1. Advanced Corporate Finance FINA 7330 Capital Structure Issues and Financing Lecture 07 and 08 Fall, 2010

2. The Theories of Capital Structure Irrelevance Static Tradeoff Pecking Order

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

4. Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT0 EQUITY3,000,000 TOTAL$3,000,000

5. Irrelevance Theorem ASSETS PVA$1,000,000 PVGO 2,000,000 TOTAL$3,000,000 LIABILITIES DEBT1,600,000 EQUITY1,400,000 TOTAL$3,000,000

6. Tax Implications ( tax rate of 30%) ASSETS PVA $1,000,000 PVGO 2,000,000 - PV of Tax Liability 900,000 TOTAL $2,100,000 LIABILITIES DEBT 0 EQUITY2,100,000 TOTAL$2,100,000

7. Tax Implications ASSETS PVA $1,000,000 PVGO 2,000,000 Less: PV of Tax Liability 420,000 TOTAL $2,580,000 LIABILITIES DEBT 1,600,000 EQUITY___________ TOTAL$2,580,000

8. Tax Implications ASSETS PVA $1,000,000 PVGO 2,000,000 Less: PV of Tax Liability 420,000 TOTAL $2,580,000 LIABILITIES DEBT 1,600,000 EQUITY 980,000 TOTAL$2,580,000

9. Stockholders’ Wealth Originally: $2,100,000 in Equity Interest Now: 980,000 in Equity Interest $1,600,000 in Cash 2,580,000 Total Stockholders’ Wealth. Notice that Stockholders’ wealth increased by an amount equal to the Present Value of the Tax Shield on Debt.

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

11. The Impact of Taxes on the Capital Structure Decisions Firm Value =  Operating Cash Flow (t) (1+r o ) t = Market Value of the Firms Liabilities (Including Equity) Let OCF(t) = Operating Cash Flow at time t

12. With Taxes Firm Value for an equity financed firm   OCF(t) - Tax on operations (1+r o ) t = Market Value of the Firm = Market Value of Equity = V(u) We call this the Value of the Unlevered Stream (Firm), or the Asset Value of the Firm)

13. Example Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = Before Tax Operating Cash Flow - Tax Before Tax Operating Cash Flow = (1000-500) = 500 Tax = T*(1000-500-300).32*200 = 64 Thus V(u) = (500 – 64)/r = 436/.1 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow

14. Example Everything is a perpetuity; Cash Revenue $1000 Cash Expense 500 Depreciation 300 Tax Rate = 32% Cost of Capital = 10% ATOCF = (1000-500) -.32*(1000-500-300) {EBIT(1-t) + Depreciation} = (1000-500-300)*.68 + 300 = 136 + 300 = 436 V(u) = $4,360 Where ATOCF is After Tax Operating Cash Flow

15. Leverage Effects Now suppose the firm issues 2000 worth of perpetual debt, paying interest at 5%. Then interest will be: INT =.05*2000 = $100

16. Now lets consider the interest deductions Cash Revenue $1000 Cash Expense 500 Depreciation 300 Interest 100 Tax Rate (t) = 32% CF = (1000-500) -.32*(1000-500-300 -100) = = 500 - 32 = 468 Or: = ATOCF + t*INT = 436 + 32 = 468

17. Now Discount CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT r o r B V = V(u) + t*B

18. Now Discount CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT r o r B V = V(u) + t*B = 4,360 +.32 * 2,000 = $5,000

19. Value of Debt and Equity Value of firm = $5,000 Value of Debt = $2,000 Value of Equity = $3,000 B/V =.4 E/V =.6

20. With Taxes In general, V(L) = V(u) Plus Present Value of Tax Shield on Debt. V(L) = V(u) + (Corp. Tax Rate) * Debt, in the special case when debt is thought of as perpetual, or is selling at par.

21. Graphically Firm Value (V) V = V(u) + T c *B V(u) Debt

22. Recall: Cost of Capital In the absence of taxes WACC = r o  r S = r o + (r o -r B )B/S rBrB

23. Cost of Capital (After Tax) WACC = r o  B/V) )  r E = r o + (r o -r B )(1-t)B/S rdrd

24. Weighted Average Cost of Capital WACC is the discount rate we use to discount the firm’s after tax Operating Cash Flow: (ATOCF) So in the example we just had: WACC = r o (1-T(B/V) ) = 8.72% = r E (E/V) + (1-T)r B (B/V), and r E =.10 + (.10-.05)(1-.32)(.6) = 12.27% WACC =.1227*.6 +.68*.05*.4 = 8.72% =.07362 +.0136 = 8.72%

25. Firm Value and the Tax Shield on Debt Notice that the value of the firm is simply the ATOCF discounted by the WACC! The greater is the amount of debt issued, the lower is the WACC, and thus the higher is the value of the firm. By assumption, the ATOCF is unaffected by the firm’s capital structure.

26. Static Tradeoff Theorem Costs of Financial Distress –Potential Bankruptcy Costs –Underinvestment –Risk Shifting –Agency Costs

27. General Approach Assume: No Taxes Single period Cost of Capital = 10%

28. Perfect Capital Market Widgets International Good State Bad State –Pure Equity 11 million 2.2 million –Probability of each state is 50% –Stockholders’ Wealth –V = $6 million –E = $6 million

29. Bond and Stock Valuation Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million. What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (r B ) is 5% Then the value is B = E{Cash Flows}/1.05

30. Debt valuation What is the Yield to Maturity? (YTM) What is the Expected Return? –This will require some work

31. Perfect Capital Markets Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%) Widgets International Good State Bad State Expected –Total 11 million 2.2 million 6.6 –Debt 4.2 million 2.2 million 3.2 –Equity 6.8 million 0 3.4 –Stockholders’ Wealth –V = $6 million – B = 3.2/(1.05) = $3.05 –E = $6 - $3.05 = $2.95 IF The Value of the Firm remains unchanged

32. Valuation of Equity If the value of the firm is independent of capital structure, r E = r o + (r o -r B )B/V Therefore; r E =.10 + (.05)(3.05/2.95) = = 15.17% And: E = 3.4/1.1517 = ??? Finally What is Stockholders’ Wealth?

33. Valuation of Equity If the value of the firm is independent of capital structure, r E = r o + (r o -r B )B/V Therefore; r E =.10 + (.05)(3.05/2.95) = = 15.17% And: E = 3.4/1.1517 = 2.96 (2.95 really, without rounding) Finally What is Stockholders’ Wealth?

34. Debt Valuation Yield to Maturity Coupon rate Expected (required) return to Bonds

35. Bankruptcy Costs Widgets International Good State Bad State Pure Equity 11 million 2.2 million Probability of each state is 50% Stockholders’ Wealth V = $6 million E = $6 million

36. Direct Bankruptcy Costs Typically amounts to 2% to 5% of the distressed value of the firm Widgets International –Again assume the same leverage of a bond promising to pay 4.4 million Good State Bad (Default) –Total 11 million 2.2 million Bankruptcy cost 0.1 million Net 11 million 2.1 million

37. Impact of Bankruptcy Costs Good State Bad (Default) –Total 11 million 2.2 million Bankruptcy cost 0.1 million Net 11 million 2.1 million Value 5.95 million Debt 3 million Equity 2.95 million stockholders’ wealthThus stockholders’ wealth declines by $50,000 (SHW = 2.95 + 3 = 5.95 not 6) Notice that it is the stockholders that pays the expected bankruptcy costs.