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1 Today Capital structure • M&M theorem • Leverage, risk, and WACC • Taxes 1 Today Capital structure • M&M theorem • Leverage, risk, and WACC • Taxes and Financial distress, Reading • Brealey and Myers, Chapter 17, 18

2 Financing decisions Key goal • Ensure that funds are available for positive NPV 2 Financing decisions Key goal • Ensure that funds are available for positive NPV projects, now and in the future • Signaling, taxes, mispricing, issue costs, and corporate control also important Observations • Firms follow a pecking order • Different industries seem to have different target debt ratios • Stock issues are bad news, but debt issues are either neutral or good news

3 Financial Decisions Two models • Pecking-order theory Firms are worried primarily about selling 3 Financial Decisions Two models • Pecking-order theory Firms are worried primarily about selling undervalued shares. They sell equity only when they have no other choice, and there isn’t a specific target debt ratio. • Trade-off theory Firms care mostly about taxes and distress costs. The tax benefits of debt dominate at low leverage, while distress costs dominate at high leverage. This trade-off leads to an optimal capital structure.

4 Trade-off theory 4 Trade-off theory

5 Financing decisions 5 Financing decisions

6 M&M Theorem Why is MM useful? • It tells us what is important 6 M&M Theorem Why is MM useful? • It tells us what is important … Does debt affect investment decisions? Does debt affect taxes? Can equity be issued at fair value? Are transaction costs or bankruptcy costs important? Impact of debt on ROE and risk Cost of debt relative to the cost of equity (r. D vs. r. E)

7 MM Theorem, cont. 7 MM Theorem, cont.

8 MM Theorem, cont. Message 2 In general, financial transactions don’t create or destroy 8 MM Theorem, cont. Message 2 In general, financial transactions don’t create or destroy value as long as securities are sold at fair value. [Unless they affect taxes, investment decisions, etc. ] Example Your firm needs to raise $100 million. Does it matter whether you decide to issue debt or equity?

9 Example 9 Example

10 MM Theorem, cont. 10 MM Theorem, cont.

11 MM Theorem, cont. 11 MM Theorem, cont.

12 Example Your firm is all equity financed and has $1 million of assets 12 Example Your firm is all equity financed and has $1 million of assets and 10, 000 shares of stock (stock price = $100). Earnings before interest and taxes next year will be either $50, 000, $125, 000, or $200, 000 depending on economic conditions. The firm is thinking about a leverage recapitalization, selling $300, 000 of debt and using the proceeds to repurchase stock. The interest rate is 10%. How would this transaction affect the firm’s EPS and cashflows to stockholders? Ignore taxes.

13 Example Current: A = $1 million; E = $1 million (10, 000 shares); 13 Example Current: A = $1 million; E = $1 million (10, 000 shares); D = $0 Recap: A = $1 million; E = $700, 000 (7, 000 shares); D =$300, 000

14 Example, cont. 14 Example, cont.

15 Leverage, EPS, and ROE 15 Leverage, EPS, and ROE

16 MM Theorem, cont. 16 MM Theorem, cont.

17 M&M Theorem, cont. 17 M&M Theorem, cont.

18 Example Your firm is all equity financed and has $1 million of assets 18 Example Your firm is all equity financed and has $1 million of assets and 10, 000 shares of stock (stock price = $100). Earnings before interest and taxes next year will be either $50, 000, $125, 000, or $200, 000. These earnings are expected to continue indefinitely. The payout ratio is 100%. The firm is thinking about a leverage recapitalization, selling $300, 000 of debt and using the proceeds to repurchase stock. The interest rate is 10%. How would this transaction affect the firm’s EPS and stock price? Ignore taxes.

19 Example, cont. 19 Example, cont.

20 • How does borrowing affect stock price under no tax? 20 • How does borrowing affect stock price under no tax?

21 Example, cont. 21 Example, cont.

22 • Share price does not change! 22 • Share price does not change!

23 M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity 23 M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Expected outcome

24 • Shareholders would be better off if the company had equal proportions of 24 • Shareholders would be better off if the company had equal proportions of debt and equity!? • 10% interest rate debt!

25 M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt @10% 25 M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt @10%

26 M&M (Debt Policy Doesn’t Matter) Leverage increase return on equity! How about investors 26 M&M (Debt Policy Doesn’t Matter) Leverage increase return on equity! How about investors buy one share and borrow $10 @10% to buy another share?

27 M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - 27 M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investors

28 Proposition I and Macbeth continued • However, share price should be the same!! 28 Proposition I and Macbeth continued • However, share price should be the same!!

29 No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing 29 No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio. AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole.

30 Debt and taxes Tax effects of financing • Corporate taxes Interest is treated 30 Debt and taxes Tax effects of financing • Corporate taxes Interest is treated as an expense for corporate tax purposes, dividends are not • Personal taxes Interest is taxed at the full income tax rate, while equity income is taxed at a lower rate Capital gains and international tax rules • Overall, debt typically has tax advantages Lower overall taxes

31 Example In 2000, Microsoft had sales of $23 billion, earnings before taxes of 31 Example In 2000, Microsoft had sales of $23 billion, earnings before taxes of $14. 3 billion, and net income of $9. 4 billion. Microsoft paid $4. 9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding. Bill Gates is thinking about a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock. How would this transaction affect Microsoft’s after-tax cashflows and shareholder wealth?

32 Microsoft 32 Microsoft

33 Microsoft 33 Microsoft

34 Debt and taxes 34 Debt and taxes

35 Debt and taxes 35 Debt and taxes

36 Leverage and firm value 36 Leverage and firm value

37 Microsoft In 2000, Microsoft had EBIT of $14. 3 billion. Microsoft paid $4. 37 Microsoft In 2000, Microsoft had EBIT of $14. 3 billion. Microsoft paid $4. 9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding. Bill Gates is considering a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock. Recapitalization • Interest expense = $50 × 0. 07 = $3. 5 billion • Tax shield = $3. 5 × 0. 34 = $1. 19 billion annually • PV(tax shields) = 1. 19 / 0. 07 = 50 × 0. 34 = $17 billion* • VL = Vu + PV(tax shields) = $440 billion

38 Microsoft 38 Microsoft

39 Debt and taxes 39 Debt and taxes

40 Leverage and the cost of capital 40 Leverage and the cost of capital

41 Financing decisions Advantages of debt Taxes Signaling Corporate control Lower issue costs Should 41 Financing decisions Advantages of debt Taxes Signaling Corporate control Lower issue costs Should firms be 100% debt financed? What are the costs?

42 Financial distress occurs when promises to creditors are broken or honored with difficulty. 42 Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice.

43 Financial distress • Direct costs • Managers’ time and effort • Legal costs 43 Financial distress • Direct costs • Managers’ time and effort • Legal costs • Professional fees • Administrative costs • Indirect costs • Foregone positive NPV projects • Loss of competitive position • Lost customers • Lost suppliers • Asset fire sales and liquidation • Loss of interest tax shields

44 Summary 44 Summary

45 Trade-off theory 45 Trade-off theory

46 Summary Financing checklist • Taxes Does the firm benefit from interest tax shields? 46 Summary Financing checklist • Taxes Does the firm benefit from interest tax shields? • Signaling and mispricing Is our equity fairly valued? How will investor react? • Expected distress costs What are our cash needs going forward (FCFs)? Cashflow volatility? How costly is it to cut back on expenditures? Customer and supplier concerns? Is renegotiation possible? Asset sales? Financially strong competitors?

47 Summary Who should have low debt? • Firms with high costs of financial 47 Summary Who should have low debt? • Firms with high costs of financial distress Assets cannot be sold easily, high intangibles, high growth options, time-sensitive investment • Firms with risky earnings and cashflows High probability of distress • Firms with financially strong competitors Predatory pricing, exploiting downturns • Firms with low earnings and cumulative losses Tax shields small

48 Summary Target: Single A rated debt • Tax shields • Prob of default 48 Summary Target: Single A rated debt • Tax shields • Prob of default and credit spreads: AAA vs. BBB • Access to credit markets Regulation International capital markets • Competitors • Bond covenants

49 Bond ratings 49 Bond ratings

50 Bond ratings 50 Bond ratings