Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2

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Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2 presents the following content: The Corporate Financing Decision; Financial Engineering, Asset Securitization, and Project Financing; Capital Budgeting: Process and Cash Flow Estimation;...Please refer to the documentation for more details.

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Nội dung Text: Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2

CHAPTER 11 The Corporate Financing Decision business invests in new plant and equipment to generate additional A revenues and income—the basis for its growth. One way to pay for investments is to generate capital from the company’s operations. Earnings generated by the company belong to the owners and can either be paid to them—in the form of cash dividends—or plowed back into the company. The owners’ investment in the company is referred to as owners’ equity or, simply, equity. If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the value of the com- pany and, hence, enhance the value of their equity. But earnings may not be sufﬁcient to support all proﬁtable investment opportunities. In that case management is faced with a decision: Forego proﬁtable investment oppor- tunities or raise additional capital. New capital can be raised by either bor- rowing or selling additional ownership interests or both. The decision about how the company should be ﬁnanced, whether with debt or equity, is referred to as the capital structure decision. In this chapter, we discuss the capital structure decision. There are different theories about how the ﬁrm should be ﬁnanced and we review these theories in this chapter. In the appendix to this chapter, we present a theory about the capital struc- ture proposed by Franco Modigliani and Merton Miller. DEBT VS. EQUITY The capital structure of a company is some mix of the three sources of capi- tal: debt, internally generated equity, and new equity. But what is the right mixture? The best capital structure depends on several factors. If a company ﬁnances its activities with debt, the creditors expect the interest and prin- cipal—ﬁxed, legal commitments—to be paid back as promised. Failure to pay may result in legal actions by the creditors. If the company ﬁnances its activities with equity, the owners expect a return in terms of cash dividends, an appreciation of the value of the equity interest, or, as is most likely, some combination of both. 375
376 FINANCIAL MANAGEMENT Suppose a company borrows $100 million and promises to repay the $100 million plus $5 million in one year. Consider what may happen when the $100 is invested: ■ If the $100 million is invested in a project that produces $120 million, the company pays the lender the $105 million the company owes and keeps the $15 million proﬁt. ■ If the project produces $105 million, the company pays the lender $105 million and keeps nothing. ■ If the project produces $100 million, the company pays the lender $105 million, with $5 million coming out of company funds. So if the company reinvests the funds and gets a return more than the $5 million (the cost of the funds), the company keeps all the proﬁts. But if the project returns $5 million or less, the lender still gets her or his $5 million. This is the basic idea behind ﬁnancial leverage—the use of ﬁnancing that has ﬁxed, but limited payments. If the company has abundant earnings, the owners reap all that remains of the earnings after the creditors have been paid. If earnings are low, the creditors still must be paid what they are due, leaving the owners nothing out of the earnings. Failure to pay interest or principal as promised may result in ﬁnancial distress. Financial distress is the condition where a com- pany makes decisions under pressure to satisfy its legal obligations to its creditors. These decisions may not be in the best interests of the owners of the company. With equity ﬁnancing there is no obligation. Though the company may choose to distribute funds to the owners in the form of cash dividends, there is no legal requirement to do so. Furthermore, interest paid on debt is deduct- ible for tax purposes, whereas dividend payments are not tax deductible. One measure of the extent debt is used to ﬁnance a company is the debt ratio, the ratio of debt to equity: Debt Debt ratio = Equity This is relative measure of debt to equity. The greater the debt ratio, the greater the use of debt for ﬁnancing operations, relative to equity ﬁnancing. Another measure is the debt-to-assets ratio, which is the extent to which the assets of the company are ﬁnanced with debt: Debt Debt-to-assets ratio = Total assets
The Corporate Financing Decision 377 This is the proportion of debt in a company’s capital structure, measured using the book, or carrying value of the debt and assets. It is often useful to focus on the long-term capital of a company when evaluating the capital structure of a company, looking at the interest-bear- ing debt of the company in comparison with the company’s equity or with its capital. The capital of a company is the sum of its interest-bearing debt and its equity. The debt ratio can be restated as the ratio of the interest-bear- ing debt of the company to the equity: Interest-bearing debt Debt-equity ratio = Equity and the debt-to-assets can be restated as the proportion of interest-bearing debt of the company’s capital: Interest-bearing debt Debt-to-capital ratio = Total capital By focusing on the long-term capital, the working capital decisions of a company that affect current liabilities such as accounts payable, are removed from this analysis. The equity component of all of these ratios is often stated in book, or carrying value terms. However, when taking a markets perspective of the company’s capital structure, it is often useful to compare debt capital with the market value of equity. In this latter formulation, for example, the total capital of the company is the sum of the market value of interest-bearing debt and the market value of equity. If market values of debt and equity are the most useful for decision- making, should management ignore book values? No, because book val- ues are relevant in decision-making also. For example, bond covenants are often speciﬁed in terms of book values or ratios of book values. As another example, dividends are distinguished from the return of capital based on the availability of the book value of retained earnings. Therefore, though the focus is primarily on the market values of capital, management must also keep an eye on the book value of debt and equity as well. There is a tendency for companies in some sectors and industries to use more debt than others. We can make some generalizations about differences in capital structures across sectors: ■ Companies that are more reliant upon research and development for new products and technology—for example, pharmaceutical compa- nies—tend to have lower debt-to-asset ratios than companies without such research and development needs.
378 FINANCIAL MANAGEMENT ■ Companies that require a relatively heavy investment in ﬁxed assets tend to have lower debt-to-asset ratios. Considering these generalizations and other observations related to dif- fering capital structures, why do some industries tend to have companies with higher debt ratios than other industries? By examining the role of ﬁnancial leveraging, ﬁnancial distress, and taxes, we can explain some of the varia- tion in debt ratios among industries. And by analyzing these factors, we can explain how the company’s value may be affected by its capital structure. THE CONCEPT OF LEVERAGE The capital structure decision involves managing the risks associated with the company’s business and ﬁnancing decisions. The concept of leverage—in both operations and ﬁnancing decisions—plays a role in the company’s risk because leverage exaggerates outcomes, good or bad. Leverage and Operating Risk The concept of leverage and the degree of leverage can be used to describe the operating risk of a company, which is a component of a company’s busi- ness risk. Business risk is the uncertainty associated with the earnings from operations. Business risk is inherent in the type of business and can be envisioned as being comprised of sales risk and operating risk. Sales risk is the risk associated with sales as a result of economic and market forces that affect the volume and prices of goods or services sold. Operating risk is the risk associated with the cost structure of the company’s assets. A cost structure is comprised of both ﬁxed operating costs and variable operating costs. The greater the ﬁxed costs relative to variable costs, the greater the leverage and, hence, operating risk. If sales were to decline, the greater the ﬁxed costs in the operating cost structure the more exaggerated the effect on operating earnings. In the context of the operating risk of a company, the degree of lever- age is referred to as the degree of operating leverage, or DOL. In this case, the ﬁxed costs operate as a fulcrum in this leverage are speciﬁcally the ﬁxed operating costs. We can demonstrate the concept of leverage by taking a look at oper- ating leverage. Consider the simple example of a company that has both ﬁxed and variable expenses. Suppose it has one product, with a sales price of $100 per unit and variable costs of $40 per unit. This means that the company has a $60 proﬁt per unit before considering any ﬁxed expenses.
The Corporate Financing Decision 379 This $60 is the product’s contribution margin—the amount that is available to cover any ﬁxed expenses. Suppose the company’s ﬁxed expenses are $20 million. If the company produces and sells 250,000 units, it has a loss of $5 million; whereas if it produces and sells 1 million units, it has a proﬁt of $40 million. The company would have to produce and sell 1/3 million units before covering its ﬁxed expenses; producing and selling more than 1/3 mil- lion produces a proﬁt and producing less than 1/3 million generates a loss. This 1/3 million is the break-even point: the number of units produced and sold such that the product of the units sold and unit price just covers both the variable and ﬁxed expenses. The relation between the ﬁxed costs, F, and the contribution margin can be speciﬁed in terms of the break-even quantity, QBE, the price per unit, P, the variable cost per unit, V, and the ﬁxed costs: F QBE = (P − V ) Looking at the proﬁt from a wider range of units produced and sold, as shown in Figure 11.1, the proﬁt is upward sloping, with a slope of $60: producing one additional unit produces a change in proﬁt of $60, which is the contribution margin. In contrast, consider a similar scenario, but with a variable cost per unit of $20 and ﬁxed costs of $40. In this case, the break- even number of units produced and sold is 500,000. However, this latter case has a greater use of ﬁxed costs. This produces a proﬁt-units relation as also shown in Figure 11.1, with a slope of $80. In the latter case, there is more leverage: a greater relative use of ﬁxed costs increases the losses and increases the proﬁts. Another way of quantifying the relation between the contribution margin and the ﬁxed costs is using the degree of operating leverage (DOL) measure: Q(P − V ) DOL = Q(P − V ) − F where Q is the number of units produced and sold, P is the sales price per unit, V is the variable cost per unit produced and sold, and F is the total ﬁxed operating cost. The DOL provides a measure of the sensitivity of the proﬁt at a given level of production. In the previous example, with variable costs of $40 per unit and ﬁxed costs of $20 million, the degree of leverage at 1 million units produced and sold is 1($100 − 40) $60 DOL = = = 1.5 1($100 − 40) − $20 $40
380 FINANCIAL MANAGEMENT FIGURE 11.1 Leverage and Fixed Costs $800 Variable cost = $40 per unit, Fixed cost = $20 million $700 Variable cost = $20 per unit, Fixed cost = $40 million $600 $500 $400 $300 $200 $100 $0 -$100 0 1 2 3 4 5 6 7 8 9 10 Number of Units Produced and Sold (in millions) At 2 million units, the degree of leverage is 2($100 − 40) $120 DOL = = = 1.2 2($100 − 40) − $20 $100 In other words, the DOL leverage depends on the level of production. The degree of leverage is undeﬁned at the break-even point—1/3 million units in this case—because the proﬁt in the denominator is zero. The DOL beyond the break-even point declines: as the company moves farther away from the break-even point, the effect of leverage—and hence risk—lessens, as shown in Figure 11.2. As you can see, the DOL differs between the two scenarios, with the cost structure with a greater reliance of ﬁxed costs having greater operating leverage. The DOL is a measure of the operating risk. Business risk, there- fore, is the combined effect of both sales risk and operating risk, both of which affect the risk associated with operating earnings. Leverage and Financial Risk The effect of the mixture of ﬁxed and variable costs on operating earnings is akin to the effect of debt ﬁnancing on earnings to owners. With respect to a ﬁrm’s capital structure it is referred to as ﬁnancial leverage, which we de- scribe shortly. The greater the ﬁxed ﬁnancing costs in the capital structure, the greater the leveraging effect on earnings to owners for a given change in
The Corporate Financing Decision 381 FIGURE 11.2 The Degree of Leverage for Increasing Number of Units Produced and Sold beyond the Break-Even Point 2 Variable cost = $40 per unit, Fixed cost = $20 million Variable cost = $20 per unit, Fixed cost = $40 million Degree of Operating Leverage 1.75 1.5 1.25 1 0 1 2 3 4 5 6 7 8 9 10 Number of Units Produced and Sold (in millions) operating earnings. The degree of leverage attributed to the capital structure of a company is referred to as the degree of ﬁnancial leverage (DFL). Both operating leverage and ﬁnancial leverage have a bearing on a com- pany’s ﬁnancial risk. This is because of the compounding effect of operating leverage upon ﬁnancial leverage, to affect the total leverage of the company. In fact, there is a multiplicative effect of the two leverages, such that the degree of total leverage of a company, DTL, is the product of its degree of operating leverage and its degree of ﬁnancial leverage: DTL = DOL × DFL Therefore, the greater the business risk of the company, the greater the risk associated with a company’s earnings to owners. The import of this is that management must consider both the degree of operating leverage and the degree of ﬁnancial leverage in managing the risk of the company. CAPITAL STRUCTURE AND FINANCIAL LEVERAGE Debt and equity ﬁnancing create different types of obligations for the com- pany. Debt ﬁnancing obligates the company to pay creditors interest and principal—usually a ﬁxed amount—when promised. If the company earns more than necessary to meet its debt payments, it can either distribute the surplus to the owners or reinvest. Equity ﬁnancing does not obligate the
382 FINANCIAL MANAGEMENT company to distribute earnings. The company may pay dividends or repur- chase stock from the owners, but there is no obligation to do so. The ﬁxed and limited nature of the debt obligation affects the risk of the earnings to the owners. Consider Capital Corporation that has $20 million of assets, all ﬁnanced with equity. There are 1 million shares of Capital Cor- poration stock outstanding, valued at $20 per share. The company’s current balance sheet is simple: Capital Corporation Balance Sheet (in millions) Assets $20 Debt $0 Equity 20 Suppose Capital Corporation has investment opportunities requiring $10 million of new capital. Further suppose Capital Corporation can raise the new capital either of three ways: Alternative 1. Issue $10 million equity (500 thousand shares of stock at $20 per share). Alternative 2. Issue $5 million of equity (250 thousand shares of stock at $20 per share) and borrow $5 million with an annual interest of 10%. Alternative 3. Borrow $10 million with an annual interest of 10%. Under each alternative, the capital structure as summarized in Table 11.1. It may be unrealistic to assume that the interest rate on the debt in Alternative 3 will be the same as the interest rate for Alternative 2 because in Alternative 3 there is more credit risk. For purposes of illustrating the point of leverage, however, let’s keep the interest rate the same. TABLE 11.1 Alternative Capital Structures for Capital Corporation: Balance Sheet (in millions) Alternative 1: Assets $30 Debt $0 Equity [1.5 million shares] 30 Alternative 2: Assets $30 Debt $5 Equity [1.25 million shares] 25 Alternative 3: Assets $30 Debt $10 Equity [1 million shares] 20
The Corporate Financing Decision 383 Stated differently, the debt ratio and the debt-to-asset ratio of Capital Corporation under each alternative are the following: Alternative Debt-Equity Ratio Debt-to-Capital Ratio 1 0.0% 0.0% 2 20.0% 16.7% 3 50.0% 33.3% How can these ratios be interpreted? The debt ratio of 20% for Alter- native 2 indicates that the company ﬁnances its assets using $1 of debt for every $5 of equity. The debt-to-assets ratio means that 16.7% of the assets are ﬁnanced using debt or, in other words, almost 17 cents of every $1 of assets is ﬁnanced with debt. Suppose Capital Corporation has $4.5 million of operating earnings. This means it has a $4.5/$30 = 15% return on assets (ROA). And suppose there are no taxes. To illustrate the concept of ﬁnancial leverage, consider the effect of this leverage on the earnings per share of a company. The earn- ings per share (EPS) under the different alternatives are given in Table 11.2. The three parts of this table show the EPS based on different assumptions for the ROA: 15%, 10%, and 5%. Notice that if the company is earning a return that is the same as the cost of debt, 10%, the earnings per share are not affected by the choice of ﬁnancing. If the return on assets is 15%, Alter- native 3 has the highest earnings per share, but if the return on assets is 5%, Alternative 3 has the lowest earnings per share. This example illustrates the role of debt ﬁnancing on the risk associated with earnings: the greater the use of debt vis-à-vis equity, the greater the risk associated with earnings to owners. Or, using the leverage terminology, the greater the degree of ﬁnancial leverage, the greater the ﬁnancial risk. Addi- tionally, by comparing the outcomes for the different operating earnings scenarios—$4.5, $3.0, and $1.5 million—the effect of adding ﬁnancial risk in addition to the operating risk magniﬁes the risk to the owners. Comparing the results of each of the alternative ﬁnancing methods pro- vides information on the effects of using debt ﬁnancing. As more debt is used in the capital structure, the greater the “swing” in EPS. The EPS under each ﬁnancing alternative and each ROA assumption shown in Table 11.3. When debt ﬁnancing is used instead of equity (Alternative 3), the own- ers don’t share the earnings—all they must do is pay their creditors the inter- est on debt. But when equity ﬁnancing is used instead of debt (Alternative 1), the owners must share the increased earnings with the additional own- ers, diluting their return on equity and earnings per share.
384 FINANCIAL MANAGEMENT TABLE 11.2 Earnings Per Share for Three Alternative Capital Structures and Differ- ent Return on Assets Assumed (a) 15% return on assets assumed Alternative 1: Alternative 2: Alternative 3: $10 million $5 million Equity $10 million Equity and $5 million Debt of Debt Operating earnings in millions $4.5 $4.5 $4.5 Less interest expense in millions 0.0 0.5 1.0 Net income in millions $4.5 $4.0 $3.5 Number of shares in millions ÷1.5 ÷ 1.25 ÷ 1.0 Earnings per share $3.00 $3.20 $3.50 (b) 10% return on assets assumed Alternative 1: Alternative 2: Alternative 3: $10 million $5 million Equity $10 million Equity and $5 million Debt of Debt Operating earnings in millions $3.0 $3.0 $3.0 Less interest expense in millions 0.0 0.5 1.0 Net income in millions $3.0 $2.5 $2.0 Number of shares in millions ÷1.5 ÷ 1.25 ÷ 1.0 Earnings per share $2.00 $2.00 $2.00 (c) 5% return on assets assumed Alternative 1: Alternative 2: Alternative 3: $10 million $5 million Equity $10 million Equity and $5 million Debt of Debt Operating earnings in millions $1.5 $1.5 $1.5 Less interest expense in millions 0.0 0.5 1.0 Net income in millions $1.5 $1.0 $0.50 Number of shares in millions ÷1.5 ÷ 1.25 ÷ 1.0 Earnings per share $1.00 $0.80 $0.50 FINANCIAL LEVERAGE AND RISK The use of ﬁnancial leverage (that is, the use of debt in ﬁnancing a com- pany) increases the range of possible outcomes for owners of the company. As we saw previously, the use of debt ﬁnancing relative to equity ﬁnancing increases both the upside and downside potential earnings for owners. In
The Corporate Financing Decision 385 TABLE 11.3 EPS for Three Financing Alternatives and Return on Asset Assump- tions Earnings per Share Assuming Financing Alternative ROA = 5% ROA = 10% ROA = 15% 1. $10 million equity $1.00 $2.00 $3.00 2. $5 million equity, $5 million debt $0.80 $2.00 $3.20 3. $10 million debt $0.50 $2.00 $3.50 other words, ﬁnancial leverage increases the risk to owners. Now that we understand the basics of leverage, let’s quantify its effect on the risk of earn- ings to owners. Another way to view the choice of ﬁnancing is to calculate the degree of ﬁnancial leverage, DFL: Earnings before interest and taxes DFL = Earnings before interest and taxes − Interest Calculating the DFL for the three alternatives at a 10% ROA, or $3 million in operating earnings, we see that Alternative 3 as the highest degree of ﬁnancial leverage: Degree of Financial Leverage Alternative at $3 million in Operating Earnings 1 1.0 2 1.2 3 1.5 The degree of ﬁnancial leverage is interpreted in a manner similar to that of DOL: A DFL of 1.25 indicates that if operating earnings increase by 1%, net proﬁt, and hence earnings per share will increase by 1.2%. In the case of Alternative 2, with a DFL of 1.2, when operating earnings change from $3 million to $4.5 million (that is, a 50% increase), earnings to owners go from $2 per share to $3.2 per share, an increase of 50% × 1.2 or 60%. The Leverage Effect Equity owners can reap most of the rewards through ﬁnancial leverage when their company does well. But they may suffer a downside when the company does poorly. What happens if earnings are so low that it cannot cover inter- est payments? Interest must be paid no matter how low the earnings. How
386 FINANCIAL MANAGEMENT can money be obtained with which to pay interest when earnings are insuf- ﬁcient? It can be obtained in three ways: ■ By reducing the assets in some way, such as using working capital needed for operations or selling buildings or equipment. ■ By taking on more debt obligations. ■ By issuing more shares of stock. Whichever the company chooses, the burden ultimately falls upon the owners. This leveraging effect is illustrated in Figure 11.3 for Capital Corpora- tion. Note that we have broadened the number of possible return on asset outcomes ranging from 0% to 30%. Alternative 3 provides for the most upside potential for the equity holders, it also provides for the most down- side potential as well. Hence, Alternative 1—all equity— offers the more conservative method of ﬁnancing operations. The three alternatives have identical earnings per share when there is a 10% return on assets. Capital Corporation’s 10% return on assets is referred to as the EPS indifference point: the return where the earnings per share are FIGURE 11.3 Capital Corporation’s Earnings per Share for Different Operating Earnings for Each of the Three Financing Alternatives $10 Alternative 1: All equity financing Alternative 2: Debt and equity financing $8 Alternative 3: All debt financing $6 All three alternatives have an Earnings per Share (EPS) EPS of $2 if operating $4 earnings are $3 million $2 $0 –$2 –$4 –$1 $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 Operating Earnings (in millions)
The Corporate Financing Decision 387 the same under the ﬁnancing alternatives. Above a 10% return on assets (that is, above operating earnings of $3,000), Alternative 3 offers the most to own- ers. But Alternative 3 also has the most downside potential, producing the worst earnings to owners below this 10% return on assets. Leverage and Financial Flexibility The use of debt also reduces a company’s ﬁnancial ﬂexibility. A company with debt capacity that is unused, sometimes referred to as ﬁnancial slack, is more prepared to take advantage of investment opportunities in the future. This ability to exploit these future, strategic options is valuable and, hence taking on debt increases the risk that the company may not be sufﬁciently nimble to act on valuable opportunities. There is evidence that suggests that companies that have more cash ﬂow volatility tend to build up more ﬁnancial slack and, hence, their invest- ments are not as sensitive to their ability to generate cash ﬂows internally. (See Booth and Cleary (2006).) Rather, the ﬁnancial slack allows them to exploit investment opportunities without relying on recent internally gener- ated cash ﬂows. In the context of the effect of leverage on risk, this means that compa- nies that tend to have highly volatile operating earnings may want to main- tain some level of ﬁnancial ﬂexibility by not taking on signiﬁcant leverage in the form of debt ﬁnancing. Governance Value of Debt Financing A company’s use of debt ﬁnancing may provide additional monitoring of a company’s management and decisions, reducing agency costs. As explained later in this chapter, agency costs are the costs that arise from the separation of the management and the ownership of a company, which is particularly acute in large corporations. These costs are the costs necessary to resolve the agency problem that may exist between management and ownership of the company and may include the cost of monitoring company management. These costs include the costs associated with the board of directors and pro- viding ﬁnancial information to shareholders and other investors. An agency problem that may arise in a company is how effectively a company uses its cash ﬂows. The free cash ﬂow of a company is, basically, its cash ﬂow less any capital expenditures and dividends. One theory that has been widely regarded is that by using debt ﬁnancing, the company reduces its free cash ﬂows and, hence company must reenter the debt market to raise new capital. (See Jensen (1986).) It is argued that this beneﬁts the company in two ways. First, there are fewer resources under control of management
388 FINANCIAL MANAGEMENT and less chance of wasting these resources in unproﬁtable investments. Sec- ond, the continual dependence of the debt market for capital imposes a monitoring, or governance discipline on the company that would not have been there otherwise. CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt ﬁnancing increases the risk to owners; the greater the use of debt ﬁnancing (vis-à-vis equity ﬁnancing), the greater the risk. Another factor to consider is the role of taxes. In the U.S., income taxes play an important role in a company’s capital structure decision because the payments to creditors and owners are taxed differently. In general, interest payments on debt obligations are deductible for tax purposes, whereas divi- dends paid to shareholders are not deductible. This bias affects a company’s capital structure decision. Interest Deductibility and Capital Structure The deductibility of interest represents a form of a government subsidy of ﬁnancing activities. By allowing interest to be deducted from taxable in- come, the government is sharing the company’s cost of debt. To see how this subsidy works, compare two companies: Company U (unlevered) and Com- pany L (levered). Suppose both have the same $5 million taxable income before interest and taxes and contributed capital of $35 million. Company U is ﬁnanced entirely with equity, whereas Company L is ﬁnanced with $10 million debt that requires an annual payment of 10% interest. If the tax rate for both companies is 30%, the tax payable and net income to owners are calculated as follows: Company U Company L (no debt) ($10 million debt) Taxable income before taxes and interest in $5.0 $5.0 millions Less interest expense in millions 0.0 1.0 Taxable income before taxes in millions $5.0 $4.0 Less taxes at 30% of taxable income in mil- 1.5 1.2 lions Net income to owners $3.5 $2.8
The Corporate Financing Decision 389 By ﬁnancing its activities with debt, paying interest of $1 million, Com- pany L reduces its tax bill by $0.3 million. Company L’s creditors receive $1 million of income, the government receives $1.2 million of income, and the owners receive $2.8 million. The $0.3 represents money Company L does not pay because it is allowed to deduct the $1 million interest. This reduc- tion in the tax bill is a type of subsidy. If Company LL (Lots of Leverage) has the same operating earnings and tax rate as Companies U and L, but uses $20 million of debt at the 10% interest rate, the interest expense is $2 million and net income to owners are as $2.1 million. Comparing Company LL relative to Company L, we see that the inter- est expense is more, taxes are less, and net income to owners less: Company L Company LL ($10 million debt) ($20 million debt) Taxable income before taxes and interest $5.0 $5.0 in millions Less interest expense in millions 1.0 2.0 $4.0 $3.0 Taxable income before taxes in millions Less taxes at 30% of taxable income in 1.2 0.9 millions Net income to owners $2.8 $2.1 If Company L were to increase its debt ﬁnancing from $10 to $20 mil- lion, like Company LL’s, the total net income to the suppliers of capital—the creditors and owners—is increased $0.3 million, from $3.8 to $4.1 million, determined as follows: Company L Company LL Company U ($10 million ($20 million (no debt) debt) debt) Income to creditors in millions $0.0 $1.0 $2.0 Income to owners in millions 3.5 2.8 2.1 Total income to suppliers of capital $3.5 $3.8 $4.1 Consider this distribution of income between creditors and owners. The total income to the suppliers of capital increases from the use of debt. For example, the difference in the total income to suppliers of capital of Com- pany U compared to Company LL is $0.6 million. This difference is due to a
390 FINANCIAL MANAGEMENT tax subsidy by the government: by deducting $2 million in interest expense, Company LL beneﬁts by reducing taxable income by $2 million and reduc- ing taxes by $2 million × 30% = $0.6 million. If we assume that there are no direct or indirect costs to ﬁnancial distress, the cost of capital for the company should be the same, no matter the method of ﬁnancing. With a 10% cost of capital, the value to the suppliers of capital is split, as shown in Table 11.4. Who beneﬁts from this tax deductibility? The owners. The owners of Company U have a return on equity of $3.5 million/$35 million = 10%. Compare this to the owners of Company L, for which owners have a return on equity of $2.8 million/$25 million = 11.2%, and to the owners of Com- pany LL, who have a return on equity of $2.1 million/$15 million = 14%. The owners of the levered ﬁrms beneﬁt from the tax deductibility of interest in terms of the return on their investment. Interest Tax Shield An interesting element introduced into the capital structure decision is the reduction of taxes due to the payment of interest on debt. We refer to the beneﬁt from interest deductibility as the interest tax shield, because the in- TABLE 11.4 Value to Suppliers of Capital of Companies U, L, and LL Company Company Company (no debt) ($10 million debt) ($20 million debt) (in millions) Value, dividing the income stream by the 10% discount rate: Value to creditors $0 $10 $20 Value to owners 35 28 21 Value of the company $35 $38 $41 Capital contributed by: By creditors $0 $10 $20 By owners 35 25 15 Total contributed capital $35 $35 $35 The difference between value and contributed capital: Added value from debt $0 $3 $6
The Corporate Financing Decision 391 terest expense shields income from taxation. The tax shield from interest deductibility is Tax shield = Tax rate × Interest expense If Company L has $10 million of 10% debt and is subject to a tax of 30% on net income, the tax shield is Tax shield = 0.30 [$10 (0.10)] = 0.30($1) = $0.3 million A $1 million interest expense means that $1 million of income is not taxed at 30%. Recognizing that the interest expense is the interest rate on the debt, rd, multiplied by the face value of debt, D, the tax shield for a company with a tax rate of τ is Tax shield = Tax rate × Interest rate × Face value of debt Tax shield = τ rd D How does this tax shield affect the value of the company? The tax shield reduces the net income of the company that goes to pay taxes. We should specify that the tax rate is the marginal tax rate—the tax rate on the next dollar of income. And since management is concerned with how interest protects income from taxation, the focus should be on how it shields taxable income beyond the income that is shielded by all other tax deductible expenses. Unused Tax Shields The value of a tax shield depends on whether the company can use an inter- est expense deduction. In general, if a company has deductions that exceed income, the result is a net operating loss. The company does not have to pay taxes in the year of the loss and may “carry” this loss to another tax year. This loss may be applied against previous years’ taxable income (with some limits). The previous years’ taxes are recalculated and a refund of taxes previously paid is requested. If there is insufﬁcient previous years’ tax- able income to apply the loss against, any unused loss is carried over into future years (with some limits), reducing future years’ taxable income. Therefore, when interest expense is larger than income before interest, the tax shield is realized immediately—if there is sufﬁcient prior years’ tax- able income. If prior years’ taxable income is insufﬁcient (that is, less than
392 FINANCIAL MANAGEMENT the operating loss created by the interest deduction), the tax shield is less valuable because the ﬁnancial beneﬁt is not received until some later tax year (if at all). In this case, we discount the tax shield to reﬂect both the uncertainty of beneﬁting from the shield and the time value of money. To see how an interest tax shield may become less valuable, let’s sup- pose The Unfortunate Company has the following ﬁnancial results: The Unfortunate Company Year 1 Year 2 Year 3 Taxable income before interest $7,000 $8,000 $6,000 Interest expense 5,000 5,000 5,000 Taxable income $2,000 $3,000 $1,000 Tax rate 0.40 0.40 0.40 Tax paid $800 $1,200 $400 Suppose further that the Unfortunate Company has the following result for Year 4: Year 4 Taxable income before interest $1,000 Less: Interest expense 8,000 Net operating loss –$7,000 And suppose the tax code permits a carryback of two years and a carryover of 20 years. The Unfortunate Company can take the net operating loss of $7,000 and apply it against the taxable income of previous two years, begin- ning with Year 1: Year 1 Year 2 Year 3 Taxable income before interest $7,000 $8,000 $6,000 Interest expense 5,000 5,000 5,000 Taxable income—original $2,000 $3,000 $1,000 Application of Year 4 loss –3,000 –1,000 Taxable income—recalculated $0 $0 Taxes paid $1,200 $400 Tax due—recalculated 0 0 Refund of taxes paid $1,200 $400
The Corporate Financing Decision 393 By carrying back the part of the loss, the Unfortunate Company has applied $4,000 of its Year 4 loss against the previous years’ taxable income: $3,000(Year 2) + $1,000(Year 3) and receives a tax refund of $1,200 + 400 = $1,600. There remains an unused loss of $7,000 – $4,000 =$3,000. This loss can be applied toward future tax years’ taxable income, reducing taxes in future years. But since we don’t get the beneﬁt from the $3,000 unused loss—the $3,000 reduction in taxes—until sometime in the future, the ben- eﬁt is worth less than if we could use it today. The Unfortunate Company, with an interest deduction of $8,000, ben- eﬁts from $5,000 of the deduction; $1,000 against current income and $4,000 against previous income. Therefore, the tax shield from the $8,000 is not $3,200 (40% of $8,000), but rather $2,000 (40% of $5,000), plus the present value of the taxes saved in future years. The present value of the taxes saved in future years depends on: ■ The uncertainty that Unfortunate Company will generate taxable income. ■ The time value of money. The Unfortunate Company’s tax shield from the $8,000 interest expense is less than what it could have been because the company could not use all of it now. The bottom line of the analysis of unused tax shields is that the beneﬁt from the interest deductibility of debt depends on whether or not the com- pany can use the interest deductions. CAPITAL STRUCTURE AND FINANCIAL DISTRESS A company that has difﬁculty making payments to its creditors is in ﬁnan- cial distress. Not all companies in ﬁnancial distress ultimately enter into the legal status of bankruptcy. However, extreme ﬁnancial distress may very well lead to bankruptcy. While bankruptcy is often a result of ﬁnancial dif- ﬁculties arising from problems in paying creditors, some bankruptcy ﬁlings are made prior to distress when a large claim is made on assets (for example, class action liability suit). Costs of Financial Distress The costs related to ﬁnancial distress without legal bankruptcy can take different forms. For example, to meet creditors’ demands, a company takes on projects expected to provide a quick payback. In doing so, the ﬁnancial
394 FINANCIAL MANAGEMENT manager may choose a project that decreases owners’ wealth or may forgo a proﬁtable project. Another cost of ﬁnancial distress is the cost associated with lost sales. If a company is having ﬁnancial difﬁculty, potential customers may shy away from its products because they may perceive the company unable to provide maintenance, replacement parts, and warranties. Lost sales due to customer concerns represent a cost of ﬁnancial distress—an opportunity cost, some- thing of value (sales) that the company would have had if it were not in ﬁnancial difﬁculty. Still another example of a cost of ﬁnancial distress is the cost associated with suppliers. If there is concern over the company’s ability to meet its obligations to creditors, suppliers may be unwilling to extend trade credit or may extend trade credit only at unfavorable terms. Also, suppliers may be unwilling to enter into long-term contracts to supply goods or materials. This increases the uncertainty that the company will be able to obtain these items in the future and raises the costs of renegotiating contracts. The Role of Limited Liability Limited liability limits owners’ liability for obligations to the amount of their original investment in the shares of stock. Limited liability for owners of some forms of business creates a valuable right and an interesting incen- tive for shareholders. This valuable right is the right to default on obligations to creditors—that is, the right not to pay creditors. Because the most share- holders can lose is their investment, there is an incentive for the company to take on very risky projects: If the projects turn out well, the company pays creditors only what it owes and keeps the remainder and if the projects turn out poorly, it pays creditors what it owes—if there is anything left. The fact that owners with limited liability can lose only their initial investment—the amount they paid for their shares—creates an incentive for owners to take on riskier projects than if they had unlimited liability: They have little to lose and much to gain. Owners of a company with limited liability have an incentive to take on risky projects since they can only lose their investment in the company. But they can beneﬁt substantially if the payoff on the investment is high. For companies whose owners have limited liability, the more the assets are ﬁnanced with debt, the greater the incentive to take on risky projects, leaving creditors “holding the bag” if the projects turn out to be unproﬁt- able. This is a problem: A conﬂict of interest between shareholders’ interests and creditors’ interests. The investment decisions are made by management (who represent the shareholders) and, because of limited liability, there is an