Transcript Finance I - Universidade Nova de Lisboa

Corporate Finance
Lecture 9
outline



Signaling
Agency cost of equity
Capital budgeting with debt
Integration of Tax Effects
and Financial Distress Costs
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
0
Debt (B)
B*
Optimal amount of debt
Signaling



The firm’s capital structure is
optimized where the marginal subsidy
to debt equals the marginal cost.
Investors view debt as a signal of firm
value.
A manager that takes on more debt
than is optimal in order to fool
investors will pay the cost in the long
run.
Agency Cost of Equity


Agency cost of equity is caused by the conflict between
the manager and the shareholders.
Shirking:
– The manager will work harder for the firm if he is one of the
owners than if he is just an employee.
– The manager will work harder for the firm if he owns a large
proportion of the firm than if he only owns a small percentage.

Perquisite
– The manager has the incentive to obtain more perquisite if he
owns a smaller proportion of the firm.

Overinvestment:
– The manager is likely to make bad investments when he owns
less of the firm.
Reducing Agency Cost of Equity



Free cash flow hypothesis: The
manager’s opportunity to obtain more
perquisite comes from free cash flow of
the firm.
Dividend payouts reduce the ability of
managers to pursue wasteful activities.
Debt also reduces the ability of
managers to pursue wasteful activities.
Integration of Tax Effects and Financial
Distress Costs and Agency Costs
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
Agency Cost of Equity
0
Agency Cost of Debt
Debt (B)
B*
Optimal amount of debt
The Pecking-Order Theory


Asymmetric information between the
manager and outside investors
The Pecking Order:
– Internal funding
– Bank loan
– Issue debt
– Issue equity
The Pecking-Order Theory
vs. the Trade-off Theory
Pecking-Order Trade-off
Theory
Theory
no
yes
Target D/E
ratio
Debt as a
bad
signal of the
firm
Financial slack yes
good
High-growth firms will have lower debt ratios than lowgrowth firms. 100% debt financing is sub-optimal.
How Firms Establish Capital
Structure




Most Corporations
Debt-Asset Ratios.
Have
Low
Changes in Financial Leverage
Affect Firm Value.
There are Differences in Capital
Structure Across Industries.
There is evidence that firms
behave as if they had a target
Debt to Equity ratio.
Factors in Target D/E Ratio




Taxes
Types of Assets
Uncertainty of Operating Income
Pecking Order and Financial Slack
Capital budgeting with
debt

Adjusted Present Value Approach

Flows to Equity Approach

Weighted Average Cost of Capital
Method
Adjusted Present Value
APV = NPV + NPVF


The value of a project to the firm can be
thought of as the value of the project to an
unlevered firm (NPV) plus the present value
of the financing side effects (NPVF):
There are four side effects of financing:
–
–
–
–
The Tax Subsidy to Debt
The Costs of Issuing New Securities
The Costs of Financial Distress
Subsidies to Debt Financing
APV Example
Consider a project of the Pearson Company, the timing and size of
the incremental after-tax cash flows for an all-equity firm are:
–$1,000
0
$125
$250
$375
$500
1
2
3
4
The unlevered cost of equity is r0 = 10%:
NPV10%
NPV10%
$125
$250
$375
$500
 $1,000 



2
3
(1.10) (1.10) (1.10) (1.10) 4
 $56.50
The project would be rejected by an all-equity firm: NPV < 0.
APV Example (continued)
Now, imagine that the firm finances the project with
$600 of debt at rB = 8%.
 Pearson’s tax rate is 40%, so they have an interest
tax shield worth TCBrB = .40×$600×.08 = $19.20
each year.
The net present value of the project under leverage is:

APV = NPV + NPV debt tax shield
4
$19.20
APV  $56.50  
t
(
1
.
08
)
t 1
APV  $56.50  63.59  $7.09
So, Pearson should accept the project with debt.