Chapter 16 Capital Structure Limits to the Use of Debt

16.1 a. b. c. d. 16.2 a. V = ($250 x 60% + $100 x 40%) / (1+12%) = $169.64 million under risk neutrality. S = ($100 x 60% + $0 x 40%) / (1+12%) = $53.57 million The total stock value of the firm is $53.57 million. Assume the expected debt payment in case of recession is $X million. B = ($150 x 60% + $X x 40%) / (1+12%) = $108.93 million  X = $80 million Therefore, the bankruptcy cost is expected to be $20 (=100 - 80) million with a probability of 40% in recession. Firm value, V = S + B = $53.57 + $108.93 = $162.50 million Promised return on bond = ($150 / $108.93) - 1 = 37.70% Duane is not correct. This risk of bankruptcy per se does not affect firm’s value. It is the costs of bankruptcy which lower firm value. VanSant Matta Recession Expansion Recession Expansion EBIT $2.0 $0.8 $2.0 $0.8 Interest 0.75 0.75 1.0 0.8 Earnings after Interest* $1.25 $0.05 $1.0 $0 (Amounts in millions) *Since there are no taxes in this world, earnings after interest (EAI) is the same as earnings after interest and taxes. Thus, EAI is the income available to the common equity holders. The value of each firm is the sum of the value of its stocks and the value of its bonds. Under the assumption of risk-neutrality, the value of the stock is the PV of the expected earnings available to common stockholders. The value of the bonds is the PV of the expected interest payments. VanSant: Stock: Bonds: Firm: $878,260.870 + $652,173.913 = $1,530,434.783 Matta: Stock: Bonds: Firm: $695,652.174 + $834,782.609 = $1,530,434.783 c. If there are significant costs associated with Matta’s insolvency, then the firms’ values will differ. 1 16.3 Direct: Legal and administrative costs: Costs associated with the litigation arising from a liquidation or bankruptcy. These costs include lawyers’ fees, courtroom costs and expert witness fees. Indirect: Impaired ability to conduct business: Loss of sales due to a decrease in consumer confidence and loss of reliable supplies due to lack of confidence by suppliers. Incentive to take large risks: when faced with projects of different risk levels, managers (who often are major stockholders) have an incentive to undertake high risk projects. If the projects pay off, the firm is solvent and the stockholders benefit. If the project does not perform well, then the firm still ends up in bankruptcy, but the bondholders bear the burden. Incentive to under-invest: investments benefit bondholders through their increased cash flows to the firm. This benefit is at the cost of stockholders who usually must finance the investment. Thus, the stockholders may have an incentive to encourage under-investment. Milking the property: In a bankruptcy the bondholders have first claim to the assets of the firm. When faced with a possible bankruptcy, the stockholders have strong incentives to vote themselves increased dividends or other distributions. This will ensure them of getting some of the assets of the firm before the bondholders can lay claim to them. 16.4 The tax carry forwards will make Chrysler’s effective tax rate zero. Therefore, the company does not need any tax deductions such as those provided by debt. Moreover, although the firm faces no taxes, it does face the very real threat of bankruptcy. Additional debt would only increase the likelihood of insolvency. Since the firm does not need the tax shield of debt and because additional debt will increase the probability of bankruptcy, Chrysler should issue equity. 16.5 Look at the expected values of Fountain’s prospective projects. Firm = Stock + Bonds Low-risk $600 = $100 + $500 High-risk $450 = $150 + $300 Stockholders would prefer the high-risk project. Although the expected value of the firm is less, the expected value of the equity is greater. If the bad economy arises, the shareholders receive no benefit irrespective of which project Fountain chooses. If the economy is good, they will receive $100 more with the high-risk project. Notice that there is a significant (50%) probability that the firm will be barely solvent or be pushed into bankruptcy. In such a situation, stockholders have strong incentives to take large risks. If the gamble pays off, they profit highly; if it fails, they are no worse off than if they had played it safe. 16.6 Disagree. If a firm has debt, it might be advantageous to the stockholders for the firm to undertake risky projects, even those with negative NPVs. This incentive comes from the fact that the risk is borne by the bondholders. Therefore, value is transferred from the bondholders to the shareholders by undertaking risky (including negative NPV) projects. This incentive is even stronger when the probability and costs of bankruptcy are high. 2 16.7 Bondholders need to raise the debt payment to $140 in case of a high risk project being taken, so that the expected payoff to stockholders in either case would be 50% x 0 + 50% x 100 = 50. This example implies that rational bondholders can price to protect themselves ex ante and stockholders ultimately are to bear the cost of selfish investment strategy by paying a higher interest demanded by the creditors. 16.8 i. ii. iii. Protective covenants: Agreements in the bond indenture which are designed to decrease the cost of debt. 1. Negative covenants: Prohibit company actions which would cause bondholders to require higher returns. 2. Positive covenants: Require actions which are designed to ensure bondholders of company solvency. Repurchase Debt: Eliminate the costs of bankruptcy by eliminating the debt. Consolidation of debt: Decrease the number of debt holders, thereby decreasing the direct costs should bankruptcy occur. 16.9 The MM Proposition with corporate tax suggests that there is positive tax advantage of debt financing. However, in reality, it cannot be optimal for a firm to adopt an all-debt financing strategy. Due to the direct and the indirect financial distress costs and the agency costs of debt, there can exist an optimal level of debt-equity ratio, i.e. optimal capital structure. At the optimal point, there is no marginal benefit to the increase/decrease of debt anymore. 16.10 There can be two major sources of the agency costs of equity. One, shirking of the management due to the fact that management doesn’t own all of the stocks of the firm. Two, more on the job perquisites for the management. These two elements constitute the agency cost of equity and will reduce the firm value accordingly. 16.11 a. Stockholders: Dividends Taxes (0.30) Bondholders: Interest income Taxes (0.30) Equity Plan Debt Plan $1,800,000 540,000 $1,260,000 $990,000 297,000 $693,000 0 0 0 $1,350,000 405,000 945,000 Total cash flows to stakeholders: Equity Plan: $1,260,000 + 0 = $1,260,000 Debt Plan: $693,000 + $945,000 = $1,638,000 Under MM without personal taxes, we know that debt increased the cash flows to all stakeholders. Since interest and dividends are taxed at the same personal rate, personal taxes only reduce the final cash flows to the stakeholders. Personal taxes do not alter the conclusion that debt increases the value of the firm. 3 b. c. The IRS prefers the plan with the higher total amount of taxes paid. That is the equity plan. The total tax bill includes the amounts paid by firms, stockholders and bondholders. Debt: Total taxes = $660,000 + $297,000 + $405,000 = $1,362,000 Equity: Total taxes = $1,200,000 + $540,000 + 0 = $1,740,000 All-equity plan: Debt Plan: d. Stockholders: Dividends Taxes (0.20) Bondholders: Interest income Taxes (0.55) Equity Plan Debt Plan $1,800,000 360,000 $1,440,000 $990,000 198,000 $792,000 0 0 0 $1,350,000 742,500 $607,500 Total cash flows to stakeholders: Equity plan: $1,440,000 + 0 = $1,440,000 Debt Plan: $792,000 + $607,500 = $1,399,500 16.12 a. b. c. 4 MM assume the TC, TB and C(B) are all zero. Under these assumptions, the capital structure is irrelevant. Thus, the debt-equity ratio can be anything. For the model with corporate taxes TC>0, but both TS and C(B) are still zero. Therefore the higher the amount of debt, the higher the value of the firm. In this model the debt-equity ratio should be infinite. In general, if TC>TB the value of the firm rises with additional debt, so the firm should be all-debt. If TC 8.1%. Group A: (1-0.5) rB > 8.1% ==> rB > 16.2% Group B: (1-0.325) rB > 8.1% ==> rB > 12% Group C: (1-0.1) rB > 8.1% ==> rB > 9% Since corporations are paying 12.46% on bonds, groups B and C will place all of their investable funds in bonds. Group A investors will place their money in stocks. The total amount of bonds outstanding is $325 million (= $220 million + $105 million). The value of stocks is the PV of the earnings available to common. S  (EBIT  rB B)(1  TC ) rS [$85,000,000 .1246($325,000,000)](1  0.35) 0.081 $357,138,888.89 Therefore, the market value of all companies is V = $325,000,000 + $357,138,888.89 = $682,138,888.89 d. The total tax bill is the sum of the taxes paid by corporations and individuals. Corporate taxes: [85 million - (12.46%)(325 million)] x 35% = $15,576,750 Interest income: Group B: [($220,000,000)(.1246)](0.325) = 8,908,900 Group C: [($105,000,000)(.1246)](0.10) = $1,308,300 Dividend income: [(357,138,888.89)(.081)](0.5) = $14,464,125 Total taxes = $24,681,325 + $15,576,750 = $40,258,075. 9 16B.3 a. The equilibrium interest rate paid by corporations is 10% [=6% / (1 - 0.4)]. Given the tax rates for the various groups, the investors will invest in bonds for interest rates which exceed: L: 12% M: 10% N: 7.5% O: 6% The indifference interest rate = 6% / (1- TB). The N and O groups will invest in bonds. The M group is indifferent between bonds and stocks. If the Ms put all of their wealth into stocks, the amount of bonds will be $700 million (= $200 million + $500 million). If the Ms put all of their wealth in bonds, the amount of bonds will be $1,000 million (= $200 million + $500 million + $300 million). The amount of equity is given by If Ms buy no bonds, the value of equity is If Ms buy bonds, the value of equity is Thus, the debt-equity ratio can range from $700 million / $800 million = 7/8 to $1,000 million / $500 million = 2. b. If the corporate tax rate is 30%, the equilibrium interest rate will be 8.57%. At this equilibrium, only the N and the O groups will purchase bonds. The amount of equity in the economy is The debt-equity ratio is $700 million / $1,050 million = 0.667. 10