16-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 16 Chapter Sixteen Capital Structure: Limits to the Use of Debt Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

16-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter Outline 16.1 Costs of Financial Distress 16.2 Description of Costs 16.3 Can Costs of Debt Be Reduced? 16.4 Integration of Tax Effects and Financial Distress Costs 16.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity 16.6 The Pecking-Order Theory 16.7 Growth and the Debt-Equity Ratio 16.8 Personal Taxes 16.9 How Firms Establish Capital Structure Summary and Conclusions

16-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.1 Costs of Financial Distress Bankruptcy risk versus bankruptcy cost. The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the costs associated with bankruptcy. It is the stockholders who bear these costs.

16-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.2 Description of Costs Direct Costs –Legal and administrative costs (tend to be a small percentage of firm value). Indirect Costs –Impaired ability to conduct business (e.g., lost sales) –Agency Costs Selfish Strategy 1: Incentive to take large risks Selfish Strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the property

16-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Balance Sheet for a Company in Distress AssetsBVMVLiabilitiesBVMV Cash$200$200LT bonds$300 Fixed Asset$400$0Equity$300 Total$600$200Total$600$200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. $200 $0

16-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Selfish Strategy 1: Take Large Risks The GambleProbabilityPayoff Win Big10%$1,000 Lose Big90%$0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × $0 = $100

16-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Selfish Stockholders Accept Negative NPV Project with Large Risks Expected CF from the Gamble –To Bondholders = $300 × $0 = $30 –To Stockholders = ($ $300) × $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble = $30 / 1.5 = $20 PV of Stocks With the Gamble = $70 / 1.5 = $47

16-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Should we accept the project? Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10%

16-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Selfish Stockholders Forego Positive NPV Project Expected CF from the government sponsored project: –To Bondholder = $300 –To Stockholder = ($350 - $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project = $300 / 1.1 = $ PV of Stocks With the project = $50 / $100 = -$54.55

16-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Selfish Strategy 3: Milking the Property Liquidating dividends –Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. –Such tactics often violate bond indentures. Increase perquisites to shareholders and/or management

16-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.3 Can Costs of Debt Be Reduced? Protective Covenants Debt Consolidation: –If we minimize the number of parties, contracting costs fall.

16-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Protective Covenants Agreements to protect bondholders Negative covenant: Thou shalt not: –Pay dividends beyond specified amount. –Sell more senior debt & amount of new debt is limited. –Refund existing bond issue with new bonds paying lower interest rate. –Buy another company’s bonds. Positive covenant: Thou shall: –Use proceeds from sale of assets for other assets. –Allow redemption in event of merger or spinoff. –Maintain good condition of assets. –Provide audited financial information. –Segregate and maintain specific assets as security for debt.

16-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.4 Integration of Tax Effects and Financial Distress Costs There is a trade-off between the tax advantage of debt and the costs of financial distress. It is difficult to express this with a precise and rigorous formula.

16-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Integration of Tax Effects and Financial Distress Costs Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B* Maximum firm value Optimal amount of debt

16-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The essence of the M&M intuition is that V T depends on the cash flow of the firm; capital structure just slices the pie. The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy lawyers, respectively. V T = S + B + G + L S G B L

16-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.5 Shirking, Perquisites, and Bad Investments: The Agency Cost of Equity An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help.” Who bears the burden of these agency costs? While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.

16-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.6 The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. –Rule 1 Use internal financing first. –Rule 2 Issue debt next, equity last. The pecking-order theory is at odds with the trade- off theory: –There is no target D/E ratio. –Profitable firms use less debt. –Companies like financial slack

16-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.7 Growth and the Debt-Equity Ratio Growth implies significant equity financing, even in a world with low bankruptcy costs. Thus, high-growth firms will have lower debt ratios than low-growth firms. Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal.

16-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.8 Personal Taxes: The Miller Model The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: Where: T S = personal tax rate on equity income T B = personal tax rate on bond income T C = corporate tax rate

16-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Personal Taxes: The Miller Model The derivation is straightforward: Continued…

16-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Personal Taxes: The Miller Model (cont.) The first term is the cash flow of an unlevered firm after all taxes. Its value = V U. A bond is worth B. It promises to pay r B B×(1- T B ) after taxes. Thus the value of the second term is: The total cash flow to all stakeholders in the levered firm is: The value of the sum of these two terms must be V L

16-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Personal Taxes: The Miller Model (cont.) Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:  In the case where T B = T S, we return to M&M with only corporate tax:

16-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes Debt (B) Value of firm (V) VUVU V L = V U +T C B when T S =T B V L < V U + T C B when T S < T B but (1-T B ) > (1-T C )×(1-T S ) V L =V U when (1-T B ) = (1-T C )×(1-T S ) V L < V U when (1-T B ) < (1-T C )×(1-T S )

16-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B* Maximum firm value Optimal amount of debt V L < V U + T C B when T S < T B but (1-T B ) > (1-T C )×(1-T S ) Agency Cost of EquityAgency Cost of Debt

16-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 16.9 How Firms Establish Capital Structure Most Corporations Have Low Debt-Asset Ratios. Changes in Financial Leverage Affect Firm Value. –Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes. –Another interpretation is that firms signal good news when they lever up. There are Differences in Capital Structure Across Industries. There is Evidence that Firms Behave as If They had a Target Debt-to-Equity ratio.

16-25 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Factors in Target D/E Ratio Taxes –If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. Types of Assets –The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income –Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. Pecking Order and Financial Slack –Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

16-26 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of debt. –Direct costs Lawyers’ and accountants’ fees –Indirect Costs Impaired ability to conduct business Incentives to take on risky projects Incentives to underinvest Incentive to milk the property Three techniques to reduce these costs are: –Protective covenants –Repurchase of debt prior to bankruptcy –Consolidation of debt

16-27 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Summary and Conclusions Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt. Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B* Maximum firm value Optimal amount of debt

16-28 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Summary and Conclusions If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-T C ) × (1-T S ) = (1-T B ) Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B* Maximum firm value Optimal amount of debt V L < V U + T C B when T S < T B but (1-T B ) > (1-T C )×(1-T S ) Agency Cost of EquityAgency Cost of Debt

16-29 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Summary and Conclusions Debt-to-equity ratios vary across industries. Factors in target D/E ratio –Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. –Types of Assets The costs of financial distress depend on the types of assets the firm has. –Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress.

16-30 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Appendix 16B The Miller Model and the Graduated Income Tax In our previous discussion, we assumed that all investors share a single personal income tax on interest income. Consistent with the real world, Miller’s model allows for the real world case where tax rates differ across individuals. In Canada, federal tax rates for individuals are 0, 17, 26, and 29-percent, depending on their income. Other entities, such as pension funds and universities, are tax exempt.

16-31 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Miller Model and the Graduated Income Tax: Example Consider an economy with: T C = 40%, T S = 0, r S = 15%, individual tax rates range between 0 and 50-percent, and all individuals are risk neutral. ABC corp. is considering a $1 million issue of debt. The after-corporate-tax cost of debt for ABC is: (1 - T C )r B, and its cost of equity is r S. The maximum interest rate that ABC can pay on its debt and still prefer issuing debt to issuing equity, is given by setting: (1 - T C )r B = r S. Or the break-even rate is given by:

16-32 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Miller Model and the Graduated Income Tax: Example (continued) Tax-exempt investors will be indifferent between purchasing ABC’s stocks or ABC’s bonds yielding also 15-percent. If ABC is the only firm issuing debt, it can pay an interest rate greater or equal to 15-percent, and well below its break- even rate of 25-percent. Noticing this advantage, other firms are likely to issue debt. However, since the number of tax-exempt individuals is limited, such new debt issues must pay interest high enough to attract individuals in higher brackets. For these individuals, the tax rate that applies to debt is greater than that applies to equity (0-percent).

16-33 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Miller Model and the Graduated Income Tax: Example (continued) Thus, tax-exempt individuals will only buy debt if its yield is greater than that of equity (15%). An individual in the 20% tax bracket, will be indifferent between debt and equity if r B = 18.75%, because ×(1-0.2) = 15%. Since 18.75% is less than the break-even rate of 25%, firms still gain from issuing debt to individuals in the 20% tax bracket. For individuals in the 40% tax bracket, the after-tax return from a bond paying 25% is 0.25×(1-0.4) = 15%. Thus, individuals in a tax bracket that equals the corporate tax rate (40%), will be indifferent between debt and equity. In equilibrium, firms will issue enough debt so these individuals will hold debt.