Chapter 18 How Much Should Firm Borrow

8/20/2019 Chapter 18 How Much Should Firm Borrow

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How Much Should a Firm

Borrow?

Principles of

Corporate

Finance

Seventh Edition

Richard A. Brealey

Stewart C. Myers

Slides by

Matthew Will

Chapter 18

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. ll rights


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18- 2


Topics Covered

Corporate Taxes and Value

Corporate and Personal Taxes

Cost of Financial istress

Pec!in" #rder of Financial Choices


3/28

18- 3


Financial Risk $ %is! to shareholders resultin" from

the use of de&t'

Financial evera!e $ (ncrease in the varia&ilit) of

shareholder returns that comes from the use of de&t'"nterest Ta# Shield$ Tax savin"s resultin" from

deducti&ilit) of interest pa)ments'

C.S. $ Corporate Ta#es


4/28

18- 4


%#a&ple $ *ou own all the e+uit) of Space Ba&ies

iaper Co'' The compan) has no de&t' The

compan),s annual cash flow is -./000/ &efore

interest and taxes' The corporate tax rate is 102'*ou have the option to exchan"e .34 of )our e+uit)

position for .02 &onds with a face value of -./000'

Should )ou do this and wh)?



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18- 5


All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Preta In!"me 1,000 #00

Taes $ 40% 400 3&0

'et (as) *l"+ $600 $540


%#a&ple $ *ou own all the e+uit) of Space Ba&ies iaper Co'' The

compan) has no de&t' The compan),s annual cash flow is -./000/ &efore interest and taxes' The corporate tax rate is 102' *ou have theoption to exchan"e .34 of )our e+uit) position for .02 &onds with aface value of -./000'


All

Equity

EBIT 1,000

Interest Pmt 0

Preta In!"me 1,000

Taes $ 40% 400

'et (as) *l"+ $600


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18- &


All Equity 1/2 Debt

EBIT 1,000 1,000

Interest Pmt 0 100

Preta In!"me 1,000 #00

Taes $ 40% 400 3&0

'et (as) *l"+ $600 $540


%#a&ple $ *ou own all the e+uit) of Space Ba&ies iaper Co'' The

compan) has no de&t' The compan),s annual cash flow is -./000/

&efore interest and taxes' The corporate tax rate is 102' *ou have the

option to exchan"e .34 of )our e+uit) position for .02 &onds with a

face value of -./000'


T"tal (as) *l"+

All Equity = 600

*1/2 Debt = 640 *1/2 Debt = 640

(540 + 100)


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18-


Capital Str'ct're

PV of Tax Shield 5

6assume perpetuit)7 D x r D x Tc

r D

= D x Tc

Example:Tax benefit = 1000 x (10) x (40) = !40

"# $f 40 perpetuity = 40 % 10 = !400

"# Tax &'iel = D x Tc = 1000 x 4 = !400


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18- 8


Capital Str'ct're

Firm Value 5Value of 8ll E+uit) Firm 9 PV Tax Shield

Example

All Equity #alue = 600 % 10 = 6000

"# Tax &'iel = 400

*irm #alue it' 1%, Debt = !6400


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18- #


C.S. $ Ta#es ()ersonal $ Corp*

elati.e A.antae *"rmula

Debt .s Equity

1-TP1-TPE 1-T(

A* 1 Debt

A* 1 Equity

A.antae


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18- 10


Eamle 1All Debt All Equity

In!"me BT(P 1600 1600

less T(764& 0600 064&

In!"me BTP 1600 0654

Taes TP 765 TPE70 0650 0600

Ater Ta In!"me 0650 0654

A* 7 6#2& A.antae Equity


In!"me BT(P 1600

less T(764& 0600

In!"me BTP 1600

Taes TP 765 TPE70 0650

Ater Ta In!"me 0650


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18- 11


Eamle 2 All Debt All Equity

In!"me BT(P 1600 1600

less T(7634 0600 0634

In!"me BTP 1600 06&&

Taes TP 7628 TPE7621 0628 0613#

Ater Ta In!"me 062 06521

A* 7 16381 A.antae Debt


In!"me BT(P 1600

less T(7634 0600

In!"me BTP 1600

Taes TP 7628 TPE7621 0628

Ater Ta In!"me 062


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18- 12


Toda),s %8F : e&t vs E+uit) preference'

1-..

(1-16) (1-.5)= 1,./A* =


'y are c$mpanie n$t all ebt2


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18- 13


Capital Str'ct're

9tru!ture " B"n :iel ates

D

E

B"n

:iel

r


14/28

18- 14


;ei)te A.erae ("st " (aitalit'$ut taxe (traiti$nal 3ie)

r

D#

r D

r Enclue anruptcy /i

;A((


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18- 15


Financial +istress

Costs o, Financial +istress $ Costs arisin" from &an!ruptc) or distorted &usiness decisions &efore

&an!ruptc)'


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18- 1&


Financial +istress

Costs o, Financial +istress $ Costs arisin" from &an!ruptc) or distorted &usiness decisions &efore

&an!ruptc)'

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress


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18- 1


Financial +istress

e&t

M a r ! e t V a l u e o f T h e F i r m

Value of unlevered

firm

PV of interest

tax shields

Costs of financial distress

Value of levered firm

#ptimal amountof de&t

Maximum value of firm


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18- 18


Con,licts o, "nterest

Circular File Co!any has "#$ of %-year de&t'

Circular File Company (Book alue!"

7et 8 ,0 50 $n $uttanin9*ixe aet 0 50 8$mm$n t$c

T$tal aet 100 100 T$tal liabilitie

Circular File Company (Book alue!"

7et 8 ,0 50 $n $uttanin9*ixe aet 0 50 8$mm$n t$c



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18- 1#



Circular File Co!any has "#$ of %-year de&t'

;h) does the e+uit) have an) value ? Shareholders have an option $$ the) can o&tain the

ri"hts to the assets &) pa)in" off the -


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18- 20



Circular File Co!any has ay in(est "%$ as follo)s'

)7 pro&a&ilit6=02-0

-.0(nvest

)7 pro&a&ilit6.02-.40 >ext *ear Pa)offsPossi&le >ow

8ssume the >PV of the proect is 6$-47'

;hat is the effect on the mar!et values?


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18- 21



Circular File Co!any (alue *!ost !roect,

Firm value falls &) -4/ &ut e+uit) holder "ains -@

Circular File Company (#arket alue!"7et 8 10 ,0 $n $uttanin9

*ixe aet 1 8$mm$n t$c

T$tal aet , , T$tal liabilitie

Circular File Company (#arket alue!"7et 8 10 ,0 $n $uttanin9

*ixe aet 1 8$mm$n t$c

T$tal aet , , T$tal liabilitie


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18- 22



Circular File Co!any (alue *assues a safe !roect)ith PV = "#,

;hile firm value rises/ the lac! of a hi"h potential pa)off for

shareholders causes a decrease in e+uit) value'

Circular File Company (#arket alue!"7et 8 ,0 .. $n $uttanin9

*ixe aet ,5 1, 8$mm$n t$c


Circular File Company (#arket alue!"7et 8 ,0 .. $n $uttanin9

*ixe aet ,5 1, 8$mm$n t$c



23/28

18- 23


Financial +istress -a&es

Cash "n and R'n

)layin! ,or Ti&e

Bait and Switch


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18- 24


Financial Choices

Tradeo,, Theory $ Theor) that capital structure is &ased on a trade$off &etween tax savin"s and distress

costs of de&t'

)eckin! /rder Theory $ Theor) statin" that firms

prefer to issue de&t rather than e+uit) if internal

finance is insufficient'


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18- 25


Trade /,, Theory $ )rices

1. Stock,ordebt Stock price

e#chan!e o,,ers ,alls

+ebt,orstock Stock price

e#chan!e o,,ers rises

0. "ss'in! co&&on stock drives down stock prices

rep'rchase increases stock prices.

2. "ss'in! strai!ht debt has a s&all ne!ative

i&pact.


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18- 2&


"ss'es and Stock )rices

Why do sec'rity iss'es a,,ect stock price3 Thede&and ,or a ,ir&4s sec'rities o'!ht to be ,lat.

Any ,ir& is a drop in the b'cket.

)lenty o, close s'bstit'tes.

ar!e debt iss'es don4t si!ni,icantly depressthe stock price.


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)eckin! /rder Theory

Consider the follo)in. story/

The anno'nce&ent o, a stock iss'e drives down the stock price

beca'se investors believe &ana!ers are &ore likely to iss'e when

shares are overpriced.

There,ore ,ir&s pre,er internal ,inance since ,'nds can be

raised witho't sendin! adverse si!nals.

", e#ternal ,inance is re5'ired6 ,ir&s iss'e debt ,irst ande5'ity as a

last resort.

The &ost pro,itable ,ir&s borrow less not beca'se they have lower

tar!et debt ratios b't beca'se they don7t need e#ternal ,inance.


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M G Hill/I i

)eckin! /rder Theory

Soe 0!lications/

"nternal e5'ity &ay be better than e#ternal

e5'ity.

Financial slack is val'able.

", e#ternal capital is re5'ired6 debt is better.

(There is less roo& ,or di,,erence in opinions

abo't what debt is worth*.

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Chapter 18 How Much Should Firm Borrow

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