1. How Much Should a Corporation Borrow?

2. Topics Covered Corporate Taxes Corporate and Personal Taxes
Cost of Financial Distress
The Pecking Order of Financial Choices 2 2 2 2 3 2

3. Industry Debt Levels
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.

4. 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.

5. Capital Structure & Corporate Taxes

6. Capital Structure & 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 $900,000 before interest and taxes. The corporate tax rate is 35%. You have the option to exchange half 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.

7. Capital Structure & 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 $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange half of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why?
Total Cash Flow
All equity = 585
*1/2 Debt = 620
( )

8. Capital Structure & Corporate Taxes
PV of tax shield = D× 𝑟 𝐷 ×𝑇 𝑐 𝑟 𝐷 =𝐷× 𝑇 𝑐
Example:
Tax benefit = 2,000,000× .05 × .35 =$35,000
PV of $35,000 in perpetuity = 35, =$700,000 or
PV of tax shield = $2,000,000 × .35 = $700,000

9. Capital Structure & Corporate Taxes
Firm value = value of all equity firm + PV tax shield
Example
All equity value = =11,700,000
PV tax shield = ,000
Firm value with 50% debt = $12,400,000

10. Market Value Balance Sheets
Table 18.3 Normal and expanded market value balance sheets.

11. Capital Structure & Corporate Taxes
Johnson & Johnson Balance Sheet
September 2014 (figures in $millions)

12. Capital Structure & Corporate Taxes
Johnson & Johnson Balance Sheet
September 2014 (figures in $millions)
(w/ $10 billion Debt for Equity Swap)

13. C.S. & Taxes (Personal & Corp)
Operating Income ($1.00)
Or paid out as equity income
Paid out as interest
Corporate Tax
None Tc
Income after corp taxes
$1.00
$1.00 – Tc
Personal taxes Tp
TpE (1.00-Tc)
Income after all taxes
$1.00 – Tp
$1.00 − Tc − TpE(1.00 − Tc) =(1.00 − TpE)(1.00 − Tc)
To bondholders To stockholders

14. C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs. Equity )
Advantage
RAF > 1 Debt
RAF < 1 Equity

15. C.S. & Taxes (Personal & Corp)
Example

16. C.S. & Taxes (Personal & Corp)
Another Example

17. C.S. & Taxes (Personal & Corp)
Today’s RAF & Debt vs. Equity preference
RAF= 1−.33 (1−.15)(1−.35) =1.21
Why are companies not all debt?

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

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

20. Default Payoff Scenarios

21. Ace Limited Example
Total payoff to Ace Limited security holders. There is a $200 bankruptcy cost in the event of default (shaded area).

22. Conflicts of Interest
Circular File Company has $50 of 1-year debt

23. Conflicts of Interest Circular File Company has $50 of one-year debt
Why does the equity have any value?
Shareholders have an option—they can obtain the rights to the assets by paying off the $50 debt.

24. Conflicts of Interest Circular File Company may invest $10 as follows
Assume the NPV of the project is -$2.
What is the effect on the market values?

25. Conflicts of Interest Circular File Company value (post project)
Firm value falls by $2, but equity holder gains $3

26. Conflicts of Interest
Circular File Company value (assumes a safe project with NPV = $5)
While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.

27. Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch

28. Ms. Ketchup Faces Credit Rationing
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.

29. The Pecking Order of Financing 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.

30. Asymmetric Information
1. Stock-for-debt exchange offers
Stock price falls
Debt-for-stock exchange offers
Stock price rises
2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact.

31. Issues and Stock Prices
Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues don’t significantly depress the stock price.

32. Pecking Order Theory Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

33. Pecking Order Theory Some Implications:
Internal equity may be better than external equity
Financial slack is valuable
If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).

34. Implications of the Pecking Order
Firms prefer internal finance
Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends
Internally generated cash flows is sometimes more than capital expenditures, other times not
Due to dividend policies, plus fluctuations in profitability and investment opportunities
If more, firm pays off debt or invests in marketable securities
If less, firm first draws down cash balance or sells marketable securities
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
The pecking-order theory explains why firms prefer internal finance.

35. The Pecking Order - Evidence
Size. Large firms tend to have higher debt ratios.
Tangible assets. Firms with high ratios of fixed assets to total assets have higher debt ratios.
Profitability. More profitable firms have lower debt ratios.
Market to book. Firms with higher ratios of market-to-book value have lower debt ratios
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.