Transcript Costs of Financial Distress
Principles of Corporate Finance
Tenth Edition Slides by Matthew Will
McGraw Hill/Irwin
Chapter 18 How Much Should A Corporation Borrow?
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Topics Covered
Corporate Taxes Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices
19-2
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Capital Structure & Corporate Taxes
19-3 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.
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Capital Structure & Corporate Taxes
Example
- You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why?
19-4
($ 1,000 s) EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow All Equity 900 0 900 315 585 1/2 Debt 900 100 800 280 520
Total Cash Flow
All Equity = 585
*1/2 Debt = 620
(520 + 100)
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Capital Structure & Corporate Taxes
19-5
PV of Tax Shield = (assume perpetuity) D x r
D
x Tc r
D
= D x Tc Example: Tax benefit = 2,000,000 x (.05) x (.35) = $35,000 PV of $35,000 in perpetuity = 35,000 / .05 = $700,000 PV Tax Shield = $2,000,000 x .35 =
$700,000
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Capital Structure & Corporate Taxes
Firm Value = Value of All Equity Firm + PV Tax Shield
19-6
Example All Equity Value = 585 / .05 = 11,700,000 PV Tax Shield = 700,000 Firm Value with 1/2 Debt = $12,400,000
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C.S. & Taxes (Personal & Corp)
Relative Advantage Formula ( Debt vs Equity ) 1-T p (1-T pE ) (1-T c ) RAF > 1 RAF < 1
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Advantage Debt Equity
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19-7
C.S. & Taxes (Personal & Corp)
Operating Income ($1.00) Paid out as interest Or paid out as equity income
19-8
Corporate Tax None T c Income after Corp Taxes Personal Taxes .
Income after All Taxes
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$1.00
T p $1.00 – T c TpE (1.00-Tc) $1.00 – T p To bondholders $1.00
–T c -T pE (1.00-T c ) =(1.00-T pE )(1.00-T c ) To stockholders
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C.S. & Taxes (Personal & Corp)
Example
Income before tax Less corporate tax at Tc =.35
Income after corpotare tax Personal tax at Tp = .35 and TpE = .125
Income after all taxes
Interest
$1 0 1 0.35
$0.650
Equity Income
$1 0.35
0.65
0.081
$0.569
Advantage to debt= $ .081
19-9
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C.S. & Taxes (Personal & Corp)
Today’s RAF & Debt vs Equity preference.
19-10
RAF = 1-.33
(1-.16) (1-.35) = 1.23
Why are companies not all debt?
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Capital Structure
Structure of Bond Yield Rates r
19-11 Bond Yield
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D E
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WACC w/o taxes (traditional view)
r Includes Bankruptcy Risk r E
19-12 WACC
r D
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D V
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Financial Distress
Costs of Financial Distress
- Costs arising from bankruptcy or distorted business decisions before bankruptcy.
19-13
Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress McGraw Hill/Irwin
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Financial Distress
Maximum value of firm Costs of financial distress PV of interest tax shields Value of levered firm
19-14
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Value of unlevered firm Debt Optimal amount of debt
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Conflicts of Interest
Circular File Company has $50 of 1-year debt.
19-15
Circular File Company (Market Values)
Net W.C.
20 25 Bonds outstanding Fixed assets Total assets 10 30 5 30 Common stock Total liabilities Why does the equity have any value ?
Shareholders have an option -- they can obtain the rights to the assets by paying off the $50 debt.
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Conflicts of Interest
Circular File Company has may invest $10 as follows.
Now Possible Payoffs Next Year $120 (10% probabilit y) Invest $10 $0 (90% probabilit y) Assume the NPV of the project is (-$2).
What is the effect on the market values?
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19-16
Conflicts of Interest
Circular File Company value (post project)
19-17
Circular File Company (Market Values)
Net W.C.
10 20 Bonds outstanding Fixed assets Total assets 18 28 8 28 Common stock Total liabilities Firm value falls by $2, but equity holder gains $3
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Conflicts of Interest
Circular File Company value (assumes a safe project with NPV = $5) Circular File Company (Market Values)
Net W.C.
20 33 Bonds outstanding Fixed assets Total assets 25 45 12 45 Common stock Total liabilities While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.
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19-18
Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch
19-19
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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.
19-20 Pecking Order Theory
- Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
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Trade Off Theory & Prices
1. Stock-for-debt exchange offers Debt-for-stock exchange offers Stock price falls Stock price rises 2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
19-21
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Issues and Stock Prices
Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.
19-22
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues don’t significantly depress the stock price.
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Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first andequity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.
19-23
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Pecking Order Theory
Some Implications:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).
19-24
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