McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Debt Policy
Changing a firms capital structure should not affect its value to shareholders.

This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm.

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Does Borrowing Affect Value?

A companys choice of capital structure does not increase the value of the firm.

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MMs Irrelevance Proposition

The value of a firm does not depend on its capital structure.

If this holds, can financial managers increase the value of the firm by changing the mix of securities used to finance the company?

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MMs Irrelevance Proposition

Assumptions of MMs argument:

Well functioning capital markets

Efficient capital markets

No taxes (therefore no distortion) Ignore costs of financial distress
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MMs Irrelevance Proposition

Example: An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value?

Before Restructuring:

After Restructuring:

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How Borrowing Affects EPS

Ceteris paribus, borrowing will increase earnings per share. However, this isnt a source of value to shareholders.

Shareholders can easily replicate a firms borrowing on their own if they choose.

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How Borrowing Affects EPS

Figure 16.1 Borrowing increases River Cruises earnings per share (EPS) when operating income is greater than $100,000 but reduces it when operating income is less than $100,000. Expected EPS rises from $1.25 to $1.50. Expected EPS with debt and equity

Equal proportions debt and equity

All equity

Earnings per share ($)

1.50
1.25

Expected EPS with all equity

Expected operating income = $125,000 50,000 100,000 Operating income ($)

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150,000

How Borrowing Affects Risk and Return

Debt financing does not affect the operating risk (or the business risk) of the firm. Debt financing does affect the financial risk of the firm.

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How Borrowing Affects Risk and Return

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Debt and the Cost of Equity

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Debt and the Cost of Equity

Example: What is the expected return on equity for a firm
with a 14% expected return on assets that pays 9% on its debt, which totals 30% of assets?

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MMs Proposition II
Debt increases financial risk and causes shareholders to demand higher rates of return.

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Debt and Taxes

Debt financing advantage: the interest that a firm pays on debt is tax deductible. Interest tax shield:

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Perpetual Tax Shield

If the tax shield is perpetual, then:

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Perpetual Tax Shield

Example: What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $12 million at an interest rate of 4% and a tax rate of 35%?

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Tax Shield and Shareholders Equity

When accounting for taxes, borrowing increases firm value and shareholders wealth.

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Taxes and WACC

Recall that the WACC takes into account the required after-tax rate of return

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Taxes and WACC

Example: What is the expected rate of return to shareholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?

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Costs of Financial Distress

Investors factor the potential for future distress into their assessment of current value.

Overall Market Value if all + PV tax = Value shield equity financed

PV costs of financial distress

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Bankruptcy Costs
If there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of all court expenses.

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Financial Distress Without Bankruptcy

Even if a firm narrowly escapes bankruptcy, this does not mean that costs of financial distress are avoided.
Stockholders may be tempted to play games at the expense of creditors

Betting the Banks Money

Not Betting Your Own Money

Loan Covenant: Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.
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Explaining Financing Choices

The Trade-off Theory
Debt levels are chosen to balance interest tax shields against the costs of financial distress.

A Pecking Order Theory:

Firms prefer to issue debt rather than equity if internal finance is insufficient.

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Financial Slack
Financial Slack: Ready access to cash or debt financing.

Financial managers usually place a very high value on having financial slack.

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Two Faces of Financial Slack

Benefits
Long run value rests more on capital investment and operating decisions than on financing. Most valuable to firms with positive-NPV growth opportunities

Drawbacks
Too much financial slack may lead to lazy management. Managers may try to increase their own perks or engage in empire-building.
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