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Corporate Finance

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Corporate Finance Lecture 17 INTRODUCTION TO CAPITAL STRUCTURE (continued) Ronald F. Singer FINA 4330 Fall, 2010 The Irrelevance Theorem Perfect Capital Market ... – PowerPoint PPT presentation

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Title: Corporate Finance


1
Corporate Finance Lecture 17 INTRODUCTION TO
CAPITAL STRUCTURE (continued) Ronald F.
Singer FINA 4330 Fall, 2010
2
The Irrelevance Theorem
  • Perfect Capital Market Setting
  • No Taxes
  • No Contracting Costs
  • Costs of Financial Distress
  • Agency Costs
  • No Information Costs

3
Irrelevance Theorem
  • LIABILITIES
  • DEBT 0
  • EQUITY 3,000,000
  • TOTAL 3,000,000
  • ASSETS
  • PVA 1,000,000
  • PVGO 2,000,000
  • TOTAL 3,000,000

4
Irrelevance Theorem
  • ASSETS
  • 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

5
The Static Tradeoff Theory
  • Benefits versus Costs of Leverage.
  • Benefits Costs
  • Taxes Financial Distress
  • Resolution of Agency Costs
  • Agency Costs Bondholder/Stockholder
  • Manager/Stockholder
  • Bankruptcy Costs
  • Direct and
  • Indirect
  • Information
    Costs

6
Tax Implications
LIABILITIES DEBT 0
EQUITY 2,100,000 TOTAL 2,100,000
  • ASSETS
  • PVA 1,000,000
  • PVGO 2,000,000
  • - PV of Tax Liability 900,000
  • TOTAL 2,100,000

7
Tax Implications (Suppose T 30)
  • ASSETS
  • PVA 1,000,000
  • PVGO 2,000,000
  • Less
  • PV of Tax Liability 420,0000
  • TOTAL 2,580,000

LIABILITIES DEBT 1,600,000 EQUIT
Y 980,000 TOTAL 2,580,000
8
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 increased by 480,000
    the reduction of taxes.

9
Firm Value Assuming Perfect Capital Markets
except for Taxes
  • Notice what happens, the (after tax) FCF
    increases due to the tax benefit from the
    interest deduction on debt. In particular,
  • FCF Before Tax FCF Tax
  • Tax T (Earnings) T (Rev-Exp-Interest)
  • (Rev-Exp)(T) (Int)(T)
  • So FCF FCF(1-T) Interest(T)

10
The Tax Benefit
  • So we can divide the After Tax Free Cash Flow
    into two separate Cash Flows
  • Cash Flow from operations
  • FCF(1-T) The Free Cash Flow (after Tax) that
    would be generated if there were no debt in the
    capital structure
  • Interest(T) The reduction of tax due to the
    Tax shield on interest.

11
Example
  • Suppose that the firms cash flows looked as
    follows
  • Revenue 20 million
  • Cash Expense 10 million
  • Interest 2 million
  • Depreciation 3 million
  • Change in WC 0

12
Calculation of Unlevered Cash Flow
  • That is, how much (after tax) would be generated
    if there were no interest payments
  • Net Operating Income (NOI)
  • (Rev-Cash Expense Depreciation)
  • 7 million
  • Tax _at_ 30 2.1 million
  • After Tax Operating Cash Flow
  • NOI Tax Depreciation
  • 7 - 2.1 3 7.9 Million

13
The Interest Tax Shield
  • Notice we can find the amount of the tax shield
    by considering how much tax saving there is for
    each dollar of interest. In particular
  • The Tax Shield T Interest (.3) 2 million
  • 0.6 million

14
PV of Cash Flow
  • V S(Y)(1-T) ST (Interest)
  • (1ro)t (1rB) t
  • V(u) PV of Tax
    Shield

15
With Taxes
  • V V(u) Plus Present Value of Tax Shield on
    Debt.
  • V V(u) (Corp. Tax Rate) Debt
  • In the special case when debt is thought of as
    perpetual.

16
Graphically
  • Firm Value (V)

V V(u) TcB
V(u)
Debt
17
Cost of Capital
rs ro (ro -rB)B/S
WACC ro
r
rB
18
Cost of Capital (After Tax)
rs ro (ro-rB)(1-T)B/S
r
WACC r0(1-T(D/v)) rs(S/V) rB(1-T) (B/V)
rB
19
The two ways of representing firm value V V
(u) T B V SY(1-T) (1WACC)t Where,
WACC r0 rs (S/V) rB (1-T)(B/V)
20
Static Tradeoff Theorem
  • Costs of Financial Distress
  • (Contracting Costs)
  • Potential Bankruptcy Costs
  • Underinvestment
  • Risk Shifting
  • Agency Costs
  • Assume
  • Not Taxes
  • Risk neutrality
  • Single period
  • Interest rate 0

21
Example of Underinvestment
  • ASSETS
  • PVA 1,000,000
  • PVGO 2,000,000
  • TOTAL 3,000,000

LIABILITIES DEBT 2,500,000 EQUITY
500,000 TOTAL 3,000,000
22
Example of Underinvestment
  • ASSETS
  • PVA 1,000,000
  • PVGO 2,000,000
  • TOTAL 3,000,000

LIABILITIES DEBT 2,500,000 EQUITY
500,000 TOTAL 3,000,000
23
Example of Underinvestment
  • ASSETS
  • PVA 1,000,000
  • (Cash 600,000)
  • (Real Assets 400,000)
  • PVGO 2,000,000
  • TOTAL 3,000,000

LIABILITIES DEBT 2,500,000 EQUITY
500,000 TOTAL 3,000,000
24
Example of Underinvestment Make a Div Payment
rather than invest
  • ASSETS
  • PVA 400,000
  • (Real Assets 400,000)
  • PVGO 2,000,000
  • TOTAL 2,400,000

LIABILITIES DEBT 2,250,000 EQUITY
1 50,000 TOTAL 2,400,000
25
Risk Shifting
  • Suppose the firm has value that will look like
    the following
  • Value in Good State 4,500,000
  • Value in Bad State 1,500,000
  • With equal probability
  • Promised payment to the Bondholder 3,500,000
  • What is the value of the equity and the debt?

26
Investment Opportunity
  • Invest 1,000,000 to generate 1,500,000 with
    probability ½ in good state, 0 otherwise, so that
    New cash flows are
  • 5,000,000 in good state
  • 500,000 in bad state
  • What is the NPV of the project, value of the debt
    and value of the equity?

27
Firm Value
Costs of Financial Distress
V V(u) PV of Tax Shield
Debt Level
Optimal Debt Level
28
Pecking Order Hypothesis
  • Costly Information
  • Conclusion
  • Firm has an ordering under which they will
    Finance
  • First, use internal funds
  • Next least risky security

29
Intuition
  • Suppose that you know your firm is undervalued,
    and you want to invest in a project How do you
    finance it?
  • Now suppose you believe the firm is overvalued

30
Pecking Order theory
  • So you have a dominating way of getting capital
  • Internal Financing
  • Risk free debt
  • Risky debt
  • Equity
  • In general, the more debt like a security is,
    the more you want to issue it.

31
So the announcement effect
  • If the firm announces it intends to issue equity
    to invest in a project, this is bad news and
    stock prices will go down. That is the market
    will ASSUME this is a bad firm.
  • Therefore the firm will never issue equity if it
    can avoid it.
  • Thus pecking order.
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