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1、How Much Should a Firm Borrow?Principles of Corporate FinanceSeventh EditionRichard A.Brealey Stewart C.MyersChapter 18McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved 18-2McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Topics
2、CoveredwCorporate Taxes and ValuewCorporate and Personal TaxeswCost of Financial DistresswPecking Order of Financial Choices18-3McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial Risk-Risk to shareholders resulting from the use of debt.Financial Leverage-I
3、ncrease in the variability of shareholder returns that comes from the use of debt.Interest Tax Shield-Tax savings resulting from deductibility of interest payments.C.S.&Corporate Taxes18-4McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Example-You own all the equ
4、ity of Space Babies Diaper Co.The company has no debt.The companys annual cash flow is$1,000,before interest and taxes.The corporate tax rate is 40%.You have the option to exchange 1/2 of your equity position for 10%bonds with a face value of$1,000.Should you do this and why?C.S.&Corporate Taxes18-5
5、McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved All Equity1/2 DebtEBIT1,0001,000Interest Pmt 0 100 Pretax Income1,000 900Taxes 40%400 360Net Cash Flow$600$540C.S.&Corporate TaxesExample-You own all the equity of Space Babies Diaper Co.The company has no debt.The
6、companys annual cash flow is$1,000,before interest and taxes.The corporate tax rate is 40%.You have the option to exchange 1/2 of your equity position for 10%bonds with a face value of$1,000.Should you do this and why?All EquityEBIT1,000Interest Pmt 0 Pretax Income1,000Taxes 40%400 Net Cash Flow$600
7、18-6McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved All Equity1/2 DebtEBIT1,0001,000Interest Pmt 0 100 Pretax Income1,000 900Taxes 40%400 360Net Cash Flow$600$540C.S.&Corporate TaxesExample-You own all the equity of Space Babies Diaper Co.The company has no debt.
8、The companys annual cash flow is$1,000,before interest and taxes.The corporate tax rate is 40%.You have the option to exchange 1/2 of your equity position for 10%bonds with a face value of$1,000.Should you do this and why?Total Cash Flow All Equity=600*1/2 Debt=640*1/2 Debt=640 (540+100)18-7McGraw H
9、ill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Capital StructurePV of Tax Shield=(assume perpetuity)D x rD x Tc rD=D x TcExample:Tax benefit=1000 x(.10)x(.40)=$40 PV of 40 perpetuity=40/.10 =$400PV Tax Shield=D x Tc=1000 x.4 =$40018-8McGraw Hill/IrwinCopyright 2003 by T
10、he McGraw-Hill Companies,Inc.All rights reserved Capital StructureFirm Value=Value of All Equity Firm+PV Tax ShieldExampleAll Equity Value=600/.10=6,000 PV Tax Shield =400Firm Value with 1/2 Debt=$6,40018-9McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved C.S.&Taxe
11、s(Personal&Corp)wTP：the personal tax rate on interestwTpE:the effective personal rate on equity income18-10McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved C.S.&Taxes(Personal&Corp)Relative Advantage Formula (Debt vs Equity)1-TP(1-TPE)(1-TC)RAF 1 DebtRAF 1EquityAd
12、vantage18-11McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Example 1All Debt All EquityIncome BTCP1.001.00less TC=.460.000.46Income BTP1.000.54Taxes TP=.5 TPE=00.500.00After Tax Income0.500.54RAF=.926 Advantage EquityC.S.&Taxes(Personal&Corp)Income BTCP1.00less
13、TC=.460.00Income BTP1.00Taxes TP=.5 TPE=00.50After Tax Income0.5018-12McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Example 2All Debt All EquityIncome BTCP1.001.00less TC=.340.000.34Income BTP1.000.66Taxes TP=.28 TPE=.210.280.139After Tax Income0.720.521RAF=1.3
14、81 Advantage DebtC.S.&Taxes(Personal&Corp)Income BTCP1.00less TC=.340.00Income BTP1.00Taxes TP=.28 TPE=.210.28After Tax Income0.7218-13McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved wTodays RAF&Debt vs Equity preference.1-.33(1-.16)(1-.35)=1.23RAF=C.S.&Taxes(Per
15、sonal&Corp)Why are companies not all debt?18-14McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Capital StructureStructure of Bond Yield RatesDEBondYieldr18-15McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Weighted Average Cos
16、t of Capitalwithout taxes(traditional view)rDVrDrEIncludes Bankruptcy RiskWACC18-16McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial DistressCosts of Financial Distress-Costs arising from bankruptcy or distorted business decisions before bankruptcy.18-17M
17、cGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial DistressCosts of Financial Distress-Costs arising from bankruptcy or distorted business decisions before bankruptcy.Market Value=Value if all Equity Financed +PV Tax Shield -PV Costs of Financial Distress18
18、-18McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial DistressDebtMarket Value of The FirmValue ofunleveredfirmPV of interesttax shieldsCosts offinancial distressValue of levered firmOptimal amount of debtMaximum value of firm18-19McGraw Hill/IrwinCopyrigh
19、t 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestCircular File Company has$50 of 1-year debt.18-20McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestCircular File Company has$50 of 1-year debt.A clear case of fina
20、ncial distress,since the face value of Circulars debt(50)exceeds the firms total market value(30)18-21McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Why does the equity have any value?wIf debt matured today,Circulars owner would default,leaving the firm bankrupt
21、.But suppose that the bond actually matures one year hence,that there is enough cash for Circular to limp along for one year,and that the bondholder can not call the question and force bankruptcy before than.wShareholders have an option-they can obtain the rights to the assets by paying off the$50 d
22、ebt.18-22McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestSuppose that Circular has$10 cash.The following oppurtunity comes up 18-23McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved wThis is a wild gamble and
23、 probably a lousy project.But you can see why the owner would be tempted to take it anyway.Why not go for broke?Circular will probably go under anyway,so the owner is essentially betting with the bondholders money.But the owner gets most of the loot if the project pays off.wAssume the NPV of the pro
24、ject is(-$2).What is the effect on the market values?Thus depressing firm value by 218-24McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestCircular File Company value(post project)-18-25McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Compani
25、es,Inc.All rights reserved Conflicts of InterestwFirm value falls by$2,but equity holder gains$3,the bonds value has fallen by$5.wWe are not calculating this 5 drop.We are simply using it as a plausible assumption.The tools necessary for a calculation come later.18-26McGraw Hill/IrwinCopyright 2003
26、by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestwWe have seen how stock holders,acting in their immediate,narrow self-interest,may take projects that reduce the overall market value of their firm.These are errors of commission.Conflicts of interest may also lead to errors o
27、f ommision18-27McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestCircular File Company value(assumes a safe project costing 10 with a PV=15 and NPV=$5)-issue 10 new stock an go ahead with the project18-28McGraw Hill/IrwinCopyright 2003 by The M
28、cGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestwThe total value of firm goes up by 15(10 of new capital and 5 NPV).Notice that Circular bond is no longer worth 25,but 33.the bondholder receives a capital gain 8 because the firms assets include a new,safe asset worth 15.the probabi
29、lity of default is less,and the payoff to the bondholder if default occurs is larger.wThe stockholder loses what the bondholder gains.Equity value goes up not by 15 but by 15-8=7.the owner puts in 10 of fresh equity capital but gains only 7 in market value.Going ahead is in the firms interest but no
30、t the owners.18-29McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Conflicts of InterestwAgain,our example illustrates a general point.If we hold business risk constant,any increase in firm value is shared among bondholders and stockholders.The value of any invest
31、ment opportunity to firm;s stockholders is reduced because project benefits must be shared with bondholders.18-30McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial Distress Games(three more games)Cash In and RunPlaying for TimeBait and Switch18-31McGraw Hi
32、ll/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved wCash in and run:Shareholders may be reluctant to put money into a firm in financial distress,but they are happy to take the money out-in the form of a cash dividend,for example.The market value of the firms stock goes down
33、by less than the amount of the dividend paid,because the decline in firm value is shared with the creditors.18-32McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved wPlaying for time:when the firm is in financial distress,creditors would like to salvage what they can
34、 by forcing the firm to settle up.Naturally,stock holders want to delay this as long as they can.There are various devious ways of doing this,for example,through accounting changes designed to conceal the true extent of trouble,by encouraging false hopes of the spontaneous recovery,or by cutting cor
35、ners on maintenance,research and development,and so on,in order to make this years operating performance look better.18-33McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved wBait and switch:this game is not always played in financial distress,but it is a quick way t
36、o get into distress.You start with a conservative policy,issuing a limited amount of relatively safe debt.Then you suddenly switch and issue a lot more.That makes all you debt risky,imposing a capital loss on the old bondholders.Their capital loss is the stockholders gain.18-34McGraw Hill/IrwinCopyr
37、ight 2003 by The McGraw-Hill Companies,Inc.All rights reserved Financial ChoicesTrade-off Theory-Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.Pecking Order Theory-Theory stating that firms prefer to issue debt rather than equity if internal fin
38、ance is insufficient.18-35McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Pecking Order TheoryConsider 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 ov
39、erpriced.Therefore firms prefer internal finance since funds can be raised without sending adverse signals.If external finance is required,firms issue debt first and equity as a last resort.The most profitable firms borrow less not because they have lower target debt ratios but because they dont nee
40、d external finance.18-36McGraw Hill/IrwinCopyright 2003 by The McGraw-Hill Companies,Inc.All rights reserved Pecking Order TheorySome Implications:Internal equity may be better than external equity.If external capital is required,debt is better.(There is less room for difference in opinions about what debt is worth).