L 07 Post-Loss Financing1.ppt

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Adding Value by Post-loss

Financing- I

Lecture 7

Dr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

Meditation for the week:

“When looked at with proper perspective, difficult

situations always yield valuable lessons.”

“Believing in yourself and your abilities is the first step to

overcoming adversity.”



Topic Objectives

We examine the implications of

recapitalising the firm after it suffers a

sudden risky event. We examine the use of equity or debt to fund

post-loss investments.

We discuss the post-loss capital structure of

the firm.

We also look at the fundability of post-loss

investment using debt or equity.

Dr. Tahir Khan Durrani 2



Post-loss Decisions

Should the firm reinvest in productive assets?

Should it undertake new investment activity?

Can these investments add value?

Can they be financed?

If they add value, how should the firm raise money?




Generic Sources of Funds

Hedging Cost of risky event borne by counter party, firm retains

internal funds and its excess to external funds

Contingent financing

Line of credit with interest rate fixed in advance, hedging risk

in future cost of capital

Put options issued on firm’s own stock

Convertible debt

Post-loss financing

Withholding of dividends

Raising new debt or equity




Financial Structure Puzzle Modigliani-Miller hypothesis (1958) :

Capital structure is irrelevant under certain conditions: no taxes

all investors are asymmetrically informed

no transaction costs

investment policy of the firm already determined. No advantage for a firm to manipulate its debt-to-equity ratio,

since the effect of any leverage choice on investors can bereplicated by the investors themselves in the management of their portfolios.

Capital structure matters, because of taxes, information cost,transaction costs, or interdependence between the firm’sfinancing and investment policies.

Optimal capital structure is a compromise between costs andbenefits of different sources of finance.




Corporate and Personal Taxes

Interest income is deductible income, but dividends are not. This creates advantage fordebt financing.

The cost of debt is partly paid by the InlandRevenue

Value of levered firm = value of all-equity firm+ PV (tax shield)

PV (tax shield) =


Dt k

Dk t

c D

E c



Corporate and Personal Taxes Deductibility of interest thereby increases the

value of disbursement that can be made to thecompany’s security holders.

The size of the pie has been increased by using

debt. But are investors necessarily better off? This depends on personal tax rates.

The slices of the bigger pie still have to be taxed at the personal rate.

It should be immediately apparent that if personaltaxes on equity income are sufficiently smallerthan on debt, investors could be better off without corporate borrowing.




Corporate and Personal Taxes

The personal rate on equity income iscomplicated by the fact that this income can be in

the form of capital gains or dividend income.

If all equity income were in the form of dividends,

investors would pay the same tax rate on interest

and dividends and corporate borrowing would be

attractive.

But equity income can be in the form of capitalgains, which are taxed at a different rate from

other income and can be deferred until realized.




Cost of financial Distress

If the risk of the cash flows is fixed, then the higher theleverage, the higher the probability of bankruptcy, andthe higher the expected value of bankruptcy costs.

Indirect costs of bankruptcy, share holders may fail toundertake positive NPV projects that simply shore up thevalue of debt

Value of levered firm = value of all-equity firm

+PV (tax shield)

-

PV (cost of financial distress)




Recapturing Value through Post-Loss Reinvestment

Does post-loss financing to fundreconstruction or new investment, add valueto existing shareholders?

Do the terms on which new money is raisedpermit value to be created for existingshareholders?

After a big loss, will investors have theconfidence to buy newly issued securities andcan the firm raise enough money for itsinvestment needs?





Suppose a firm has a loss of value from somerisky event that is not hedged and nocontingent financing available.

To undertake post-loss investment it must useinternal funds available after loss or raise newmoney.

Definitionally, it must use post-loss financing

to fund reconstruction of the destroyed assets,or to fund new investment, add value forexisting shareholders?





The question can be asked with a different emphasis.

Do the terms on which new money is raised

permit value to be created for existingshareholders?

More pointedly, if a firm has just suffered amajor setback, say a major liability suit, willinvestors have the confidence to buy newlyissued securities and can the firm raise enoughmoney for its investment needs?




Value of Equity Before a Loss

From previous lecture we derived this equation onthe value of equity:

V(E) = V0 + L - Kt + Vt - D -T

V(E) = Value of equity before a loss

V0 = PV of earnings from existing operations

L = liquid assets

- Kt + Vt = the value added by new investment

D = the existing debt

T = transaction costs of any new issues




Value of Equity Before a Loss

Firm refinances using debt / equity raises amount denoted by

S. The PV of dividends / interest payment is denoted by R.

Cost of new investment is Kt

V(E) = V0 + L + (S - R - Kt ) + Vt - D -T

Term R represents a set of future payments expressed as thevalue raised S, times the expected rate of return “r”.

R = rS/r = S

R and S cancel out, as these are competitively priced

If existing share holders can attract capital in a competitivecapital market, they only offer a competitive rate of return oncapital raised. They need not share added value with newinvestors. All NPV of new investment is captured by existingshare holders.




Value of Equity After a Loss

Will investors be willing to pay enough forthese new security issues after a loss to fund

reconstruction of old assets and possibly new

investments? V'(E) = - C + V0' + L - Kt ' + Vt ' - D -T

The primes denotes post-loss values

C is the direct cost of the risky event




Value of Equity After a Loss

Rewriting the previous equation showingamount new investors pay for a post-loss

security as S.

The PV of expected payments to shareholdersis rS/r, if the new issue is competitively

priced

The bracket in the equation below simplifies to-C,

V'(E) = (S - rS/r - C) + V0' + L - Kt ' + Vt ' - D -T




Fundability with Post-loss Equity Financing

Is the amount investors are willing to pay,S, sufficient to pay for the capitalinvestment of C?

Existing shareholders hold a total of m

shares & new shares n sold to new investors(n + m), who receive a proportion n/(n+m)of total value of equity ET.

ET

= V0' + L - Kt ' + Vt ' - D -T’ The aggregate sum paid in a competitive

market for new shares is nET/(m + n).





This will be sufficient to raise enough money to pay forrequired post-loss capital needs, C, if.

(ET)n/(m + n) C

which requires n mC/(ET - C), if ET>C

If ET were exactly equal to C, then mathematically Nwould have to be infinite to satisfy the inequality.

There is no value added from continuing to run thefirm, as firm is on the verge of insolvency.

Principle: As long as the cost of post-loss investment is less than the

post-reinvestment value of total equity, it is alwayspossible to finance the investment from a new equityissue.


F d bili i h P l E i




If post-loss investment is fundable, it does not followthat it should be undertaken.

Example:

Chair and Wares makes furniture and expects an earningsstream of £1,000 (after deduction of costs of renewing

plant) indefinitely from its current operations. The firm canreinvest two-year earnings in some product improvement,and expect earnings stream to grow by 2%. Cash at hand is£1,000, with the existing plant and other productive assetshave a replacement cost of £8,000 with a salvage value of £5,000.

The firm has existing debt of £5,000; the cost of debt is 0.05,The firm’s WACC is 0.1. The owners hold 1,000 shares of stock.




Value of Equity Without New Investment

E = e/(k-g) - D + L

= £1,000/(0.1 - 0) - £5,000 + £1,000

= £6,000

Where:

e = c/f from current operations

g = growth of this cash flow

k = cost of capital




Value of Equity With New Investment

E = 0/(1 + 0.1) + 0/(1 + 0.1)2 + [1/(1+0.1)2][1,000/(0.1-0.02) -5,000 + 1,000 = £6,331

The new investment adds value (6331 is more than 6000) andshould be undertaken.

Suppose the existing plant suffers an explosion and is uninsured.The plant can still partly operate, and earnings are reduced to£300, but this figure is not expected to grow. However, an

investment of £3,000 will fully restore the plant, and earnings willreturn to the pre-loss level of £1,000.

The firm must raise new money for this reconstruction, but stillplans to pay for the new investment in two years from retainedearnings.

Does the reinvestment add value to equity? What opportunities exist for raising new money by an equity

issue after the loss?

The transaction cost of new issue is £200.




No Reinvestment

The firm has insufficient funds toundertake the new investments, thevalue is as follows:

V'(E) = 300/(0.1 - 0) - 5000 + 1000

= 0 (limited liability)

The value of equity should be -1000,however because of limited liability,the equity is worthless.




With Reinvestment They can raise £3,200, with the £200 covering transaction

costs.

V'(E) = - 3,200 + [1/(1+0.1)2][1,000/(0.1-0.02)]

- 5,000 + 1,000 = 3,131

Notice reinvestment is necessary for survival and raises levelof owner’s equity from zero to 3,131.

How many shares must be issued to fund thereconstruction?

The firm needs enough shares to raise 3200 (3000 forreconstruction and 200 for transaction costs. Total value of

equity is 6331 (firm raises 3200 in new equity and existingshares are worth 3131).

The firm need to issue 1,022 new shares. This ensures totalequity of 6331 is divided into a total of 2022 shares, eachworth 3.131.




No Future Risk It would seem that because the value of equity is

positive after reinvestment, the firm hadsufficient value to pay off all debt (senior debt of 5000 and junior debt of 3200) and still have aresidual value of 3131.

Suppose that the story was as follows. The firm takes the reinvestment and is then is

immediately obligated to sell off the firm anddischarge all claims to existing credits.

The firm would receive the full firm value, 11,331(the earnings stream is worth 10,331 and there iscash of 1000), in a competitive market, and pay5000 to senior creditors and 3200 to juniorcreditors, leaving 3131 to shareholders.


N F Ri k



No Future Risk Then investors would be willing to pay at par for debt

with a face value of 3200.

But now suppose there is no such obligation to sell thefirm in this way. Can junior bondholders always be surethat they will paid in full in the future?

If the earnings stream of 1000, growing at 2%, wereentirely risk- free, there would be no problem and theanalysis of this paragraph would still apply; the juniordebt would still be worth its face of 3200.

Since there is no future risk, the simply fundabilitycondition for news investors to subscribe fully to new

debt is fulfilled. The condition was V’(F) – D – C > 0, where V’(F) is post -

loss firm value after reinvestment, D is preexisting debt,and C is the capital cost.

The condition fills out as 11,331 – 5000 – 3200 > 0.Dr. Tahir Khan Durrani 25



Fundability with Post-loss DebtFinancing

Whether debt or equity is used, investors will be

willing to subscribe a sufficient amount to fund the

new investment if the post-loss value of the firm,

minus any pre-existing debt, exceeds the direct cost,

C.

Even if the expected value of E(V'(F)) - C > D, thefirm is still exposed to future risk.





To see whether investor in a new debt issuewould be willing to pay a sufficient amount forthe firm’s debt to pay for the direct cost, C, wewill simply the default assumption.

The firm may become insolvent directly as aresult of the risky event (i.e., the post-lossvalue of equity, even with reinvestment, is

negative). But even if the post-loss equity value is

positive, future risk could lead to insolvency

and default on debt. Dr. Tahir Khan Durrani 27

d b l h l b




The firm needs an amount of C to pay for the direct costs.

If debt is raised, the amount subscribed is S, but theface value of the debt is C. the amount S will be equal

to C if the value of the firm, after payment for any seniordebt, exceeds C. In equation, the firm did have pressingdebt of D, so we will call the value of the firm after lossV (F) = V0 + L – Kt +Vt - T.

Furthermore, this value is risk-free because we haveignored future risk.

If the existing debt is senior to any post loss issue, thecondition for S to equal C is that V (F) - D – C > 0.





But notice that when discussing post-loss debt wehad defined ET= V0 + L – Kt + Vt –D –T.

So clearly, V = ET + D.

Thus, the fundability condition that V(F) – D – C ispositive the same as ET – C is positive.

This is exactly the same fundability condition wederived for post-loss equity financing.

Whether debt or equity is used, investors will bewilling to subscribe a sufficient amount to fund thenew investment if the post-loss value of the form,minus any pressing debt, exceeds the direct cost,C.




Fundability with Post-loss Debt Financing

We return to Chairs and Wares, and we compute the

post-loss values as follows:No reinvestment:

V(F) = 300/(0.1-0) - 5,000 + 1,000

= 0 (Limited liability)With Reinvestment:

V(F) = -3,200 + [1/(1+0.1)2][1,000/0.1-0.02]

- 5,000 +1,000

= -3,200 + 10,331 - 5,000 + 1,000 = 3,131

Fundability condition is V'(F) - D - C > 0




Debt or Equity Refinancing

Optimal capital structure after a loss must balance the tax effects, the direct and indirect cost of financial distress.

The tax effect diminishes with leverage, andthus debt is tax-preferred.

The cost of financial distress, includingunderinvestment and asset substitution costs,increase with leverage.




Debt or Equity Refinancing The issue to be addressed are summarized in

the next Figure.

The solid n- shaped line at the top shows howthe value of the firm depends on the level of

leverage. The value-maximizing capital structure is

identified by the highest point on the curveand is shown as leverage A.

The position and n shape to the value curvestart with the unlevered value line shown as adashed horizontal.




Debt or Equity Refinancing Taxes reduce value and are shown in the negative

quadrant. The tax effect diminishes with leverage, and thus

debt is tax- preferred.

In contrast, cost of financial distress, includingunderinvestment and asset substitution costs,increase with leverage as shown.

Combining the tax effect of leverage and costs of

distress leads to the n shape in pre-loss value. Now suppose the firm has chosen its optimal

capital structure A and then some risky lossoccurs. There are two major effects:




The effect of Loss on Leverage The value curve now shifts down to the post-

loss curve.

The downward shift reflects the loss of value.

The downward shift occurs in two stages;

if no post-loss investment is undertaken (i.e.

destroyed assets are not replaced and/ or new

post-loss investment opportunities are not

undertaken), then the loss in value will be

severe.




The effect of Loss on Leverage The downwards arrow shows the fall in value

curve.

However, much of this lost value can be

recaptured by post-loss investment and the

value curve shifts upwards again towards the

original curve.

As shown, not all pre-loss value is recaptured.

There can be some permanent loss of value if the event shifts demand or leads to an increase

in frictional costs.




The effect of Loss on Leverage


Cost of Distress

Taxes

LeverageA C

Unlevered

Present

Value Pre-Loss

Post-loss

0

Eff f L f P d i A



Effects of Loss of Productive Assets The event itself will fall disproportionate on

equity; probably increasing leverage to some

point such as B. If no post-loss investment activity is undertaken,

the firm is likely to be over levered, and positionB does not indeed shows this.

Depending on what level of post-loss investment is undertaken and how it is financed, the post-loss leverage will resettle at some point such as Con the recaptured value curve.

The post-loss optimal capital structure may not be the same as the pre-loss capital structure.

As shown, the optimal post-loss leverage, C, ishigher than pre-loss, B, but it could go the other

way. Dr. Tahir Khan Durrani 37



Effects of Loss of Productive Assets


Leverage

A C

Unlevered

Present

Value Pre-Loss

AfterPost-loss

Investment

0

Before

Post-lossInvestment

B



Debt or Equity Refinancing

After a loss the leverage

of the firm changes.

Creditors being

protected by their

priority claim, most of

the fall in value is a

dead-weight cost to

Shareholders.

Thus leverage usually

rises after a loss.

In the post-loss decision on

how to pay for newinvestment, the cost of

financial distress, plays an

important role.

From the high post-lossleverage position,

underinvestment and asset

substitution problems are

more prominent and the firmmay therefore have difficulty

in raising enough debt.




Framework for Comparing Post-lossDebt and Equity Financing

The before-loss value of equity is:

V(E) = V0 + L + (S - R - Kt ) + Vt - D -T

V(E) = V0 + L - Kt + Vt - D -T

The After-loss value of the original equity is:

V'(E) = (S - rS/r - C) + V0' + L - Kt ' + Vt ' - D –T ‘

V'(E) = - C + V0' + L - Kt ' + Vt ' - D –T ‘




Framework for Comparing Post-loss Debtand Equity Financing

Equity Refinancing Debt Refinancing

EBITInterestTax

123

123

Net Icome

Cost of Equity, KE

Growth RateValue of Equity, E

456

456

Value of the Firm, V 7 7

No. of Shares (m+n) 8 8

Share Price 9 9


F k f C i P t l D bt




EBIT Choice of debt/equity

affects direct and

indirect costs of

bankruptcy Interest

Debt financing incurs an

additional interest and

affects the cost of debt due to increased

leverage.

Tax: Debt financing is

advantageous because

interest payment are tax

deductible. Tax benefits from debt

financing rats on both

corporate and personal

tax liabilities. Tax advantage =

(1 - t p)/(1 - t e)(1 - t c)





Cost of Equity, KE:

Leverage affect the cost

of equity and WACC

depending on the risk

characteristics of c/f.

Growth Rate, gN:

The additional direct

and indirect bankruptcy costs from

additional debt will

affect future earnings.

Value of Equity and

No. of Shares:

There will be dilution

with new issues andthe share price will

reflect values of debt

vs. equity financing to

the firm’s originalowners.


Framework for Comparing Post-loss Debt




Value of the Firm, V: The difference in

earnings and growthrates between equity

and debt financing areconsidered.

Value of levered firm =value of all-equity firm+ PV(tax shield)

- PV(cost of financialdistress)

Share Price:

provides a measure of the residual value tothe firm’s originalowners from thedifferent forms of financing.

Question:

Under what circumstances after a

loss do companieschoose to refinanceusing debt rather thanequity?




Learning Outcomes

We learnt that: loss changes the context in which capital

budgeting decisions are made.

Losses tend to fall disproportionately on equityand consume cash.

Post-loss stresses may prevent the firm from

raising external capital.

Post-loss financing decision still needs to balance

the tax advantages of debt with various frictional

costs.

L 07 Post-Loss Financing1.ppt

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