CORPORATE FINANCING DECISIONS

Through its financing decisions, a firm provides “financial services” to investorsI.e., the firm packages its operating cash flows

as interest, dividends, capital gains, offering different risk-return profiles to investors, depending on the mix of stock and bonds

The securities the firm issues also provide clues (“signals”) to investors about what is happening inside the firm

CAN WE CREATE VALUE THROUGH FINANCING DECISIONS?

Competition is heavy in financial servicesfinancial institutionsother nonfinancial corporationsinvestors themselves

Opportunities for value creation will be limited

These opportunities arise primarily from market “frictions”

CAPITAL MARKET FRICTIONS

TaxesCan financing reduce taxes? For whom?

Bankruptcy CostsIs anything lost when the firm goes broke?

Agency CostsWhat conflicts of interest arise between

shareholders, managers and bondholders?

Costs of imperfect information

FINANCING AND THE COST OF CAPITAL

Cost of capital concepts:• WACC = weighted average cost of capital

• rE = cost of equity

• rD = cost of debt

• r = unlevered cost of capital (i.e., cost of capital the firm would have if it didn’t have any debt)

COMPANY VALUATION

E

D

r

D)T1(rATOCFE

WACC

ATOCFDEV

VALUATION:A DIFFERENT APPROACH

Total cash flows to bondholders and shareholders:

rDD + ATOCF - rD(1-T)D

= ATOCF + TrDD

We should be able to value the firm by valuing these two pieces. Discount ATOCF at r and TrDD at rD.

ADJUSTED PRESENT VALUE

shields tax of luepresent va

plus valueunlevered V

TDVV

r

DTr

r

ATOCFV

U

D

D

ANOTHER EXPRESSION FOR WACC

)TL1(rWACC)TL1(r

ATOCFV

V

ATOCF)

V

DT1(r

rTDATOCFrV

TDr

ATOCFV

EFFECTS OF PERSONAL TAXES

• Debt has a tax advantage to the firm

• BUT: for investors, cash received as interest is more heavily taxed than equity income

• Net tax advantage of debt = T* < T

LTrLrWACC

LTrWACC

DTr

ATOCFV

DE )1()1(

)*1(

*

FINANCING DECISION TRADEOFFS

Tax considerations favor debt over equity but debt financing has its costs:Financial distress costs

Trouble with suppliers and other disruptionsLoss of tax shields

Agency CostsThe Asset Substitution ProblemClaim DilutionThe underinvestment problem

ASSET SUBSTITUTION PROBLEM

Firm has 50% chance of earning $415 before interest

50% chance of earning $215

rf = 5%

Debt has $150 face value, 5% coupon

15005.1

)5.157215(5.)5.157415(5.E

15005.1

)05.1)(150(5.)05.1)(150(5.D

30005.1

)215(5.)415(5.V

ASSET SUBSTITUTION (cont.)

Now firm switches suddenly to riskier assets

50% chance of earning $515

50% chance of earning $115

24.17005.1

)0(5.)5.157515(5.E

76.12905.1

)115(5.)05.1)(150(5.D

30005.1

)115(5.)515(5.V

ASSET SUBSTITUTION (cont.)

Shareholders have gained at bondholders’ expense, because of the fixed nature of the bond contract

Had the bondholders known about this in advance, they would have demanded a higher coupon rate

They will protect themselves by adding restrictive covenants or refusing credit

CLAIM DILUTION

In the same way shareholders can undermine bondholders by:Issuing more debt of same priorityGiving new bondholders a secured claim on

specific assetsSelling assets and leasing backPaying dividendsRepurchasing shares

UNDERINVESTMENT PROBLEM

• Consider same firm, earning either $515 or $115

• New project costs $90 and returns $105 in one period no matter what

25005.1

)5.157220(5.)5.157620(5.E

15005.1

)05.1)(150(5.)05.1)(150(5.D

40005.1

)220(5.)620(5.V

UNDERINVESTMENT (cont.)

For firm as a whole, new project has positive NPVNPV= 105/1.05 - 90 = 10

But for shareholders, NPV negative: Shareholder gain = 250 - 170.24 = 79.76

Cost = 90; NPV = 79.76 - 90 = -10.24

Shareholders will not be willing to fund project

WHO SHOULD ISSUE DEBT?

Favorable to debt:• Stable cash flows

• Mature industry

• Few investment opportunities

• Assets suitable for use as collateral

• Good reputation for treatment of bondholders

Unfavorable to debt• Lots of uncertainty

• Rapid technological change

• Large future investment opportunities

• Intangible assets

• Unknown to bondholders