CAPITAL STRUCTURE WITH TAXES AND FINANCIAL DISTRESS COSTSOutline for toda y• Demonstrate how leverage can aff ect 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, corpor ate 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 PaymentsExample• 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 lever age? SolutionHow large is the interest tax shield?Taxes, 648Taxes, 525Debt, 350Equity, 1202Equity, 9750200400600800100012001400160018002000Without leverage With leverageCash flowInterest tax shieldEBITThe 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 tak e 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)• 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 ha ve the same risk as the debt itself, so we can discount them at the cost of debt How do we calculate the present value of the interest tax shield?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:PV Interest tax shield  $42 million ∗ 10.06∗ 111.06 $309 million• 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 shieldExample: 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 repurchaseExample: 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)•