advanced corporate finance fina 7330 capital structure issues and financing lecture 07 and 08
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Advanced Corporate Finance FINA 7330 Capital Structure Issues and Financing Lecture 07 and 08 Fall, 2010. The Theories of Capital Structure. Irrelevance Static Tradeoff Pecking Order. The Irrelevance Theorem. Perfect Capital Market Setting No Taxes No Contracting Costs - PowerPoint PPT PresentationTRANSCRIPT
Advanced Corporate
FinanceFINA 7330
Capital Structure Issues and Financing
Lecture 07 and 08
Fall, 2010
The Theories of Capital Structure
• Irrelevance
• Static Tradeoff
• Pecking Order
The Irrelevance Theorem
• Perfect Capital Market Setting
• No Taxes
• No Contracting Costs
• Costs of Financial Distress
• Agency Costs
• No Information Costs
Irrelevance Theorem
• ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
• LIABILITIES
DEBT 0
EQUITY 3,000,000
TOTAL $3,000,000
Irrelevance TheoremASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 1,600,000
EQUITY 1,400,000
TOTAL $3,000,000
Tax Implications ( tax rate of 30%)
ASSETS
PVA $1,000,000
PVGO 2,000,000
- PV of Tax Liability 900,000
TOTAL $2,100,000
LIABILITIES
DEBT 0
EQUITY 2,100,000
TOTAL $2,100,000
Tax Implications
ASSETS
PVA $1,000,000
PVGO 2,000,000
Less: PV of Tax Liability 420,000
TOTAL $2,580,000
LIABILITIES
DEBT 1,600,000
EQUITY ___________
TOTAL $2,580,000
Tax Implications
ASSETS
PVA $1,000,000
PVGO 2,000,000
Less: PV of Tax Liability 420,000
TOTAL $2,580,000
LIABILITIES
DEBT 1,600,000
EQUITY 980,000
TOTAL $2,580,000
Stockholders’ Wealth
• Originally: $2,100,000 in Equity Interest
• Now: 980,000 in Equity Interest
$1,600,000 in Cash 2,580,000 Total Stockholders’ Wealth. Notice that
Stockholders’ wealth increased by an amount equal to the Present Value of the Tax Shield on Debt.
The Static Tradeoff Theory
• Benefits versus Costs of Leverage. • Benefits Costs
Taxes Financial Distress Resolution of Agency Costs
Agency Costs Bondholder/StockholderManager/Stockholder
Bankruptcy CostsDirect and Indirect
Information Costs
The Impact of Taxes on the Capital Structure Decisions
Firm Value = Operating Cash Flow (t)
(1+ro)t
= Market Value of the Firms Liabilities
(Including Equity)Let OCF(t) = Operating Cash Flow at time
t
With Taxes
Firm Value for an equity financed firm
OCF(t) - Tax on operations
(1+ro)t
= Market Value of the Firm = Market Value of Equity
= V(u) We call this the Value of the Unlevered Stream (Firm), or the Asset Value of the Firm)
Example
Everything is a perpetuity;Cash Revenue $1000Cash Expense 500Depreciation 300Tax Rate = 32%Cost of Capital = 10%ATOCF = Before Tax Operating Cash Flow - TaxBefore Tax Operating Cash Flow = (1000-500) = 500Tax = T*(1000-500-300) .32*200 = 64Thus V(u) = (500 – 64)/r = 436/.1 V(u) = $4,360Where ATOCF is After Tax Operating Cash Flow
Example
Everything is a perpetuity;Cash Revenue $1000Cash Expense 500Depreciation 300Tax Rate = 32%Cost of Capital = 10%
ATOCF = (1000-500) -.32*(1000-500-300) {EBIT(1-t) + Depreciation}
= (1000-500-300)*.68 + 300 = 136 + 300 = 436V(u) = $4,360Where ATOCF is After Tax Operating Cash Flow
Leverage Effects
• Now suppose the firm issues 2000 worth of perpetual debt, paying interest at 5%.
• Then interest will be:
INT = .05*2000 = $100
Now lets consider the interest deductions
Cash Revenue $1000Cash Expense 500Depreciation 300Interest 100Tax Rate (t) = 32%
CF = (1000-500) -.32*(1000-500-300 -100) = = 500 - 32 = 468 Or:
= ATOCF + t*INT = 436 + 32 = 468
Now Discount
• CF = ATOCF + Interest Tax Shield
• And V = ATOCF + t*INT
ro rB
V = V(u) + t*B
Now Discount
• CF = ATOCF + Interest Tax Shield• And V = ATOCF + t*INT
ro rB
V = V(u) + t*B
= 4,360 + .32 * 2,000
= $5,000
Value of Debt and Equity
• Value of firm = $5,000
• Value of Debt = $2,000
• Value of Equity = $3,000
• B/V = .4
• E/V = .6
With Taxes
In general,
V(L) = V(u) Plus Present Value of Tax Shield on Debt.
V(L) = V(u) + (Corp. Tax Rate) * Debt,
in the special case when debt is thought of as perpetual, or is selling at par.
Graphically
Firm Value (V)
V = V(u) + T c
*B
V(u)
Debt
Recall: Cost of CapitalIn the absence of taxes
WACC = ro
rS = ro + (ro-rB)B/S
rB
Cost of Capital (After Tax)
WACC = roB/V) )
rE = ro + (ro-rB)(1-t)B/S
rd
Weighted Average Cost of Capital
• WACC is the discount rate we use to discount the firm’s after tax Operating Cash Flow: (ATOCF)
• So in the example we just had:
WACC = ro(1-T(B/V) ) = 8.72%
= rE(E/V) + (1-T)rB(B/V), and
rE = .10 + (.10-.05)(1-.32)(.6) = 12.27%
WACC = .1227*.6 + .68*.05*.4 = 8.72%
= .07362 +.0136 = 8.72%
Firm Value and the Tax Shield on Debt
• Notice that the value of the firm is simply the ATOCF discounted by the WACC!
• The greater is the amount of debt issued, the lower is the WACC, and thus the higher is the value of the firm.
• By assumption, the ATOCF is unaffected by the firm’s capital structure.
Static Tradeoff Theorem
• Costs of Financial Distress– Potential Bankruptcy Costs– Underinvestment – Risk Shifting – Agency Costs
General Approach
• Assume:• No Taxes• Single period• Cost of Capital = 10%
Perfect Capital Market
• Widgets International
• Good State Bad State – Pure Equity 11 million 2.2
million – Probability of each state is 50%
– Stockholders’ Wealth– V = $6 million– E = $6 million
Bond and Stock Valuation
• Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million.
• What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (rB) is 5%
• Then the value is B = E{Cash Flows}/1.05
Debt valuation
• What is the Yield to Maturity? (YTM)
• What is the Expected Return?
– This will require some work
Perfect Capital Markets
• Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%)
Widgets International • Good State Bad State Expected
– Total 11 million 2.2 million 6.6– Debt 4.2 million 2.2 million 3.2– Equity 6.8 million 0 3.4– Stockholders’ Wealth– V = $6 million– B = 3.2/(1.05) = $3.05 – E = $6 - $3.05 = $2.95 IF The Value of the Firm
remains unchanged
Valuation of Equity
• If the value of the firm is independent of capital structure,
• rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:
E = 3.4/1.1517 = ???
Finally What is Stockholders’ Wealth?
Valuation of Equity
• If the value of the firm is independent of capital structure,
• rE = ro + (ro-rB)B/V
Therefore; rE = .10 + (.05)(3.05/2.95) = = 15.17% And:
E = 3.4/1.1517 = 2.96 (2.95 really, without rounding)
Finally What is Stockholders’ Wealth?
Debt Valuation
• Yield to Maturity
• Coupon rate
• Expected (required) return to Bonds
Bankruptcy Costs Widgets International
Good State Bad State Pure Equity 11 million 2.2 million
Probability of each state is 50%
Stockholders’ Wealth
V = $6 million
E = $6 million
Direct Bankruptcy Costs
• Typically amounts to 2% to 5% of the distressed value of the firm
• Widgets International – Again assume the same leverage of a bond promising
to pay 4.4 million
• Good State Bad (Default) – Total 11 million 2.2 million
Bankruptcy cost 0.1 million
• Net 11 million 2.1 million
Impact of Bankruptcy Costs
• Good State Bad (Default) – Total 11 million 2.2 million
Bankruptcy cost 0.1 million • Net 11 million 2.1 million • Value 5.95 million • Debt 3 million • Equity 2.95 million • Thus stockholders’ wealthstockholders’ wealth declines by $50,000 • (SHW = 2.95 + 3 = 5.95 not 6)• Notice that it is the stockholders that pays the
expected bankruptcy costs.