W1 - BFC 3140 Adv Finance: Capital Structure

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• BFC 3140 - Corporate Finance 2 readings for week 1 are chapters 14 & 15
• Week 1 introduces unit with Capital Structure: Irrelevance Theory, Corporate Tax and Personal Tax

Teaching Team

• Lecturers: Yongxin Xu (chief examiner) – [email protected]
• Tutors: Lin Wang – [email protected]

Tutorial Questions

• Contact respective tutors for tutorial questions.
• Yongxin Xu can answer other questions.

Course Schedule

• Week 1: Capital Structure I
• Week 2: Capital Structure II
• Week 3: Capital Budgeting with Leverage
• Week 4: Equity Finance
• Week 5: Leasing
• Week 6: Mid-Semester Test (Refer to Allocate+ for timing)
• Week 7: Real Options
• Week 8: Mergers and Acquisitions
• Week 9: Risk Management
• Week 10: International Corporate Finance
• Week 11: Corporate Governance
• Week 12: Technological advancement and corporate finance

Assessments

• In-semester test: 30% (Week 6, centrally organised assessmnet)
• Online quizzes: 10% (Friday 11:55pm each week)
• Examination: 60% (To be advised)
• The mid-semester test is centrally organised with details announced on Moodle.
• The test is worth 30% of the total assessment.
• The format is MCQs.
• Topics from Week 1 to Week 4 are covered.
• A practice test will be made available on Moodle.
• Tutorials in Week 6 will run as usual

Online Quizzes

• There are ten weekly post-lecture online quizzes, worth 10% of the final grade, and 1% each.
• Available from 12pm Tuesday to Friday of the following week.
• First quiz is after Week 1 lecture, closing 11:55pm Friday Week 2.
• There is a time limit of 60 minutes.
• Two attempts are allowed per quiz.
• Access via the MyLab Finance link on Moodle (rego once only).
• Failure to complete the exercise will result in a grade of 0 for that week.

Final Exam

• The final assessment is worth 60%
• Held during the Official Examination Period
• Two hours and ten minutes will be allocated for completion
• This unit has no threshold mark hurdle.

Study Resources

• Textbook: Berk, J. B., & DeMarzo, P. (2024). Corporate finance (6th global ed.). Pearson Education.
• The fifth edition is usable with changes in end-of-chapter questions.

Week 1 Focus

• Topics: Capital Structure, Irrelevance Theory, Corporate Tax and Personal Tax
• Readings: Chapters 14 & 15

Capital Structure Irrelevance Argument

• Modigliani and Miller (1958) proposed that in perfect capital markets, a firm's value is independent of its capital structure.

Hypothetical Firm Armin

• Armin considers a project with potential success ($150 million) or failure ($80 million).
• Capital structures include all-equity financing or debt maturing at year-end with $100 million due.

Project Succeeds: Comparison of Leverage

• Without leverage, equity holders own the full $150 million.
• With leverage, equity holders own the remaining $50 million after the $100 million debt payment.

Project Fails: Comparison of Leverage

• Without leverage, equity holders own the full $80 million.
• With leverage, Armin experiences financial distress and defaults.
• Debt holders receive assets valued at $80 million, incurring a $20 million loss.

Without and With Leverage

• Without leverage, equity holders losing $70 million if the project fails
• With leverage losing of equity holders ($50 million) and debt holders ($20 million) in total are the same at $70 million.
• Modigliani-Miller (MM) Proposition I: In perfect capital markets, the total value to all investors does not depend on the firm's capital structure.

MM Propositions

• Proposition I: A firm's total value equals the present value of cash flows from assets, unaffected by capital structure.
• Proposition II: A firm's WACC is independent of capital structure.

Interest Tax Deduction

• Corporations pay taxes on profits after deducting interest payments, creating an incentive to use debt.
• Macy's in 2014 had $2.8 billion earnings before interest and taxes, $400 million interest expenses, and a 35% corporate tax rate.
• Macy's net income in 2014 was lower with leverage.
• Without Leverage EBIT of $2800 million reduced to net income $1820 million
• With Leverage EBIT of $2800 million reduced to net income $1560 million after ineterest expsnes

Interest Tax Deduction Impact

• Macy's debt obligations reduced the value of its equity
• However, there was a higher amount available to all investors with leverage.
• With leverage, Macy's payed $400 million in interest to debt holders

Interest Tax Shield

• Macy's without leverage was able to pay out $1.82 billion to investors, while with leverage, it was $1.96 billion.
• Interest Tax Shield: The reduction in taxes paid due to the tax deductibility of interest.
• Interest Tax Shield = Corporate Tax Rate × Interest Payments.
• Macy's gain equals a reduction in taxes with leverage: $980 million − $840 million = $140 million. Tax savings provided: 35% x $400 million = $140 million.

Interest Tax Shield & Leveraged Firms

• Cash flows for levered firms will be higher than without leverage by the interest tax shield amount.
• The value of the levered firm should be higher than the value of the unlevered firm.

MM Proposition I with Taxes

• VL = VU + PV(Interest Tax Shield), meaning the total value of the levered firm exceeds the value of the firm without leverage due to the present value of tax savings from debt.

ALCO Temporary Debt Example

• ALCO plans to pay $60 million in interest each year for 8 years, repaying $1 billion in year 8. Payments risk-free, marginal tax rate remains 39%.
• With a risk-free interest rate of 6%, The annual interest tax shield is 60 million x 39% = $23.4 million for 8 years. PV (Interest Tax Shield) = $23.4 million × 1/0.06(1-1/1.06^8) = $145.31 million

Interest Tax Shield

• Future interest tax shield is uncertain. This is due to fluctuating the marginal tax rate, amount of debt outstanding, interest rate, and firm risk
• Constant variables: PV(Interest Tax Shield) = c (rf D) / r = c D τ × × τ ×τ

Recapitalising To Capture The Tax Shield: Example

• Midco Industries to boost its stock price, they plans to borrow $100 million on a permanent basis and they will use the borrowed funds to repurchase outstanding shares.

Impact of recapitalisation

• Original equity market capitalisation Vu =(20 million shares) × ($15) = $300 million
• PV(interest tax shield) = cD = 35% x $100 million = $35 million
• Value of the levered firm after borrowing will be VL = VU +τcD = $300 million + $35 million = $335 million
• Market cap value to equity after debt is E = VL – D = $335 million – $100 million = $235 million

Equity Repurchase Impacts

• $100 million / $15/share = - 6.67 million shares repurchased
• 20 million – 6.67 million = 13.33 million shares outstanding
• Total value of equity $235 /13.33 M = $17.625 share (after repayment)
• Gain of remaining shareholders = $17.625/ share - $15 = $2.625/ share.
• Overall Gain $2.625/share x 13.33 million shares = $35 million

Equity Repurchase impacts after Arbitrage

With share price rise $17.625 to $15/share , would they tender their shares to Midco at $15/share? Investors immediately before the repurchase and those sell immediately afterward would represent an arbitrage opportunity. Equity will value would rise to $335 million equity .

• Share price will rise to $335/20 = 16.75

Recapitalisation Cont'd: and Conclusions

• $16.75 share holders are will to retain and tender equity
• $16.75 – $15 = + $1.75
• $1.75 × 20 shares = $35

Equity Repurchase impacts without Arbitrage

• $100 capital repyrches price $675/share, they are will = $5.9 shares
• Remain shares are 20-5.9 =14.03 million
• 14x16.75 is $235, same as market
• Benefit of the interest tax shield goes to all 20 million of the original shares outstanding for a total benefit of $35 million.

Optimal Capital Structure with Taxes

• Firms primarily issue debt when raising new capital from investors for financing
• Aggregate equity issues are negative, meaning firms reduce equity outstanding by repurchasing shares,
• Markets increase value and debt
• The use of debt varies greatly by industry.

Limits to the Tax Benefit of Debt

• Firms need taxable earnings to receive the full tax benefits from leverage.
• This constraint may limit the amount of debt needed as a tax shield.

Corporate Tax Savings leverage example

• $1000 EBIT with no leverage gives $0 of saving and $790 net income
• $1000 EBIT with moderate leverage gives $63 of saving and $553 net income
• *Note $300 income limit for deduction
• $1000 EBIT with excess leverage gives $63 of saving and $353 net income
• *Note $300 income limit for the deduction

Corporate Tax Savings leverage recap

• No leverage, the firm receives no tax benefit.
• With moderate leverage, the firm saves $63 in taxes.
• With excess leverage, interest payments exceed the 30% income limit, capping the interest deduction.
• No immediate tax shield from the excess leverage once the 30% limit is reached.

Debt Optimization: Tax Benefits

• In the tax savings the optimal level of leverage equals the interest of EBIT.

Level of Debt to Tax shield optimization

• Firm shields all taxable income while avoiding tax-disadvantaged excess interest at the optimal level of leverage.
• Future Ebit should be used, instead of Historical, should be predicted

External Tax Shield

• There are numerous provisions in the tax laws for deductions and tax credits. Tax credists carry forwards of past operating losses, etc.

Low Leverage Puzzle

• Figures demonstrate important
• Firms have used debt to shield less than one-third of their income from taxes and about 50% in downturns.
• About 10% of firms have negative taxable income, so firms have far less leverage than our analysis of the interest tax shield.

The Low Leverage Puzzle cont

• Firms worldwide have similar low proportions of debt financing, even though Personal tax codes are similar worldwide, but personal tax codes aren't

The Low Leverage Puzzle

• Key factor for why the numbers dont reconcile
• Increasing debt may lead to bancyptcy
• If bankruptcy is costly, this could offset the debt

General Summary:

• Modigliani and Miller (MM) showed that capital structure does not affect firm value under a set of conditions referred to as perfect capital market
• Investors and firms can trade the same asset at competitive market
• Market no taxation or trading fees

Conditions relaxed with debt and capstructure

• VL = VU + PV (Interest Tax Shield)
• PV (Interest Tax Shield) = ( T (r X d ) ) r = r T (D) (r) / = r dC f fT −xC

Debt conclusion

• Firms worldwide have similar low proportions of debt financing because. They might factor bankruptcy