Chapter 15 Debt Policy Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 1 1 1 1 2 1

Topics Covered Debt and Value in a Tax Free Economy Capital Structure and Corporate Taxes Cost of Financial Distress Explaining Financial Choices 2

Value and Capital Structure Assets Liabilities 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 Value of Firm 2

Average Book Debt Ratios 2

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. 3

M&M (Debt Policy Doesn’t Matter) Assumptions By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives 4

M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed 5

M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt 6

M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed - Debt replicated by investors 7

M&M (Debt Policy Doesn’t Matter) Example - River Cruises – Firm debt at 50% - Investor can unwrap debt 7

C.S. & Corporate Taxes 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. 10

Cost of Capital

MM’s Proposition II (w/fixed interest rate) rD D V

MM’s Proposition II (w/risky debt) rE rA rD Risk free debt Risky debt D V Includes Bankruptcy Risk 9

Weighted Average Cost of Capital rE WACC with no bankruptcy risk WACC rD D V

C.S. & 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 $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? 11

C.S. & 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 $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? 13

C.S. & 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 $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? Total Cash Flow All Equity = 6,500 *1/2 Debt = 7,550 (4,550 + 3,000) 14

Capital Structure D x rD x Tc rD PV of Tax Shield = = D x Tc Example: (assume perpetuity) = D x Tc Example: Tax benefit = 10,000 x (.06) x (.35) = $210 PV of 210 perpetuity = 210 / .06 = $3,500 PV Tax Shield = D x Tc = 10,000 x .35 = $3,500 18

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 24

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 25

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 26

Web Resources Web Links http://finance.yahoo.com Click to access web sites Internet connection required http://finance.yahoo.com http://moneycentral.msn.com http://edgarscan.pwcglobal.com www.bankruptcydata.com www.abiworld.org www.bankrupt.com www.turnaround.org