Lecture Notes

1
Lecture Notes

• June 4, 2002
• Chapter 16 Capital Structure Limits to the
  Use of Debt
• Grading system described in the course outline
• Grading curve for Midterms 1 and 2 on the class
  page under All TAs.

2
Note

• In Ch. 15, you dont need to cover the material
  from p. 411, middle, to end of chapter.
• This deals with MM proposition 2 in the presence
  of taxes.

3
Final Exam

• Either here or in Engr1 1104 (note that this is
  in Engineering 1)
• For concreteness, suppose students A-M come here
  students N-Z go to Engr1 1104,
• Obviously we wont be enforcing this.

4
MM propositions firms dont care about capital
structure

• WACC doesnt depend on capital structure
• Equivalently, value of the firm doesnt depend on
  capital structure
• Equivalently, a change in S (or B) results in an
  equal and opposite change in B (or S)
• Only because we abstracted from some important
  considerations

5
Another analogy

• Price of whole milk is related to price of cream,
  price of skim milk
• arbitrageurs can separate cream and skim milk
• Or recombine them.

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Example

• Knight and Day Corporations (text, p. 423)
• Each has cash flow of 100 in boom, 50 in
  recession
• Knight has 49 in bonds outstanding
• Therefore payments to stockholders are
• (51,1).

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Example, contd

• Day Corp. is the same, except that it has 60 in
  bonds outstanding
• Therefore bondholders cant be paid in full if a
  recession occurs.
• Lets compute the value of these firms, assuming
  risk neutrality and a 10 discount rate
• Each state occurs with probability 1/2

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Example, contd
9
Example, contd
10

• Conclusion If Day Corp. increases its bonds
  outstanding from 49 to 60, its value doesnt
  change, even though it now risks bankruptcy.
• Thats because even though there is bankruptcy,
  there are no bankruptcy costs bankruptcy is just
  a transfer of assets.

11
In practice

• Capital structure is not random
• Airlines lots of debt
• Pharmaceuticals not much debt
• So maybe it isnt this simple

12
It isnt

• MM propositions fail in the presence of
• tax effects
• bankruptcy costs

13
Taxes

• Interest costs are deductible from corporate
  profits, whereas dividends are paid out of
  aftertax profits.
• This kills the equivalence between changing
  capital structure and homemade leverage.
• Changing capital structure changes corporate
  profits tax
• Invalidates MM propositions

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Pizza

• Its as if you had a tax on pizza, and the tax
  rate on big slices (per ounce of pizza) were
  different from the tax rate on little slices.
• Then the amount of aftertax pizza you have would
  depend on how you slice it.

15
Firm Value

• The value of a firm is the present value of its
  aftertax cash flow.
• If capital structure affects taxes, it affects
  aftertax cash flows, and therefore also the value
  of the firm.

16
Tax shield

• the decrease in taxes due to deductibility of
  bond interest
• tax shield corporate tax rate times interest
  payments
• corporate tax rate times interest rate times
  debt level

17
Present value of tax shield

• corporate tax rate times bonds (assume the
  bonds are perpetuities)
• PV of tax shield PV of the tax reduction
  (relative to the unlevered firm) made possible by
  deductibility of bond interest payments.

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Value of levered firm

• value of unlevered firm value of tax shield
• Stock is the residual claim, so the value of
  stock per share increases with leverage, due to
  taxation

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• So borrowing 1 and using the proceeds to buy
  back equity decreases the total value of equity
  by less than 1
• Therefore the price per share will increase.

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Example

• Divided Airlines (text, p. 411). Initially its
  unlevered. Aftertax earnings 100, r0 20, so
  its value is 500. Suppose there are 100 shares
  outstanding, so each share is worth 5
• Now DA borrows 200, buys back shares.
• At a 35 corporate tax rate, value of tax shield
  is 70, so the firm is worth 570.

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Example, contd

• The stock is now worth 5.70 per share, so the
  firm buys 200/5.7035.09 shares.
• Value of equity 570-200370 64.91 times 5.70

22
Qualification

• This assumes that before the debt is issued,
  equity markets ignored the possibility of issuing
  debt.
• In an efficient market, they wouldnt (text says
  that in an efficient market the change would
  occur when the debt issue is announced. Why not
  before?)

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• We assumed risk neutrality here, but the MM
  proposition (as illustrated in this example)
  doesnt require this.
• Under risk aversion youd have to compute the
  betas of stock and bonds (youd have to assume
  that you know the beta of the unlevered stream),
  so the calculation would be messier.

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A problem with this story

• How much debt would capital markets assume D. A.
  would issue?
• This story makes it sound as if the firm can
  raise its value without limit by issuing debt
• Thats because we are ignoring bankruptcy costs
  (so far).

25
Junk bonds

• A large part of the popularity of junk bonds is
  that they are tax advantaged, even though they
  are really much like equity.

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Costless bankruptcy

• Assuming risk aversion, bonds would bear a higher
  return under bankruptcy risk than without it
  (return would depend on bonds beta),
• That is consistent with MM, as long as bankruptcy
  leads to a COSTLESS transfer of assets to the
  creditors.
• We already saw that MM propositions are still
  valid if rb gt rf, so that bankruptcy risk exists

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Bankruptcy isnt costless

• Costs of bankruptcy
• impaired ability to do business
• do you want to buy a computer from a company
  thats about to go under?
• Legal, administrative costs are huge.

28
Agency costs

• for a firm that has high bankruptcy risk, theres
  a conflict between debt and equity.
• Management will accept negative NPV projects if
  most of the downside is born by bondholders
• milking the assets -- the firm wont maintain
  the capital even if doing so is a positive-NPV
  project. Why benefit the creditors?
• These agency costs decrease value of firm

29
Free cash flow

• if firms have lots of cash, they will waste it on
  perks.
• If they have lots of debt, theyll have to run a
  tighter operation
• This works in the opposite direction
• Protective covenants in the bond indenture are
  intended to decrease these costs

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2 theories of capital structure

• (1) Pecking order theory
• (2) Tradeoff theory

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Pecking order theory

• pecking order
• (1) internal financing
• (2) safe securities
• (3) risky securities
• If management works for existing stockholders,
  and if management has better information about
  the value of the firm, new equity will be issued
  only when (management believes) equity is
  overvalued

32
Tradeoff Theory

• So there are 2 major qualifications to MM taxes
  and bankruptcy costs
• Leads to a tradeoff
• Optimal capital structure
• Consider a small increase in debt and decrease in
  equity
• present value of increased bankruptcy cost
  increase in tax shield

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• Pecking order theory works off transactions costs
  (internal financing is cheapest )
• Tradeoff theory is based on tax advantage of debt
  vs. bankruptcy costs.
• Empirical results inconclusive.