Capital structure Flashcards
What are we going to talk about today?
How do I determine the optimal capital structure for my company?
When should one use equity financing? When to use debt?
Why is there a bias for companies to use debt?
Historically, interest is regarded as a cost of doing business and as a result is tax deductible
Whereas, dividends are treated as a return to the firm owners and are therefore not tax deductible ( included in taxable income)
What is perpetual debt?
Wha is tax shield, how do you calculate it?
Perpetual debt has no maturity date, requiring indefinite interest payments by the issuer without principal repayment obligation.
A tax shield is a strategy to decrease taxable income, lowering a company’s or individual’s tax liability. ( the amount of debt x interest rate x tax rate) ( the amount of debt x interest rate is the coupon payment sometimes).
Tax shield = 30% x 10% x 200 = 6, THE PV of tax shield = 6/0.1 = 60
What are benefits of taking on debt for the company in terms of shareholders?
1) Increased market value - leading to higher stock prices and potentially higher dividends
2) Lower overall cost of capital of firm, leading to higher valuation - Debt financing often has a lower cost compared to equity financing. This is because debt holders have a higher priority in the capital structure than equity holders, and interest payments on debt are tax-deductible
Do a check that for the market value of equity should be the total value - MV of debt?? Also what is the pv of the tax shield. RECAPITALISATION MEANS = Leveraged recapitalization is a financial restructuring where a company issues more debt and uses the proceeds to repurchase equity shares, resulting in a higher debt-to-equity ratio.
Remember value of levered firm = value of unlevelled firm + PV( tax shields)
Present value of tax shield: The tax shield is a perpetuity, so we can use the perpetuity formula to calculate its present value.
PV of Tax Shield = Tax Shield / Risk-Free Interest Rate
PV of Tax Shield = $34 / 0.10
PV of Tax Shield = $340
AS YOU CAN SEE SHAREHOLDERS ARE BETTER OFF AS AGGREGRATE WEALTH INCREASED.
So it looks like there are tax advantages of debt, which is true, so firms should be financed with 100% debt, but this isn’t the case, as average debt ratios are low ( between 30-40%) This is because of what?
The cost of financial distress, which can be director or indirect.
debt becomes risky but no bankruptcy cost)
V debt = 1250 and value of equity = 250
Therefore, the value of the firm will remain the same at $1,500, as the debt and the repurchased equity offset each other, and there’s no change in the underlying cash flow structure.
Continued example ( shows bankruptcy cost. How much will the value of debt go down by?
Debtholders have to pay yhe cost as equity holders have 0 and its paid next year. The value of debt will go down by 5 ( the pv of the bankruptcy cost)
What do we tend to find with direct bankruptcy costs?
They tend to be very small, so cannot explain low debt ratios. So it must be indirect bankruptcy costs, which are large.
What are some potentially large indirect costs of financial distress?
1) Firms may have to sell assets in fire sales ( sell assets at value lower than their worth)
2) Firms may lose flexibility ( go into administration and also debt holders can steer from to investing in sage projects )
3) May lose customers who think the firm might go out of business.
4) Agency costs between debt holders and management become amplified when firms enter into in financial distress.
With agency costs what might management ( remember management represent equity holder interests)
1) Invest in risky projects even if these have negative NPV( overinvestment)
2) Be unable to raise new capital for positive NPV projects when the firms’ has too much debt ( underinvestment)
3) Pay out large dividends to shareholders even if its costly.
( NUMBERS ARE GOING TO REPLAP ITS SELF FOR CONTINUING EXAMPLES ) So imagine this as the management are investing in going to casino.
NPV OF ASSETS = -100
NPV OF DEBT = -250
NPV OF EQUITY = 150.
So essentially 150 is being transferred to equity holders, while 100 is lost from firm value.
This is essentially showing they companies choose not to finance NPV projects.
They invested 100 but got 50 and bondholders eat the gains, so the NPV from shareholders point of view is negative. Most of the NPV it creates is going to pay existing debt and the left overs not enough to motivate shareholders to invest in first place. So generally, the firm will only invest In superlarge NPV so that the value of equity > the initial cost.
fire sales, DOES THIS LOOK ILLEGAL?
Yes it looks illegal hence we have debt covenants.
so WHATS THE OPTIMAL CAPITAL STRCUTURE?
Suppose a company has issued $1,000,000 of debt at an annual interest rate of 5%. The company’s corporate tax rate is 30%, and we’ll use a discount rate of 5% (equal to the interest rate) for simplicity. calculate the PV of tax shield?
