Post on 06-Jul-2018
8/17/2019 Lecture_22-23 Optimal Capital Structure and Tradeoff Theory
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Professor Sang Byung Seosseo@bauer.uh.edu
Optimal capital structure and
tradeoff theory
8/17/2019 Lecture_22-23 Optimal Capital Structure and Tradeoff Theory
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Deviations from M&M assumptions
• The M&M world provides a very useful startingpoint.
• The M&M Propositions essentially give us a “laboratory
control” of corporate financing decisions.
• If some of the assumptions do not hold in the
real world, capital structure decisions do
matter and affect the value of a firm.
1. Corporate taxes
2. Cost of financial distress
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Corporate taxes
• What happens if we include corporate taxes in the
model? Does the M&M propositions then change?
• Under the U.S. tax code, and that of many countries,debt interest payments are tax deductible.
• This implies that capital structure is no longer irrelevant tofirm value.
• M&M world + corporate taxes
= +
• : The value of levered firm
•
: The value of unlevered firm (100% equity)
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Interest tax shield
•EBIT are taxed at the corporate rate.
• Interest expenses and dividends are taxed
differently:• Corporations can deduct interest payments as business
expense.
• Interest payments are NOT taxed at the corporate level, giving
rise to an interest tax shield.• Retained earnings and dividends are taxed at the corporate
level.
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Example
•
You own all the equity of Space Babies Diaper Co.The company has no debt, i.e. its current capitalstructure is 100% equity. The company’s annualearnings before interest and taxes (EBIT) is $1,000.The corporate tax rate is 40%.
• You have the option to exchange ½ of your equityposition for bonds with a face value of $1,000. Thecurrent interest rate you need to pay for issuingdebt is 10%.
• Should you?
• If so, why or why not?
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Example
All Equity 1/2 DebtEBIT $1,000 $1000
Interest payment @10% $0 $100
EBT $1000 $900
Taxes @40% $400 $360
Net Income $600 $540
Total CF to investors $600 $540+100 = $640
•
Note that• $600 (all equity firm) < $640 (1/2 Debt firm)
• The difference ($40): interest tax shield
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PV of the tax shield
• What is the present value of the tax shield?
• If the same savings occur every year, we can find the PV of the taxshield as a perpetuity.
• If the savings are as risky as the debt, we can discount them at cost ofdebt:
= ℎ
= × ×
=
• : corporate tax rate
• For the Space Babies Diaper Co. example, we have:
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Firm value and corporate taxes
•If we simplify and assume that the cash flows toall stakeholders occurs forever, then we can
again value that cash flow as a perpetuity.
• Note that we use a different discount rate on the
interest tax shield.
• That shield is only as risky as the debt part of our capital
structure: No debt, no interest!
= 1 −
+ × ×
= +
The value of unlevered firm ()PV (interest tax shield)
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Corporate taxes and M&M Prop I
• Proposition I (with corporate taxes)
• Firm value increases with leverage.
= +
• Firm’s cost of capital () is no longer invariant to
leverage (D/E ratio).
=
+ +
+ −
•
Intuitively, we reduce cost of debt by 1 − because the debtinterest is tax-deductible to the firm.
• Here, the cost of capital is called (post-tax) WACC:
= =
+
+
+
−
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Corporate taxes and M&M Prop II
• In the WACC equation, how do we calculate the cost of
equity () under the M&M world with corporate taxes?
• Proposition II (with corporate taxes)
• Some of the increase in equity risk and return is offset by the interesttax shield:
= +
− −
• is the return on equity cost of equity
• ℎ ℎ
• ℎ ℎ
• ℎ
• ℎ
• ℎ ( )
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Corporate taxes & the cost of capital
T l h fl i d h
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Total cash flow to investors under each
capital structure with corporate taxes
• The levered firm pays less in taxes than does the all-equity firm.
• Thus, the sum of debt (D) and equity (E) of the levered firm is greater than theequity of the unlevered firm.
• This is how cutting the pizza differently can make the pizza larger!
• The government (T) takes a smaller slice of the pizza if the firm is levered!
• That is, financial leverage adds firm value.
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Limits to the use of debt
• The above analysis would suggest that firmsshould maximize PV(tax shield), such that weexpect 100% debt.
• Yet, outside the financial sector, D/(D+E) tendsto be below 40%.
•
Why don’t companies fully take advantage ofthe tax shield?
• Personal taxes (small effects)
• Costs of financial distress (most important limit to
debt’s use)
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Personal Taxes
• What happens if we have both a corporate tax and a
personal tax that is imposed on investors?• Merton Miller has extended the above model to account for
personal taxes:
• For large public firms, it is in practice difficult to consider personal tax rates when setting the optimal leverage.
• The bottom line is that any effect from personal taxes is
likely to be small.
Note: in the case
where = , wereturn to M&M with
only corporate tax.
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Costs of financial distress
• With more debt, there is a greater chance that the
firm will be unable to make its obligations.
• Bankruptcy is a long and complicated process that imposesboth direct and indirect costs on the firm and its investors.
• They are called “bankruptcy cost” or more generally “costs of
financial distress.”
• Bankruptcy risk vs Bankruptcy costs
•
Note that higher bankruptcy itself does not lower value.• Debtholders are rewarded by a higher return on debt.
• It is the costs associated with bankruptcy that lower value.
• Costs of financial distress is something that the assumption ofperfect capital markets ignores.
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Costs of financial distress
•
Direct bankruptcy costs• Legal and administrative costs
• Hiring lawyers, consultants, accountants, etc.
• Tend to be a small percentage of firm value; around 3-5%
• Indirect costs
• Impaired ability to conduct business
•
For example, nobody wants to be a customer of a firm that may gobankrupt.
• Agency costs
• Conflicts of interest between stockholders and bondholders.
• Tend to be substantial; 10 to 20% of firm value.
8/17/2019 Lecture_22-23 Optimal Capital Structure and Tradeoff Theory
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Coprate taxes + financial distress costs
•
Recall: M&M world + corporate taxes: = + tax shield
•
M&M world + corporate taxes + costs of financialdistress:
= + tax shield
−(Financial distress costs)
• The value of the firm is equal to [the value of firmif all equity financed] plus [PV of tax shield] minus[financial distress costs].
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Optimal capital structure
•This is a powerful way of thinking about whatcapital structure should be.
• The benefits of leverage from the interest tax shield
• The costs of financial distress
Determine the amount of debt that a firm should issue to
maximize its value
• This approach to optimal capital structure is
called the tradeoff theory.
• Debt’s benefits vs costs
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Tradeoff theory
Loss of PV(Financial distress costs)
= + tax shield − (Financial distress costs)
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Different levels of financial distress costs