IFM- Lecture 8

The required return on equity is a linear function of the firm's debt to equity ratio.

-> risk to equity holders rises with leverage
(remember: increasing risk means increasing potential return)
-> required return to equity holders rises with leverage

implication of MM I:
a firm's weighted average cost of capital is (r_wacc) is indipendent on the capital structure of the firm

r_S: expected return on equity
r_B: cost of debt
r_0: cost of capital of an all-equity (unlevered) firm
B: market value of debt
S: market value of equity
 

1. share price of a firm is indipendant of its capital structure
2. weighted average cost of capital of a firm is indipendant of its capital structure

presence of coorporate taxes -> tax advantage of levered firm (less taxes to pay) -> firm's value is positivley related to its debt

because of a quirk in corporate tax law, the proportion of the pie allocated to taxes is less for the levered firm than it is for the unlevered firm

• interest rate is tax deductable -> debt reduces the corporate tax by t_C * r_B * B (annual amount) with
  t_C: corporate tax rate
  r_B: interest rate on amount borrowed
  R: amount borrowed (debt)
• debt protects some of the firm's cash flows from taxes
• present value of tax shield (assuming perpetual cash flows): PV_taxshield = t_C*R

EBIT = earning before interest and taxes

EBIT is a company's net income before income tax expense and interest expenses are deducted. 

EBIT = Revenue - Expenses (without tax and interest)

Leverage increases the value of a firm by the tax shield.
-> Value of levered firm = Value of an all-equity firm + PV of the tax shield
 

• corporate leverage reduces tax payment
• tax shield increases with rising debt -> raising cash flow b substituting debt for equity

The cost of equity rises with leverage because the risk to equity rises with leverage. The required return on equity is a linear function of the firm's debt to equity ratio. Extended by t_C denoting the corporate tax rate.

-> this means that the MM II without taxes still holds true but is extended by the effect of the tax shield

• interest payments on debt are tax deductable
• dividends are not deductable at te coorporate level

• the wacc is extended by the coorporate tax factor (1-t_c)
• r_wacc declines with leverage

equity (dividend to shareholder): is being taxed twice -> coporate level t_c & personal level t_s

debt (interest payment to bondholders): is being taxed once -> personal level t_B

if t_s = t_B -> bondholders receive more than shareholders -> firm should issue debt

If t_s < t_B -> tax advantage of debt at coorporate level is partially offeset

1. financial distress

financial distress = not being able to meet payments and obligations -> debt causes distress
ultimate distress = bankruptcy
financial distress costs = costs you have in order to avoid bankruptc (ex: consultants, lawyers)

-> bankruptcy costs rise faster than the tax shield with increased leverage-> distress costs tend to offset the advantages to debt -> tradeoff between tax benfit and costs of financial distress

2. Agency costs

costs due to the conflict of interest between shareholders and bondholders

in times of financial distress shareholders and bondholders tend to choose selfish strategies to help themselves

-> these strategies are costly because they lower the firm's value and therefore hurt the shareholders

=> change in the value of the firm = tax shield on debt - agency costs - costs of financial distress

• it considers timing of capital strucutre decisions
• underlying assumption: the manager of a firm estimates the true value of their firm better than a typical investor does.
• the pecking order theory includes the resulting signals to the public implied in a firm's investment decisions

Rules / The Pecking Order

1. Use Internal Financing First
both equity and debt fiancing signals overvaluation of the firm
-> financing projects through retained earnings (earnings not paied out to investors) solves this problem

2. Issue Safe Securities (debt) befor Unsafer Securities (equity)
-> for investors coorporate debt is less risk than coorporate equity because investors receive fixed returns
-> issue equity only when the firm's debt capacity is reached

=> Pecking Order: 1. Internal fiancing (signal: strong firm) -> 2. debt financing (signal: firm is confident to be able to meet finacial obligations) -> 3. equity financing (signal: share prices are overvalued)

• refuses both trade-off model and pecking order theory
• the capital structure level a firm is driven by differences in market and book values

=> managers take advantage of market conditions when deciding on how to raise capital