This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Now suppose borrow $500, in addition to selling equity» Note: Project Cash Flows > Debt Owed in each state
Payoffs to Debt and Equity
M&M I Value of firm is independent of capital structure in perfect capital markets E = 500» Cash flows of D and E sum to Project cash flows D and E must sum to value
of firm (Law of One Price)» M&M I says that V = D + E, regardless of what D and E are!
Effect of Leverage on Risk and ReturnExample (Cont.)
Why isn’t the value of equity
Look at the returns to shareholders now
Levered equity carries a higher risk premium than unlevered equity rE≠15% anymoreLevered equity = higher risk = higher return (25%)» This is not due to default risk! (Debt is risk-free)» Project risk is the same 15%
Imagine entrepreneur creates all-equity firm, but investor wants levered equity» Investor just needs to borrow to replicate cash flows to levered equity
Loan is risk-free (Rf = 5%) since cash flows on equity serve as collateralWe just replicated the payoffs to the levered equity & law of one price value of levered equity = $500
In a “perfect capital market,” the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure» Value of Firm (V) = Value of Debt (D) + Value of Equity (E) (No
matter what D and E are since investors can undo anything the firm does with perfect capital markets, so capital structure doesn’t matter.)
» Only thing that matters for value (size of the pie) is the PV of the cash flows…doesn’t matter how you divide them up (slice the pie)
M&M Proposition II says:» The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value debt-equity ratio
The WACC,
is a constant function of leverage in perfect capital markets because as D/E changes, rE changes to compensate» For really high leverage, rD will change as well (rD=rA in limit)
M&M tells us that there can be no benefit so something must give...Imagine that EBIT was only $4mil (instead of $10mil)» Before debt issuance EPS =» After debt issuance and share repurchase EPS =
Assume:» LVI’s EBIT is constant in the future (10mil)» All earnings are paid out in dividends» If we increase EPS, what will happen to the share price?
Unlevered:» Recall: Earnings = $10mil & Shares = 10mil EPS = $1» Dividends/Share (DPS) =» Value the company as a perpetuity to get the WACC
The firm issues 62.5mil new shares @ $16/share to get $1bilFirm grows by $1bil, which offsets increase in sharesAny gain or loss from issuance comes from project NPVKey assumption:» Sell the shares at a fair price!
What are the assumptions behind M&M? That is, when are the M&M propositions true?
1. no taxes, 2. no bankruptcy costs, 3. no agency costs/benefits, 4. no information asymmetry, and5. no transaction costsWhat the !@#$% ? What’s the point of this?
» If financial policy is to matter, it must be that it mitigates (or takes advantage of) one or more of these frictions
» Devise financial strategies around minimizing (maximizing) the adverse (beneficial) effects of these frictions
The interest tax shield is:» Corporate Tax Rate x Interest Payments
What is the benefit for firm value?» Present value of the interest tax shield!
In a perfect market, we had: VL = VU.M&M I with Taxes:» VL = VU + PV(Interest Tax Shield).
To get at PV(Interest Tax Shield) we need:» Forecast of firm’s debt forecast of interest payments» With forecasted interested payments interest tax shield» Discount the interest tax shield at the “appropriate” risk-adjusted rate
Why would anyone tender their shares for $15 if they know that after the recap their shares will be worth $17.63?» I would buy shares @ $15 before the repo, and then sell after the repo
@ $17.63 for an arbitrage profit?It is precisely this arbitrage activity that will drive up the price before the recap!» The announcement of the recap will drive up the stock price to
incorporate the PV (interest tax shield) ex ante» So Midco’s equity will rise from $300mil to $335mil before the repo» Price per share will increase to $335mil / 20mil = $16.75» Tax shield surplus will be split evenly between those who tender their
shares and those who keep their shares– Original shareholders capture all of the surplus: $1.75 x 20mil = $35mil
Double taxation of equity income:» Cash flows to firm taxed at τC and then again at the personal rate τP when
distributed to investors– Debt holders pay taxes on interest payments (as ordinary income)– Equity holders pay taxes on dividends and capital gains
The amount of money an investor will pay for a security depends on the cash flows the investor will receive after all taxes have been paid.
Personal taxes reduce the cash flows to investors and can offset some of the corporate tax benefits of leverage.
The actual interest tax shield depends on both corporate and personal taxes that are paid.» To determine the true tax benefit of leverage, the combined effect of both
corporate and personal taxes needs to be evaluated.
With:1. no leverage, the firm receives no tax benefit.
2. high leverage, the firm saves $350 in taxes.
3. excess leverage, the firm has a net operating loss and there is no increase in the tax savings.– Because firm is not paying taxes, no immediate tax shield from the excess
leverage (ignoring carry-back and carry-forward)
No corp tax benefit from incurring interest payments that regularly exceed EBIT» Because interest payments constitute a tax disadvantage at the investor
level, investors will pay higher personal taxes with excess leverage
We can quantify the tax disadvantage for excess interest payments (Assuming there’s no reduction in corporate tax for excess interest payments & investors will pay higher personal taxes with excess leverage):
This is < 0 because equity is taxed less heavily than interest for investors (τe < τi)Optimal level of leverage from a tax perspective is such that interest equals EBIT» The firm shields all taxable income and no tax-disadvantaged excess
Limits of Tax Benefit of DebtPractical Considerations
However, it is unlikely that a firm can predict its future EBIT (and the optimal level of debt) precisely. » If there is uncertainty regarding EBIT, then there is a risk
that interest will exceed EBIT. As a result, the tax savings for high levels of interest falls, possibly reducing the optimal level of the interest payment.
In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt declines, limiting the amount of debt the firm should use.
Growth will affect the optimal leverage ratio. » To avoid excess interest, a firm with positive earnings should have a
level of debt such that interest payments are below its expected taxable earnings.
From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings. However, the value of the firm’s equity will depend on the growth rate of earnings: » The higher the growth rate, the higher the value of equity
The optimal proportion of debt in the firm’s capital structure [D / (E + D)] will be lower, the higher the firm’s growth rate.
There are numerous provisions in the tax laws for deductions and tax credits:» R&D,» depreciation, » investment tax credits, » carry forwards of past operating losses, etc.
To the extent that a firm has other tax shields, its taxable earnings will be reduced and it will rely less heavily on the interest tax shield.
Financial Distress occurs when a firm has difficulty meeting its debt obligationsDefault» Technical Default is the violation of a covenant other than one
requiring the payment of interest or principal» Payment Default is the violation of a covenant requiring the payment
of interest or principal» Defaults entitle debt holders certain rights, typically the ability to
accelerate all payments and terminate any unutilized commitments.Bankruptcy» Ch 11 – Reorganization» Ch. 7 – Liquidation
Without debt, there is no risk of any of these events
Financial Distress and Firm ValueArmin Industries Revisited
Same setup as before but now assume:» Debt holders receive only $60mil if product fails due to financial
distress costs
Financial distress costs lower the value of the firm and M&M I no longer holds» Recall VU = $109.52mil (from before)» VL =» Costs of financial distress =
If new product fails, shareholders lose their investment but don’t care about bankruptcy costs (limited liability)Debt holders know about loss of value in bankruptcy and therefore pay less for debt initially» The present value of the distress costs
This means the firm receives less money from debt offering» This difference comes out of shareholders pockets (so they
Agency Costs are costs that arise when there are conflicts of interest between the firm’s stakeholdersDifferent claimants have different incentives, which can lead firms to undertake actions that hurt one groups to benefit another» Overinvestment and Asset Substitution» Underinvestment and Debt Overhang
Agency costs are another cost of increasing leverage, just like bankruptcy costs
Owes $1mil due at end of yearWithout a change in strategy, assets will be worth only $0.9mil
Baxter will default if they take no actionBaxter’s considering a new strategy:» No upfront investment» Success will increase firm’s assets to $1.3mil w.p. 50%» Failure will decrease firm’s assets to $0.3mil w.p. 50%
This is a negative NPV project since expected value of firm’s assets decline from $0.9mil to $0.8mil» Cash Flow from Strategy|Success = $0.4mil» Cash Flow from Strategy|Failure = -$0.6mil» E(Cash Flow from Strategy) = -$0.1mil
But, does this mean Baxter won’t undertake the investment?
Asset Substitution or OverinvestmentBaxter Inc. (Cont.)
Note:» Equityholders gain $0.150mil from investment (0 to $0.150mil)» Debtholders lose $0.250mil from investment ($0.900mil to $0.650mil)» Net gain (loss) in firm value of -$0.100mil = NPV of strategy =
0.5(1.300-0.900) + 0.5(0.300-0.900) = -0.100mi
Equity holders have incentive to “gamble” with debt holder’s money but debt holders will anticipate this and pay less ex ante
Owes $1mil at end of year but without a change in strategy, assets will be worth only $0.9mil defaultConsidering alternative strategy:» Requires initial investment of $0.1mil» Generates risk-free return of 50%» Clearly a positive NPV investment
Problem (?): Baxter doesn’t have the cash on hand» Can they raise the money in the equity market?
Debt Overhang and UnderinvestmentBaxter Inc. (Cont.)
If equity holders contribute $0.1mil, they only get back $0.05mil» $0.1mil goes to debt holders, whose payoff goes from $0.9mil to $1mil
Even though project is positive NPV, equity holders won’t undertake it because most of the benefit goes to debt holdersUnderinvestment or Debt Overhang
Leverage can encourage managers and shareholders to act in ways that reduce firm value.» It appears that equity holders benefit at expense of debt holders. » But, ultimately the shareholders bear these agency costs.
When a firm adds leverage to its capital structure, the decisionhas two effects on the share price.» The share price benefits from equity holders’ ability to exploit debt
holders in times of distress. » But, debt holders recognize this possibility and pay less for the debt
when it’s issued reduces amount firm can distribute to shareholders. Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm.
Shorter maturity debt can offset agency costs by limiting scope of expropriationCovenants can mitigate agency costs by forcing managers to commit not to expropriate debtholders
Managerial Entrenchment occurs from the separation of ownership and control in which managers make decisions to benefit themselves at the expense of investorsLeverage can preserve ownership concentration and mitigate agency costs» Issuing debt can maintain the original shareholders stake, while issuing
equity can dilute original shareholders incentives because any agency costs are shared with others
Leverage can mitigate empire building tendencies arising from incentives to run large firms (e.g., salary structure, perquisites)» Leverage imposes discipline by pre-committing the cash flows and by
Adverse selection refers to the idea that with asymmetric information, the average quality of assets in the market will differ from the average overall qualityLemons principle: when seller has private information about the value of a good, buyers will discount the price they will pay because of adverse selectionThink used cars: » The desire to sell the car suggest it sucks so buyers won’t pay much» Owners of good cars don’t want to sell because buyers will think
they’re selling a lemon and offer a low price» The quality and prices of cars sold in the used-care market are both
Same idea can be applied to equity markets» Firms that issue equity have private information about the quality of the future
projects.» Lemon principle suggests that buyers are reluctant to believe management’s
assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.
» Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity.
» Only those managers who know their firms have poor prospects (and whose securities will have low value) are willing to sell new equity.
The lemons principle implies:» The stock price declines on the announcement of an equity issue.» The stock price rises prior to the announcement of an equity issue.» Equity issues occur when information asymmetries are minimized (e.g.,