How Much Should A Corporation Borrow?: Principles of Corporate Finance

Chapter 18
Principles of
Corporate Finance
Tenth Edition
How Much Should

a Corporation
Borrow?
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Topics Covered
Corporate Taxes
Corporate and Personal Taxes
Cost of Financial Distress
Pecking Order of Financial Choices
18-2
Capital Structure & Corporate Taxes

Financial Risk - Risk to shareholders resulting from
the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.
18-3

The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.
18-4

28
$350
.08
Interest payment return on debt X amount borrowed
PV (tax shield)
rD D
rcorporate tax rate X interest payment

expected return on debt
T (r D)
C D
TC D
rD
PV (tax shield)
18-5

Example - You own all the equity of Space Babies
Diaper Co. The company has no debt. The
companys annual cash flow is $900,000 before
interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your equity
position for 5% bonds with a face value of
$2,000,000.
Should you do this and why?
18-6

Example - You own all the equity of Space Babies Diaper Co. The company
has no debt. The companys annual cash flow is $900,000 before interest
and taxes. The corporate tax rate is 35% You have the option to exchange
1/2 of your equity position for 5% bonds with a face value of $2,000,000.
Should you do this and why?
Total Cash Flow

All Equity = 585
*1/2 Debt = 620

(520 + 100)
18-7

PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
= D x Tc
rD
Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
PV Tax Shield = $2,000,000 x .35 = $700,000
18-8

Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield =
700,000
Firm Value with 1/2 Debt = $12,400,000
18-9

Merck Balance Sheet, December 2008
(figures in $millions)
18-10

Merck Balance Sheet, December 2008 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)
18-11
C.S. & Taxes (Personal & Corp)

Operating Income ($1.00)
Or paid out as
equity income
Paid out as
interest
Corporate Tax
None
Tc
Income after
Corp Taxes
$1.00
$1.00 Tc
Personal Taxes .
Tp
TpE (1.00-Tc)
Income after All

Taxes
$1.00 Tp
$1.00Tc-TpE (1.00-Tc)
=(1.00-TpE)(1.00-Tc)
To bondholders
To stockholders
18-12

Relative Advantage Formula
( Debt vs Equity )
1-Tp
(1-TpE) (1-Tc)
Advantage
RAF > 1
Debt
RAF < 1
Equity
18-13

Example
18-14

Another Example
18-15

Todays RAF & Debt vs Equity preference.
RAF =
1-.33
(1-.16) (1-.35)
= 1.23
Why are companies not all debt?
18-16
18-17
Capital Structure
Structure of Bond Yield Rates
r
Bond
Yield
D
E
WACC w/o taxes (traditional view)

r
Includes Bankruptcy Risk
rE
WACC
rD
D
V
18-18
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
18-19
Financial Distress
Costs 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 Distress
18-20
Financial Distress
Market Value of The Firm
Maximum value of firm

Costs of
financial distress
PV of interest
tax shields
Value of
unlevered
firm
Debt
Optimal amount
of debt
Value of levered firm
18-21
Default Payoff Scenarios
18-22
Ace Limited Example

Total payoff to Ace Limited security holders. There is a $200
bankruptcy cost in the event of default (shaded area).
18-23
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular
Circular File
FileCompany
Company(Book
(BookValues)
Values)
Net
20
50
NetW.C.
W.C.
20
50
Fixed
80
50
Fixedassets
assets
80
50
Total
100
100
Totalassets
assets
100
100
Bonds
Bondsoutstanding
outstanding
Common
Commonstock
stock
Total
Totalliabilities
liabilities
18-24
Circular File Company has $50 of 1-year debt.
Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
20
25
Bonds
NetW.C.
W.C.
20
25
Bondsoutstanding
outstanding
Fixed
10
55
Common
Fixedassets
assets
10
Commonstock
stock
Total
30
30
Total
Totalassets
assets
30
30
Totalliabilities
liabilities
Why does the equity have any value ?

Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.
18-25
Circular File Company has may invest $10 as
follows.
Now
Possible Payoffs Next Year

$120 (10% probability)
Invest $10
$0 (90% probability)
Assume the NPV of the project is (-$2).
What is the effect on the market values?
18-26
Circular File Company value (post project)
Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
10
20
Bonds
NetW.C.
W.C.
10
20
Bondsoutstanding
outstanding
Fixed
18
88
Common
Fixedassets
assets
18
Commonstock
stock
Total
28
28
Total
Totalassets
assets
28
28
Totalliabilities
liabilities
Firm value falls by $2, but equity holder gains $3
18-27
Circular File Company value (assumes a safe project
with NPV = $5)
Circular
Circular File
FileCompany
Company(Market
(MarketValues)
Values)
Net
20
33
Bonds
NetW.C.
W.C.
20
33
Bondsoutstanding
outstanding
Fixed
25
12
Common
Fixedassets
assets
25
12
Commonstock
stock
Total
45
45
Total
Totalassets
assets
45
45
Totalliabilities
liabilities
While firm value rises, the lack of a high potential payoff for
shareholders causes a decrease in equity value.
18-28
Financial Distress Games

Cash In and Run
Playing for Time
Bait and Switch
18-29
Financial Choices
Trade-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
finance is insufficient.
18-30
Trade Off Theory & Prices

1. Stock-for-debt
Stock price
exchange offers
falls
Debt-for-stock
Stock price
exchange offers
rises
2. Issuing common stock drives down stock prices;

repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
18-31
Issues and Stock Prices

Why do security issues affect stock price?
The demand for a firms securities ought to be
flat.
Any firm is a drop in the bucket.

Plenty of close substitutes.
Large debt issues dont significantly depress
the stock price.
18-32
Pecking Order Theory

Consider 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 overpriced.
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 don't need external finance.
18-33
Pecking Order Theory

Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).
18-34
Web Resources
Click to access web sites
Internet connection required
http://astro.temple.edu/~tub06197/Wk1Myers1984.pdf
18-35

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Chapter 18

How Much Should

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Capital Structure & Corporate Taxes

Capital Structure & Corporate Taxes

Capital Structure & Corporate Taxes

rcorporate tax rate X interest payment

Capital Structure & Corporate Taxes

Capital Structure & Corporate Taxes

Total Cash Flow

*1/2 Debt = 620

Capital Structure & Corporate Taxes

PV Tax Shield = $2,000,000 x .35 = $700,000

Capital Structure & Corporate Taxes

Firm Value with 1/2 Debt = $12,400,000

Capital Structure & Corporate Taxes

Capital Structure & Corporate Taxes

C.S. & Taxes (Personal & Corp)

Income after All

C.S. & Taxes (Personal & Corp)

C.S. & Taxes (Personal & Corp)

C.S. & Taxes (Personal & Corp)

C.S. & Taxes (Personal & Corp)

Why are companies not all debt?

WACC w/o taxes (traditional view)

Includes Bankruptcy Risk

Value if all Equity Financed

Market Value of The Firm

Maximum value of firm

Value of levered firm

Default Payoff Scenarios

Ace Limited Example

Why does the equity have any value ?

Possible Payoffs Next Year

Firm value falls by $2, but equity holder gains $3

Financial Distress Games

Trade Off Theory & Prices

2. Issuing common stock drives down stock prices;

Issues and Stock Prices

Any firm is a drop in the bucket.

Pecking Order Theory

Pecking Order Theory

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