How MUCH Should A CORPORATION BORROW? 18 How MUCH Should A CORPORATION BORROW?

TABLE 18.1 RATIOS OF DEBT TO DEBT-PLUS-Equity FOR NONFINANCIAL BUSINESSes 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.

TABLE 18.2 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.

18-1 CORPORATE TAXES This example is the same as in the book. PV of tax shield = 28/0.08 = $350 = (0.35)(1000). This assumes permanent debt.

18-1 CORPORATE TAXES Examples You own all equity of Space Babies Diaper Co. Company has no debt Company has annual cash flow of $900,000 before interest and taxes Corporate tax rate is 35% You have the option to exchange 1/2 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.

18-1 CORPORATE TAXES Example Continued Total Cash Flow All equity = 585 *1/2 debt = 620 (520 + 100) With 50% debt, the net cash flow to the equity is $585 (in thousands). There is a reduction in taxes by $35 (in thousands). Total cash flow to the holder of equity and debt is $620 (in thousands). $35 (in thousands) is the tax saving through interest expense deduction. The total cash flow with all equity is $585,000. The total cash flow with 50% debt is $620,000. The difference of $35,000 is the tax savings.

18-1 CORPORATE TAXES   Tax benefit per year is $35 (in thousands). Assuming that this benefit will occur through perpetuity, the present value of the tax shield is 35/0.05 = $700 (in thousands). The same result is obtained by using the formula (D)(Tc) = (2,000,000)(0.35) = $700,000.

Table 18.3 Market value balance sheets Table 18.3 Normal and expanded market value balance sheets.

TABLE 18.4A SIMPLIFIED BALANCE SHEETS JOHNSON & JOHNSON, OCTOBER 2011 This is the balance sheet for Johnson & Johnson as of October 2011.

TABLE 18.4B BALANCE SHEETS JOHNSON & JOHNSON This is the Johnson & Johnson balance sheet with $1 billion debt for equity swap.

18-1 CORPORATE TAXES Example All-equity value = 585/.05 = 11,700,000 PV tax shield = 700,000 Firm value of ½ debt = $12,400,000 The increase in the value of the firm due to the debt is the present value of the tax shield. Firm value = value of an equivalent all-equity firm + PV of tax shield. All-equity value = 585/0.05 = $11,700,000. PV of tax shield is $700,000. Firm Value with ½ debt is 11,700,000 + 700,000 = $12,400,000.

Figure 18.1 Capital structure determines payout The diagram shows how personal taxes affect the payoffs to bondholders and stockholders.

18-2 CORPORATE AND PERSONAL TAXES Relative Advantage Formula (RAF) Debt vs. equity RAF > 1 = debt RAF < 1 = equity If we consider corporate taxes, we should also consider personal taxes, as we have a two-tier tax system in the U.S. The relative advantage formula (RAF): (1 − TP)/[(1 − TPE) (1 − TC)] shows the effect of considering personal taxes. The relative advantage of debt depends on the differential personal tax rate. If TPE = TP, then the value of the tax shield is (Tc)(D), same as before, without personal taxes. For RAF>1 debt, is advantageous. For RAF<1, equity is advantageous.

18-2 corporate and personal taxes Example For example where RAF>1. RAF = (1 − 0.35) / [(1 − 0.1125) (1 − 0.35)] = 1.1267. Debt is advantageous in this case.

18-3 costs of financial distress   Costs of financial distress; this is another breakdown of the value of a firm.

Figure 18.2 FIRM value Firm value is true if all-equity-financed plus PV tax shield minus PV costs of financial distress Figure 18.2: The graph illustrates the way to understand the true value of a firm.

18-3 costs of financial distress Cost of Financial Distress Costs arising from bankruptcy or distorted business decisions before bankruptcy Market Value Equals Value If: All-equity financed + PV tax shield − PV costs of financial distress At higher levels of debt, costs of financial distress have to be considered. Financial distress occurs when promises to creditors are broken or honored with difficulty. Financial distress includes failure to pay interest or principal or both. Formally, financial distress is defined as events preceding and including bankruptcy, such as violation of a loan or bond contract. Financial distress has both direct and indirect costs. The market value of a firm when bankruptcy costs are considered:   Market value = value if all equity financed + PV tax shield – PV costs of financial distress

Figure 18.3 Comparison of limited and unlimited liability This frame shows the advantages of limited liability to shareholders. The value of the option is positive. Shareholders hold the option to obtain the rights to the assets by paying off debt. Limited liability gives the stockholders a right to default.

Figure 18.4 payout to ace limited security holders Here there is a $200 bankruptcy cost in the event of default. The graph is the total payoff to security holders (bondholders and stockholders).

18-3 costs of financial distress Circular File company has $50 of one-year debt Circular File Company has $50 of one-year debt as reflected in the balance sheet.

18-3 costs of financial distress Circular File Company has $50 of one-year debt Here is the balance sheet in market values—firm is in financial distress. The reason the equity has any value is because of the one-year time period it has before the bond requires payment. Shareholders control investment and operating strategy. Why does equity have any value? Shareholder option to obtain rights to assets by paying $50 debt

18-3 costs of financial distress Circular File Company invests $10 Risk shifting: The firm can invest $10 and can have a payoff of $120 (10% probability); or a payoff of $0 (90% probability). This is a very risky project that would normally be rejected as it has a negative NPV (–$2). [It assumes a discount rate of 50% for the project.] This is a high-risk investment, but it gives the shareholders a small chance to get out of bankruptcy if the project is successful and pays $120. Assume NPV of project is (=$2) What is effect on market values?

18-3 costs of financial distress Circular File Company Value, Post-Project Firm value falls by $2 Equityholder gains $3 Even though the firm value falls by $2, the equityholders gain $3 in value because the bond value has fallen by $5. The $10 that could have been used to pay the bond has been replaced by a risky project worth only $8. So they accept the project. This is called risk shifting. The bond value drops by $5. This game is played at the expense of the bondholders. Stockholders, when faced with bankruptcy, might be tempted to take high-risk projects, even with negative NPVs, in an effort to avoid bankruptcy. This is an error of omission, as normally firms would not accept such a high-risk project with negative NPV.

18-3 costs of financial distress Circular File Company Value Assumes safe project with NPV = $5 Firm value rises and lack of potential payoff for shareholders causes decrease in equity value Here is an opportunity to invest in a safe project (NPV = +$5) by investing $10. The value of the bond increases by $8. The value of the firm increases by $15. The value of equity increases by only $7. Therefore, shareholders will reject this project. Conflicts of interest may lead to errors of omission, as normally firms would accept such a project. Here shareholders are refusing to contribute equity capital.

18-3 costs of financial distress Financial Distress Games Cash In and Run Playing for Time Bait and Switch These are three more games that shareholders play when in financial distress. Cash in and run: Pay cash dividends (large if possible). Playing the time: Delay settlement. Bait and switch: Issue large amounts of debt. These problems can be minimized through bond covenants. At higher levels of debt, the risk of bankruptcy outweighs the advantages of debt.

18-3 Costs of financial distress 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.

18-4 PECKING ORDER OF FINANCIAL 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.

18-4 PECKING ORDER OF FINANCIAL CHOICES Pecking-Order Theory 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 What a firm will do if external finances are required.

18-4 PECKING ORDER OF FINANCIAL CHOICES Pecking-Order Theory Internal equity may be better than external equity If external capital is required debt is better 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.