How Much Should a Firm Borrow?Corporate TaxesPresent Value of Tax ShieldTable 18.1: Comparison of Unlevered Firm and Levered Firm with $1000 of Debt at 8%Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:Slide 6Claims on FirmM&M and TaxesPfizer Balance Sheet 2004 and Adjusted for $1 billion Debt for Equity TradeWhat’s Wrong with Pfizer’s CFO?Corporate and Personal TaxesExample – Advantage to DebtExample - continuedCalculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ; Tp = Personal tax rate on interest income = 20% :Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20%Costs of Financial DistressFinancial DistressTypes of Financial DistressCosts of Financial Distress by Asset TypeTrade-off Theory of Capital StructurePecking Order of Financing ChoicesTests of Pecking OrderNext ClassHow Much Should a Firm Borrow?•Student Presentations•Why M & M Does Not Hold–Corporate Taxes–Personal Taxes–Financial Distress•Pecking Order of Financing ChoicesCorporate Taxes•Debt provides a tax shield–Interest is tax deductible–Government’s share of income declines–Value of bondholders’ and stockholders’ share increasesPresent Value of Tax Shield•Present value of tax shield•If debt is assumed to be a perpetuitynttDDcrDrTShieldTaxPV1)1()()(DTrDrTShieldTaxPVcDDc)()(Table 18.1: Comparison of Unlevered Firm and Levered Firm with $1000 of Debt at 8%Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:1 year $1,000,000 loan at 8%A) $25,926B) $28,000C) $35,000D) $350,000E) None of the aboveCompute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:$1,000,000 perpetuity loan at 8%A) $28,000B) $80,000C) $324,074D) $350,000E) None of the aboveClaims on Firm•Bondholders: Debt•Government: Taxes•Equityholders: Remainder of firm valueM&M and TaxesValue of firm = Value of all-equity-financed firm + PV(tax shield)Pfizer Balance Sheet 2004 and Adjusted for $1 billion Debt for Equity TradeACTUALADJUSTEDWhat’s Wrong with Pfizer’s CFO?•Should also consider personal taxes•Cost of financial distressCorporate and Personal TaxesRelative tax advantage of debt vs. equityIf the relative advantage is > 1, debt is preferredIf the relative advantage is < 1, equity is preferredincomeequityontaxPerson alTerestontaxPersonalTLetpEp int)1)(1(1cpEpTTTExample – Advantage to DebtAssume dividends are 40% of earningsEach dollar of earnings generates $0.40 in dividends and $0.60 in capital gainsMarginal investor is in the 35% tax bracket on interest and 15% on dividends and capital gainsDeferral of capital gains reduces capital gains rate in half (to 7.5%)%5.10)5.76(.)154(.  xxTpEExample - continuedInterest Equity IncomeIncome before tax $1 $1Less corporate tax at Tc =.35 0 0.35Income after corporate tax 1 0.65Personal tax at Tp = .35 and Tpe = .105 0.35 0.068Income after all taxes $0.675 $0.582Advantage to debt= $ .068Calculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ;Tp = Personal tax rate on interest income = 20% : A) 0.76 B) 1.16 C) 1.35 D) 1.76E) None of the aboveGiven the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20%A) $0.66 B) $0.25 C) -$0.66 D) -$0.34 E) None of the aboveCosts of Financial DistressValue of firm = Value of all-equity-financed firm + PV(tax shield) – PV(costs of financial distress)Financial DistressDebtMarket Value of The FirmValue ofunleveredfirmPV of interesttax shieldsCosts offinancial distressValue of levered firmOptimal amount of debtMaximum value of firmTypes of Financial Distress•Bankruptcy costs–Direct: legal and court costs–Indirect: Inefficient operations, creditors, employees, suppliers, customers•Financial distress without bankruptcy•Incentives for a firm in difficulty–Risk shifting–Refusing to contribute equity capital–Taking cash from firm–Delaying tactics–Bait and switch on use of funds from debtCosts of Financial Distress by Asset Type•Tangible assets unaffected by ownership–Real estate–Airplanes•Intangible assets–Brand image–Technology–Human capitalTrade-off Theory of Capital Structure•Capital structure depends on trade-off between interest tax shield and financial distress•High debt firms–Safe, tangible assets–High taxable income•Low debt firms–Risky, intangible assets–Unprofitable companies•Does theory work?–Yes and noPecking Order of Financing Choices1. Firms prefer internal finance2. Firms adapt payout targets to investment opportunities trying to avoid sudden changes3. Sticky dividend policies and fluctuations in profitability and investment opportunities lead to cash flow shifts 4. If external finance is required, firms issue debt first, then equityTests of Pecking Order1. Large firms tend to have higher debt ratios2. Firms with high ratios of fixed assets to total assets have higher debt ratios3. More profitable firms have lower debt ratios4. Firms with higher ratios of book-to-market values have lower debt ratiosNext Class•Thursday, April 12–Financing and Valuation – Chapter 19–Problem Set