capital gains rate in half (to 7.5%)

Example - continued

A) 0.76 B) 1.16 C) 1.35 D) 1.76 E) None of the above Calculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ; Tp = Personal tax rate on interest income = 20% : A) 0.76 B) 1.16 C) 1.35 D) 1.76 E) None of the above

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20% A) $0.66 B) $0.25 C) -$0.66 D) -$0.34 E) None of the above

Costs of Financial Distress Value of firm = Value of all-equity-financed firm + PV(tax shield) – PV(costs of financial distress)

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

Types of Financial Distress Bankruptcy costs Direct: legal and court costs Indirect: Inefficient operations, creditors, employees, suppliers, customers Financial distress without bankruptcy Incentives for a firm in difficulty Risk shifting Refusing to contribute equity capital Taking cash from firm Delaying tactics Bait and switch on use of funds from debt

Costs of Financial Distress by Asset Type Tangible assets unaffected by ownership Real estate Airplanes Intangible assets Brand image Technology Human capital

Trade-off Theory of Capital Structure Capital structure depends on trade-off between interest tax shield and financial distress High debt firms Safe, tangible assets High taxable income Low debt firms Risky, intangible assets Unprofitable companies Does theory work? Yes and no

Pecking Order of Financing Choices Firms prefer internal finance Firms adapt payout targets to investment opportunities trying to avoid sudden changes Sticky dividend policies and fluctuations in profitability and investment opportunities lead to cash flow shifts If external finance is required, firms issue debt first, then equity

Tests of Pecking Order Large firms tend to have higher debt ratios Firms with high ratios of fixed assets to total assets have higher debt ratios More profitable firms have lower debt ratios Firms with higher ratios of book-to-market values have lower debt ratios

Next Class Thursday, April 12 Financing and Valuation – Chapter 19 Problem Set 3