Long-term Financing

1
Chapters 1516
The Capital Structure Questions
The balance sheet of the firm(market
values) We can write V B S Or, draw a
pie Two questions 1. Should the management
aim at maximizing V or S? 2. What is the debt
to equity ratio (B/S) that will maximize S?
Debt (B) Equity (S)
Assets (V)
B
S
2
Is There An Optimal Capital Structure?

• Modigliani Miller (MM) Proposition I (No Taxes)
• Firm value is not affected by financial
  leverage
• VL VU
• MM assume (among other things)
• No risk of default
• Perpetual Cash Flows
• Firms and investors can borrow/lend at the same
  rate
• No taxes

3

• Proving MM Proposition I (No Taxes)
• Consider two firms, identical in every way except
  that one is levered and the other is all equity
  (unlevered)
• Unlevered Levered
• Assets VU 1,000,000 VL ?
• Equity SU 1,000,000 SL ?
• Debt BU 0 BL 400,000
• Cost of Debt rB 5
• Recall Firms and investors can borrow/lend at
  the same rate, and there are no taxes
• The (uncertain) dollar return on the firms
  assets is given by Y

4
Consider the following two investment
strategies Strategy A Dollar
Investment Dollar Return Buy 10 of SL 0.1SL
0.1(VL - BL) 0.1(Y - rBBL)
0.1(Y -
0.05400,000) Total CF from A 0.1(VL - BL)
0.1Y - 2,000 Strategy B
Dollar Investment Dollar Return 1) Buy 10 of
VU 0.1VU 0.1Y 2) Borrow 10 of BL
- 0.1BL - 0.1rBBL - 0.1
0.05400,000
- 2,000 Total CF
from B 0.1(VU - BL) 0.1Y -
2,000 Since the dollar return from A and B is
identical, the initial cost of both strategies
must be identical, thus 0.1(VL - BL) 0.1(VU -
BL), and VL VU MM Proposition I (No
Taxes) Firm value is not affected by leverage
(VL VU )
5
The Value of a Levered Firm UnderMM Proposition
I with No Corporate Taxes
Value ofthe firm(VL )
VL VU
VU
Debt-equity ratio (B/S)
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MM Proposition II (No Taxes) The cost of equity
and financial leverage A. Because of Prop. I,
the WACC must be constant. With no taxes, WACC
rU (S/A) rS (B/A) rB, where A S
B where rU is the constant return on the firms
assets B. Solve for rS to get MM Prop. II (No
Taxes) rS rU (rU - rB) (B/S) Cost of
equity has two parts 1. rU and business
risk the risk inherent in the firms
operations (beta of assets) 2. B/S and
financial risk extra risk from using debt
financing
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The Cost of Equity, the Cost of Debt, and the
Weighted Average Cost of Capital MM Proposition
II with No Corporate Taxes
Cost of capital
rS rU (rU rB) x (B/S)
WACC rU
rB
Debt-equity ratio (B/S)
8
Debt, Taxes, and Firm Value

• The interest tax shield and firm value
• For simplicity (1) perpetual cash flows (2) no
  depreciation (3) no fixed asset or NWC spending
• A firm is considering going from zero debt to
  400 at 10
• Firm U Firm L (unlevered) (levered)
• EBIT 200 200
• Interest 0 40
• Tax (40) 80 64
• Net income 120 96
• Cash flow from
• assets (EBIT-Taxes) 120 136
• Tax saving 16 0.4 40 TC rB B

16
9
Debt, Taxes, and Firm Value (concluded)

• Whats the link between debt and firm value?
• Since interest creates a tax deduction,
  borrowing creates an interest tax shield. Its
  value is added to the value of the firm.
• PV(perpetual tax savings) 16/0.1 160
• (TC rB B)/rB TC B
• MM Proposition I (with taxes)
• VL VU TC B

10
The Value of a Levered Firm UnderMM Proposition
I with Corporate Taxes
Value ofthe firm(VL )
VL VU TC B
Present value of taxshield on debt
VU
VU
Total Debt (B)
11
Debt, Taxes, and the WACC

• Taxes and firm value an example
• EBIT 100
• TC 30
• rU 12.5
• Q. Suppose debt goes from 0 to 100 at 10,
  what happens to equity value, S?
• VU EBIT(1 - TC) / rU
• VL
• SL VL - B

12
Debt, Taxes, and the WACC (concluded)

• WACC and the cost of equity (MM Proposition II
  with taxes) With taxes
• Recall WACC (S/A) rS (B/A) rB (1-TC)
• MM Proposition II (with taxes)
• rS rU (rU - rB) (B/S) (1 - TC )
• In the above example
• rs
• WACC
• The WACC decreases as more debt financing is used
  
• gt since WACC is a discount rate for future cash
  flows, the optimal
• capital structure is all debt!

13
Taxes, the WACC, and Proposition II
Cost of capital
rS
rU
rU
WACC
rB (1 TC)
Debt-Equity Ratio (B/S)
14
Financial Distress

• MM with taxes
• VL VU TC B
• debt provides tax benefits to the firm gt the
  firm should borrow an infinite amount
• In reality
• the firm has to pay interest and principal to
  bondholders regardless of profitability
• if the firm defaults on a payment to its
  bondholders, it will enter a phase of financial
  distress (e.g. Eatons), or
• ultimately, if financial distress persists, the
  firm will declare bankruptcy
• there are costs involved in both financial
  distress and bankruptcy

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Costs of Financial Distress

• Direct Costs
• Legal and administrative costs (e.g. lawyers,
  accounting, expert witnesses)
• Indirect Costs
• Impaired ability to conduct business (e.g. lost
  sales)
• Agency costs -
• In financial distress, stockholders may engage
  in
• Selfish strategy 1 Incentive to take large risks
• Selfish strategy 2 Incentive toward
  underinvestment
• Selfish Strategy 3 Milking the property
  (liquidating dividend, or Increase perks to
  owners/management )

16
Selfish Strategy 3 Milking the Property

• Liquidating dividends
• Such tactics are often illegal
• Increase perks to owners/management

17
The Firm Value, Tax-Shield of Debt, and Financial
Distress Costs

• The Value of a levered firm
• VL VU TC B - PVexpected costs of financial
  distress
• For firms with a low financial leverage, the
  probability of default is close to zero, and
• PVexpected costs of financial distress 0
• a 1 increase in debt, will increase tax
  benefits (and the firm value) at a constant rate
  of TC
• For highly levered firms, the probability of
  default is positive, and
• PVexpected costs of financial distress gt 0
• a 1 increase in debt, will
• increase tax benefits at a constant rate of TC
• increase costs of financial distress at
  increasing rates
• Conclusion - increase debt as long as tax
  benefits exceed the PV
• of the costs of financial distress (up to the
  optimal level of debt B)

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The Optimal Capital Structure and the Value of
the Firm
Value ofthe firm(VL )
VL VU TC B
Present value of taxshield on debt
Financial distress costs
Maximumfirm value VL
Actual firm value
VU
VU Value of firm with no debt
Total Debt (B)
B Optimal Level of Debt
19
The Optimal Capital Structure and the Cost of
Capital
WACC (S/V) rS (B/V) rB (1-TC) Premium
for Costs of Financial Distress
Cost ofcapital()
rS
rU
rU
WACC
Minimum cost of capital
rB (1 TC)
WACC
Debt/equity ratio (B/S)
(B/S) Optimal Leverage Ratio