CAPITAL STRUCTURE WITH TAXES AND FINANCIAL DISTRESS COSTS Outline for today Demonstrate how leverage can affect firm value through the tax benefit of debt and financial distress costs Show how the optimal mix of debt and equity trades off the benefits of debt tax advantage and the costs of debt financial distress costs Market imperfections can make capital structure relevant We previously assumed that the financing choice did not affect the total cash flows or value of the firm MM Capital structure is irrelevant Often called the irrelevance principle But corporate taxes favor debt Corporations can deduct interest expenses This reduces taxes paid to the government and increases amount to pay investors increases value of the firm How much more to investors Interest Tax Shield Corporate Tax Rate Interest Payments Example Safeway has earnings before interest and taxes of 1 85 billion Their interest expense is 350 million and their Corporate tax rate is 35 What is Safeway s total payments to all investors What would the total payments be without leverage Solution How large is the interest tax shield 2000 EBIT 1800 1600 Cash flow 1400 1200 Equity 975 Equity 1202 1000 800 Debt 350 600 400 Taxes 648 200 Taxes 525 0 Without leverage With leverage Interest tax shield The interest tax shield increases firm value Cash flows of a levered firm are equal to the sum of the cash flows from an unlevered firm plus the interest tax shield Cash Flows to Investors with Leverage Cash Flows to Investors without Leverage Interest Tax Shield Let s take the present value of these cash flows PV Cash Flows to Investors with Leverage PV Cash Flows to Investors without Leverage PV Interest Tax Shield MM Proposition I with taxes Value of Levered Firm Value of Unlevered Firm PV Interest Tax Shield How do we calculate the present value of the interest tax shield Suppose a firm borrows debt D and keeps this debt amount permanently The firm s marginal tax rate is tc and the debt has interest rate rd The interest tax shield each year is tc rd D and this tax shield can be valued as a perpetuity What discount rate If debt amount is fixed the tax savings have the same risk as the debt itself so we can discount them at the cost of debt Example PV of interest tax shield Suppose ECB Inc borrows 2 billion by issuing 10 year bonds ECB s cost of debt is 6 The interest payments will be 120 million each year for the next 10 years The principal of 2 billion will be repaid in year 10 ECB s marginal tax rate is 35 By how much does the interest tax shield from this debt increase the value of ECB Solution The interest tax shield each year is 35 120 million 42 million Valued as a 10 year annuity and discounted at the cost of debt the tax savings are worth 1 1 PV Interest tax shield 42 million 1 309 million 0 06 1 06 Note Because only interest is tax deductible the final repayment of principal in year 10 is not deductible so it does not contribute to the tax shield Example Raising debt to repurchase shares Midco Industries currently has 20 million shares outstanding with a market price of 15 per share and no debt Midco s marginal tax rate is 35 Management plans to borrow 100 million on a permanent basis and use the borrowed funds to repurchase shares How does this transaction affect the value of Midco Solution Without leverage VU 20 million shares 15 share 300 million If Midco borrows 100 million the present value of the firm s future tax savings is PV interest tax shield cD 35 100 million 35 million Thus the total value of the levered firm will be VL VU cD 300 million 35 million 335 million The value of the new debt is 100 million so the new value of the equity will be E VL D 335 million 100 million 235 million Note Although the value of the shares outstanding drops to 235 million shareholders will also receive the 100 million in cash that Midco will pay out through the share repurchase Example Raising debt to repurchase shares 2 What price will Midco repurchase the shares at Suppose Midco were to repurchases its shares at the current price of 15 share the firm would repurchase 100 million 15 share 6 67 million shares Midco will then have 20 million 6 67 million 13 33 million shares outstanding The total value of equity is 235 million therefore the new share price is 17 625 share But if the shares will be worth 17 625 share after the repurchase why would shareholders sell their shares back to Midco for 15 share in the first place The alternative for shareholders is to wait and have the shares be worth 17 625 Example Raising debt to repurchase shares 3 To resolve this puzzle note that the value of the Midco s equity will rise immediately from 300 million to 335 million after the debt issuance announcement So the share price will rise to 335 million 20 million shares 16 75 per share Midco will then repurchase 100 million 16 75 share 5 97 million shares so there are 14 03 million shares remaining The remaining shares value is now 235 million 14 03 16 75 so the shareholders who tender their shares are indifferent between tendering and holding on to the shares WACC with Taxes With tax deductible interest the effective cost of debt capital is rD 1 c and WACC is the familiar rwacc E D rE rD 1 c E D E D rwacc E D D rE rD rD c E D E D E D Pretax WACC Reduction Due to Interest Tax Shield The higher the firm s leverage the more the firm exploits the tax advantage of debt and the lower its WACC Comparing WACC with and without taxes VL and WACC We can value a levered firm VL by discounting its free cash flow using the weighted average cost of capital Since we typically use the same WACC for every year of cash flow we re implicitly assuming that the firm will maintain its debt equity ratio fixed If the firm does not maintain a constant debt equity ratio we instead need to value the unlevered firm and the tax shield separately VL VU PV Interest Tax Shield For example if the amount of debt is fixed the debt equity ratio will vary over time as the equity value changes This is the principle behind APV Adjusted Present Value to be discussed a little later in the course Including Personal Taxes in the Interest Tax Shield Cash flows to investors are typically taxed also at the personal level Interest payments are taxed as income Equity investors must pay taxes on dividends and capital gains The tax on interest income is often higher than the tax on dividends and capital gains This can offset some of the corporate tax benefits of debt To determine the