The Financing Decision B

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The Financing Decision (B)
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Modigliani and Miller II

• With Taxes

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• How are operating profits (EBIT) split?
• EBIT 2000
• Cash Flows to Investors CF(debt) CF(Equity)
  1200
• Interest tax shield Interest ? Tax Rate 0

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• Now look at the same company using 5000 debt

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• Now how are operating profits split?
• EBIT 2000
• Cash Flows to Investors
• CF(debt) CF(Equity) 500 900 1400
• Interest tax shield Interest ? Tax Rate 500
  ? 40 200

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Their Conclusions

• The Interest tax shield revisited
• Tax Shield Interest ? Tax Rate 500 ? 40
  200
• Now lets assume that this tax shield is a
  perpetuity
• Proposition I
• VL VU PV(Tax Shield) VU TCD
• VU 10,000
• VL 10,000 2,000 12,000
• D 5000 EL 7000
• Conclusion A firm should use as much debt as
  possible.

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• Proposition II
• kE(L) kE(U) (1-T) (kE(U) kD) (D/E)
• Assume kE(U) 12
• WACC
• Like a world with no taxes, leverage increases
  the risk and the required return on equity.

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• The unlevered firm
• WACCU kE(U) 12
• The levered firm
• kE(L) kE(U) (1-T) (kE(U) kD) (D/EL)
• kE(L) 12 (1-.40)(12 - 10)(5000/7000)
• kE(L) 12.86

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• What was it before???
• Increasing debt reduced our WACC making the firm
  more valuable

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Summary of MM With Taxes

• As we use more debt the WACC decreases
• Due to the interest tax shield
• The lower WACC results in a higher firm value for
  firms that use debt.
• The cost of equity increases with the use of debt
  but not as quickly as the WACC decreases.
• Firms should be 100 debt financed
• Obviously not possible
• Assumes no bankruptcy costs

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What about Bankruptcy Costs

• The debt used by corporations provides a valuable
  interest tax shield for a firm.
• The discussion so far has ignored the cost of
  bankruptcy.
• Bankruptcy-related costs depend on three things
• The probability of bankruptcy
• The costs the firm will incur if financial
  distress arises, and
• The adverse effect that the potential for
  bankruptcy has on current operations.
• Bankruptcy costs certainly increase with the
  level of debt

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A Hypothetical Analysis
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Bankruptcy Costs

• Direct Costs
• Legal and administrative costs of bankruptcy
• Indirect Costs
• The costs associated with trying to manage a firm
  in bankruptcy
• Efforts to prevent further deterioration are
  often undermined by the delays and legal tangles
  of bankruptcy.

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Financial Distress Costs

• Not every firm in financial trouble goes
  bankrupt.
• What costs are generated in financial distress
• The cost of investments that are forsaken because
  of cash problems.
• The cost of important maintenance and upkeep that
  might be skipped to conserve cash.

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Financial Distress Costs

• During conflicts the shareholders and debt
  holders may battle over business decisions that
  affect them unequally.
• Games
• Risk shifting
• Refusing to contribute new capital
• Etc.

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Costs of Financial Distress

• Varies with assets
• Firms with tangible and marketable assets are
  exposed to less financial distress costs.
• Even when cash flow problems exist there still
  exists value in the business
• Companies that own lots of real estate and
  buildings fit this niche
• Firms with less tangible assets are exposed to
  higher financial distress costs.
• High tech firms value is primarily in copy writes
  and human capital.
• These assets provide little collateral
• This may explain why we do not see high levels of
  debt financing in high-tech firms.

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The Trade-Off Theory

• The firms debt-equity decision as a trade-off
  between interest tax shields and the cost of
  financial distress.
• Target debt ratios may vary from firm to firm and
  industry to industry.
• Companies with safe tangible assts, predictable
  cash flows, and plenty of taxable income ought to
  have high levels of debt.
• Companies with risky, intangible assets and
  unprofitable companies should use equity
  financing.
• The trade-off of business and financial risks

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• Does the Trade-off theory of capital structure
  successfully explain how companies behave?
• Yes Sometimes
• High tech firms use relatively little debt
• Airlines use relatively large amounts of debts
• Aircraft can support debt even if airline cannot.
• The trade-off theory works well at describing
  what companies tend to go private in Leveraged
  Buyouts.

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• No Sometimes
• Some highly profitable firms use little or no
  debt
• Merck
• Most assets intangible
• But the company paid 1.4 billion in taxes in
  1994
• The paradox
• Within an industry the most profitable firms use
  the least debt
• Remember Boeing vs. its competitors

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The Pecking Order

• Asymmetric Information/Signaling Theory
• MM theories assume that investors and managers
  have symmetric information.
• However managers have superior information.

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• The decision to issue debt by a firm may send any
  of the following signals to investors
• The firms prospects are good because managers
  are not afraid of adding more fixed cost
  financing
• The managers believe the stock is undervalued and
  do not want to share future appreciation with new
  shareholders.
• Stock is undervalued and too cheap to issue.

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• The signals of equity financing
• Mangers are reluctant to add fixed interest
  expense
• Cash flows and profits unstable.
• Stock price is high and its a good time to issue
  and capitalize on the high price.
• Evidence
• Companies announcing seasoned equity issues
  usually experience share price drops.
• Debt issues and bank loans have the opposite
  effect.
• This helps explain the dominance of debt
  financing over new equity financing.

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• Firms prefer internal financing.
• Retained earnings and depreciation funds
• They adapt their dividend policy to their
  investment opportunities
• High growth companies retain most or all of NI to
  reduce to maximize internal funds.
• Sticky Dividends and and unpredictable
  fluctuations in profitability and investment
  opportunities results in a need for backup
  financing.
• Draw down cash reserves
• Sells marketable securities

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• If External financing is needed
• Issue safest securities first
• Debt
• Convertible Debt
• Preferred Stock
• Issue Equity as a last resort
• There is no well defined target debt-equity mix
• Equity is first in the pecking order and last
• The pecking order may explain why successful
  firms do not issue as much debt
• They do not need to

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Financial Slack/Flexibility

• Other things equal it is better to be at the top
  of the pecking order than at the bottom.
• Firms that are at the bottom need external
  financing and face the discipline of the capital
  markets.
• Firms that have borrowed a lot lose that
  financial flexibility and need to issue equity.
• Having financial slack means
• Having cash, securities, and ready access to debt
  markets to meet financing needs
• Do not want financial constraints to prevent you
  from making profitable investments

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• Financial slack will be most important to
  companies with many good investment opportunities
• Positive NPV projects
• Helps explain why growth companies avoid debt
  financing
• The most powerful driver of value is a firms
  investment decisions
• Maintain financial slack and flexibility in order
  to take advantage of investment opportunities.

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The Financing Decision and Sustainable Growth

• Remember,
• G PM ? AT ? LEV ? RR
• The goal is to develop both operating and
  financial strategies that meet your growth
  expectations.
• Without resorting to equity financing
• But maintaining flexibility if necessary

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• Rapid Growth and Conservatism
• Need to balance
• the negative signal of equity issues
• The need for flexibility
• For fast growing companies
• The most important drivers of value are
  investments not interest tax credits
• Do not give up flexibility and financial slack

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• Conservative Strategy
• Maintain conservative leverage ratios
• And financial slack
• Minimum dividends
• Maximize internal funds
• Use Cash, securities etc.
• Use debt financing when necessary but maintain a
  conservative ratio
• Sell equity or reduce growth as a last resort.

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• Slow growth and the appeal of aggressive
  financing
• Generating excess cash
• Lack good investment opportunities
• If we cant make more with our investment
  decisions
• Lever returns through your financing decision

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• Strategy
• Aggressive dividend payout
• You do not need the cash
• Take advantage of interest tax shields by issuing
  debt
• Possibly swap debt for equity
• Evidence

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Free Cash Flow -- Agency Theory

• The dark side of financial slack
• Agency Costs occur when managers and
  shareholders interests arent completely aligned.
• When a firm has ample or excess cash
• Companies growing too slowly
• Mangers may be encouraged to take it easy
• Expand Perks
• Empire Build
• Or even invest in negative NPV projects
• Free cash flow is defined as
• Cash Flow Investment in Positive NPV projects

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• Examples of Free cash flow problems in the 80s
• Mobile Oil
• Exxon
• Debt financing is one way of reducing free cash
  flow.
• Interest and Principle payments are contractual
  obligations
• Forces cash payments and reduces free cash flow
• Sealed Air Recapitalization in 1989
• Highly profitable because of patent protection
• Lacked competitive incentives
• Borrowed money to pay 328 million special
  dividend
• Debt increased 10 times

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Summary

• In summary a firms financing strategy is a
  function of the trade-offs of debt financing

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The End