1. INTRODUCTION TO CAPITAL STRUCTURE (continued)
Corporate Finance
Lecture 17 and 20
INTRODUCTION TO CAPITAL STRUCTURE (continued)
Ronald F. Singer
FINA 4330
Fall, 2010

2. The Irrelevance Theorem
Perfect Capital Market Setting
No Taxes
No Contracting Costs
Costs of Financial Distress
Agency Costs
No Information Costs

3. Irrelevance Theorem LIABILITIES ASSETS DEBT 0 PVA $1,000,000
EQUITY 3,000,000
TOTAL $3,000,000
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000

4. Irrelevance Theorem ASSETS LIABILITIES PVA $1,000,000 DEBT 1,600,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 1,600,000
EQUITY 1,400,000
TOTAL $3,000,000

5. The Static Tradeoff Theory
Benefits versus Costs of Leverage.
Benefits Costs
Taxes Financial Distress
Resolution of Agency Costs
Agency Costs Bondholder/Stockholder
Manager/Stockholder
Bankruptcy Costs
Direct and
Indirect
Information Costs

6. Tax Implications LIABILITIES ASSETS PVA $1,000,000 DEBT 0
EQUITY 2,100,000
TOTAL $2,100,000
ASSETS
PVA $1,000,000
PVGO ,000,000
- PV of Tax Liability 900,000
TOTAL $2,100,000

7. Tax Implications (Suppose T = 30%)
ASSETS
PVA $1,000,000
PVGO ,000,000
Less:
PV of Tax Liability 420,0000
TOTAL $2,580,000
LIABILITIES
DEBT ,600,000
EQUITY ,000
TOTAL $2,580,000

8. Stockholders’ Wealth Originally: $2,100,000 in Equity Interest
Now: ,000 in Equity Interest
$1,600,000 in Cash
2,580,000
Total Stockholders’ Wealth increased by 480,000 = the reduction of taxes.

9. Firm Value Assuming Perfect Capital Markets except for Taxes
Notice what happens, the (after tax) FCF increases due to the tax benefit from the interest deduction on debt. In particular,
FCF = Before Tax FCF – Tax
Tax = T (Earnings) = T (Rev-Exp-Interest)
= (Rev-Exp)(T) – (Int)(T)
So FCF = FCF(1-T) + Interest(T)

10. The Tax Benefit
So we can divide the After Tax Free Cash Flow into two separate Cash Flows:
Cash Flow from operations
FCF*(1-T) = The Free Cash Flow (after Tax) that would be generated if there were no debt in the capital structure
Interest*(T) = The reduction of tax due to the Tax shield on interest.

11. Example Suppose that the firm’s cash flows looked as follows:
Revenue $20 million
Cash Expense $10 million
Interest $2 million
Depreciation $3 million
Change in WC

12. Calculation of Unlevered Cash Flow
That is, how much (after tax) would be generated if there were no interest payments
“Net Operating Income” (NOI)=
(Rev-Cash Expense – Depreciation)
= $7 million
30 % = $2.1 million
After Tax Operating Cash Flow
NOI – Tax + Depreciation
$ = Million

13. The Interest Tax Shield
Notice we can find the amount of the tax shield by considering how much tax saving there is for each dollar of interest. In particular
The Tax Shield = T * Interest = (.3) * 2 million
= 0.6 million

14. PV of Cash Flow: V = S(Y)(1-T) + ST (Interest) (1+ro)t (1+rB) t
= V(u) PV of Tax Shield

15. With Taxes V = V(u) Plus Present Value of Tax Shield on Debt.
V= V(u) + (Corp. Tax Rate) * Debt
In the special case when debt is thought of as perpetual.

16. Graphically
Firm Value (V)
V = V(u) + Tc*B
V(u)
Debt

17. Cost of Capital
rs = ro + (ro -rB)B/S
WACC = ro r rB

18. Cost of Capital (After Tax)
rs = ro + (ro-rB)(1-T)B/S r
WACC = r0(1-T(D/v))
= rs(S/V) + rB(1-T) (B/V) rB

19. The two ways of representing firm value V = V (u) + T
The two ways of representing firm value V = V (u) + T * B V = SY(1-T) (1+WACC)t Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)

20. Static Tradeoff Theorem
Costs of Financial Distress
(“Contracting Costs”)
Potential Bankruptcy Costs
Underinvestment
Risk Shifting
Agency Costs
Assume:
Not Taxes
Risk neutrality
Single period
Interest rate = 0%

21. Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO ,000,000
TOTAL $3,000,000
LIABILITIES
DEBT ,500,000
EQUITY ,000
TOTAL $3,000,000

22. Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO ,000,000
TOTAL $3,000,000
LIABILITIES
DEBT ,500,000
EQUITY ,000
TOTAL $3,000,000

23. Example of Underinvestment
ASSETS
PVA $1,000,000
(Cash = 600,000)
(Real Assets = 400,000)
PVGO ,000,000
TOTAL $3,000,000
LIABILITIES
DEBT ,500,000
EQUITY ,000
TOTAL $3,000,000

24. Example of Underinvestment Make a Div Payment rather than invest
ASSETS
PVA $400,000
(Real Assets = 400,000)
PVGO ,000,000
TOTAL $2,400,000
LIABILITIES
DEBT ,250,000
EQUITY ,000
TOTAL $2,400,000

25. Risk Shifting
Suppose the firm has value that will look like the following:
Value in Good State = $4,500,000
Value in Bad State = ,500,000
With equal probability
Promised payment to the Bondholder: $3,500,000
What is the value of the equity and the debt?

26. Investment Opportunity
Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are:
$5,000,000 in good state
500,000 in bad state:
What is the NPV of the project, value of the debt and value of the equity?

27. Firm Value
Costs of
Financial
Distress
V = V(u) + PV of Tax Shield
Debt Level
Optimal Debt Level

28. Pecking Order Hypothesis
Costly Information
Conclusion
Firm has an ordering under which they will Finance
First, use internal funds
Next least risky security

29. Intuition
Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it?
Now suppose you believe the firm is overvalued

30. Pecking Order theory So you have a dominating way of getting capital
Internal Financing
Risk free debt
Risky debt
Equity
In general, the more “debt like” a security is, the more you want to issue it.

31. So the announcement effect
If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm.
Therefore the firm will never issue equity if it can avoid it.
Thus pecking order.