Lecture 17: Lecture 17: Financial Leverage & Capital Structure Policy Financial Leverage & Capital Structure

Policy Objectives Objectives

Introduce taxes in the M&M framework Optimal capital structure is determined by the tradeoff between - Tax savings - Bankruptcy costs Explain concepts like Underinvestment Problem, debt overhang and risk shifting Describe a Go-for-Broke behavior
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So Does Capital Structure Policy Matter? So Does Capital Structure Policy Matter?
The M&M proposition suggest that the capital structure does not matter in perfect capital markets with no taxes and no bankruptcy costs. No matter how much the firm borrows, the value of the firm remains the same, and so does the WACC. In reality, however, managers do worry about a firms capital structure. They try to find the mix that optimize firm value and to reduce its cost of capital. As a result, we observe different capital structures across industries. What is going on?
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Introducing Corporate Taxes Introducing Corporate Taxes

Recall that interest expenses are deductible against taxable income. So debt increases the CF to the firms stakeholders. Interest tax shield: The tax saving attained by a firm from interest expenses
Tax saving in each period = TC RD D

This saving is usually valued by discounting at RD (the tax shield has the same risk as D). In the case of a perpetual debt,

Present value of tax saving = (TC RD D) / RD = TC D

M&M I with Taxes: VL = VU + TC D
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M&M II with Taxes M&M with Taxes

VL=VU+TCD
=TC

TC D

Implications of M&M II with taxes Implications of M&M with taxes

1. Debt financing always increases firm value, so using debt is very attractive. Capital structure matters a lot! 2. The value of the corporate tax shield is represented in the lower after-tax cost of debt

WACC = R A =

D E RD (1 TC ) + RE V V

This means that WACC decreases in leverage. Value increases because we are discounting the cash flows with a lower WACC.
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M&M II with taxes M&M II with taxes

Note that now the WACC decreases with D/E The formula for M&M II with taxes cannot be derived from the previous equation of WACC. Define RU to be the WACC when D = 0, so RU is the unleveraged cost of capital M&M II with taxes: RE = RU +

D ( RU RD ) (1 TC ) E

Implications are similar to the case without taxes

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Corporate Taxes and WACC Corporate Taxes and WACC

With taxes capital structure matters a lot! Now we know that the value of the tax shield increases as D/E ratio increases. Thus, with taxes firm value increases and the cost of capital decreases with leverage Why dont all business borrow as much as they can? It seems that the optimal capital structure is 100% debt. Having lots of debt is always good?
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Optimal Capital Structure Optimal Capital Structure

As D/E increases, the probability of financial distress also increases. One cost of having debt is the expected bankruptcy costs (legal and adm. expenses + difficulty of running a distressed firm) As the D/E ratio , the costs of financial distress

VL = VU + PV (Tax Shield ) PV (Costs of Financial Distress)

The optimum capital structure is the D/E level at which the PV of the tax shield from borrowing an additional dollar is just offset by the increase in the PV of financial distress costs - This is the Static Theory of Capital Structure
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The Static Theory of Capital Structure The Static Theory of Capital Structure

VL=VU+TCXD

Bankruptcy Costs Bankruptcy Costs

Direct bankruptcy costs: The costs that are directly associated with bankruptcy, such as legal and administrative expenses Indirect bankruptcy costs: The difficulties of running a business that is experiencing financial distress. Some examples: normal operations are disrupted, valuable employee leave, the firms reputation is damaged, investment opportunities are not taken and more

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Examples of Bankruptcy Costs Examples of Bankruptcy Costs

Go-for Broke Behavior: Shareholders of financially distressed firms have the tendency to invest in high risk, negative NPV projects (also called risk-shifting) Intuition: if project succeeds, the shareholders keep the benefit. If it fails, shareholders dont lose anything due to limited liability. Example: Suppose a firm has only a $1,000 cash. The face value due at the end of this year on the firms bonds is $5,000. If nothing happens the firm goes bankrupt and is liquidated, bondholders get the cash, and shareholders get nothing.
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Go-for-Broke Behavior: Example Go-for-Broke Behavior: Example

Strategy A (safe): The firm could invest $1,000 in government securities at 15%. A the end of the year the firms cash will be $1,150, the firm is liquidated, bondholders get the cash, shareholders get nothing.

Summary: PV (Bonds) = $1,000 PV (Shares) = $0

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Go-for-Broke Behavior: Example Go-for-Broke Behavior: Example

Strategy B (very risky): Invest the $1,000 in a project that will pay $20,000 with 2% probability, and zero otherwise.

NPV = $1,000 +
PV (Bonds) =

$400 .02($20,000) = $1,000 + < $0 1+ r 1+ r

.02 5,000 100 = < $1,000 1+ r 1+ r

PV (Shares) =

.02 15,000 300 = > $0 1+ r 1+ r

Shareholders will typically prefer strategy B!

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Examples of Bankruptcy Costs Examples of Bankruptcy Costs

Underinvestment Problem: Shareholders of levered firms might forego investment in positive NPV projects because bondholders will capture most of the benefit (Debt overhang problem) Suppose a firm has a debt obligation due next year with a face value of $10,000 and R=10%. It also has the opportunity to take a very attractive project: If it invests $2,000 now it will get back $11,000 for sure next year. NPV = -$2,000 + $11,000/1.1 = $8,000 > 0

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Underinvestment Problem Underinvestment Problem

A: Suppose the firm has no cash and it cant borrow via issuing debt due to its poor financial condition and has to depend on the shareholders for funding the project. If shareholders fund the project, it will cost them $2,000 now, and they will get $11,000 at the end of the year. Since they have to pay $10,000 to bondholders, they will be able to recover only $1,000 of their original investment. So they will not undertake the project even though it has a positive NPV. B: Suppose the firm has $2,000 cash If they dont undertake the project, shareholders lose the cash in liquidation. By undertaking the project shareholders generate $11,000, of which $10,000 go to bondholders, so they will keep $1,000, which is better than nothing.
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Other Reasons for not Borrowing up to the Limit Other Reasons for not Borrowing up to the Limit
If the firm does not expect to use the extra tax shields arising from debt financing, then debt is not that attractive. Only high operating income firms have the need to use extremely high tax shields. There are also non-debt tax shields that reduce the need to rely on debt tax shields. These are depreciation and other expenses that are tax deductible.

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The Trade-Off Theory and Capital The Trade-Off Theory and Capital Structure Differences Across Industries Structure Differences Across Industries
Costs of distress vary with asset type: firms with tangible assets lose less value in bankruptcy than firms with intangible asset. High D/E firms: safe, tangible assets (utilities, retailers) Low D/E firms: risky, intangible assets (high-tech companies, pharmaceutical companies) Other issues: some highly profitable firms employ little debt, which contradicts the trade-off theory. These firms seem to follow a pecking order: internal funds are preferred to debt, and debt is preferred to equity.
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Optimal Capital Structure: A Recap Optimal Capital Structure: A Recap

Case I: No taxes, no bankruptcy costs the total value of the firm and its WACC are not affected by capital structures - capital structure does not matter. Case II: With corporate taxes and no bankruptcy costs the value of the firm increases and the WACC decreases as the amount of debt goes up maximize borrowing Case III: With corporate taxes and bankruptcy costs the value of the firm reaches a maximum (WACC reaches a minimum) when the tax benefit from an extra dollar in debt is exactly equal to the increase in expected bankruptcy costs there exists an optimal capital structure
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Assigned Reading and Questions Assigned Reading and Questions

Questions 14,16,17 p.559 Ch. 17

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