Financing Decisions

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Finance 419

• Financing Decisions
• (Based on RWJ Chapters 15-16)

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Outline

• (1) Descriptive Data and Overview of Financing
• (2) The Debt versus Equity Decision
• Is debt a cheaper source of finance?

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Where do Firms Get Money From?

• Self Financing (or using internal cash flow)
• Accounts for 80 of financing
• Difficult for start-up companies
• External Financing
• Borrowing from banks or issuing bonds
• Sharing the business with investors by issuing
  stock

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Where do Small Businesses Get Money?
Source 1987 SBA survey of firms with less than
500,000 in assets.
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What Happens as Firms Get Larger?
Firm Size
Information
Medium-sized
Small with growth potential
Large with Track record
Very small, no track record
Inside seed money
Self
Short-term commercial loans
Commercial paper
Short Debt
Intermediate-term commercial loans
Medium-term Notes
Inter- mediate Debt
Mezzanine Finance
Private Placements
Long-Term Debt
Bonds
Outsider Equity
Public Equity
Venture Capital
Source FRB Report on Private Placements, Rea et.
al., 1993
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Size of U.S. Bond Market
Source Merrill Lynch Bond Indices, 10/96
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Privately Placed Debt

• Private placement debt is not placed with the
  public at large.
• In 1990, Rule 144a was passed which relaxed
  restrictions on the private placement market.
• Did not have to conform to GAAP accounting.
• Must be sold to qualified institutional buyers
  (QIBs).
• This made it very attractive for foreign issuers
  to enter the U.S. market.
• Private placements are mainly sold to insurance
  companies.

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Project Finance

• Financing structure for a project only, rather
  than a whole firm.
• Must be physically isolated and provide the
  lender some type of tangible security.
• Used heavily for high dollar projects in oil,
  gas, infrastructure and film.
• Used extensively in high growth countries like
  China.

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New Stock Issues

• Are called initial public offerings.
• Firm issues through primary market with an
  underwriter.
• IPO's are underpriced, on average, by about 15.
• Example IPO of Foundry Networks in September
  1999. Jumped over 525 in first day.

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What is Different Between Debt and Equity?
Debt
Equity

• Fixed Promised payments
• Senior to equity
• Interest is deductible
• Only get control rights in default

• Uncertain residual cash flows
• Subordinated to debt
• Dividends are not deductible
• Comes with control rights (can vote)

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Capital StructureHow should a firm structure
the liability side of the balance sheet?

• Debt vs. Equity
• We have seen how to do capital budgeting when the
  firm has debt in its capital structure.
• However, we have not figured out how much debt
  the firm should have.
• Can the firm create value for shareholders
  through its financing decisions?
• In particular, should the firm load up with low
  cost debt?

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One possible answer It makes no difference.

• Suppose that there are no taxes (plus other
  stuff), and that the firms operating cash flows
  are unaffected by how it finances.
• Modigliani and Miller won the Nobel Prize for
  showing
• The value of a firm with debt is in this case
  equal to the value of the same firm without debt.
  
• The key to this is that they showed that the
  expected return on equity rises with leverage
  according to (L leverage ratio -- market
  value of debt over market value of equity, and r
  denotes expected return).

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• MM More Formally
• The WACC for a firm is constant

and
rEquity rAssets (B/S)(rAssets- rB)

• The capital structure decision is irrelevant
• VU VL EBIT/rSU, where RSU is the cost of
  capital in an all equity firm. Notice it will
  just be WACC (rAssets)

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WACC under MM Proposition I
Let the expected return on the underlying assets
be 9 and the cost of debt be 6.
With no taxes the WACC is the same regardless of
leverage! Since we assumed that operating cash
flows were also unaffected, firm value is
unaffected by leverage!
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Graphic Illustration of MM
Return
V
RS
WACC
VL VU
RB
B/(SB)
B/V
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What about tax deductions for interest?

• Interest is tax deductible (dividends are not).
• This creates a valuable debt tax shield.
• Modigliani and Miller also showed that if the
  only change in their analysis is the presence of
  taxes, then
• The value of a levered firm is
• the value of an equivalent unlevered firm
• the value of the tax shields from debt.
• Firm Value always rises with borrowing!

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MM with Corporate Taxes
Q What affect does the U.S. tax code have on
the capital structure
decision?
A Interest payment made by firms are tax
deductible
1 Dividends
1(1 - TC) in Revenues
1 in Revenues
1 Interest
Tax Shield to Debt is 1(TC)
Financing Decision Now Becomes Important
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MM with Corporate Taxes
where the cost of equity capital in a levered
firm is, rSL rAssets (rAssets - rB)(1 -
TC)(B/S) with rSU the cost of equity capital
in an identical unlevered firm (rAssets) rB
the cost of debt capital (We will assume debt is
riskless)
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Simple Numerical Example Suppose that EBIT
100, rAssets 15, RB 10, and TC 40
Case I B 0 Yearly Cash Flows 100(1-.4)
60 V 60/.15 400 Case II B 100 Yearly
Cash Flows 100(.6) .1(100)(.4) V 60/.15
.1(100)(.4)/.10 64
440 Case III B 500 Yearly Cash Flows
100(.6) .1(500)(.4) V 60/.15
.1(500)(.4)/.10 80 600
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Problem Delta Computer is a zero-growth firm
with an EBIT of 2M per year. The cost of equity
for Delta if it was all equity financed would be
14. However, Delta currently uses 1M of debt
financing with an interest rate of 10.
Assuming a corporate tax rate of 40, what is
the value of Delta according to MM with corporate
taxes? What is the cost of equity for Delta
with debt financing?
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Again, why is the cost of debt capital RD(1 - TC)?
Another Example Suppose that you borrow 100 at
12 and TC 40 Since the interest payment is
tax deductible you reduce your tax bill
by 12(.4) 4.8. So you are really paying
12 - 4.8 7.2 for the loan. The true cost of
debt capital is 7.2 or 7.2. Using the formula
Cost of Debt 12(1-.4) 7.2.
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Graphic Illustration of MM with Taxes
Return
V
RS
VL
WACC
RB (1-TC)
B/SB
B/V
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Limits to The Use of Debt

• Given the treatment the U. S. corporate tax code
  gives to interest payments versus dividend
  payments, firms have a big incentive to use debt
  financing.
• Under the MM assumptions with corporate taxes the
  argument goes to extremes and the message
  becomes firms should use 100 debt financing.
• What other costs are associated with the use of
  debt?
• Bankruptcy costs and/or financial distress costs!

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Bankruptcy Costs

• Direct costs
• Legal fees
• Accounting fees
• Costs associated with a trial (expert witnesses)
• Indirect costs
• Reduced effectiveness in the market.
• Lower value of service contracts, warranties.
  Decreased willingness of suppliers to provide
  trade credit (e.g., Pennzoil v. Texaco).
• Loss of value of intangible assets--e.g., patents.

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Agency costs of debt

• When bankruptcy is possible incentives may be
  affected.
• Example (Risk Shifting)
• Big Trouble Corp. (BTC) owes its creditors 5
  million, due in six months.
• BTC has liquidated its assets because it could
  not operate profitably. Its remaining asset is
  1 million cash.
• Big Bill, the lone shareholder and general
  manager is considering two possible investments.
  
• (1) Buy six month T-bills to earn 3 interest.
• (2) Go to Vegas and wager the entire 1 million
  on a single spin of the roulette wheel.
• Why might Bill consider the second investment?
• Would he have considered it in the absence of
  leverage?

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A Theory of Capital Structure

• The value of the levered firm can be thought of
  as
• value of equivalent unlevered firm
• present value of tax shields
• -
• present value of bankruptcy and agency costs.

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The Value of the Firm with Costs of Financial
Distress
Value of firm (V)
VL VU TC B Value of firm under
MM with corporate Maximum taxes and
debt firm value V Actual value of
firm VU Value of firm with no debt
Debt (B) B Optimal
amount of debt The tax shield increases the value
of the levered firm. Financial distress costs
lower the value of the levered firm. The two
offsetting factors produce an optimal amount of
debt.
Present value of financial distress costs
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Choosing an Amount of Debt

• The theory provides no clear formula (unlike NPV)
  but the tradeoffs are clear the benefits versus
  the costs of debt.
• Use more debt if
• effective tax rates are higher,
• operating cash flows are more predictable,
• agency costs can be controlled by contracts.
• A safe strategy might be to emulate the industry
  average. After all these are the firms who have
  survived. From there you make alterations as your
  own situation dictates.