Debt I. and val ue
We examine two important stories for the benefit and cost tradeoffs from using debt. Later we will examine more stories A. Tax shields and bankruptcy cost B. Agency costs of debt and equity C. Sum up
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Income Statement
Sales t COGS and SG&A t EBDITAt DDEPt EBIT t Interest Expenset EBT t Taxest NIt
Earnings before depreciation, interest and taxes Depreciation Earnings before interest and taxes The borrowing rate times the par value; rBB Earnings before taxes T x [EBIT rBB], where T is the tax rate Net Income ( Profit ); (1 T)x[EBIT rBB]
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A. Debt tax shields and bankruptcy cost
Look at the tax shield f rom the debt, Company U Company L TxEBIT Tx[EBIT - rBB] TxEBIT TxEBIT - TxrBB Co. L pays TrBB less in taxes. T his is worth
TrBB = TxB. So V L = V u + TB rB
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Example I.1, Debt tax shield
EBIT = $150, T=30%, and rA = 13.33%. The firm issues $375 in perpetual bonds, at interest cost of 8%. By how much does f irm value change? Per period tax savings are TrBB = $9.The present value of these savings is TrBB/ rB = TB = $9/.08 = $112.5!
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Bankruptcy
The firm is in financial distress when operating cash flows are insuf ficient to meet current obligations, and the firm must take some sort of corrective action. But bankruptcy alone does not destroy value (it is priced in-a zero sum game in which some win and some lose). It is bankruptcy cost that destroys value.
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The Absolute Priority Rule
Claims are f ully satisfied by seniority. Creditors: nSecured: Paid first, may not be paid in f ull nUnsecured: Paid after secured is paid in f ull may receive nothing Equity holders: Paid last and likely paid nothing
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How to go bankrupt?
Private workout: n Lower direct costs than bankruptcy n Fewer advantages f or stockholders, since absolute priority tends to be violated in bankruptcy settlements Formal bankruptcy: n Allows DIP debt that is senior to outstanding n Tax carry-forwards are preserved n Easier for more complicated capital structures
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Expected bankruptcy cost
Direct costs (2% to 5%) are legal expenses, accounting fees, and administrative costs. Indirect (17%) costs are sales lost due to heightened chance of bankruptcy. Ex ante, expected costs are smaller depending on the probability of bankruptcy E[BCost] = Pbankrupt(Lev)xBankruptcyCosts
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2. Non-debt tax shields
Firms may have non -debt tax shields, like depreciation expense, investment tax credits, and loss -carry forwards that compete with the debt interest tax shield. Redundant (i.e., competing) tax shields can cause declining marginal benef its of debt financing.
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Example I.2, Non-debt tax shield
THE CO. has no non -debt tax shields, EBDIT A is $400, and T= 50%. THE CO. is all equity financed. Compute THE CO. s tax bill. Pro Forma Income EBDITA $400 Non-debt tax shields 0 rB B 0 EBT $400 Taxes (@ 0.5) $200
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Example I.2, Non-debt tax shields
Evaluate two borrowing strategies B $2000 $4000 EBDITA $400 $400 Non-debt tax shields 0 0 rB B $200 $400 EBT $200 $0 Taxes $100 $0 Debt subsidy, T rBB: $100 $200 Debt subsidy value = $1,000 $2,000 TxB (1/2)($2000) (1/2)( $4000)
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Example I.2, Non-debt tax shields
B EBDITA Non-debt tax shields rB B EBT Taxes Debt subsidy, T rBB: Debt subsidy value = $2000 $400 $200 $200 $0 $0 $100 $1,000 TB=5($2000) TB $4000 $400 $200 $400 $0 $0 $100 $1,000 TB/2=.5($2000) T(1/2)B
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Debt versus non -debt tax shields
In effect, as leverage increases the non-debt tax shield lowers the tax rate in the debt tax shield. T he firm receives only a f raction g(L) of the debt tax shield Vl = V u + g(L)TB g(L) is near one at low leverage and fall at higher leverage. For the earlier example, g(L) = 1/2. In the example, the second firm has not benef it from the added debt due to non-debt tax shields.
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3. There are personal taxes
We note more tax ef fects arise because investors pay personal taxes on their income f rom corporations.
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As more pre tax income is used to service debt, less income is paid as stockholder dividends. T hus, more debt lowers stockholders taxes on dividends. Bondholders pay taxes on their interest income. As more debt is used bondholders pay more taxes on interest income.
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The tax shield-bankruptcy cost story
Debt is increased as long as the tax benefits exceed the bankruptcy costs.
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Rising tax benefits
Rising bankruptcy costs
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B. Agency Costs
A second capital structure story is agency problems; between stockholders and bondholders, and between stockholders and managers. We view agency costs as the sum of debt agency costs A(B), and equity agency costs A(S), A(T) = A(B) + A(S)
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1. A(B): Debt Agency Costs
Management, acting in stockholders interests, may make decisions that help stockholders at bondholders expense. Debt agency costs are the loss in value due to this stockholder -bondholder conflict.
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a. Underinvestment or debt overhang
A troubled firm s new investment might raise f irm value but not stockholders wealth. Acting in stockholders interest, management may turn down such projects, hurting bondholders.
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Example I.3, Debt overhang
Assets are worth $120 or $80 if times are good (prob. = .5) or bad (prob. = .5), and debt par value is $100. A new project costing $25 has present value of $30 in good or times, bad so NPV is $30 -$25 = $5, for sure! Should management accept this project ? Assume the interest rate is zero.
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Example I.3, Debt overhang
If the project is not taken, the returns to bondholders and stockholders are, Payoff Value Good (.5) Bad (.5) Bonds $100 $80 $90 Stocks $20 $0 $10 V = $100
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Example I.3, Debt overhang
If the project is taken, what are the returns to bondholders and stockholders? Project Value Good (.5) Bad (.5) Bonds $100 $80+$20 $100 Stocks $20+$30-$25 $0+$10-$25 $5 V = $105
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Example I.3, Debt overhang
Management, in stockholders interests, turns down the project despite its positive net present value. So there is underinvestment and lost value: Agency cost of debt overhang or underinvestment Underinvestment is more severe when the f irm is in financial distress, and worse for firms having more growth assets. A role here f or spin-offs, sell-offs and project f inance.
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b. Risk shifting to bondhol ders Example I.4
A firm is financed claiming all f unds will be invested in risk-free T-bills, whether the f uture is good (prob. = .5) or poor ( prob. = .5). What is the value of the debt and equity? Payoff Good (.5) Bad (.5) $100 $100 $100 $100 Value $100 $100 V = $200
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Bonds Stocks
Example I.4, Risk shifting
Now management sells the T -bills and reinvests the funds into a risky project that pays $350 if the year is good and $50 if the year is bad. What is the value of the debt and equity? Payoff Good (.5) Bad (.5) $100 $50 $250 $0 Value $75 $125 V = $200
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Bonds Stocks
Example I.4, Risk shifting
By increasing the risk of the assets without increasing firm value, management has expropriated wealth from bondholders to stockholders. Bondholders will spend resources to prevent this, which is more agency costs of debt.
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c. Other debt agency costs
Equity W ithdrawal
Management may try to s imply pay out the fi rm s wealth directly to stockholders, before bondholders can stop them.
Protective covenants
Bondholders protect themselves against wealth expropriation by contracting in advance, restricting the courses of action management may take, with protec tive covenants in the bond indenture. Covenants are a form of debt agenc y costs.
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d. A(B) and Leverage
Debt agency costs are largest when the f irm is heavily debt financed. As leverage decreases, there is less chance for debt agency costs to arise, and debt agency costs decrease.
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2. A(S): Equity Agency Costs
Equity agency costs are the losses arise f rom the stockholder -management conflict, as management and stockholders interests diverge. Here we note three costs, FCF/Overinvestment Shirking and perquisites Monitoring
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a. Free Cash Fl ow/Overinvestment
Free cash flow (FCF) is cash in excess of that needed to take on all positive net present value projects. Without discipline management may invest FCF in negative NPV projects. FCF thus causes conf licts over the use of funds. There is overinvestment in negative NPV projects and waste. T hese agency costs of FCF are worse if managers tend to maximize growth, rather than firm value. FCF is not FCFF in our valuation models!
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Why do managers l ike FCF?
It puts more resources under their control. They can grow the firm, yielding the ability to reward middle managers with promotions, rather than, or in addition to bonuses.
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Overinvestment
Cash Core business Diversified asset s Managers invest FCF and diversify asset s wastefully, as they can t manage a bigger firm efficiently.
Moderate debt
Using FCF to takeover other firms, may rid FCF better than will diversification.
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b. Other equity agency costs
Shirking and perquisites
Consumption goods for management. E.g., buying and using a corporate jet for personal use. More difficult to assess examples include foolish investments (e.g., lousy mergers).
Monitoring costs
One way to obtain monitoring is to pay dividends. This increases the probability that the firm will hire an investment bank to raise more capital, inducing monitoring by the bank .
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A(S) and Leverage
Equity agency costs are largest if the firm is all equity, when stockholders have maximum wealth subject to losses. More leverage reduces their wealth under management control and thus equity agency costs. Debt causes payout of FCF, motivating managers and their organization, lowering costs an reducing wasteful expenditures, to behave more efficiently. Raises the probability the firm will have to use the primary market and be monitored.
Note debt beats dividends as it has bonding power; management can skip the dividend but will go into bankruptcy if interest is not paid.
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c. Resolving Agency Costs
Internal Controls Bolckholders Board oversight Compensation policy Decision function Top-down monitoring Bottom-up monitoring Using leverage Using dividends
External Controls Corporate control market Primary market Product and factor markets
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The agency cost story
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Debt is increased as long as the overinvestment benefits exceed the underinvestment costs.
Reduced FCF, hence less overinvestment , and less perquisite consumption
Rising costs of underinvestment , and risk shifting
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C. Sum: Tax and agency cost stories
V
V l = V u + g(L)TB - E[Bcost] - [A(S) + A(B)]
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