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ECON 2560 (71)
Chapter 16

Chapter 16 ECON 2560

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University of Guelph
ECON 2560
Tahsin Mehdi

Chapter 16 ECON 2560 Debt Policy HOW BORROWING AFFECTS VALUE IN A TAX-FREE ECONMOMY Capital Structure: A firm’s mix of long-term financing  If the fir changes the capital structure, overall value shouldn’t change  Financial managers cant increase value by changing the mix of securities used to finance the company  This has some assumptions such as capital markets are “well-functioning” (investors can trade securities without restrictions & can borrow and lend on same terms as firm) and that capital markets are efficient  Also assumes there aren’t any distorting taxes and ignores costs encountered if a firm borrows too much an lands in financial distress  The firm’s capital structure decision can matter if these assumptions are not true How Borrowing Affects Earnings per Share  As long as investors can borrow or lend on their own account on the same terms as the firm, they aren’t going to pay more for a firm that has borrowed on their behalf  The value of the firm after restructuring must be the same as before Debt Irrelevance Position: The principle that the value of a firm is unaffected by its capital structure How Borrowing Affects Risks & Return  Restructuring doesn’t affect operating income regardless of the state of the economy  Therefore debt financing doesn’t affect the operating risk or the business risk of the firm Operating risk/Business Risk: Risk in a firm’s operating income  BUT w/ less equity outstanding, a change in operating income has a greater impact one earnings per share CAPITAL STRUCTURE & CORPORATE TAXES  Financial managers do worry about the debt policy because…  If the debt policy were completely irrelevant, actual debt ratios would vary randomly from firm to firm & industry to industry BUT almost all airlines, utilities, banks & real estate development companies rely heavily on debt  Capital-intensive industries like steel, aluminum, chemicals & mining do too  Rare to find a drug company or ad agency that isn’t mostly equity-financed Debt & Taxes at River Cruises  Debt financing has an important advantage that the interest the company pays is a tax-deductible expense but equity income is subject to corporate tax Interest tax shield: Tax savings resulting from deductibility of interest payments  The interest tax shield is a valuable asset  The most common assumption is that the risk of the tax shield is the same a that of the interest payments generating them PV tax shield = interest tax shield (interest payments x tax rate) Risk Annual tax shield = corporate tax rate x interest payment = T x (rc debtX D) If the tax shield is perpetual, we use the perpetuity formula to calculate the present value: PV tax shields = annual tax shield = T X (r c debt D) rdebt rdebt  The present value of the tax shield is less if the firm doesn’t plan to borrow permanently or if it may not be able to use the tax shield in the future How Interest Tax Shields Contribute to the Value of Shareholders’ Equity  One way to decrease amount the government gets is to borrow money…. this reduces the firm’s tax bill & increases the cash payments to the investors  The value of their investment increases by the PV of the tax savings Value of levered firm = value if all-equity financed + PV of tax shield In the case of permanent debt… Value of levered firm = value if all-equity financed + T c Corporate Taxes & the Weighted-Average Cost of Capital  Few companies explicitly calculate the PV of interest tax shields associated w/ a particular borrowing policy  The tax shields aren’t forgotten b/c they show up in the discount rate used to evaluate capital investments  Since debt-interest is tax-deductible, the government pays part of the interest cost  To keep investors happy, the firm has to earn the after-tax rate of interest on its & the return required by shareholders  Once we recognize the tax benefit of debt, the weighted-average cost of capital formula becomes…. WACC = (1 – T )C debt(D/D+E) + r equity E/ D+E) The Implications of Corporate Taxes For Capital Structure  If borrowing provides an interest tax shield, the implied optimal debt policy appears to be embarrassingly extreme: all firms should borrow to the hilt  This maximizes firm value & minimizes the weighted average cost of capital COSTS OF FINANCIAL DISTRESS  Financial distress occurs when promises to creditors are broken or honored w/ difficulty  Sometimes financial distress leads to bankruptcy and sometimes only means skating on thin ice  Financial distress f costly Costs of Financial Distress: Costs arising from bankruptcy or distorted business decisions before bankruptcy  Investors factor in potential for future distress in assessment Overall Market value of firm = value of all-equity financed + PV Tax shield – PV costs of financial distress  The theoretical optimum is reached when PV of tax savings due to additional borrowing is offset by increases in the PV of costs of distress Trade-off Theory: The idea that debt levels are chosen to balance the interest tax shields against the costs of financial distress Bankruptcy Costs  In principle bankruptcy is just legal mechanism for allowing creditors (lenders) to take over the firm when the decline in value of its assets triggers a default on outstanding debt  Bankruptcy isn’t the cause of the decline in the value of the firm but the result  Fees involved in a bankruptcy proceeding are paid out of the remaining value of the firm’s assets  If there’s a chance of bankruptcy, the current market value of the firm is reduced by the PV of these potential costs  The more the firm owes, the higher the chance of default and the greater the expected value of the associated costs  This reduces the current market value of the firm  Creditors foresee these costs and demand compensation in advance in the form of higher promised interested rates which reduces the possible payoffs to shareholders & reduces the current market value of their shares Evidence on Bankruptcy Costs  When large firms file for bankruptcy they usually do so under regulations provided in the bankruptcy & insolvency act of 1992  Some companies governed by the Companies Creditors Arrangement Act & the Winding-up & Restructuring Act  Purpose of these are to help firm get healthy and enable it to live again  Requires approval of a reorganization plan for who gets what – under the plan each class of creditors needs to give up its claim in exchange for new securities or a mixture of new securities & cash  Challenge is to design new capital structure that will satisfy creditors & allow the firm to solve the business problems that got them in trouble to begin w/  Sometimes this works but often there are costly play and legal tangles and the business continues to struggle Direct vs. Indirect Costs of Bankruptcy  Directs costs are the legal & administrative costs of bankruptcy  The indirect costs reflect the difficulties of running a company while its going through bankruptcy  Managements effort to stop further deterioration of firm’s business Financial Distress without Bankruptcy  NAs long as a firm can scrape up enough cash to pay the interest on its debt it may be able to postpone bankruptcy for a while and may even recover  A narrow escape
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