Financing decisions (3) Class 17 Financial Management, 15.414MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Today Financing decisions • Debt, taxes, and the after-tax WACC • Financial distress Reading • Brealey and Myers, Chapter 18, 19.1 – 19.4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Financing decisions M&M theorem Financing decisions don’t affect firm value if … (1) the market is efficient and no asymmetric information (2) tax considerations are unimportant (3) transaction and distress costs are small (4) they do not affect the firm’s investment policies 3MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Trade-off theory VU VU + tax shields of debt VLand distress VL according to MM Optimal capital structure Firm value with tax shields Leverage 4MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Debt and taxes Tax effects of financing Corporate taxes Interest is treated as an expense for corporate tax purposes, dividends are not Personal taxes Interest is taxed at the full income tax rate, while equity income is taxed at a lower rate Capital gains and international tax rules Overall, debt typically has tax advantages Lower overall taxes 5MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 6Debt and taxes Pie theory Debt Equity TaxesMIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Debt and taxes Pie theory →DebtEquity Tax DebtEquity Tax 7MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Example In 2000, Microsoft had sales of $23 billion, earnings before taxes of $14.3 billion, and net income of $9.4 billion. Microsoft paid $4.9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding. Bill Gates is thinking about a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock. How would this transaction affect Microsoft’s after-tax cashflows and shareholder wealth? 8MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Microsoft Balance sheet ($ millions) Year 1997 1998 1999 2000 Cash 8,966 13,927 17,236 23,798 Current assets 10,373 15,889 20,233 30,308 Current liabs 3,610 5,730 8,718 9,755 LT debt 0 0 0 0 Bk equity 9,797 15,647 27,485 41,368 Mkt equity 155,617 267,700 460,770 422,640 Sales 11,358 14,484 19,747 22,956 EBIT 5,314 7,117 11,891 14,275 Taxes 1,860 2,627 4,106 4,854 Net income 3,454 4,490 7,785 9,421 Oper CF 4,689 6,880 10,003 13,961 9MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Microsoft Income statement, 2000 ($ millions) EBIT Interest (r × 50,000) Earnings before taxes Taxes (34%) Net income Cashflow to debtholders Cashflow to equityholders* Total cashflows to D & E Current w/ Leverage $14,275 $14,275 0 3,500 $14,275 $10,775 4,854 3,664 $9,421 $7,111 $0 $3,500 $9,421 $7,111 $9,421 $10,611 *before reinvestment 10MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Debt and taxes Tax savings of debt Marginal tax rate = τ Taxes for unlevered firm ………… τ EBIT Taxes for levered firm …………… τ (EBIT – interest) Interest tax shield ……………… τ interest Interest = rd D Interest tax shield (each year) = τ rd D [Only interest, not principal, payments reduce taxes] 11MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Debt and taxes Value implication 1 With corporate taxes (but no other complications), the value of a levered firm equals VL = VU + PV(interest tax shields) If debt is a perpetuity PV(tax shields) = shields tax per year τ rd D = τ = D rate interest rd VL = VU + τ D 12MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Leverage and firm value VU VL without tax shields (MM) VL with tax shields Firm value 0.00 0.15 0.30 0.45 0.60 Leverage 13MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Microsoft In 2000, Microsoft had EBIT of $14.3 billion. Microsoft paid $4.9 billion in taxes, had a market value of $423 billion, and had no long-term debt outstanding. Bill Gates is considering a recapitalization, issuing $50 billion in long-term debt (rd = 7%) and repurchasing $50 billion in stock. Recapitalization Interest expense = $50 × 0.07 = $3.5 billion Tax shield = $3.5 × 0.34 = $1.19 billion annually PV(tax shields) = 1.19 / 0.07 = 50 × 0.34 = $17 billion* VL = Vu + PV(tax shields) = $440 billion 14MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Microsoft Current After recap Assets Net Assets $423 billion Long-Term Debt $0 Equity $423 billion Liab & Eq Assets Net Assets $440 billion Long-Term Debt $50 billion Equity $390 billion Liab & Eq 15MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Debt and taxes Value implication 2 With corporate taxes (but no other complications), the firm’s WACC declines as leverage increases. Firm value goes up because WACC drops. D ENo taxes: WACC = rD + rE [WACC = rA]AA DEWith taxes: WACC = V -(1 τ) r + rE [WACC < rA]D V 16MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Leverage and the cost of capital 20% 18% 16% 14% 12% 10% 8% 6% rE with taxes rE w/o taxes rA WACC with taxes rD 0 0.2 0.4 0.6 0.8 1 1.2 Debt-to-equity ratio 17MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Financing decisions Advantages of debt Taxes Signaling Corporate control Lower issue costs Should firms be 100% debt financed? What are the costs? 18MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Financial distress Direct costs Managers’ time and effort Legal costs Indirect costs Foregone positive NPV projects Loss of competitive position Lost customers Lost suppliers Asset fire sales and liquidation Loss of interest tax shields 19MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Summary 0 Costs of financial distress Leverage 22MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Trade-off theory VU VU + tax shields of debt VL with tax shields and distress VL according to MM Optimal capital structure Firm value Leverage 23MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Summary Financing checklist Taxes Does the firm benefit from interest tax shields? Signaling and mispricing Is our equity fairly valued? How will investor react? Expected distress costs What are our cash needs going forward (FCFs)? Cashflow volatility? How costly is it to cut back on expenditures? Customer and supplier concerns? Is renegotiation possible? Asset sales? Financially strong competitors? 24MIT SLOAN SCHOOL OF MANAGEMENT 15.414 Class 17 Summary Who should have low debt? Firms with high costs of financial distress Assets cannot be sold easily, high intangibles, high growth