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1、McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-0Chapter Outline16.1 Costs of Financial Distress16.2 Description of Costs16.3 Can Costs of Debt Be Reduced?16.4 Integration of Tax Effects and Financial Distress Costs16.5 Shirking, Perquisites, and Bad Investm
2、ents: A Note on Agency Cost of Equity16.6 The Pecking-Order Theory16.7 Growth and the Debt-Equity Ratio16.8 Personal Taxes16.9 How Firms Establish Capital Structure16.10 Summary and ConclusionsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-116.1 Costs of Fi
3、nancial Distress Bankruptcy risk versus bankruptcy cost. The possibility of bankruptcy has a negative effect on the value of the firm. However, it is not the risk of bankruptcy itself that lowers value. Rather it is the costs associated with bankruptcy. It is the stockholders who bear these costs.Mc
4、Graw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-216.2 Description of Costs Direct Costs Legal and administrative costs (tend to be a small percentage of firm value). Indirect Costs Impaired ability to conduct business (e.g., lost sales) Agency Costs Selfish st
5、rategy 1: Incentive to take large risks Selfish strategy 2: Incentive toward underinvestment Selfish Strategy 3: Milking the propertyMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-3Balance Sheet for a Company in DistressAssetsBVMVLiabilitiesBVMVCash$200$200
6、LT bonds$300Fixed Asset$400$0Equity$300Total$600$200Total$600$200What happens if the firm is liquidated today?The bondholders get $200; the shareholders get nothing.$200$0McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-4Selfish Strategy 1: Take Large RisksTh
7、e GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is $200 (all the firms cash)Required return is 50%Expected CF from the Gamble = $1000 0.10 + $0 = $100133$50. 1100$200$NPVNPVMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-5Selfish Sto
8、ckholders Accept Negative NPV Project with Large Risks Expected CF from the Gamble To Bondholders = $300 0.10 + $0 = $30 To Stockholders = ($1000 - $300) 0.10 + $0 = $70 PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0 PV of Bonds With the Gamble = $30 / 1.5 = $20 PV of Sto
9、cks With the Gamble = $70 / 1.5 = $47McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-6Selfish Strategy 2: Underinvestment Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so th
10、e stockholders will have to supply an additional $100 to finance the project Required return is 10%18.18$10. 1350$300$NPVNPVShould we accept or reject?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-7Selfish Stockholders Forego Positive NPV Project Expected
11、CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 - $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0 PV of Bonds With the Project = $300 / 1.1 = $272.73 PV of Stocks with the project = $50 / 1.1 - $100 = -$54.55McGraw-Hill/I
12、rwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-8Selfish Strategy 3: Milking the Property Liquidating dividends Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shar
13、eholders. Such tactics often violate bond indentures. Increase perquisites to shareholders and/or management McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-916.3 Can Costs of Debt Be Reduced? Protective Covenants Debt Consolidation: If we minimize the numbe
14、r of parties, contracting costs fall.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-10Protective Covenants Agreements to protect bondholders Negative covenant: Thou shalt not: Pay dividends beyond specified amount. Sell more senior debt & amount of new debt
15、 is limited. Refund existing bond issue with new bonds paying lower interest rate. Buy another companys bonds. Positive covenant: Thou shall: Use proceeds from sale of assets for other assets. Allow redemption in event of merger or spinoff. Maintain good condition of assets. Provide audited financia
16、l information.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-1116.4 Integration of Tax Effects and Financial Distress Costs There is a trade-off between the tax advantage of debt and the costs of financial distress. It is difficult to express this with a pr
17、ecise and rigorous formula.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-12Integration of Tax Effects and Financial Distress CostsDebt (B)Value of firm (V)0Present value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with
18、 corporatetaxes and debtVL = VU + TCBV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debtMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-13The Pie Model Revisited Taxes and bankruptcy costs can be viewed as just an
19、other claim on the cash flows of the firm. Let G and L stand for payments to the government and bankruptcy lawyers, respectively. VT = S + B + G + L The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie.SGBLMcGraw-Hill/IrwinCopyright
20、2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-1416.5 Shirking, Perquisites, and Bad Investments: The Agency Cost of Equity An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help”. Who bears the burden of these agency costs? While ma
21、nagers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity. The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities. The free cash fl
22、ow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-1516.6 The Pecking-Order Theory Theory stating that
23、firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1 Use internal financing first. Rule 2 Issue debt next, equity last. The pecking-order Theory is at odds with the trade-off theory: There is no target D/E ratio. Profitable firms use less debt. Companies like fin
24、ancial slackMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-1616.7 Growth and the Debt-Equity Ratio Growth implies significant equity financing, even in a world with low bankruptcy costs. Thus, high-growth firms will have lower debt ratios than low-growth fi
25、rms. Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-1716.8 Personal Taxes: The Miller Model The Miller Model shows that the value of a levered firm can be expr
26、essed in terms of an unlevered firm as:BTTTVVBSCUL1)1 ()1 (1Where:TS = personal tax rate on equity incomeTB = personal tax rate on bond incomeTC = corporate tax rateMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-18Personal Taxes: The Miller ModelThe derivat
27、ion is straightforward:)1 ()1 ()(receive firm levered ain rsShareholdeSCBTTBrEBIT)1 (receive sBondholderBBTBr)1 ()1 ()1 ()(is rsstakeholde all toflowcash total theThus,BBSCBTBrTTBrEBITBSCBBSCTTTTBrTTEBIT1)1 ()1 (1)1 ()1 ()1 (asrewritten becan This Continued McGraw-Hill/IrwinCopyright 2002 by The McG
28、raw-Hill Companies, Inc. All rights reserved.16-19Personal Taxes: The Miller Model (cont.)BSCBBSCTTTTBrTTEBIT1)1 ()1 (1)1 ()1 ()1 (The first term is the cash flow of an unlevered firm after all taxes. Its value = VU. A bond is worth B. It promises to pay rBB(1- TB) after taxes. Thus the value of the
29、 second term is:BSCTTTB1)1 ()1 (1The total cash flow to all stakeholders in the levered firm is:The value of the sum of these two terms must be VLBTTTVVBSCUL1)1 ()1 (1McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-20Personal Taxes: The Miller Model (cont.)
30、Thus the Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:BTTTVVBSCUL1)1 ()1 (1In the case where TB = TS, we return to M&M with only corporate tax:BTVVCULMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-21E
31、ffect of Financial Leverage on Firm Value with Both Corporate and Personal TaxesDebt (B)Value of firm (V)VUVL = VU+TCB when TS =TBVL VU + TCBwhen TS (1-TC)(1-TS)VL =VU when (1-TB) = (1-TC)(1-TS)VL VU when (1-TB) (1-TC)(1-TS)BTTTVVBSCUL1)1 ()1 (1McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Comp
32、anies, Inc. All rights reserved.16-22Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency CostsDebt (B)Value of firm (V)0Present value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + TCBV = A
33、ctual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debtVL VU + TCBwhen TS (1-TC)(1-TS)Agency Cost of EquityAgency Cost of DebtMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-2316.9 How Firms Establish Capital Structure Mos
34、t Corporations Have Low Debt-Asset Ratios. Changes in Financial Leverage Affect Firm Value. Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes. Another interpretation is that firms signal good news when they lever up. There are Differences in Capi
35、tal Structure Across Industries. There is evidence that firms behave as if they had a target Debt to Equity ratio.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-24Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates,
36、 there is an advantage to debt. Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. Pecking Order and Financial S
37、lack Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-2516.10 Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of d
38、ebt. Direct costs Lawyers and accountants fees Indirect Costs Impaired ability to conduct business Incentives to take on risky projects Incentives to underinvest Incentive to milk the property Three techniques to reduce these costs are: Protective covenants Repurchase of debt prior to bankruptcy Con
39、solidation of debtMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-2616.10 Summary and Conclusions Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt.Debt (B)Value of firm (V)0Present value of taxs
40、hield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + TCBV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debtMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.1
41、6-2716.10 Summary and Conclusions If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) (1-TS) = (1-TB)Debt (B)Value of
42、firm (V)0Present value of taxshield on debtPresent value offinancial distress costsValue of firm underMM with corporatetaxes and debtVL = VU + TCBV = Actual value of firmVU = Value of firm with no debtB*Maximumfirm valueOptimal amount of debtVL VU + TCB when TS (1-TC)(1-TS)Agency Cost of EquityAgenc
43、y Cost of DebtMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.16-2816.10 Summary and Conclusions Debt-to-equity ratios vary across industries. Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress.