Transcript TITLE HERE - Texas Tech University

Capital Structure
What finance functions add the most to
firm value?
2
Corporate Financing

We have been focusing on investment decision
 What

should the firm buy?
Now we are turning to the financing decision
 How
does the firm pay for it?
3
How do Firms Pay for Stuff

Companies prefer to use the cash they generate
 This

account for about 70-90% of all purchases
If cash is insufficient they sell securities
4
Capital-Structure

Addresses: What securities should the firm sell
 This
determines how the firm’s cash
flows are divide


5
Capital Structure becomes
important if the division affects
the size of the cash flows
S
B
Remember: A firm is simply worth the PV of its
expected future cash flows to investors
The Value of E and D

E: The PV of cash flows to equity holders
 If
a company pays $1.5 mil. in dividends each
year (re=8%) E =

D: The PV of the cash flows to debt holders
 If
a company pays $0.75 mil. in interest each
year (rd=4%) D =

V=
6
The Value of E and D



E: The PV of cash flows to equity holders
 If a company pays $1.5 mil. in dividends each year
(re=8%) E =
1.5 / 0.08 = $18.75mil
D: The PV of the cash flows to debt holders
 If a company pays $0.75 mil. in interest each year
(rd=4%) D =
0.75/0.04= $18.75mil
V = 18.75 + 18.75 = $37.5 mil
7
Cap Structure and Value

While capital structure appears to influence
firm value in the real world to understand
how/why we need to start with a situation
where it doesn’t
8
Modigliani-Miller Proposition 1
Capital Structure
DOES NOT MATTER
VL = VU
9
MM1: The Simplest of Worlds

Perfect capital markets
No
taxes or transaction costs
 No Bankruptcy Costs
 Everyone borrows at the same rate
 Investment decisions are fixed
 Operating cash
flow is independent of capital structure
10
MM Investment Intuition Set up
Suppose you have two firms that each make
$50/ year
 The firms are identical except that one has $50
of debt and the other has no debt

11
MM Intuition


Suppose Vl < Vu
Consider a 1% investment in EU



Now buy 1% of EL & 1% of DL




Cost = 1% EU =
Payoff = 1% Earnings =
Cost = 1% EL +1%DL=
Payoff
Receive 1%*Interest=
Receive 1%*(Earnings -Int)=
Total dollar payoff =
Can Vl < Vu?
Vu
Vl
V
$100
$90
E
$100
$40
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
12
MM Intuition


Suppose Vl < Vu
Consider a 1% investment in EU



Now buy 1% of EL & 1% of DL




Cost = 1% EU = $1.00
Payoff = 1% Earnings =
Cost = 1% EL +1%DL=
Payoff
Receive 1%*Interest=
Receive 1%*(Earnings -Int)=
Total dollar payoff =
Can Vl < Vu?
Vu
Vl
V
$100
$90
E
$100
$40
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
13
MM Intuition


Suppose Vl < Vu
Consider a 1% investment in EU



Now buy 1% of EL & 1% of DL




Cost = 1% EU = $1.00
Payoff = 1% Earnings = $0.50
Cost = 1% EL +1%DL=
Payoff
Receive 1%*Interest=
Receive 1%*(Earnings -Int)=
Total dollar payoff =
Can Vl < Vu?
Vu
Vl
V
$100
$90
E
$100
$40
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
14
MM Intuition


Suppose Vl < Vu
Consider a 1% investment in EU



Now buy 1% of EL & 1% of DL






Cost = 1% EU = $1.00
Payoff = 1% Earnings = $0.50
Cost = 1% EL +1%DL=
0.40 + 0.50=$0.90
Payoff
Receive 1%*Interest=
0.01*10=$0.10
Receive 1%*(Earnings-Int)=
0.01*40=$0.40
Total dollar payoff =
$0.10+$0.40=$0.50
Can Vl < Vu?
Vu
Vl
V
$100
$90
E
$100
$40
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
15
MM Intuition


Suppose Vl < Vu
Consider a 1% investment in EU



Now buy 1% of EL & 1% of DL






Cost = 1% EU = $1.00
Payoff = 1% Earnings = $0.50
Cost = 1% EL +1%DL=
0.40 + 0.50=$0.90
Payoff
Receive 1%*Interest=
0.01*10=$0.10
Receive 1%*(Earnings -Int)=
0.01*40=$0.40
Total dollar payoff =
$0.10+$0.40=$0.50
Can Vl < Vu?
Vu
Vl
V
$100
$90
E
$100
$40
D
$0
$50
Earnings
$50
$50
Int
$0
$10
$1
$0.9
$0.50
$0.5
Cost
Payoff
16
If Vl < Vu then
An investor can purchase a claim in the
levered firm with the same payoff as a claim in
the un-levered firm, for a lower price!
 This situation is impossible in a well
functioning capital market (arbitrage)

 Investors
will buy Vl and sell it for Vu until Vl = Vu
17
MM Intuition the Other Way


Suppose Vl > Vu
Consider a1% investment in El



Cost = 1% EL =
Payoff = 1%(Earnings –Int)=
Alt. buy 1% EU, & borrow1% of DL




Cost= 1%Vu-1%DL=
Payoff
Owe 1%*Interest=
Receive 1%* Earnings =
Total dollar payoff =
Vu
Vl
V
$90
$100
E
$90
$50
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
18
MM Intuition the Other Way


Suppose Vl > Vu
Consider a1% investment in El



Cost = 1% EL = $0.50
Payoff = 1%(Earnings –Int)=
Alt. buy 1% EU, & borrow1% of DL




Cost= 1%Vu-1%DL=
Payoff
Owe 1%*Interest=
Receive 1%* Earnings =
Total dollar payoff =
Vu
Vl
V
$90
$100
E
$90
$50
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
19
MM Intuition the Other Way


Suppose Vl > Vu
Consider a1% investment in El



Cost = 1% EL = $0.50
Payoff = 1%(Earnings –Int)= $0.40
Alt. buy 1% EU, & borrow1% of DL




Cost= 1%Vu-1%DL=
Payoff
Owe 1%*Interest=
Receive 1%* Earnings =
Total dollar payoff =
Vu
Vl
V
$90
$100
E
$90
$50
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
20
MM Intuition the Other Way


Suppose Vl > Vu
Consider a1% investment in El



Cost = 1% EL = $0.50
Payoff = 1%(Earnings –Int)= $0.40
Alt. buy 1% EU, & borrow1% of DL





Cost= 1%Vu-1%DL=
$0.90-$0.50=$0.40
Payoff
Owe 1%*Interest=
0.01*10=$0.10
Receive 1%* Earnings =
0.01*50=$0.50
Total dollar payoff =
-$0.10+$0.50=$0.40
Vu
Vl
V
$90
$100
E
$90
$50
D
$0
$50
Earnings
$50
$50
Int
$0
$10
Cost
Payoff
21
MM Intuition the Other Way


Suppose Vl > Vu
Consider a1% investment in El



Cost = 1% EL = $0.50
Payoff = 1%(Earnings –Int)= $0.40
Alt. buy 1% EU, & borrow1% of DL





Cost= 1%Vu-1%DL=
$0.90-$0.50=$0.40
Payoff
Owe 1%*Interest=
0.01*10=$0.10
Receive 1%* Earnings =
0.01*50=$0.50
Total dollar payoff =
-$0.10+$0.50=$0.40
Vu
Vl
V
$90
$100
E
$90
$50
D
$0
$50
Earnings
$50
$50
Int
$0
$10
$0.4
$0.5
$0.4
$0.4
Cost
Payoff
22
If Vl > Vu then

In perfect capital markets the inequality cannot
hold. Since both strategies have the same
payoff, they should cost the same.
23
On balance


The intuition shows how we can take positions in
the levered and un-levered company that generate
the same payoff, but which only costs the same if
the two firms have the same firm value
The law of one price states that investments with
the same payoffs need to cost the same, therefore
the two firms must be equally valuable
 Arbitrage
24
MM 1 Cash Flow Proof

Two firms
 Earn

Unlevered
 re

$1,000
= 10%
Levered
Earn
Un-Levered
Levered
$1,000
$1,000
Interest
Equity
 re
= 15%
 rd = 5%
 D= 5,000
E
D
V
25
MM 1 Cash Flow Proof

Two firms
 Earn

Unlevered
 re

$1,000
= 10%
Levered
Earn
Interest
Un-Levered
Levered
$1,000
$0
$1,000
$250
Equity
 re
= 15%
 rd = 5%
 D= 5,000
E
D
V
26
MM 1 Cash Flow Proof

Two firms
 Earn

Unlevered
 re

$1,000
= 10%
Levered
Earn
Interest
Equity
Un-Levered
Levered
$1,000
$0
$1,000
$1,000
$250
$750
 re
= 15%
 rd = 5%
 D= 5,000
E
D
V
27
MM 1 Cash Flow Proof

$1,000
Unlevered
 re

Levered
Equity
$1,000
$0
$1,000
$1,000
$250
$750
E
$10,000
$5,000
Two firms
 Earn

Un-Levered
= 10%
Levered
Earn
Interest
 re
= 15%
 rd = 5%
 D= 5,000
D
V
28
MM 1 Cash Flow Proof

Two firms
 Earn

Unlevered
 re

$1,000
= 10%
Levered
Earn
Interest
Equity
Un-Levered
Levered
$1,000
$0
$1,000
$1,000
$250
$750
$10,000
$0
$5,000
$5,000
 re
= 15%
 rd = 5%
 D= 5,000
E
D
V
29
MM 1 Cash Flow Proof

Two firms
 Earn

Unlevered
 re

$1,000
= 10%
Levered
Earn
Interest
Equity
Un-Levered
Levered
$1,000
$0
$1,000
$1,000
$250
$750
$10,000
$0
$10,000
$5,000
$5,000
$10,000
 re
= 15%
 rd = 5%
 D= 5,000
E
D
V
30
Main result in this “perfect world”
The value of the firm
is independent of
its capital structure
V
D/V
31
Investors and Capital Structure
While leverage does not affect the risk of the
overall firm, it does affect investors’ risks
 Leverage increases:
Financial/Default Risk

32
MM Proposition 2: D/E and re, βe


As leverage increases so does financial risk
D/E relation with re, βe
 ra = D/V * rd + E/V*re
 re = ra + D/E * (ra - rd)
a = D /V * d + E/V*e
 e = a + D /E * (a - d)

33
βe Break-Down
e = a + D /E * (a - d)
 a: Captures the Business Risk of the firm

D /E * (a - d): Captures the Financial Risk of
the firm
34
MM 2: Graph
23%
Required Return
Re
18%
13%
Ra
Rd
8%
3%

D/V (5%)
Look familiar?
Re
Rd
WACC
35
Question 1


Shareholders demand a higher rate of return
than bondholders. As debt is cheaper, we
should increase the D/V ratio as it reduces ra.
True or False?
False. As D/E increases, re & rd also increase
(financial risk) → So ra will not change
36
Question 2


As the firm borrows more and debt becomes riskier,
both shareholders and bondholders demand a higher
rate of return. Thus by reducing the debt-equity
ratio, we can reduce the cost of debt and the cost of
equity. This makes everybody better off. True or
False?
False. rd & re will fall, but a larger proportion of
the firm is financed by relatively expensive
equity. So the overall effect is to leave ra
unchanged.
37
Cash flows and Firm Value 1
A firm is only worth the PV of it’s cash flows
to investors
 Consider an un-levered firm, which has an
EBIT of $1,500.
 The company’s investors require a return on
12%.
 Assume no taxes, what is the firm worth?
 Vu = E
 Vu = 1,500 / 0.12 = $12,500
38
Cash flows and Firm Value 2
Consider a levered firm, which has an EBIT of
$1,500.
 The firm owes $1,000 in interest payments/year
 The company’s investors (equity and debt)
require a return on 12%.
 Assume no taxes, what is the firm worth?
 VL = D + E
D= 1,000/0.12 = $8,333.33
E= 500/0.12 = $4,166.67
VL =$12,500

39
Lets get Real


MM showed us that in the theoretical world capital
structure does not matter
But by relaxing the MM assumptions and allowing
for a more realistic world, we can see how capital
structure affects firm value
40
Corporate Taxes

When we include taxes will the firm be more
or less valuable than in a world without taxes?
 LESS

Valuable
As some of the money generated by the
company is now needed to pay taxes less
flows to the investor, reducing firm value
41
Who gets paid first?

Debt
 Interest
payments reduce our taxable income
→ reducing our taxes
Less money to Uncle Sam mean more for
investors
 Firm value will increase as debt increases

42
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
UnLevered
Levered
$1,000
$1,000
Interest
EBT
Tax @ 40%
Net Income
NI + Interest
Tax Shield
43
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
Interest
UnLevered
Levered
$1,000
$0
$1,000
$300
EBT
Tax @ 40%
Net Income
NI + Interest
Tax Shield
44
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
Interest
EBT
UnLevered
Levered
$1,000
$0
$1,000
$1,000
$300
$700
Tax @ 40%
Net Income
NI + Interest
Tax Shield
45
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
Interest
EBT
Tax @ 40%
UnLevered
Levered
$1,000
$0
$1,000
$400
$1,000
$300
$700
$280
Net Income
NI + Interest
Tax Shield
46
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
Interest
EBT
Tax @ 40%
Net Income
UnLevered
Levered
$1,000
$0
$1,000
$400
$600
$1,000
$300
$700
$280
$420
NI + Interest
Tax Shield
47
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%
EBIT
Interest
EBT
Tax @ 40%
Net Income
NI + Interest
UnLevered
Levered
$1,000
$0
$1,000
$400
$600
$600
$1,000
$300
$700
$280
$420
$720
Tax Shield
48
Example

We have two
identical firms
 EBIT
$1,000
 L: debt of
$5,000 @ 6%

The tax shield
increases the
cash available
for investors
EBIT
Interest
EBT
Tax @ 40%
Net Income
NI + Interest
Tax Shield
UnLevered
Levered
$1,000
$0
$1,000
$400
$600
$600
$1,000
$300
$700
$280
$420
$720
$120
49
Tax Shield’s Effect on Firm Value
The tax shield increases firm value by the
present value of the tax reduction
 Tax Shield = Tax Rate * Dollar Interest
 PV (T.S.) = Tax Rate * Dollar Interest / rd

= Tax Rate * (Debt * rd) / rd
= Tax Rate * Debt
= 0.4 * 5,000 = $2,000
50
Vl with Corporate Taxes
 Vl
= Vu + PV(Tax Shield)
 Vl = Vu + D*Tc
 As the tax shield increases company
value, how should the company be
financed?
 Entirely
debt financed
51
Cash flows and Firm Value 3
Consider an un-levered firm, which has an
EBIT of $1,500.
 The company’s investors require a return on
12%.
 Taxes are 34%, what is the firm worth?

52
Cash flows and Firm Value 3





Consider an un-levered firm, which has an EBIT of
$1,500.
The company’s investors require a return on 12%.
Taxes are 34%, what is the firm worth?
The cash flow to equity is: 1,500 (1-0.34) = $990
Vu = 990 / 0.12 = $8,250
53
Cash flows and Firm Value 4




Consider a levered firm, which has an EBIT of
$1,500.
The firm owes $1,000 in interest
The company’s investors (equity and debt) require a
return on 12%.
Taxes are 34%, what is the firm worth?
54
Cash flows and Firm Value 4

Consider a levered firm, which has an EBIT of $1,500.
The firm owes $1,000 in interest
The company’s investors (equity and debt) require a return on
12%.
Taxes are 34%, what is the firm worth?

The cash flow to investors are:



 Debt:
1,000
 Equity: (1,500-1,000) * (1-0.34) = 330

VL = (330/0.12)+(1,000/0.12)=$11,083
55
Cash flows and Firm Value 4 ALT





Consider a levered firm, which has an EBIT of $1,500.
The firm owes $1,000 in interest
The company’s investors (equity and debt) require a return on 12%.
Taxes are 34%, what is the firm worth?
VL = VU + D*T
D
= 1,000/0.12 = 8,333
 VL = 8,250 + 8,333*0.34 = $11,083
56
Personal Taxes
Investors also pay taxes
 Now the firm is only worth the present value
of the cash investors put in their pocket

 The

firm wants to minimize total taxes paid
Corporate and personal
57
Personal Taxes
CG
$ Capital Gains
Div
$ Dividends
Ti, Td
Income Tax Rate (Personal)
Tcg
Capital Gains Tax Rate
Te
Personal Equity Tax Rate:
Te=CG/(Div+CG)*Tcg+Div/(Div+CG)*Ti
58
Personal Taxes and the Tax Shield

The inclusion of personal taxes generally
reduces the value of the tax shield because
interest is generally taxed more heavily than
equity at the personal level
 The
preferential tax treatment of capital gains on the
personal level reduces the value of the debt tax shield

PV(Tax Shield) < D*Tc
59
Including Personal Taxes
Vl = Vu + D {1-[(1-Tc)(1-Te)/(1-Td)]}
This account for the investor’s preference for
equity income over debt income
 (1-Tc)(1-Te): Represents the after-tax return ($)
from $1 in equity income
 (1-Td): Represents the after-tax return ($) from
$1 in debt income

60
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
D=
E=
 Vl =

61
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
Debt holders receive:
 They keep:

62
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
Debt holders receive: $1,000
 They keep:

63
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
Debt holders receive: $1,000
 They keep: 1,000 * (1-0.2) = $800

64
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
Debt holders receive: $1,000
 They keep: 1,000 * (1-0.2) = $800
 D = 800/0.12 = $6,666.67

65
Cash flows and Firm Value 5


Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%
Equity holders receive:
 They keep:

66
Cash flows and Firm Value 5

Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%

Equity holders receive:

 (1,500

– 1,000)*(1-0.34) = $330
They keep:
67
Cash flows and Firm Value 5

Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require a
return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%

Equity holders receive:

 (1,500

– 1,000)*(1-0.34) = $330
They keep: 330 * (1-0.15) = $280.50
68
Cash flows and Firm Value 5

Consider a levered firm, which has an EBIT of $1,500. The
firm owes $1,000 in interest. The company’s investors (equity
and debt) require a return on 12%.
Taxes are: Corp 34%, Income 20%, Equity 15%

Equity holders receive:

 (1,500


– 1,000)*(1-0.34) = $330
They keep: 330 * (1-0.15) = $280.50
E = 280.5/0.12 = $2,337.50
69
Cash flows and Firm Value 5
Consider a levered firm, which has an EBIT of
$1,500. The firm owes $1,000 in interest. The
company’s investors (equity and debt) require
a return on 12%.
 Taxes are: Corp 34%, Income 20%, Equity
15%

 Vl
=E+D
 Vl = 2,337.50 + 6,666.67 = $9,004.17
70
Cash flows and Firm Value 5 Alt.
Vl = VU + TS
 VU = {1,500(1-0.34)(1-0.15)}/0.12 = 7,012.50
 D = 1,000 (1-0.2)/0.12 = 6,666.67
 TS = D {1-[(1-Tc)(1-Te)/(1-Td)]}
 TS = 6,666.67*{1-(1-0.34)(1-0.15)/(1-0.2)} =
1,991.67
 Vl=7,012.50 + 1991.67 = $9,004.17

71
Bankruptcy Costs

Direct Costs: Legal and Administrative costs
 These

are small
Indirect Costs: Impaired ability to conduct
business
 These
are BIG
 Start when a firm becomes Financially Distressed

Bankruptcy costs increase with debt, making more
debt less attractive
 Shareholders
pay these costs
72
Agency Costs

In addition to bankruptcy costs, when a firm
becomes financially distressed the conflict
between bondholders and stockholders
increases
 This

can result in managers playing games
Who is the manager likely to side with?
Shareholders
73
Asset Substitution
A firm has $6m in assets, and has $10m in
debt outstanding → Financial Distress
 The firm has a project requiring a $2m
investment and pays $7m (PV) with a 10%
probability or pays nothing with a 90%
 Project NPV?

 -2

+ [(0.1*7)] = -1.3
Will the firm take the project?
 Probably
74
Potential Payoffs

If forgo the project: FV = $__
 Debt

Take the project and it turns out bad: FV = $__
 Debt

gets $___, Equity gets $___
gets $___, Equity gets $___
Take the project and it turns out good: FV = $_
 Debt
gets $___, Equity gets $___
75
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$
 Debt
gets $, Equity gets $
76
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$
 Debt
gets $, Equity gets $
77
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$11
 Debt
gets $, Equity gets $
78
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $6, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$11
 Debt
gets $, Equity gets $
79
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $6, Equity gets $0
gets $, Equity gets $
Take the project and it turns out good: FV=$11
 Debt
gets $, Equity gets $
80
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $6, Equity gets $0
gets $4, Equity gets $
Take the project and it turns out good: FV=$11
 Debt
gets $, Equity gets $
81
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $6, Equity gets $0
gets $4, Equity gets $0
Take the project and it turns out good: FV=$11
 Debt
gets $, Equity gets $
82
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $6, Equity gets $0
gets $4, Equity gets $0
Take the project and it turns out good: FV=$11
 Debt
gets $10, Equity gets $
83
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $4
 Debt

gets $4, Equity gets $0
Take the project and it turns out good: FV=$11
 Debt

gets $6, Equity gets $0
gets $10, Equity gets $1
A chance at something is better than
nothing
84
Underinvestment



Now instead of taking –NPV projects the firm passes
on +NPV projects
The same firm has a project requiring $2m
investment and pays $5m (PV) with a 50%
probability or pays $1m (PV) with a 50% probability
What is the NPV?
 -2

+ [(0.5*5) + (0.5*1)] = $1
Will the firm take the project?
 Probably
not
85
Potential Payoffs

If forgo the project: FV = $__
 Debt

Take the project and it turns out bad: FV = $__
 Debt

gets $__, Equity gets $__
gets $__, Equity gets $__
Take the project and it turns out good: FV= $_
 Debt
gets $__, Equity gets $__
86
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$
 Debt
gets $, Equity gets $
87
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$
 Debt
gets $, Equity gets $
88
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$9
 Debt
gets $, Equity gets $
89
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $6, Equity gets $
gets $, Equity gets $
Take the project and it turns out good: FV=$9
 Debt
gets $, Equity gets $
90
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $6, Equity gets $0
gets $, Equity gets $
Take the project and it turns out good: FV=$9
 Debt
gets $, Equity gets $
91
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $6, Equity gets $0
gets $5, Equity gets $
Take the project and it turns out good: FV=$9
 Debt
gets $, Equity gets $
92
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $6, Equity gets $0
gets $5, Equity gets $0
Take the project and it turns out good: FV=$9
 Debt
gets $, Equity gets $
93
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $6, Equity gets $0
gets $5, Equity gets $0
Take the project and it turns out good: FV=$9
 Debt
gets $9, Equity gets $
94
Potential Payoffs

If forgo the project: FV = $6
 Debt

Take the project and it turns out bad: FV = $5
 Debt

gets $5, Equity gets $0
Take the project and it turns out good: FV=$9
 Debt

gets $6, Equity gets $0
gets $9, Equity gets $0
If I don’t get anything I don’t want you
getting more
95
Milk the Property (Cash out)

If the value of the firm is less than the value of
the debt holders claims, then the shareholders
have an incentive to sell off the assets pay
themselves
96
Example, names changed to protect the guilty

Marriot Inc
 Owes

$1 billion and has $500 million in assets
Management creates a new firm Marriot Co
 Every

Inc shareholder receives shares in Co
The same shareholders own both firms
Inc sells its $500m in assets to Co for $1.00
 Co has $499,999,999 in assets and no debt
 Inc has $1 in assets and $1b in debt

 How
happy are debt holders?
97
Intelligent Bondholders

Bondholders know about these agency
problems and act accordingly
 Requiring:


Higher rd, covenants
Limit possible div payments, Restrict debt issuances or
sales of assets
All of this requires costly monitoring of the
firm
 This
is another costs borne by equity holders
98
Trade-Off
The firm trades off the benefits and costs
associated with debt to maximize firm value
 If we put everything we talked about together
we get:
Vl = Vu + PV (Tax shields) – PV (Bankruptcy
costs) – PV (Agency costs)

99
Trade-Off Graph
Market
Value of the
Firm
Bankruptcy Costs
Agency Costs
PV of Tax Shield
Unlevered Firm
Debt
100
Trade-off Implications

Firms have an optimal level of debt
 The

amount will depend on the industry and firm
Safe, highly profitable firms with lots of
tangible assets should have lots of debt
 US
studies finds that profitable firms have little
debt

Risky, marginally profitable firms with lots of
intangible assets should have little debt
101