16- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard.

16- 1

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

Fundamentals of Corporate

Finance

Sixth Edition

Richard A. Brealey

Stewart C. Myers

Alan J. Marcus

Slides by

Matthew Will

Chapter 16

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Debt Policy

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Topics Covered

Debt and Value in a Tax Free Economy Capital Structure and Corporate Taxes Cost of Financial Distress Explaining Financial Choices Bankruptcy Procedures

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Value and Capital Structure

Assets Liabilities and Stockholder’s Equity

Value of cash flows from firm’s real assets and operations

Market value of debt

Market value of equity

Value of Firm Value of Firm

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Average Book Debt Ratios

Industry Debt RatioInternet information 0.07 Biotech 0.12 Communications equipment 0.19 Semiconductors 0.21 Oil exploration 0.29 Aerospace defense 0.32 Beverages (alcohol) 0.36 Consumer appiances 0.40 Hotels and motels 0.53 Gas utilities 0.53 Airlines 0.73

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M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller When there are no taxes and capital markets

function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix securities used to finance the company.

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M&M (Debt Policy Doesn’t Matter)

Assumptions

By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities

Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives

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Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

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Example

cont.

50% debt

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

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M&M (Debt Policy Doesn’t Matter)

Borrowing increases EPS for River Cruises

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Example - River Cruises - All Equity Financed

- Debt replicated by investors

25%15%5% investment$10 on Return

2.501.50$.50investment on earningsNet

1.001.00$1.0010% @Interest :LESS

3.502.50$1.50shares twoon Earnings

BoomExpectedSlump

Economy theof State Outcome

M&M (Debt Policy Doesn’t Matter)

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Example - River Cruises – Firm debt at 50%

- Investor can unwrap debt

17.5%12.5%7.5% investment$10 on Return

3.502.50$1.50investmenton earningsNet

1.001.00$1.0010% @Interest :PLUS

2.501.50$0.50share oneon Earnings

BoomExpectedSlump

Economy theof State Outcome

M&M (Debt Policy Doesn’t Matter)

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River Cruise’s “Value Pie”

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Operating Risk (business risk) – Risk in the firm’s operating income.

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

C.S. & Corporate Taxes

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Cost of Capital

)( debtassetsassetsequity rrE

Drr

ED

Er

ED

DrTWACC c equitydebt)1(

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r

DV

rD

rE

MM’s Proposition II (w/fixed interest rate)

rA

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Includes Bankruptcy Risk

r

DV

rD

rE

MM’s Proposition II (w/risky debt)

rA

Risk free debt Risky debt

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r

DV

rD

rE

WACC

Weighted Average Cost of Capital

WACC with no bankruptcy risk

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River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders.

48,75081,250FlowCash Net

26,25043,75035% @ Taxes

75,000125,000IncomePretax

50,0000PmtInterest

125,000125,000EBIT

Debt 1/2Equity All

C.S. & Corporate Taxes

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River Cruise DOES create value in a corporate tax environment by using debt financing. This is done by maximizing the cash flows to both equity and bondholders.

48,75081,250FlowCash Net

26,25043,75035% @ Taxes

75,000125,000IncomePretax

50,0000PmtInterest

125,000125,000EBIT

Debt 1/2Equity All

C.S. & Corporate Taxes

16- 20

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Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.

Should you do this and why?

C.S. & Corporate Taxes

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Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.

Should you do this and why?

4,5506,500FlowCash Net

2,4503,50035% @ Taxes

7,00010,000IncomePretax

3,0000PmtInterest

10,00010,000EBIT

Debt 1/2Equity All

C.S. & Corporate Taxes

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C.S. & Corporate Taxes

Total Cash Flow

All Equity = 6,500

*1/2 Debt = 7,550*1/2 Debt = 7,550

(4,550 + 3,000)

Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $10,000, before interest and taxes. The corporate tax rate is 35%. You have the option to exchange part of your equity position for 6% bonds with a face value of $50,000.

Should you do this and why?

4,5506,500FlowCash Net

2,4503,50035% @ Taxes

7,00010,000IncomePretax

3,0000PmtInterest

10,00010,000EBIT

Debt 1/2Equity All

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Capital Structure

PV of Tax Shield = (assume perpetuity)

D x rD x Tc

rD

= D x Tc

Example:

Tax benefit = 50,000 x (.06) x (.35) = $1,050

PV of 1,050 perpetuity = 1,050 / .06 = $17,500

PV Tax Shield = D x Tc = 50,000 x .35 = $17,500

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Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

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Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value of all equity financed

firm

PV of interesttax shields

PV costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

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Financing Games

The First Game: Bet the Bank’s Money

The Second Game: Don’t Bet Your Own Money

These games demonstrate an inherent conflict between shareholders and bondholders.

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Financial Choices

Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Financial Slack

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