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FINM7402 Tutorial 3: Capital Structure – MM theory with tax

Question 1*

Assume that the Munch Company operates in a perfect capital market, with one exception being that companies pay tax at the rate of 30%.  Munch generates an annual cash flow of $1 million.  No funds are retained in the firm.  That is, each year Munch pays interest to debtholders, tax to the government, and the balance as dividends to equityholders.

In each of the following cases, calculate (i) the total interest paid on debt, (ii) the tax payment, and (iii) the dividend paid to equityholders. Also add (i) and (iii) to get the total payout to Munch's claimholders.

a) Assume Munch is unlevered.

b) Now assume Munch is slightly levered.  The cost of debt  is 10% p.a. and the annual interest payments on its debt amount to $100,000.

c) Now assume Munch has substantially more debt in its capital structure.  The cost of debt is still 10% p.a., but annual interest payments on the debt amount to $400,000.

Commentary:

· The series of calculations above show two things: (i) as the level of debt increases, Munch pays less tax, and (ii) as the level of debt increases, the total cash payouts to claimholders increases.

· The introduction of corporate tax effectively subsidizes the firm's interest payment to debtholders.  That is, interest payments on debt are tax deductible but dividends paid to equityholders are not.  This creates a bias towards debt financing and leads to the conclusion that firms will be financed entirely by debt.

Question 2*

Assume the same information as Question 1. When the Munch Company is unlevered, its weighted-average cost of capital  is 15% p.a. For cases (a), (b), and (c) above, calculate (i) the return required by equityholders , and (ii) the weighted average cost of capital .

Commentary:

· These calculations show that, in a world with corporate taxes, (i) the WACC decreases as the proportion of debt increases, and (ii) the return required by equityholders increases as the proportion of debt increases.

Question 3

Assume the same information as Questions 1 & 2. If the Munch Company has an unlevered beta (asset beta) of 1, what will be the levered equity beta for case (b)?

Commentary:

· These calculations show that, in a world with corporate taxes, the equity beta for a firm increases as leverage increases.

Question 4*

Carnegie Enterprises is currently financed entirely by equity.  There are one million shares on issue. Assume that Carnegie generates an annual (before-tax) cash profit of $400,000. All after-tax profits are paid out to the firm's claimholders. Also assume the corporate tax rate is 30% and that there are no personal taxes.

a) If the required return on this unlevered firm is 10%, what is the total value of the firm? Equivalently, what is the market price for Carnegie shares?

Recalling her days as an MBA student, Carnegie's manager remembers hearing something about the tax advantage of debt during a finance lecture.  Although she never properly understood it at the time, she recalls that issuing some debt creates a tax advantage that somehow increases the net worth of shareholders.  Being a major shareholder in Carnegie, she decides to give it a go.

Carnegie raises $200,000 by issuing (i.e., selling) perpetual bonds.  The yield on these bonds is 6% p.a.  The entire $200,000 is paid out as a special dividend to shareholders.

b) Complete the following schedule for annual after-tax cash flows:

Annual After-tax Cash Flows
Profit
Interest payment
Taxable profit
Tax payment
Profit (after-tax) = dividend

Compare how much tax Carnegie pays per annum now that it is levered with how much tax was paid in (a).  What is the present value in perpetuity of this tax saving?

c) Calculate (i) the total value of Carnegie after this restructuring, (ii) the market value of equity after paying the special dividend (also convert this to price per share).  Are shareholders better or worse off after the restructuring to put debt in the capital structure?

d) Ignore the information about raising $200,000 through a bond issue.  Instead, assume that $800,000 was raised by 6% debt.  This money is paid out as a special dividend.  Repeat the requirements of (b) and (c).

Commentary:

· This fully-worked example shows that the present value of the tax savings on interest payments benefit the shareholders.  That is, issuing debt creates tax deductible interest payments. This increases the total value of the firm (as MM predict).

Question 5*

The costs of financial distress take the form of both direct and indirect costs. Compare and contrast the nature of these two costs. Your answer could consider: how the magnitude of the respective costs differs across industries, the difficulty in estimating these costs, and the timing of the inception of these costs.

Question 6

The indirect costs of financial distress provide greater incentives for firms in some industries to avoid financial distress than others. Evaluate and explain with reference to the nature of the firm’s operations whether each of the following firms is likely to face significant indirect costs from financial distress:

a) A white goods manufacturer – including washing machines, refrigerators and other household appliances.

b) A soft drink manufacturer.  

c) A services firm whose key professional staff strongly influence the firm’s ability to retain and generate clientele.

d) A pharmaceutical research firm with a need to finance manufacturing facilities to realise the commercial value of its laboratory findings.

The following are the questions from the text

Chapter 15: Questions 1, 2*, 3, 6, 8, 10, 12, 16, 19, 21, 22

Chapter 16: Questions 4*, 6, 9, 10, 11, 13, 14, 15

Chapter 18: Questions 13*

15-1. Pelamed Pharmaceuticals has EBIT of $133 million in 2006. In addition, Pelamed has interest expenses of $49 million and a corporate tax rate of 35%.

a. What is Pelamed’s 2006 net income?

b. What is the total of Pelamed’s 2006 net income and interest payments?

c. If Pelamed had no interest expenses, what would its 2006 net income be? How does it compare to your answer in part b?

d. What is the amount of Pelamed’s interest tax shield in 2006?

15-2. Grommit Engineering expects to have net income next year of $24.21 million and free cash flow of $12.11 million. Grommit’s marginal corporate tax rate is 30%.

a. If Grommit increases leverage so that its interest expense rises by $9.2 million, how will its net income change?

b. For the same increase in interest expense, how will free cash flow change?

15-3. Suppose the corporate tax rate is 30%. Consider a firm that earns $1000 before interest and taxes each year with no risk. The firm’s capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 8%.

a. Suppose the firm has no debt and pays out its net income as a dividend each year. What is the value of the firm’s equity?

b. Suppose instead the firm makes interest payments of $700 per year. What is the value of equity? What is the value of debt?

c. What is the difference between the total value of the firm with leverage and without leverage?

d. The difference in part (c) is equal to what percentage of the value of the debt?

15-6. Arnell Industries has just issued $15 million in debt (at par). The firm will pay interest only on this debt. Arnell’s marginal tax rate is expected to be 35% for the foreseeable future.

a. Suppose Arnell pays interest of 7% per year on its debt. What is its annual interest tax shield?

b. What is the present value of the interest tax shield, assuming its risk is the same as the loan?

c. Suppose instead that the interest rate on the debt is 6%. What is the present value of the interest tax shield in this case?

15-8. Bay Transport Systems (BTS) currently has $60 million in debt outstanding. In addition to 10% interest, it plans to repay 4% of the remaining balance each year. If BTS has a marginal corporate tax rate of 35%, and if the interest tax shields have the same risk as the loan, what is the present value of the interest tax shield from the debt?

15-10. Rogot Instruments makes fine violins and cellos. It has $1.3 million in debt outstanding, equity valued at $2.7 million, and pays corporate income tax at rate of 33%. Its cost of equity is 12% and its cost of debt is 6%.

a. What is Rogot’s pretax WACC?

b. What is Rogot’s (effective after-tax) WACC?

15-12. Summit Builders has a market debt-equity ratio of 1.30, a corporate tax rate of 38%, and pays 9% interest on its debt. The interest tax shield from its debt lowers Summit’s WACC by what amount?

15-16. Milton Industries expects free cash flow of $18 million each year. Milton’s corporate tax rate is 38%, and its unlevered cost of capital is 16%. Milton also has outstanding debt of $75.25 million, and it expects to maintain this level of debt permanently.

a. What is the value of Milton Industries without leverage?

b. What is the value of Milton Industries with leverage?

15-19. Rally, Inc., is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding. Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 35%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.

a. Without the increase in leverage, what would Rally’s share price be?

b. Suppose Rally offers $2.75 per share to repurchase its shares. Would shareholders sell for this price?

c. Suppose Rally offers $3.00 per share, and shareholders tender their shares at this price. What will Rally’s share price be after the repurchase?

d. What is the lowest price Rally can offer and have shareholders tender their shares? What will its stock price be after the share repurchase in that case?

15-21. Facebook, Inc. had no debt on its balance sheet in 2014, but paid $2 billion in taxes. Suppose Facebook were to issue sufficient debt to reduce its taxes by $250 million per year permanently. Assume Facebook’s marginal corporate tax rate is 35% and its borrowing cost is 5%.

a. If Facebook’s investors do not pay personal taxes (because they hold their Facebook stock in tax-free retirement accounts), how much value would be created (what is the value of the tax shield)?

b. How does your answer change if instead you assume that Facebook’s investors pay a 20% tax rate on income from equity and a 39.6% tax rate on interest income?

15-22. Markum Enterprises is considering permanently adding $127 million of debt to its capital structure. Markum’s corporate tax rate is 40%.

a. Absent personal taxes, what is the value of the interest tax shield from the new debt?

b. If investors pay a tax rate of 35% on interest income, and a tax rate of 25% on income from dividends and capital gains, what is the value of the interest tax shield from the new debt?

16-4. Which type of firm is more likely to experience a loss of customers in the event of financial distress:

a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)?

b. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports equipment)?

16-6. Suppose Tefco Corp. has a value of $179 million if it continues to operate, but has outstanding debt of $181 million that is now due. If the firm declares bankruptcy, bankruptcy costs will equal $11 million, and the remaining $168 million will go to creditors. Instead of declaring bankruptcy, management proposes to exchange the firm’s debt for a fraction of its equity in a workout. What is the minimum fraction of the firm’s equity that management would need to offer to creditors for the workout to be successful?

16-9. Kohwe Corporation plans to issue equity to raise $40 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $9 million each year. Kohwe currently has five million shares outstanding and has no other assets or opportunities. Suppose the appropriate discount rate for Kohwe’s future free cash flows is 9%, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of Kohwe’s investment?

b. Given these plans, what is Kohwe’s value per share today?

Suppose Kohwe borrows the $40 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $40 million on the loan. Suppose that Kohwe’s corporate tax rate is 30%, and expected free cash flows are still $9 million each year.

c. What is Kohwe’s share price today if the investment is financed with debt?

Now suppose that with leverage, Kohwe’s expected free cash flows will decline to $8 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe’s future free cash flows is still 9%.

d. What is Kohwe’s share price today given the financial distress costs of leverage?

16-10. You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, “If we go bankrupt, we don’t have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right?

16-11. Facebook, Inc. has no debt. As Problem 21 in Chapter 15 makes clear, by issuing debt Facebook can generate a very large tax shield potentially worth nearly $2 billion. Given Facebook’s success, one would be hard pressed to argue that Facebook’s management are naïve and unaware of this huge potential to create value. A more likely explanation is that issuing debt would entail other costs. What might these costs be?

16-13. Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:

 

Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if, in the event of distress,the firm will have distress costs equal to

a. $1 million?

b. $5 million?

c. $27 million?

16-14. Marpor Industries has no debt and expects to generate free cash flows of $17 million each year. Marpor believes that if it permanently increases its level of debt to $45 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Marpor’s expected free cash flows with debt will be only $16 million per year. Suppose Marpor’s tax rate is 40%, the risk-free rate is 3%, the expected return of the market is 13%, and the beta of Marpor’s free cash flows is 1.3 (with or without leverage).

a. Estimate Marpor’s value without leverage.

b. Estimate Marpor’s value with the new leverage.

16-15. Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.

18-13. Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.16. Its current stock price is $48 per share, with 2.6 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.4 and can borrow at 4.7%, just 20 basis points over the risk-free rate of 4.5%. The expected return of the market is 10%, and PKGR’s tax rate is 32%.

a. This year, PKGR is expected to have free cash flows of $5.8 billion. What constant expected growth rate of free cash flow is consistent with its current stock price?

b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.4, it believes its borrowing costs will rise only slightly to 5%. If PKGR announces that it will raise its debt-equity ratio to 0.4 through a leveraged recap, determine the increase in the stock price that would result from the anticipated tax savings.