Lecture 13
Valuation with
Leverage
Class 12: Summary
The required return on debt is lower than the required
return on equity:
Debt is senior
Modigliani-Miller (M&M) irrelevance results. Under perfect
capital markets:
1.
Leverage by itself does not increase firm value
1.
2.
2.
Leverage (debt financing) increases the risk of equity
The benefit of debts lower cost is exactly offset by the higher equity cost
of capital (higher equity risk)
The WACC is unaffected by financing
M&M: the capital structure benchmark
M&M: focus on the key source of value
Cash flows, cash flows, cash flows!
2
Beyond M&M
Capital structure decisions seem to matter. Evidence:
Stock prices react to financing decisions
Increase if firms: increase leverage
Decrease if firms: decrease leverage
Corporations spend resources on capital structure design
Ex. Investment banking fees
Managers are reluctant to change them:
Tell a CFO that debt policy does not matter
M&M does not predict any patterns for capital structure
But, capital structure shows lots of patterns
Across time for a given firm: life cycle
Across industries: different asset or cash-flow characteristics
Across countries: different institutional factors
3
Leverage and Taxes
MM relied on perfect or frictionless capital markets
MM: any capital structure is as good as any other!
Thus, capital structure must matter due to some market
imperfection that affects cash-flows/value
Corporate income taxes
Bankruptcy costs
Agency costs (incentives)
Differences in information
Security mispricing
Corporate income taxes:
Can leverage be used to reduce the corporate income taxes that
the firm must pay, and thereby increase its value for investors?
4
The Corporate Income Tax
Income Statement
2010
2011
2012
2013
2014
Sales Revenues
4,405
4,669
4,985
5,347
5,747
Cost of Goods Sold
-2,908
-3,059
-3,240
-3,448
-3,679
SG&A Expenses
-705
-747
-797
-856
-920
Depreciation
-132
-140
-149
-160
-172
Operating Income
660
724
799
883
976
Interest expenses
deducted before
tax
No corresponding
deduction for
dividends or share
repurchases
Other Income
13
10
15
20
24
EBIT
673
734
814
903
1,000
Interest Expense
-65
-65
-80
-100
-100
Income Before Tax
608
669
734
803
900
Taxes (35%)
-213
-234
-257
-281
-315
Net Income
395
435
477
522
585
Gain from Leverage
With vs. Without Leverage (2014)
All Equity Firm
EBIT
Levered Firm
$1000
$1000
$0
$100
$1000
$900
Tax at 35%
$350
$315
Net Income to Equity
$650
$585
Interest Paid to Debt Holders
Pre-Tax Income
What is the benefit?
Total income to all investors:
All equity firm = $650
Levered firm = 100 + 585 = $685
Gain from leverage = 685 650 = $35
All Equity Firm
$650
Levered Firm
$585 (equity)
$100 (debt)
$685
Tax savings = 350 315 = $35
6
The Interest Tax Shield
Debt gives the firm an interest tax shield which reduces taxes
each year:
Tax reduction = Corporate Tax Rate Interest Payments
This tax shield:
Reduces the taxes paid by the firm
Increases the net-of tax cash-flows available to both debt and equity
Increases the value of the firm:
PV(future interest tax shields) = Tc PV(future interest payments)
Tc : corporate tax rate
Value of the Interest Tax Shield
Special and simplest case:
Firm increases debt by D permanently: perpetually rolled over
Each period, the tax shield is = Tc D rD. Given that D is permanent, the
present value of tax shields is:
PV ( ITS )
Tc D rD
Tc D
rD
Gain from leverage:
V(Levered Firm) = V(Unlevered) + Tc D
Change in value:
V(Levered Firm) = 1 + Tc D
V(Unlevered)
V(Unlev)
Are these effects meaningful?
If Tc= 35%:
for D / V(Unlev)= 20%, firm value increases by about 7%
for D / V(Unlev)= 50%, firm value increases by about 17.5%
Bottom line: debt tax shields matter!
What happens if a competent CEO does not want to lever up?
Call Offer !!!! Do it! or someone will do it for you!
Weighted Average Cost of Capital
The After-Tax Cost of Debt
Each $1 of interest paid gives the firm a $0.35 tax benefit
Net after-tax cost of paying $1 in interest is only $0.65!
Effective after-tax interest rate on debt = rD (1 Tc)
Unchanged by
leverage ratio
Pretax WACC:
rWACC
E
D
rE
rD
DE
DE
ru
Decreasing
with leverage
WACC with Taxes:
rWACC
E
D
rE
rD (1 TC )
DE
DE
ru
D
TC rD
DE
u-unlevered
9
Weighted Average Cost of Capital
40%
35%
30%
25%
20%
Equity Cost of Capital r E
pretax WACC
15%
WACC with taxes
10%
Debt Cost of Capital r
5%
After-Tax Debt Cost of Capital r (1 )
D
c
0%
0%
20%
40%
60%
80%
100%
% Debt-to-Value Ratio D/(E+D)
10
2/5/2015
For years, RadioShack the retailer that helped bring personal
computers to the masses outlasted untold predictions that it
would buckle in the face of bigger rivals and online competitors.
But its clock has finally run out.
RadioShack which listed $1.2 billion in assets and nearly $1.4
billion in total debt could still survive in a much smaller form.
11
Mexico
12
Optimal Leverage
Fact: firms dont fully exploit the interest tax shield
What is the tradeoff?
60
50
Interest/EBIT
40
30
20
10
0
1975
1980
1985
1990
1995
2000
2005
2010
13
Direct and indirect costs of financial distress
If debt tax savings are so large what limits debt use?
Direct bankruptcy costs:
Cost of the legal proceedings around reorganization or liquidation
Any costs directly related to the event of bankruptcy:
Legal fees
Accounting fees
Advisory fees
Indirect costs of financial distress:
Loss of (or damage to) intangibles, such as brands
Difficulty retaining valuable employees
Difficulty of maintaining relationships with customers and suppliers
Distortions to investment behavior when firm is close to default
Distortions to managers incentives when firm is close to default
14
Example cost of financial distress: GM
This idea that you just go into Chapter 11 and hang
around for three months and agree to reduce your debt
obligations and don't pay your retirees, this is a fantasy.
Most people will stop buying the cars of a bankrupt
company.
Rick Wagoner (Source: Reuters, Nov 16, 2008)
15
Trade-Off theory of capital structure
Firms trade off tax benefits of debt against bankruptcy
and financial distress costs
Optimal leverage ratio is determined by:
a. The value and probability of using tax shields, and
b. The costs and probability of financial distress
Characteristic
Profitability
Nondebttaxshields(eg.Depreciation)
Tangibilityofassets
Volatilityofcashflows
Size
Indirectcostsoffinancialdistress*
EffectonOptimalLeverage
Positive
Negative
Positive
Negative
Positive
Negative
*Customerconfidence,laborforcemightleave,supplierswon'tship,etc)
16
Tradeoff Theory
Optimal leverage balances tax advantages and direct
and indirect bankruptcy costs
17
Valuation with Leverage
Main methods for valuing a firm or project with leverage
WACC: Weighted Average Cost of Capital Method: this class
Cash Flows:
Discount Rate:
Determines:
Unlevered Free Cash Flow
WACC (after tax) using constant leverage ratio
Enterprise Value
APV: Adjusted Present Value Method (Corporate finance class, etc.)
Cash Flows:
Discount Rates:
Determines:
Unlevered Free Cash Flow
Interest Tax Shield
Unlevered (Asset) Cost of Capital
Tax Shield Cost of Capital
Enterprise Value
18
Example: Diptron Incs expansion
A manufacturer of electronic switches is evaluating an expansion:
1.
2.
3.
$60 million expansion
Expected to increase its FCF by $7.5 m the first year, with 4% growth thereafter
Diptrons tax rate is 40%
The debt-equity ratio is 1/3 or D/(D+E)=25%
The equity cost of capital is 14.33%, and its cost of debt is 5% (pre-tax)
Questions:
What is the WACC?
What is the NPV of this project?
How large are the expected tax savings from using debt financing?
19
Solution
Unlevered Cost of Capital: Diptrons pre-tax WACC:
NPV without leverage
Tax savings:
20
10
WACC Method: Assumptions
Assumptions:
Risk:
Expansion has similar risk to the rest of the firm
Leverage: Diptron D/E = D/E project today and in the future
How much debt will Diptron use to fund the expansion?
Capital structure = 75% equity + 25% debt (market value)
25% $60 million investment
= $15 million
25% $40 million inc. in mkt value = $10 million
Total new debt
= $25 million
21
Adjusted Present Value (APV) Method
Unlevered Cost of Capital: Diptrons pre-tax WACC:
rUnlevered
= (E/V) rE + (D/V) rD = 75% 14.3333% + 25% 5.0%
= 12%
NPV without leverage
NPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million
Interest Tax Shield
First Year: $25 million 5% 40% = $0.5 million
PV(Int Tax Shield) = 0.5/(12% - 4%) = $6.25 million
Adjusted Present Value
Increases
by 4%/yr
Same risk
as project
APV = NPVU + PV(Int Tax Shield) = 33.75 + 6.25 = $40 million
U-unlevered
22
11
Alternative Leverage Policies
Suppose Diptron will not maintain a fixed D/E ratio
Instead Diptron plans to:
Borrow $60 million initially
Repay $60 million after 2 years
NPV without leverage
NPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million
Interest Tax Shield
Interest
Interesttaxshield
PresentvalueITS(at12%)
PresentvalueITS(at5%)
Sum
Year1
Year2
2,028
2,231
3,000
1,200
1,071
1,143
3,000
1,200
957
1,088
APV (at 5%) = 33.75 + 2.23 = $35.98 million
23
Valuation Methods in Practice
WACC is the most common method
Easiest to apply when the project has a constant target D/E ratio
Implicitly assumes that the debt tax savings are as risky as the
projects cash flows
Important note:
Many firms calculate a single firm-wide WACC and apply it to all
new projects: that is typically wrong!
Only valid if all projects have:
(a) same target D/E as the firm and
(b) similar business risk
APV is useful if the leverage ratio (D/E) is not constant
Easiest to apply when future debt levels are known
Easy to use a different (lower) discount rate for the debt tax
savings
Easy to adjust for other costs or benefits of debt
24
12
Big picture
25
26
13
Belgium: Notional Interest Deduction
Since 2006, firms receive a tax deduction based on the
book value of equity (deduction=Equity*rD)
Level the financing playing field
Percentages
44%
42%
PreReform
PostReform
40%
38%
36%
34%
32%
30%
2002
2003
2004
2005
2006
2007
2008
2009
Equitytoassetsratio
Source: Panier, Perez-Gonzalez and Villanueva (2014)
27
Summary
M&M: capital structure affects value if D,E affect cash flows
Corporate income taxes: Interest payments are tax-deductible.
Debt financing can increase the net-of-tax cash flows and hence value
M&M intuition holds
Trade-off theory of capital structure. Firms choose an optimal level of
debt financing that balances:
1. The tax benefit of using debt financing (tax-shield) against
2. The costs of financial distress (ex. bankruptcy costs)
Valuation methods to capture the effect of debt tax shields on firm value:
WACC: discount FCFs using the weighted average of after-tax debt costs and
equity costs
Adjusted Present Value (APV). Two steps:
1. Value projects as if 100% equity financed: FCFs & all-equity cost of capital
2. Add the present value of the tax shield of debt: using the expected interest
tax shield and the tax shield cost of capital
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