Corporate Financing and Market Efficiency

Corporate Financing and Market Efficiency

Chapter 16: Payout Policy Many companies pay a regular cash dividend. Public companies often pay quarterly. Sometimes firms will throw in an extra cash dividend. The extreme case would be a liquidating dividend. Often companies will declare stock dividends. No cash leaves the firm. The firm increases the number of shares outstanding. Some companies declare a dividend in kind. Wrigleys Gum sends around a box of chewing gum. Dundee Crematoria offers shareholders discounted cremations. 1 Standard Method of Cash Dividend Payment Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend.

2 Procedure for Cash Dividend Payment 25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec. Declaration Date ExCumdividend dividend Date Date Record Date

Payment Date Declaration Date: The board of directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders (typical clearing is 3 days). 3 Price Behavior around the Ex-Dividend Date In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. -t -2 -1

0 +1 +2 $P $P - div The price drops Exby the amount of dividend Date the cash dividend Taxes complicate things a bit. Empirically, the price drop is less than the dividend and occurs within the first few minutes of the ex-date. 4 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

A compelling case can be made that dividend policy is irrelevant. Since investors do not need dividends to convert shares to cash they will not pay higher prices for firms with higher dividend payouts. Under some important assumption, M&M (1961) proved that dividend policy is irrelevant. The assumptions are 1. No taxes. 2. No transaction costs. 3. Perfect capital market (symmetric information, no agency problems, other) 5 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy (example 1) York Corporation , an all-equity firm At date 0, the managers are able to forecast

cash flows perfectly. The firm will receive a cashflow of $10,000 at date 0 and $10,000 at date 1 The firm will dissolve at date 1.(end its life) The firm has no additional positive NPV projects 6 An Illustration of the Irrelevance of Dividend Policy (example 1) I ) Current Policy:Dividends set equal to cashflow Dividends (Div.) at each date = $10000 The firm value will be : DIV 1 V 0 DIV 0 1 rs $10000 V 0 $10000 $19090.91 1.1 7 An Illustration of the Irrelevance of

Dividend Policy (example 1) Assume 1,000 shares are outstanding, then, price just before dividend is paid is $10 P 0 $10 $19.09 1.1 After the imminent dividend is paid, the stock price will fall to $9.09 (19.09-10) 8 An Illustration of the Irrelevance of Dividend Policy (example 1) I I) Alternative Policy: Initial dividend > cash flow Pay $11 per share immediately i.e., $11 X 1000 shares = $11,000 as dividend. The extra $1,000 must be raised by issuing new stock. Since the investment decision did not change, the required return (cost of capital) is still 10%. So the new shareholders should receive at t=1: $1000 1.1 $1100 Total dividends to old shareholders Dividends per share Date 0

$11,000 $11 Date1 $8,900 $8.9 9 An Illustration of the Irrelevance of Dividend Policy (example 1) The PV of dividends per share (cum-dividend) with the alternative policy: $8.9 P 0 $11 $19.09 1.1 The indifference proposition: -The value of the firm at t=0 is the same not matter which scenario we consider . -The change in dividend policy did not affect the value of the share (cum-dividend). 10

An Illustration of the Irrelevance of Dividend Policy (example 1) The mechanics of the policy: At t=0 (Ex-dividend), the price of the share will drop to $8.09 (8.9/1.1). This means that York needs to issue 1000/8.09 = 123.61 shares. There will be a total of 1123.61 shares outstanding. This leads to the following distribution of t=1 cash flow: old shareholders new shareholders Total Number of shares (%) 1000 (89%) 123.61 (11%) 1123.61(100%) T=1 Dividend $8,900 $1,100 $9,000 11

An Illustration of the Irrelevance of Dividend Policy (example 2) Pumpkin Pie Inc. currently has 1,000 shares outstanding with a total market value of $42,000. It expects cash flows from operations to be $10,000 next year. It wants to expand its product lines to include cookies and determines that it is a positive NPV project. The new product line requires a new oven that costs $8,000. Dividend Policy #1 Pay out any cash that is leftover after investing in all positive NPV projects. For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 - $8,000) as cash dividend. Dividend Policy #2 Pumpkin Pie is considering a $3,000 cash dividend ($3 per share). 12 Homemade Dividends Pumpkin Pie Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers $3 cash dividend. Bobs homemade dividend strategy: Sell two shares ex-dividend homemade dividends

Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 78 = $3,120 $3 Dividend $240 $0 $240 $39 80 = $3,120 13 Dividend Policy is Irrelevant Since investors do not need dividends to convert shares to cash, dividend policy will have no impact on the value of the firm. In the above example, Bob Investor began with total

wealth of $3,360: $42 $3,360 80 shares share After a $3 dividend, his total wealth is still $3,360: $39 $3,360 80 shares $240 share After a $2 dividend, and sale of two ex-dividend shares,his total wealth is still $3,360: $40 $3,360 78 shares $160 $80 share 14 Irrelevance of Stock Dividends XYZ Inc. has two million shares currently outstanding at $15

per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid? A 50% stock dividend will increase the number of shares by 50%: 2 million1.5 = 3 million shares After the stock dividend what is the new price per share and what is the new value of the firm? The value of the firm was $2m $15 per share = $30 m. After the dividend, the value will remain the same. Price per share = $30m/ 3m shares = $10 per share 15 Dividends and Investment Policy Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). Note that the dividend-irrelevance argument assumes that The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy. A final note: -Dividends are relevant -Dividend policy is irrelevant 16

Repurchase of Stock Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock. Recently share repurchase has become an important way of distributing earnings to shareholders. When tax avoidance is important, share repurchase is a potentially useful adjunct to dividend policy. 17 Share Repurchase Types: 1. Tender offers - If offer price is set wrong, some stockholders lose. 2. Auction 3. Open-market repurchase 4. Targeted repurchase (Greenmail) 18 Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders. Assets A.Original balance sheet Liabilities & Equity Cash $150,000 Debt 0 Otherassets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding = 100,000 Price per share= $1,000,000 /100,000 = $10 19 Stock Repurchase versus Dividend If they distribute the $100,000 as cash dividend, the balance sheet will look like this: Assets

Liabilities & Equity B. After $1 per share cash dividend Cash $50,000 Debt Other assets 850,000 Equity Value of Firm 900,000 0 900,000 Value of Firm 900,000 Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9

20 Stock Repurchase versus Dividend If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this: Assets C. After stock repurchase Liabilities & Equity Cash $50,000 Debt 0 Other assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000 Shares outstanding= 90,000 Price pershare = $900,000 / 90,000 = $10 21 Violation of M&M Assumptions (1) Taxes In Canada, individual investors face a lower dividend tax rate due to the dividend tax credit.

However, capital gains for individuals are taxed at 50% of the marginal tax rate so the effective tax rate on dividend income is higher than the tax rate on capital gains. If dividends are taxed more heavily than capital gains, investors should pay more for stocks with low dividends (i.e., investors would be happy with a lower pretax rate of return from firms offering capital gains rather than dividends). 22 Example (Table 16.1) Firm A Firm B Next years price $112.50 $102.50 Dividend

$0 $10 Total pretax payoff $112.50 $112.50 Todays stock price $100 $97.78 A is preferred to B because it does not pay highly taxed dividends Dividend tax (40%) 0 100.4= $4.00 Capital gain tax (20%)

12.50.2=$2.5 4.720.2=$0.94 After tax income 12.5-2.5=$10 14.72-4.94=$9.78 After tax return 10/100=10% 9.78/97.78=10% Before tax return 12.5/100=12.5% 14.72/97.78=15.05% A and B provide same return after tax, B provides higher return pretax

23 Dividends Decrease Value (if one considers only the issue of taxes) Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. Since capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible. Dividend policy should adjust to changes in the tax code. 24 Evidence on Dividends and Taxes in Canada Prior to 1972, capital gains were untaxed in Canada In 1985, a life-time exemption on capital gains was introduced. Anticipation of the tax break on capital gains caused investors to bid up prices of low-dividend yield stocks.

Firms responded by lowering their dividend payouts. The dividend tax credit works to reduce taxes on dividends received from Canadian firms. 25 Violation of M&M Assumptions (2) Transaction costs Also, in the real world there are transaction costs. This may suggest that Shareholders may pay high transaction costs for selling shares instead of receiving dividends. Issuing shares to raise equity my involve high fees to investment bankers. 26 Violation of M&M Assumptions (3) Agency Costs Consider a firm with excess cash. Consider a firm that has $1 million in cash after selecting all available positive NPV projects. The firm has several options: Select additional capital budgeting projects (by

assumption, these are negative NPV). Acquire other companies (empire building) Purchase financial assets Repurchase shares 27 Violation of M&M Assumptions (4) Information Asymmetry Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a companys good fortune and its managers confidence in future cash flows. 28 Desire for Current Income (5) Market Imperfection Dividends and Income Trusts and endowment funds may be

prohibited to invest in non-dividend paying firms. Since they manage funds by themselves, they may not be willing to spend the fees required in other intermediaries to pass this requirement. 29 Summary of all Effects Reasons for Low Dividend Personal Taxes High Issuing Costs Reasons for High Dividend Information Asymmetry Dividends as a signal about firms future performance Lower Agency Costs capital market as a monitoring device reduce free cash flow, and hence wasteful spending Desire for Current Income 30 The Clientele Effect: A Resolution of RealWorld Factors? (cont.) Clienteles for various dividend payout policies

are likely to form in the following way: Group High Tax Bracket Individuals Low Tax Bracket Individuals Tax-Free Institutions Corporations Stock Zero to Low payout stocks Low-to-Medium payout Medium Payout Stocks High Payout Stocks Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy. 31 The Clientele Effect Example 40% of investors prefer high dividends 60% of investors prefer low dividends 20% of firms pay high dividends 80% of firms pay low dividend High dividend firms in short supply (price ), Low dividends

firm in high supply (price ). Some firms will change policy and increase dividends, till 40% of firm pay high dividends, and 60% of firms will pay low dividends. Once payouts of corporations conform to the desires of shareholders, no single firm can affect its market value by switching from one dividend strategy to another. 32 The Dividend Decision Lintners Stylized Facts (How Dividends are Determined) 1. Firms have longer term target dividend payout ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings. 4. Managers are reluctant to make dividend changes that might have to be reversed. 5. Firms repurchase stock when they have accumulated a large amount of unwanted cash or wish to change their 33 capital structure by replacing equity with debt.

Summary and Conclusions The optimal payout ratio cannot be determined quantitatively. In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept. A firm should not reject positive NPV projects to pay a dividend. Personal taxes and issue costs are real-world considerations that favor low dividend payouts. Many firms appear to have a long-run target dividendpayout policy. There appears to be some value to dividend stability and smoothing. There appears to be some information content in dividend payments. Agency consideration may also lead to high dividends. 34 Practice question 1: Time Line On April 5, the board of directors of Capital City Golf Club declared a dividend of $0.75 per share payable on Tuesday, May 4, to shareholders of record as of Tuesday April 20. Suppose you bought 350 shares of Capital City stock on April 6 for $8.65 a share. Assume there are no taxes,

no transaction costs, and no news between your purchase and sale of the stock. If you were to sell your stock on April 16, for how much would you be able to sell your stock? What if you were to sell the stock on April 21? 35 Practice question 2: M&M Theorem 1. 2. 3. The net income of Novis Corporation, which has 10,000 outstanding shares and a 100% payout policy is $32,000. The expected value of the firm one year hence is $1,545,600. The appropriate discount rate for Novis is 13%. What is the current value of the firm? What is the ex-dividend price of Noviss stock if the board follows its current policy? At the dividend declaration meeting, several board members claimed that the dividend is too small and is probably depressing Novis price. They proposed that Novis sell enough new shares to finance a $4.25 dividend. (a)

comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations. (b) If the proposal is adopted, at what price will the new shares sell and how many will be sold? 36 Practice question 3: Dealing with Taxes National Business Machine Co. (NBM) has $2 million of extra cash. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in TB yielding 7%, or an 11% preferred stock. Only 30% of the dividends from investing in preferred stock would be subject to corporate taxes. Another alternative is to pay out the cash as dividends and let the shareholders invest on their own in treasury bills with the same yield. The corporate tax rate is 35%, and the individual tax rate is 31%. Should the cash be paid today or in three years? Which of the two options generates the highest after-tax income for the shareholders? 37 Practice question 4: Real World Factors?

In the May 4, 1981, issue of Fortune, an article entitled Fresh Evidence That Dividends Dont Matter stated, All told, 115 companies of the S&P 500 firms raised their payout every year during the period 1970-1989. Investors in this group would have fared somewhat better than investors in the 500 as a whole with a median return of 10.7% versus 9.4% for the S&P 500. Is the evidence that investors prefer dividends to capital gains? Why or why not? 38 Chapter 17 Does Debt Policy Matter? The Effect of Capital Structure in a Competitive Tax Free Environment Financial Risk and Expected Returns The Weighted Average Cost of Capital A Final Word on After Tax WACC 39 M&M (What is it all about?)

What is the capital structure question? Why maximizing equity value and firm value is the same (under what assumptions)? 40 M&M (Debt Policy Doesnt Matter) Modigliani & Miller It makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. Major Assumptions (not all): (1) Individuals and firms borrow/lend at same rate. (2) No Bankruptcy costs (3) No transaction costs (4) No taxes 41 The Idea.. Can We Create Value By Splitting a Pie?

The derivation is straightforward: Shareholders in a levered firm receive Bondholders receive EBIT rD D rD D Thus, the total cash flow to all stakeholders is ( EBIT rD D) rD D The present value of this stream of cash flows is VL Clearly ( EBIT rD D) rD D EBIT The present value of this stream of cash flows is VU VL VU 42 M&M (Debt Policy Doesnt Matter) Dollar Investment Dollar Return .01VU .01 Profits

Debt Equity Total Dollar Investment Dollar Return .01DL .01EL .01(DL E L ) .01VL .01 Interest .01 ( Profits - Interest) .01 Profits 43 M&M (Debt Policy Doesnt Matter) Dollar Investment Dollar Return .01E L

.01 ( Profits - interest) .01(VL DL ) Dollar Investment Dollar Return Borrowing .01DL - .01 Interest Equity .01VU .01 Profits Total .01(VU DL ) .01 ( Profits - Interest)

44 Example 1 Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000

$8,000 $12,000 2/3 8% 240 $50 45 EPS and ROE Under Current Capital Structure Recession ExpectedExpansion EBIT $1,000$2,000$3,000 Interest 00 0 Net income $1,000$2,000$3,000 EPS $2.50$5.00$7.50 EBIT/A 5%10% 15% ROE 5%10% 15%

Current Shares Outstanding = 400 shares 46 EPS and ROE Under Proposed Capital Structure Recession ExpectedExpansion EBIT $1,000$2,000$3,000 Interest 640640 640 Net income $360$1,360$2,360 EPS $1.50$5.67$9.83 EBIT/A 5%10% 15% ROE 3%11% 20% Proposed Shares Outstanding = 240 shares 47 EPS and ROE Under Both Capital Structures All-Equity Recession

EBIT $1,000 Interest 0 Net income $1,000 EPS $2.50 EBIT/A 5% ROE 5% Current Shares Outstanding = 400 shares EBIT Interest Net income EPS EBIT/A ROE Expected $2,000 0

$2,000 $5.00 10% 10% Expansion $3,000 0 $3,000 $7.50 15% 15% LeveredRecessionExpected Expansion $1,000$2,000 640640 $360$1,360 $1.50$5.67 5%10% 3%11%

$3,000 640 $2,360 $9.83 15% 20% Proposed Shares Outstanding = 240 shares 48 Financial Leverage and EPS 12.00 Debt 10.00 EPS 8.00 6.00 4.00 No Debt

Advantage to debt Break-even point 2.00 0.00 1,000 (2.00) Disadvantage to debt 2,000 3,000 EBI EBIT in dollars, no taxes 49 Homemade Leverage

Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 Less interest on $800 (8%) $64 Net Profits $36 ROE (Net Profits / $1,200) 3% $200 $64 $136 11% $300 $64 $236 20% We are buying 40 shares of a $50 stock on margin. We

get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is: D $800 2 3 E $1,200 50 Homemade (Un)Leverage RecessionExpectedExpansion EPS of Levered Firm $1.50$5.67$9.83 Earnings for 24 shares $36$136$236 Plus interest on $800 (8%) $64$64 $64 Net Profits $100$200$300 ROE (Net Profits / $2,000) 5%10% 15% Buying 24 shares of an other-wise identical levered firm along with the some of the firms debt gets us to the ROE of the unlevered firm.

This is the fundamental insight of M&M 51 M&M (Debt Policy Doesnt Matter) Example (text) - Macbeth Spot Removers - All Equity Financed Data Number of shares Price per share 1,000 $10 Market Value of Shares $ 10,000 Outcomes A B C D Operating Income

$500 1,000 1,500 2,000 Earnings per share Return on shares (%) $.50 5% 1.00 10 1.50 15 2.00 20 Expected outcome 52 M&M (Debt Policy Doesnt Matter) Example cont.

50% debt Data Number of shares Price per share Market Value of Shares Market value of debt 500 $10 $ 5,000 $ 5,000 Outcomes Operating Income Interest Equity earnings Earnings per share Return on shares (%) A $500 $500 $0

$0 0% B 1,000 500 500 1 10 C 1,500 500 1,000 2 20 D 2,000 500 1,500 3 30

53 M&M (Debt Policy Doesnt Matter) Example - Macbeths - All Equity Financed - Debt replicated by investors Outcomes A B C D Earnings on two shares $1.00 2.00 3.00 4.00 LESS : Interest @ 10% $1.00 1.00 1.00 1.00

Net earnings on investment $0 1.00 2.00 3.00 Return on $10 investment (%) 0% 10 20 30 54 No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio.

AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole. Proposition I and Macbeth Macbeth continued Expected earnings per share ($) Cuttent Structure : Proposed Structure : All Equity Equal Debt and Equity 1.50 2.00 Price per share ($) Expected return per share (%) 56 Leverage and Returns expected operating income Expected return on assets ra market value of all securities

D E rA rD rE DE DE 57 M&M Proposition II Macbeth continued (All equity firm) D rE rA rA rD E expected operating income rE rA market value of all securities 1500

.15 10,000 58 M&M Proposition II D rE rA rA rD E Macbeth continued (D/E=1) expected operating income market value of all securities 1500 .15 10,000 rE rA 5000 rE .15 .15 .10 5000 .20 or 20%

59 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares All Allequity equity Earnings Earningsper pershare share($) ($) Return Returnon onshares shares 50 50% %debt debt:: Earnings Earningsper pershare share($)

($) Return Returnon onshares shares Operating Operating $1,500 $1,500to to 1.50 1.50 15% 15% 22 20% 20% Income Income $500 $500 0.50

0.50 5% 5% 00 00 Change Change --$1.00 $1.00 --10% 10% --$2.00 $2.00 --20% 20% 60 Leverage and Returns Market Value Balance Sheet example Asset Value Asset Value

rd = 7.5% re = 15% 100 100 Debt (D) 30 Equity (E) 70 Firm Value (V) 100 D E rA rD

r E D E D E 30 70 rA .075 . 15 12.75%

100 100 61 Leverage and Returns Market Value Balance Sheet example continued What happens to Re when debt costs rise? Asset Value Asset Value 100 100 Debt (D) 40 Equity (E) 60

Firm Value (V) 100 rd = 7.5% changes to 7.875% re = ?? 40 60 .1275 .07875 re 100 100 re 16.0% 62 Leverage and Returns DD EE

BBAA BBDD BBEE VV VV DD BBEE BBAA BBAA BBDD EE 63 r M&M Proposition II rE rA rD Risk free debt Risky debt

D E 64 WACC (traditional view) r rE WACC rD D V 65 After Tax WACC Tax Adjusted Formula E D WACC rD (1 Tc ) rE V V 66

After Tax WACC Example - Union Pacific The firm has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC? 67 After Tax WACC Example - Union Pacific - continued Balance BalanceSheet Sheet(Market (MarketValue, Value,billions) billions) Assets 22.6 7.6 Debt Assets

22.6 7.6 Debt 15 Equity 15 Equity Total 22.6 22.6 Totalassets assets 22.6 22.6 Total Totalliabilities liabilities MARKET VALUES 68 Summary: No Taxes In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I:

VL = VU Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of no taxes, M&M Proposition II states that leverage increases the risk and return to stockholders D rE rA (rA rD ) E 69 Question (illustrating Prop I and II) a. b. c. d. Turtle Motors, and all-equity firm, has an expected cash flow of $10 million per year in perpetuity. There are 10 million shares outstanding, implying expected annual cash flow of $1 per share. The cost of capital for this unlevered firm is 10%. The firm will soon

build a new plant for $4 million. The plant is expected to generate additional cash flow of $1 million per year. Find the projects NPV Write down the market value balance sheet of Turtle Motors before and after the new project is announced (assume efficient capital markets and that the firm announces it will raise equity to finance the new plant). Assume the firm decides to finance the new project by issuing shares. Write down the market balance sheet upon share issuing and upon payment of the project. How many shares are issued? Describe the change in firm value, shareholders required return and share price throughout the process. Repeat (c) but assume that the firm decides on issuing debt which entail a 6% interest in perpetuity. 70 Chapter 18 How Much Shout a Firm Borrow Corporate Taxes and Value

Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices 71 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. 72 Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders. Income Statement of Firm U

Earnings before interest and taxes Interest paid to bondholders Pretax income Tax at 35% Net income to stockholders Total income to both bondholders and stockholders Interest tax shield (.35 x interest) $1,000 1,000 350 650 $0+650=$650 $0 Income Statement of Firm L $1,000 80 920 322 598

$80+598=$678 $28 73 Capital Structure & Corporate Taxes 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 $2,000,000. Should you do this and why? ($ 1,000 s) EBIT Interest Pmt Pretax Income Taxes @ 35% Net Cash Flow All Equity 900 0 900 315

585 1/2 Debt 900 100 800 280 520 Total Cash Flow All Equity = 585 *1/2 Debt = 620 (520 + 100) 74 Capital Structure & Corporate Taxes 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 75 The MM Proposition I (Corp. Taxes) Shareholders in a levered firm receive Bondholders receive ( EBIT rD D) (1 TC ) rD D Thus, the total cash flow to all stakeholders is ( EBIT rD D) (1 TC ) rD D The present value of this stream of cash flows is VL Clearly ( EBIT rD D) (1 TC ) rD D EBIT (1 TC ) rD D (1 TC ) rD D EBIT (1 TC ) rD D rD DTC rD D The present value of the first term is VU The present value of the second term is TCD VL VU TC D

76 The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: VL VU TC D Since VL E L D E L D VU TC D VU EL D(1 TC ) The cash flows from each side of the balance sheet must equal: EL rE DrD VU rA TC DrD E L rE DrD [ E L D(1 TC )]rA TC rD D Divide both sides by EL D D D rE rD [1 (1 TC )]rA TC rD EL EL EL D

rE rA (1 TC ) (rA rD ) Which quickly reduces to EL 77 The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital: r (%) rE rA rE rA D (rA rD ) EL D (1 TC ) (rA rD ) EL rA

rWACC D EL rD (1 TC ) rE DEL D EL rD Debt-to-equity ratio (D/EL) 78 Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-Equity EBIT Interest EBT Taxes (Tc = 35% Total Cash Flow to S/H Recession $1,000

0 $1,000 $350 Expected $2,000 0 $2,000 $700 Expansion $3,000 0 $3,000 $1,050 $650 $1,300 $1,950 LeveredRecessionExpected EBIT

Interest ($800 @ 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H): EBIT(1-Tc)+TCrDD Expansion $1,000$2,000 $3,000 640640 640 $360$1,360 $2,360 $126$476 $826 $234+640$468+$640$1,534+$640 $874$1,524 $2,174 $650+$224$1,300+$224$1,950+$224 $874$1,524 $2,174

79 Capital Structure & Corporate Taxes Pfizer Balance Sheet, March 2004 (figures in $millions) Net working capital Long-term assets Total assets Net working capital PV interest tax shield Long-term assests Total assets Book values 10,752 7,144 21,460 86,900 69,048 97,652 97,652

Long-term debt Other long-term liabilities Equity Total value Market values 10,752 7,144 2,500 21,460 283,373 268,021 296,625 296,625 Long-term debt Other long-term liabilities Equity Total value 80 Capital Structure & Corporate Taxes Pfizer Balance Sheet, March 2004 (figures in $millions)

(w/ $1 billion Debt for Equity Swap) Net working capital Long-term assets Total assets Net working capital PV interest tax shield Long-term assests Total assets Book values 10,752 8,144 21,460 86,900 68,048 97,652 97,652 Long-term debt Other long-term liabilities Equity Total value

Market values 10,752 8,144 2,850 21,460 283,373 267,371 296,975 296,975 Long-term debt Other long-term liabilities Equity Total value 81 Can Debt Be So Valuable? 1. What about personal taxes? 2. Perhaps firms that borrow incur other costs bankruptcy costs, for example. 82 C.S. & Taxes (Personal & Corp)

Relative Advantage Formula ( Debt vs Equity ) 1-Tp (1-TpE) (1-Tc) RAF > 1 Advantage Debt RAF < 1 Equity 83 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 84 C.S. & Taxes (Personal & Corp) Example Income before tax Less corporate tax at Tc =.35 Income after corporate tax Personal tax at Tp = .35 and Tpe = .105 Income after all taxes Interest Equity Income $1 0

1 0.35 $0.675 $1 0.35 0.65 0.068 $0.582 Advantage to debt= $ .068 85 Personal Taxes The value of a levered firm can be expressed in terms of an unlevered firm as: (1 TC ) (1 TpE ) VL VU 1 D 1 TP

Where: TpE = personal tax rate on equity income TP = personal tax rate on bond income TC = corporate tax rate 86 Value of Leverage with Personal Taxes The derivation is straightforward: Shareholders in a levered firm receive ( EBIT rD D ) (1 TC ) (1 T pE ) Bondholders receive rD D (1 Tp ) Thus, the total cash flow to all stakeholders is ( EBIT rD D) (1 TC ) (1 TpE ) rD D (1 Tp ) This can be rewritten as (1 TC ) (1 TpE ) EBIT (1 TC ) (1 TpE ) rD D (1 Tp ) 1 1 Tp 87 Continued

Value of Leverage with Personal Taxes The total cash flow to all stakeholders in the levered firm is: (1 TC ) (1 TpE ) EBIT (1 TC ) (1 TpE ) rD D (1 Tp ) 1 1 Tp The first term is the cash flow of an unlevered firm after all taxes. The second term is the advantage of leverage. Its PV in perpetuity is. (1 TC ) (1 TpE ) D 1 1 Tp

The value of the sum of these Its value = VU. two terms must be VL (1 TC ) (1 TpE ) VL VU 1 D 1 TP 88 Value of firm (V) Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes VU (1 TC ) (1 T pE ) VL VU 1

D 1 Tp VL = VU+TCD TpE T p VL > VU T pE T p and (1 - Tp ) (1 TC ) (1 TpE ) VL =VU VL < VU TpE Tp and (1 - Tp ) (1 TC ) (1 TpE ) (1 - Tp ) (1 TC ) (1 TpE ) Debt (D) 89 Capital Structure Structure of Bond Yield Rates

r Bond Yield D E 90 Costs of Financial 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. 91 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 Strategy 1: Incentive to take large risks Selfish Strategy 2: Incentive toward underinvestment Selfish Strategy 3: Cash In and Run Other 92 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

93 Financial Distress Market Value of The Firm Maximum value of firm Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt 94 Conflicts of Interest (1)

Circular File Company has $50 of 1-year debt. Why does the equity have any value ? Circular CircularFile 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 Circular CircularFile 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 95 Conflicts of Interest (1) Circular File Company 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? 96 Conflicts of Interest (1) 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 97 Conflicts of Interest (2) Assumes a safe project with NPV = $5 and initial outlay of $10 Circular CircularFile 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 Circular CircularFile FileCompany Company(Market (MarketValues) Values) Net W.C. 20 33 Bonds Net 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 may rise by pursuing project, the lack of a high potential payoff for shareholders makes shareholders reject the project. 98 Example 2

Balance Sheet of Faster Airlines Assets BVMVLiabilities Cash $200$200LT bonds Fixed Asset $400$0Equity $300 Total $600$200Total $600 BVMV $300 $200 $0 $200 What happens if the firm is liquidated today? The bondholders get $200; the shareholders get nothing. Faster Airlines is contemplating on being the first to buy a new jet that can make the Vancouver-London flight in 2 hours. 99

Example 2 The Gamble Win Big Lose Big Probability 10% 90% Payoff $1,000 $0 Cost of investment is $200 (all the firms cash) Required return is 50% Expected CF from the Gamble = $1000 0.10 + $0 = $100 $100 NPV = $200 + (1.50) NPV = $133 100 Example 2

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 Stocks With the Gamble = $70 / 1.5 = $47 101 Example 2 (cont) Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200) so the stockholders will have to supply an additional $100 to finance the project Required return is 10% $350 NPV $300 1.10 NPV $18.18 Should we accept the project?

102 Example 2 (cont) Expected 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 = -$54.55 103 Cash In and Run (example 2 cont) 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 shareholders. Such tactics often violate bond indentures. Increase perquisites to shareholders and/or management 104

Protective Covenants Agreements to protect bondholders Negative covenant: Thou shalt not: Pay dividends beyond specified amount. Sell more senior debt & amount of new debt 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 financial information. Segregate and maintain specific assets as security for debt. 105 Other Financial Distress Games

Playing for Time Bait and Switch 106 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. 107 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.

108 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 last resort. equity as a The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance. 109 The Pecking-Order Theory Theory stating that 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 financial slack 110 How Do Companies Behave in Reality? Most 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 Capital Structure Across Industries (Note that growth implies significant equity financing, even in a world with low bankruptcy costs). There is Evidence that Firms Behave as If They had a Target Debt-toEquity ratio. 111 A Recipe for Capital Structure Decisions 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. Pecking Order and Financial Slack Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. 112 Summary and Conclusions Costs of financial distress cause firms to restrain their issuance of debt. 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 Pecking order provides another issue to consider the

signaling to the market There are other practical issues to consider such as tangibility of assets, variability of EBIT, etc. 113 Practice Q1: M&M (Taxes) Big-Red Company has $2 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firms debt is held by one institution that is willing to sell it back to Big-Red for $2 million. Once Big-Red becomes an all equity firm, it will remain unlevered forever. If Big-Red does not retire the debt, the company will use the $2 million in cash to buy back some of its stock on the open market. The company will generate $1.1 million of annual earnings before interest and taxes in perpetuity regardless of its capital structure. The firm immediately pays out all earnings as dividends at the end of each year. Big-Red is subject to corporate tax rate of 35%, and the required rate of return on the firms unlevered equity is 20%. The personal tax rate on interest is 25% and the personal tax rate on equity is 10%. Ignore bankruptcy costs. a. What will be the value of Big-Red if it chooses to retire all of its debt and become an unlevered firm? b. What will be the value of Big-Red if it decides to repurchase stock instead of retiring the debt?

114 Practice Q2: Financial Distress Water Corp. economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Water Corp. must choose between two mutually exclusive projects. Assume that the firm will liquidate one year from today (the day of the projects payoff). Water Corp. is obliged to make a $500 payment to bondholders at the end of the year. Assume the firms shareholders are risk-neutral. Consider the following information pertaining to the two projects: 115 Practice Q2: Financial Distress (cont) Economy Prob Project Value Payoff of Firm

Value Equity Value Debt Low Risk Project Bad 0.5 $500 $500 $0 $500 Good 0.5 700 700 200 500 High Risk Project Bad 0.5 $100 $100

$0 $100 Good 0.5 800 800 300 500 A. Which of the two projects maximizes the value of the firm? B. What is the value of the firms equity if the low risk project is undertaken, if the high risk project is undertaken? C. Suppose that bondholders are fully aware that shareholders might choose to maximize equity value rather than total firm value. To minimize this agency cost, the firms bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Water Corp. chooses to take on the high-risk project. By how much would bondholders need to raise the debt payment so that shareholder would be indifferent between the two projects?116

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