1. Chapter 18 Principles of Corporate Finance Eighth Edition How Much Should a Firm Borrow? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 2 McGraw-Hill/Irwin Topics Covered  Corporate Taxes and Value  Corporate and Personal Taxes  Cost of Financial Distress  Pecking Order of Financial Choices

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 3 McGraw-Hill/Irwin Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. Capital Structure & Corporate Taxes

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 4 McGraw-Hill/Irwin Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 5 McGraw-Hill/Irwin 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 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? Capital Structure & Corporate Taxes

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 6 McGraw-Hill/Irwin 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 1/2 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 (520 + 100)

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 7 McGraw-Hill/Irwin Capital Structure & Corporate Taxes PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 2,000,000 x (.05) x (.35) = $35,000 PV of $35,000 in perpetuity = 35,000 /.05 = $700,000 PV Tax Shield = $2,000,000 x.35 = $700,000

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 8 McGraw-Hill/Irwin Capital Structure & Corporate Taxes Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 585 /.05 = 11,700,000 PV Tax Shield = 700,000 Firm Value with 1/2 Debt = $12,400,000

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 9 McGraw-Hill/Irwin Capital Structure & Corporate Taxes Pfizer Balance Sheet, March 2004 (figures in $millions)

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 10 McGraw-Hill/Irwin Capital Structure & Corporate Taxes Pfizer Balance Sheet, March 2004 (figures in $millions) (w/ $1 billion Debt for Equity Swap)

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 11 McGraw-Hill/Irwin C.S. & Taxes (Personal & Corp) Relative Advantage Formula ( Debt vs Equity ) 1-T p (1-T pE ) (1-T c ) RAF > 1 Debt RAF < 1Equity Advantage

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 12 McGraw-Hill/Irwin C.S. & Taxes (Personal & Corp) Corporate Tax Income after Corp Taxes $1.00 TpTp $1.00 – T p Personal Taxes. Income after All Taxes $1.00–T c -T pE (1.00-T c ) =(1.00-T pE )(1.00-T c ) TpE (1.00-Tc) $1.00 – T c TcTc None To bondholdersTo stockholders Operating Income ($1.00) Paid out as interest Or paid out as equity income

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 13 McGraw-Hill/Irwin Example C.S. & Taxes (Personal & Corp)

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 14 McGraw-Hill/Irwin  Today’s RAF & Debt vs Equity preference. 1-.33 (1-.16) (1-.35) = 1.23 RAF = C.S. & Taxes (Personal & Corp) Why are companies not all debt?

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 15 McGraw-Hill/Irwin Capital Structure Structure of Bond Yield Rates D E Bond Yield r

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 16 McGraw-Hill/Irwin Weighted Average Cost of Capital without taxes (traditional view) r DVDV rDrD rErE Includes Bankruptcy Risk WACC

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 17 McGraw-Hill/Irwin Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 18 McGraw-Hill/Irwin 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 19 McGraw-Hill/Irwin Financial Distress Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 20 McGraw-Hill/Irwin Conflicts of Interest Circular File Company has $50 of 1-year debt.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 21 McGraw-Hill/Irwin Conflicts of Interest Circular File Company has $50 of 1-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.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 22 McGraw-Hill/Irwin Conflicts of Interest Circular File Company has may invest $10 as follows.  Assume the NPV of the project is (-$2). What is the effect on the market values?

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 23 McGraw-Hill/Irwin Conflicts of Interest Circular File Company value (post project)  Firm value falls by $2, but equity holder gains $3

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 24 McGraw-Hill/Irwin 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.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 25 McGraw-Hill/Irwin Financial Distress Games  Cash In and Run  Playing for Time  Bait and Switch

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 26 McGraw-Hill/Irwin Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 27 McGraw-Hill/Irwin Trade Off Theory & Prices 1.Stock-for-debtStock price exchange offersfalls Debt-for-stockStock price exchange offersrises 2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 28 McGraw-Hill/Irwin 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.

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 29 McGraw-Hill/Irwin 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 andequity 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.

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 18- 30 McGraw-Hill/Irwin 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).