Tax savings of debt: value implicationsValuing the Tax Shield (to make things clear)To make things clear (cont.)Leverage and firm valueRemarksBack to the Microsoft example…Is This Important or Negligible?Bottom LineMarginal tax rate (MTR)Tax-Loss Carry Forwards (TLCF)Tax-Loss Carry Forwards (TLCF): ExampleMarginal Tax Rates for U.S. firmsPlease see the graph showing Marginal Tax Rate, Percent of Population, and Year in:GrahPersonal TaxesPre ClintonPost ClintonBottom LineThe Dark Side of Debt: Cost of Financial Distress“Pie” TheoryCosts of Financial DistressCosts of Financial DistressDirect bankruptcy costsEvidence for 11 bankrupt railroads (Warner, Journal of Finance 1977)Direct bankruptcy costs and firm sizeEvidence for 11 bankrupt railroads (Warner, Journal of Finance 1977)Direct Bankruptcy CostsDebt OverhangDebt Overhang (cont.)Debt Overhang (cont.)Debt Overhang (cont.)What Can Be Done About It?Raising New Equity?Financial Restructuring?Financial Restructuring? (cont.)Financial Restructuring? (cont.)Issuing New DebtBankruptcyDebt Overhang: Preventive MeasuresExampleExample, cont.Excessive Risk-TakingExcessive Risk-Taking: IntuitionEquity holders have unlimited upside potential but bounded lossesSummary: Expected costs of financial distressSummary: Capital structure choiceTextbook View of Optimal Capital StructurePractical ImplicationsExpected Distress CostsIdentifying Expected Distress CostsSetting Target Capital Structure:A ChecklistDoes the Checklist Explain Observed Debt Ratios?What Does the Checklist Explain?Key PointsKey PointsTax savings of debt: value implicationsWith corporate taxes (but no other complications), the value of a levered firm equals:shields) tax (int erestPVVVUL+=Discount rate for tax shields = rdIf debt is a perpetuity:D rD r rateinterest yearper shieldstax shields)tax V(interst Pddτ=τ==VL= VU+ τ D1Valuing the Tax Shield (to make things clear) Firm A: is all equity financed¾ has a perpetual before-tax, expected annual cash flow X Firm B: is identical but maintains debt with value D¾ It thus pays a perpetual expected interest rd*D )X-(1 CAτ=⇒⋅⋅τ+τ=+τ= Dr )X-(1 Dr D)r-)(X-(1CdddBDrC C dAB⋅⋅τ+= Note: the cash flows differ by the tax shield τ*rd*D2To make things clear (cont.) We want to value firm B knowing that: Apply value additivity: Value separately CAand τ*rd*D¾ The value of firm A is: ¾ The present value of tax shields is: So, the value of firm B is:DrC C dAB⋅⋅τ+=AAV)C(PV=DrDr )TS(PVdd⋅τ=⋅⋅τ=DVVAB⋅τ+=3Leverage and firm value VU0.00 0.15 0.30 0.45 0.60LeverageFirmvalue4Remarks Raising debt does not create value, i.e., you can’t create valueby borrowing and sitting on the excess cash. It creates value relative to raising the same amount in equity. Hence, value is created by the tax shield when you:→ finance an investment with debt rather than equity→ undertake a recapitalization, i.e., a financial transaction in which some equity is retired and replaced with debt.5Back to the Microsoft example…What would be the value of tax shields for Microsoft?¾Interest expense = $50 × 0.07 = $3.5 billion¾Interest tax shield = $3.5 × 0.34 = $1.19 billion¾PV(tax shields) = 1.19 / 0.07 = 50 × 0.34 = $17 billion¾VL= Vu+ PV(tax shields) = $440 billion6Is This Important or Negligible? Firm A has no debt and is worth V(all equity). Suppose Firm A undertakes a leveraged recapitalization:→ issues debt worth D,→ and buys back equity with the proceeds. Its new value is: Thus, with corporate tax rate t = 35%:→ for D = 20%, firm value increases by about 7%.→ for D = 50%, it increases by about 17.5%.UULVD 1VV⋅τ+=7Bottom Line Tax shield of debt matters, potentially a lot. Pie theory gets you to ask the right question: How does this financing choice affect the IRS’ bite of the corporate pie? It is standard to use τ*D for the capitalization of debt’s tax break. Caveats:→ Not all firms face full marginal tax rate→ Personal taxes8Marginal tax rate (MTR) Present value of current and expected future taxes paid on $1 of additional income Why could the MTR differ from the statutory tax rate?¾ Current losses¾ Tax-Loss Carry Forwards (TLCF)9Tax-Loss Carry Forwards (TLCF) Current losses can be carried backward/forward for 3/15 years¾ Can be used to offset past profits and get tax refund¾ Can be used to offset future profits and reduce future tax bill Valuing TLCF, need to incorporate time value of money Bottom line: More TLCF D Less debt10Tax-Loss Carry Forwards (TLCF): Exampletime (t) -3 -2 -1 0 1 2NI 100 100 100 -500 100 100Carryforward 0 0 0 200 100 0Tax paid at time t 35 35 35 0 0 0Tax refund 0 0 0 105 0 0Suppose Net Income increases by $1 in year 0time (t) -3 -2 -1 0 1 2NI 100 100 100 -499 100 100Carryforward 0 0 0 199 99 0Tax paid at time t 35 35 35 0 0 0.35Tax refund 0 0 0 105 0 0MTR at time 0 = PV (Additional Taxes) = 0.35/1.12 = 0.29(assuming that r = 10%)11Marginal Tax Rates for U.S. firmsPlease see the graph showing Marginal Tax Rate, Percent of Population, and Year in:Graham, J.R. Debt and the Marginal Tax Rate. Journal of Financial Economics. May 1996, pp. 41-73.12Personal Taxes Investors’ return from debt and equity are taxed differently¾ Interest and dividends are taxed as ordinary income¾ Capital gains are taxed at a lower rate¾ Capital gains can be deferred (contrary to dividends and interest)¾ Corporations have a 70% dividend exclusion So: For personal taxes, equity dominates debt.13Pre ClintonDebtEquity with deferred capital gains*Equity with dividendsCorporate levelStart with $100 100 100 100Tax rate = 34% 0 34 34Net 100 66 66Personal levelTax rate = 31% 31 0 20.46Botton line 69 66 45.54* Extreme assumption: No tax on capital gains14Post ClintonDebtEquity with deferred capital gains*Equity with dividendsCorporate levelStart with $100 100 100 100Tax rate = 35% 0 35 35Net 100 65 65Personal levelTax rate = 40% 40 0 26Botton line 60 65 39* Extreme assumption: No tax on capital gains15Bottom Line Taxes favor debt for most firms We will lazily ignore personal taxation in the rest of the course But, beware of particular cases16The Dark Side of Debt: Cost of Financial Distress If taxes were the only issue, (most) companies would be 100% debt financed Common sense suggests otherwise ¾ If the debt burden is too high, the company will have trouble paying¾ The result: financial distress17“Pie”