How Much Should a Firm Borrow?

PGDM
Acharya School of Management
http://www.acharya.ac.in/asm.php
 How Much Should a Firm Borrow?
 Trade off Theory
 Corporate Taxes and Value
 Corporate and Personal Taxes
 Cost of Financial Distress
 Pecking Order of Financial Choices
 Information Asymmetry

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The Trade Offs
Financial Risk - Risk to shareholders resulting from the
use of debt.

Financial Leverage - Increase in the variability of

shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from

deductibility of interest payments.

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 Capital Structure and Corporate
Taxes
The tax deductibility of interest increases the total distributed
income to bondholders and shareholders put together.

Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes Rs.1,000 Rs.1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598

Total income to both bondholders

and stockholders Rs.0+650=Rs.650 Rs.80+598=Rs.678

Interest tax shield (.35 x interest) Rs.0 Rs.28

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 Capital Structure and Corporate
Taxes
Example - You own all the equity of
Space Babies Diaper Co. The company
has no debt. The company’s annual
cash flow is `900,000 before interest
and taxes. The corporate tax rate is
35% You have the option to exchange
1/2 of your equity position for 5% bonds
with a face value of Rs.2,000,000.

Should you do this and why?

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 Capital Structure and Corporate
Taxes
Example - You own all the equity of Space Babies Diaper Co.
The company has no debt. The company’s annual cash flow is
`900,000 before interest and taxes. The corporate tax rate is
35% You have the option to exchange 1/2 of your equity
position for 5% bonds with a face value of Rs.2,000,000.
Should you do this and why?

(` 1,000 s) All Equity 1/2 Debt Total Cash Flow

All Equity = 585
EBIT 900 900
Interest Pmt 0 100
Pretax Income 900 800 With 1/2 Debt = 620
Taxes @ 35% 315 280 (520 + 100)
Net Cash Flow 585 520

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 Capital Structure and Corporate
Taxes D x r x Tc D
PV of Tax Shield = = D x Tc
(assume perpetuity)
rD

Example:
Tax benefit = 2,000,000 x (.05) x (.35) = Rs.35,000
PV of Rs.35,000 in perpetuity = 35,000 / .05 = Rs.700,000

PV Tax Shield = Rs.2,000,000 x .35 = Rs.700,000

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 Capital Structure and Corporate
Taxes
Firm Value =
Value of All Equity Firm + PV Tax Shield

Example
All Equity Value = 4,000,000
PV Tax Shield = 700,000

Firm Value with 1/2 Debt = Rs.4,700,000

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 Capital Structure and Corporate
Taxes
Asian Paints Balance Sheet, March 2005 (figures in Rs.
Crores)

Book Values
Secured and Unsecured Loans Rs. 83.88 Rs. 108.7 Net Current Assets
Deferred Tax Liability 30.54
Equity 572.22 577.94 Long term Assets
Total Value Rs. 686.64 Rs. 686.64 Total Assets

Market Values
Secured and Unsecured Loans Rs. 83.88 Rs. 108.7 Net Current Assets
Deferred Tax Liability 30.54 28.23 PV of interest tax shield
Equity 3751.42 3728.91 Long term Assets
Total Value Rs.3865.84 Rs.3865.84 Total Assets

Tax Rate = 33.66%

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 Capital Structure and Corporate
Taxes
Asian Paints Balance Sheet, March 2005 (figures in Rs. Cr.)
(With Rs. 50 cr. Debt for Equity Swap)

Book Values
Secured and Unsecured Loans Rs. 133.88 Rs. 108.7 Net Current Assets
Deferred Tax Liability 30.54
Equity 522.22 577.94 Long term Assets
Total Value Rs. 686.64 Rs. 686.64 Total Assets

Market Values
Secured and Unsecured Loans Rs. 133.88 Rs. 108.7 Net Current Assets
45.06
Deferred Tax Liability 30.54 61.89 PV of interest tax shield
3728.91
Equity 3718.25 3712.08 Long term Assets
Total Value Rs.3882.67 Rs.3882.67 Total Assets

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 Personal and Corporate Taxes
Operating Income
(Rs.1.00) Or paid out as
Paid out as
interest equity income

Corporate Tax None Tc

Income after Rs.1.00 Rs.1.00 – Tc

Corp Taxes

Personal Taxes Tp TpE (1.00-Tc)

.

Income after All Rs.1.00 – Tp Rs.1.00–Tc-TpE (1.00-Tc)

Taxes =(1.00-TpE)(1.00-Tc)
To bondholders To stockholders
Tp = Personal tax rate on interest, TpE = Effective personal tax rate on equity, Tc = Corporate tax rate
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 Personal and Corporate Taxes
Relative Advantage Formula (RAF) ( Debt vs
Equity )
Tp = Personal tax rate
1-Tp on interest
TpE = Effective
(1-TpE) (1-Tc) personal tax rate on
equity
Tc = Corporate tax
rate
Advantage
RAF > 1 Debt

12
RAF < 1
ASM - PGDM10 - CF15
Equity 04-Jan-11
 Personal and Corporate Taxes
If TpE = Tp, then RAF = 1/ (1- Tc)
 Only the corporate tax would need to be considered
 Personal taxes need not be considered zero, but
can be ignored.
If RAF = 1 Debt policy becomes irrelevant
[In this form it is mostly > 1]

Advantage Tp = Personal tax rate

on interest
RAF > 1 Debt TpE = Effective
personal tax rate on
RAF < 1 Equity equity
13 ASM - PGDM10 - CF15 Tc = Corporate04-Jan-11
tax
rate
 Personal and Corporate Taxes
Example
Interest Equity Income
Income before tax Rs. 1 Rs. 1
Less corporate tax
at T c = 0.3366 0 0.34
Income after corporate tax 1 0.66
Personal tax at T p = 0.3366
and T pE = 0.02856 0.34 0.02
Income after all taxes Rs. 0.66 Rs. 0.64

Advantage to debt = Rs.0.02

TpE = (0.1403*20% + 0.000625*80%) = 2.856%

Payout ratio = 20%

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 Personal and Corporate Taxes
 Today’s RAF & Debt vs Equity preference.

(1-.3366)
RAF = = 1.03
(1-.02866)(1-.3366)

RAF > 1. Having Debt is advantageous.

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 Capital Structure
Structure of Bond Yield Rates
r

Bond
Yield

D
E
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 Weighted Average Cost of Capital
without taxes (traditional view)
r Includes Bankruptcy Risk
rE

WACC

rD
D
V
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 Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield
- PV Costs of Financial Distress

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 Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
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 Conflicts of Interest
Circular File Company has Rs.50 of 1-year
debt.
Circular File Company (Book Values)
Net W.C. 20 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets 100 100 Total liabilities

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 Conflicts of Interest
Circular File Company has Rs.50 of 1-year
debt.
Circular File Company (Market Values)
Net W.C. 20 25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities

 Why does the equity have any value ?

 Shareholders have an option -- they can
obtain the rights to the assets by paying off
the Rs.50 debt.
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 Conflicts of Interest
Circular File Company may invest Rs.10
(part of Net WC of Rs. 20) as follows.

Now Possible Payoffs Next Year

Rs.120 (10% probability)
Invest Rs.10
Rs.0 (90% probability)
 Assume the NPV of the project is (-Rs.2).
What is the effect on the market values?
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 Conflicts of Interest
Circular File Company value (post project)

Circular File Company (Market Values)

Net W.C. 10 20 Bonds outstanding
Fixed assets 18 8 Common stock
Total assets 28 28 Total liabilities

 Firm value falls by Rs.2, but equity holder

gains Rs.3
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 Conflicts of Interest
Circular File Company value (assumes a safe
project with NPV = Rs.5) by issuing equity of Rs. 10.

Circular File Company (Market Values)

Net W.C. 20 33 Bonds outstanding
Fixed assets 25 12 Common stock
Total assets 45 45 Total liabilities

 While firm value rises by Rs. 15 (10+5), the lack of a high

potential payoff for shareholders causes a decrease in
equity value.

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 More Financial Distress Games
 Cash In and Run:
 Take dividend
 Playing for Time
 Delay Settlements

 Bait and Switch

 Issue low debt initially and then
much more
25 ASM - PGDM10 - CF15 04-Jan-11
 Financial Choices
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings
and distress costs of debt.

Pecking Order Theory - Theory stating that

firms prefer to issue debt rather than equity if
internal finance is insufficient.

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 Trade Off Theory & Prices
1.Stock-for-debt Stock price
exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices;

repurchase increases stock prices.
3. Issuing straight debt has a small negative
impact.
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 Issues and Stock Prices
 Why do security issues affect stock
price? The demand for a firm’s securities
ought to be flat.

 Any firm is a drop in the bucket.

 Plenty of close substitutes.

 Large debt issues don’t significantly

depress the stock price.
28 ASM - PGDM10 - CF15 04-Jan-11
 Pecking Order Theory
The announcement of a stock issue drives down the
stock price because investors believe managers are more
likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can

be raised without sending adverse signals.

If external finance is required, firms issue debt first

and equity as a last resort.

The most profitable firms borrow less not because

they have lower target debt ratios but because they don't
need external finance.

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 Pecking Order Theory
Some Implications:
 Internal equity may be better than external
equity.
 Adapt target payout ratios to available
investment opportunities.
 Financial slack is valuable.

 If external capital is required, debt is better.

(There is less room for difference in opinions
about what debt is worth).

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 BMAM PQ18-7

PGDM
Acharya School of Management
http://www.acharya.ac.in/asm.php