Corporate Financial Policy Notes

1. Introduction
Investment
activities
Sources of
funding
Assets
Liabilities
Equity

1.1. The Liability Side (RHS): Financing
Financing activities (Sourcer of financing): focus on liability side of Balance Sheet taking the firms assets as
a given;
o How to finance the firms assets?
o Can we create value on the RHS?
Funding needs can be funded by:
o Debt;
o Equity;
o Other sources retained earnings.
What should be done with the excess cash?
When should the funds be raised in the capital markets Equity IPOs, etc.
1.2. The Asset Side (LHS): Valuation
Valuation: focus on how to maximize the value of the assets, taking into account their financing.
o How to create value on the LHS?
Evaluation of a corporate investment project:
o New plant and equipment;
o Market entry.
How to compare projects:
o Payoffs today vs. down the road;
o Projects with different risks.
Different valuations per different types of companies:
o An established company vs. a start-up;
o A merger.
1.3. Corporate Finance & Corporate Strategy

o
o Market Value of a firm: how much you need to pay to acquire the firm;
There is the case that the value of the firm is forward looking as it seeks the potential of the
firm in the future;
Market Value of the firm is forward looking expresses the expectations of investors on
future growth of the firm
EBITDA of the firm is backward looking based on past results

A Higher multiple will imply expectations of a higher growth!
Sustainable growth rate:

( )

o
o ( )
o

returns on equity at the beginning of the period:

Maximum amount of sales with the lower amount of assets used

Companies finance the purchase of assets either through equity or debt, so a high
equity multiplier indicates that a larger portion of asset financing is being done
through debt.
o Drivers of Sustainable growth rate
Decrease in payout ratio (dividends have remained constant but earnings increased);
Increase in Financial Leverage;
Increase in Profit margins;
Increase in Asset turnover.

What if Company is growing at a faster pace (Growth rate of Sales) than the sustainable growth rate?
o Retained earnings are not enough to cover the necessary investment to grow and the company is
bounded to increase leverage (or reduce its Cash account) unless it issues Equity or Debt.
o Most likely, the firm did not issue equity and has little excess cash.
o

How to finance this growth:
o Retained earnings;
o Debt issues;
o Stock issues;
Example: During the 1980s it was very popular to perform LBOs:
The acquisition of another company using a significant amount of borrowed
money (bonds or loans) to meet the cost of acquisition.
Often, the assets of the company being acquired are used as collateral for the loans
in addition to the assets of the acquiring company.
The purpose of leveraged buyouts is to allow companies to make large acquisitions
without having to commit a lot of capital.
Very risky capital structure due to high financial leverage!
Upshot of financial policy decisions:
o The financial policy (decision of leverage) must be consistent with the product market strategy
(growth rate);
o When evaluating a strategy, you need to incorporate:
realistic assumptions about your financial policy (e.g., can I really keep leverage low)
realistic implications of this policy (e.g., how likely I am to get into financial distress)
o Must choose a sensible financial structure optimal for the firms financial needs.
1.4. The case of Unidentified Industries (Financial ratios)


Services Industry:
o Is not likely to have large inventories check first the ones with very low inventories will have
low of inexistent Inventory turnover:

o Banks: Notes payable Receivables collection period is very high
Banks take a lot of time to get back the money from the investments/ clients case of the
mortgages;
o Insurance Company: Cash and Marketable securities Receivables collection period
Insurance receive first the money, only in the case of needing to pay for the services it pays;
o Electric & Gas company Airline: PPE should be very high
Companies with Low margins:
o Companies that due to their activity collect very low margin rates from their sales:

A higher profit margin indicates a more profitable company that has better control over its
costs compared to its competitors;
o Important ratio here is the Inventory turnover: because it measures how fast the inventory must be
replaced Grocery Chain and Meat Packer have a higher necessity of rotating faster their inventory.
More different companies:
o Pharmaceutical manufacturer: should have a higher PPE in the sense of all the patents that are
included here in this section;
o Software Developer: Profit Margins Cash and Marketable Securities Capital stock and
capital surplus
Summary on Financial Ratios:

2. Capital Structure 1- Basics M&M
2.1. The correct Financial Policy
The base question is: How should we finance the investment projects we choose to undertake?
Real investment policies imply funding needs.
We have tools to forecast the funding needs to follow a given real investment policy.
Sources of funds:
o Internal Funds: cash reserves vs. cutting dividends;
o Debt borrowing: banks vs. corporate bonds;
o Equity issuing stock: Venture Capitals vs. IPO;
2.2. Capital Structure
Capital Structure: represents the mix of claims against a firms assets and free cash flow.
Some characteristics of financial claims:
o Payoff structure: fixed promised payments;
o Priority : debt paid before equity;
o Maturity;
o Restrictive covenants;
o Voting rights
o Embedded options: convertible securities, call provisions, etc.;
Mostly focus on leverage (debt vs. equity) and how it can affect firm value.
M&M proposition I without taxes Firms value is independent of the Capital structure:
EV
E= 50%

EV
E= 75%

D= 50%


D= 25%
The Enterprise Value is the same despite having different Capital Structures;
However, in reality there are Taxes Assumptions dont hold there is an OPTIMAL CAPITAL
STRUCTURE
2.2.1. Optimal Capital Structure
Optimal Capital structure: is the optimal mix between debt and equity;
It is acquired when it is added value on the RHS of the balance sheet by following a good financial policy;
o If yes, does the optimal financial policy depend on the firms operations (Real Investment policy),
and how?
Different Industries have different capital structures (Debt ratio):





o In fact more correctly we should use the Market value of Debt BUT there is hardly the case
where Debt is traded
Volatility vs. Excess Return: of U.S. Small Stocks, Large Stocks (S&P 500), Corporate Bonds, and Treasury
Bills, 19262011:

ROE is higher than the Earnings on Debt because equity is riskier and it is exposed to the residual
claim;
Returns volatility Returns on Equity
2.2.2. Financing a firm with Equity
You are considering an investment opportunity:
For an initial investment of $800 this year;
The project will generate cash flows of either $1400 ( if the economy is strong) or $900 ( if the economy is
weak) next year.
o Both scenarios are equally likely.
{
()
()

The project cash flows depend on the overall economy and thus contain market risk:
As a result, you demand a 10% risk premium over the current risk-free interest rate of 5% to invest in
this project:

Thus, the cost of capital for this project is 15% (MRP=15%).

o Expected cash flow for this project: 1150
Fully Equity financed project
If you finance this project using only equity, how much would you be willing to pay for the project?

( )

o If you can raise $1000 by selling equity in the firm, after paying the investment cost of $800, you can
keep the remaining $200, the NPV of the project NPV, as a profit.
Unlevered Equity Equity in a firm with no debt Because there is no debt, the cash flows of the
unlevered equity are equal to those of the project;
Returns:
{
()
()
{

()

( ) ( )
( )


Cost of Capital

=15% and Expected Returns on Equity=15%

Shareholders are earning an appropriate return for the risk they are taking.
Financing the project with Equity and Debt
Suppose you decide to borrow $500 initially, in addition to selling equity.
o The projects cash flow will always be enough to repay the debt (900 or 1400):
o The debt is risk free and you can borrow at the risk-free interest rate of 5%

.
o You will owe the debt holders:
( )
(

)
Levered Equity equity in a firm that also has debt outstanding:
{





The question now is: what is the value of Equity?
Modigliani and Miller argued that with perfect capital markets, the total value of a firm should not depend
on its capital structure:
o They reasoned that the firms total cash flows still equal the cash flows of the project, and
therefore have the same present value.
Law of One Price:
o The cash flows of the debt and equity sum to the cash flows of the project;
The combined values of debt and equity must be $1000 = PV(future expected CF):
( )

EV=
1000
E= 500
D= 500
The company is not worse off.
o You will still raise a total of $1000 by issuing both debt and levered equity.
o Consequently, you would be INDIFFERENT t between these two choices for the firms capital
structure.
The Effect of Leverage on Risk and Return
Leverage increases the risk of the equity of a firm:
o Therefore, it is inappropriate to discount the cash flows of levered equity at the same discount
rate of 15% that you used for unlevered equity.
Investors in levered equity will require a higher expected return to compensate for the increased risk.
In the case of bankruptcy the shareholders (equity holders) are the last to receive any money
higher risk must have a higher ROE:
{


{

()

( )

The relationship between risk and return: can be evaluated more formally by computing the sensitivity of
each securitys return to the systematic risk of the economy:

( ) () ()
()

o Because the DEBTs return bears no systematic risk, its risk premium is zero.
o In this particular case, the levered equity has twice the systematic risk of the unlevered equity
has twice the risk premium.
In Summary:
In the case of perfect capital markets:
o If the firm is 100% equity financed
The equity holders will require a 15% expected return.
o If the firm is financed 50% with debt and 50% with equity
The debt holders will receive a return of 5%;
While the levered equity holders will require an expected return of 25% (because of their
increased risk).
Leverage increases the risk of equity even when there is no risk that the firm will default.
Thus, while debt may be cheaper its use raises the cost of capital for equity.
Considering both sources of capital together: the firms average cost of capital with leverage is the
same as for the unlevered firm.
2.3. Modigliani-Miller I: Leverage, Arbitrage, and Firm Value
The Law of One Price: implies that leverage will not affect the total value of the firm.
o Instead, it merely changes the allocation of cash flows between debt and equity, without altering
the total cash flows of the firm.
Modigliani and Miller (MM) showed that this result holds more generally under a set of conditions
referred to as perfect capital markets:
1. Investors and firms can trade the same set of securities at competitive market prices equal to the present
value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firms financing decisions do not change the cash flows generated by its investments, nor do they reveal
new information about them.
MM Proposition 1:
In a perfect capital market, the total value of a firm is equal to the market value of the total cash
flows generated by its assets and is not affected by its choice of capital structure.
MM established their result with the following argument:
o In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firms
security holders is equal to the total cash flow generated by the firms assets.
By the Law of One Price the firms securities and its assets must have the same total market value!
Information issues on deciding issuing Debt or Equity:
o Equity: has a NEGATIVE effect on Markets perception;
o Debt: has a POSITIVE effect on Markets perception;
2.4. Homemade Leverage
Homemade Leverage: when investors use leverage in their own portfolios to adjust the leverage choice
made by the firm.
o Investors can borrow money by themselves to invest and, thus, the company may not be levered but
as they incurred on a debt their investment will be levered;
Levering the investment on an unlevered firm!
MM demonstrated that if investors would prefer an alternative capital structure to the one the firm has
chosen investors can borrow or lend on their own and achieve the same result.





o If the cash flows of the unlevered equity serve as collateral for the margin loan (at the risk-free rate
of 5%);
o Then by using homemade leverage the investor has replicated the payoffs to the levered equity,
as illustrated in the previous slide, for a cost of $500.
Law of One Price, the value of levered equity must also be $500!

Now assume you use debt but the investor would prefer to hold unlevered equity:
o The investor can re-create the payoffs of unlevered equity by buying both the debt and the equity
of the firm:
o Combining the cash flows of the two securities produces cash flows identical to unlevered equity,
for a total cost of $1000.

In each case, your choice of capital structure does not affect the opportunities available to investors:
o Investors can alter the leverage choice of the firm to suit their personal tastes either by adding
more leverage or by reducing leverage.
o With perfect capital markets different choices of capital structure offer no benefit to investors
and do not affect the value of the firm.
Homemade Leverage and Arbitrage
Problem
Firms cash flows at date 1 are:
o $1400 in the good state of the economy;
o $900 in the weak state of the economy.
2 firms different with different capital structure:
o Unlevered Equity has a market value of $990;
o Levered Borrowed $500 (Debt) and Equity has a market value of $510.
Does MM I Proposition hold?
What arbitrage opportunity is available using Homemade Leverage?

MM I Proposition states that the value of each firm should be equal to the value of its assets because the
firms hold the identical assets their total values should be the same.
o Unlevered firm values $990 while it should value $1000 Undervalued;
o Levered Firm values () () while it should value $1000
Overvalued;
To enjoy the arbitrage opportunity we can:
o Borrow $500;
o Sell the Overvalued firms equity for $510 (Short-selling);
o Buy the Undervalued firms equity for $990;
Make a gain of $20 with no risk!

2.5. The Market Value Balance Sheet
Market Value Balance Sheet is balance sheet where:
o All assets and liabilities of the firm are included (even intangible assets such as reputation, brand
name, or human capital that are missing from a standard accounting balance sheet).
o All values are current market values (rather than historical costs).
o The total value of all securities issued by the firm must equal the total value of the firms assets.

Using the market value balance sheet, the value of equity is computed as:


Problem
Suppose the entrepreneur decides to sell the firm (EV=$1000=PV(future expected cash flows) by splitting
it into 3 securities:
o Equity;
o Debt= $500;
o {




Mkt. V. Bal. Sheet
EV= 1000
E= 440
W=60
D= 500
{
()
()
{

2.6. A Leverage Recapitalization
Leveraged Recapitalization: is when a firm uses borrowed funds to pay a large special dividend or
repurchase a significant amount of outstanding shares.
o Example:
o Harrison Industries is currently an all-equity firm operating in a perfect capital market, with 50
million shares outstanding that is trading for $4 per share plans to increase its leverage by
borrowing $80 million and using the funds to repurchase 20 million of its outstanding shares.
This transaction can be viewed in two stages:
1. Harrison sells debt to raise $80 million in cash;
2. Harrison uses the cash to repurchase shares.

Initially: Harrison is an all-equity firm and the market value of Harrisons equity is $200 million
(50 million shares $4 per share = $200 million) equals the market value of its existing
assets.
After borrowing, Harrisons liabilities grow by $80 million, which is also equal to the
amount of cash the firm has raised.
Because both assets and liabilities increase by the same amount the market
value of the equity remains unchanged.
To conduct the share repurchase: Harrison spends the $80 million in borrowed cash to
repurchase 20 million shares
($80 million $4 per share = 20 million shares.)
Because the firms assets decrease by $80 million and its debt remains
unchanged, the market value of the equity must also fall by $80 million, from
$200 million to $120 million, for assets and liabilities to remain balanced.
The shares price remains unchanged.
With 30 million shares remaining, the shares are worth $4 per
share, just as before:
($120 million 30 million shares = $4 per share).
2.7. Capital Structure Fallacies
2.7.1. EPS Fallacy: Debt is Better When It Makes EPS Go Up
1. EPS can go up (or down) when a company increases its leverage True
2. Companies should choose their financial policy to maximize their EPS False

EBI(T) is unaffected by a change in capital structure (Recall that we assumed no taxes for now).
Creditors receive the safe (or the safest) part of EBIT.
Expected EPS might increase but EPS has become riskier!
Remarks:
P/E ratios of companies with different capital structures.
Further confusing effect in share-repurchases: The number of shares changes as well as expected earnings.

Example:
LVI is currently an all-equity firm.
It expects to generate earnings before interest and taxes (EBIT) of $10 million over the next year.
Currently, LVI has 10 million shares outstanding:
o Its stock is trading for a price of $7.50 per share.
LVI is considering changing its capital structure by:
o Borrowing $15 million at an interest rate of 8%
o Using the proceeds to repurchase 2 million shares at $7.50 per share.
Solving:
1. Initially:
LVI has no debt.
Since there is no interest and no taxes
LVIs earnings would equal its EBIT and LVIs earnings per share without leverage would be:

2. After the Leverage Recap.
The new debt will obligate LVI to make interest payments each year of $1.2 million/year:
o
LVI will have expected earnings after interest of $8.8 million:



Uses the 15million of debt to buy 2 million at 7.5 price per share:
o Shares outstanding:




LVIs expected earnings per share increases with leverage.
Question: Are shareholders better off?
NO!
Although LVIs expected EPS rises with leverage the risk of its EPS also increases.
While EPS increases on average this increase is necessary to compensate shareholders for the additional
risk they are taking, so LVIs share price does not increase as a result of the transaction.
Other Problem
Imagine that LVIs EBIT is not expected to grow ( );
All earnings are paid as dividends;
Use MM I and II Propositions to prove that the increase in EPS will not lead to an increase in the
shares price!

1. Initially:

2. After issuing Debt and do the Leverage Recap:

( )

Even though, EPS is higher given that risk is higher (

) Shareholders demand a higher

returns Price per share is the same
{

(

2.7.2. Win-Win Fallacy: Debt Is Better Because Some Investors Prefer Debt to Equity.
Investors differ in their preferences and needs, and thus want different cash flow streams (True)
o Example: Young professionals vs. Retirees
The sum of what all investors will pay is greater if the firm issues different securities (e.g., debt and equity)
tailored for different clienteles of investors (Financial Marketing). (False)

This reasoning assumes incomplete markets, i.e., that:
o There are indeed clienteles for different securities;
o These clienteles are unsatisfied;
, i.e.: that investors cannot replicate the security at the same or even lower cost;
A large unsatisfied clientele for corporate debt is unlikely as it exist close substitutes to any particular
firms debt.
Also, financial intermediaries are in the business of identifying unsatisfied clientele.
o Win-Win situation is more likely for more exotic securities.
The firms value is considered to be the same with different capital structures (MM I) Should not
pay more for a certain type of Capital Structure.
2.7.3. Equity Issuances and Dilution
Dilution: is an increase in the total of shares that will divide a fixed amount of earnings;
Issuing equity will dilute existing shareholders ownership so debt financing should be used instead
(Incorrect)
Example
Suppose Jet Sky Airlines (JSA) currently has:
o no debt and;
o 500 million shares of stock outstanding, currently trading at a price of $16.
Last month the firm announced that it would expand and the expansion will require the purchase of $1
billion of new planes, which will be financed by issuing new equity.

Results:
o The market value of JSAs assets grows because of the additional $1 billion in cash the firm has
raised.
o The number of shares increases Although the number of shares has grown to 562.5million, the
value per share is unchanged at $16 per share.
Conclusions
As long as the firm sells the new shares of equity at a fair price there will be no gain or loss to
shareholders associated with the equity issue itself.
Any gain or loss associated with the transaction will result from the NPV of the investments the firm
makes with the funds raised.
2.7.4. WACC Fallacy: Debt is Better Because Debt Is Cheaper Than Equity.
Because (for essentially all firms) debt is safer than equity investors demand a lower return for holding
debt than for holding equity. (True)
o The difference is significant: 4% vs. 13% expected return!
Companies should always finance themselves with debt because they have to give away fewer returns to
investors, i.e., debt is cheaper. (False)
Explanation
This reasoning ignores the hidden cost of debt Raising more debt makes existing equity more risky;
o Unrelated to default risk:
i.e., true even if debt is risk-free.
People often confuse the two meanings of cheap:
o Low cost
o Good deal
2.8. Conclusions on Mondigliani & Miller
2.8.1. MM Intuitions
Intuition 1
If Firm A were to adopt Firm Bs capital structure its total value would not be affected (and vice versa).
This is because ultimately, its value is that of the cash flows generated by its operating assets (e.g.,
plant and inventories).
The firms financial policy divides up this Cash Flow pie among different claimants:
o E.g., debt-holders and equity-holders.
BUT the size (i.e., value) of the pie is independent of how the pie is divided up:

Intuition 2
Investors will not pay a premium for firms that undertake financial transactions that they can undertake
themselves (at the same cost).
o For instance, they will not pay a premium for Firm A over Firm B for having less debt.
Indeed, by combining Firm Bs Debt and Equity in appropriate proportions any investor can in fact
Unlever Firm B and reproduce the Cash Flow of Firm A.
Curse of MM
M-M Theorem was initially meant for capital structure.
But it applies to all aspects of financial policy:
1. Capital structure is irrelevant.
2. Long-term vs. Short-term debt is irrelevant.
3. Dividend policy is irrelevant.
4. Risk management is irrelevant.
Indeed, the proof applies to all financial transactions because they are all zero NPV transactions.


2.8.2. Practical Implications
When evaluating a decision (e.g., the effect of a merger):
1. Separate financial (RHS) and real (LHS) parts of the move
2. MM tells that most value is created on LHS
When evaluating an argument in favor of a financial decision:
1. Understand that it is wrong under MM assumptions
2. What departures from MM assumptions does it rely upon?
3. If none very dubious argument.
4. If some try to assess their magnitude.
2.8.3. Problems of M&M Assumptions and Reality
Taxes:
o Corporate taxes;
o Personal taxes.
Costs of Financial Distress;
Transaction costs for issuing debt or equity;
Capital structure may influence managers investment decisions;
Asymmetric information about the firms investments.
3. Capital Structure 2
3.1. Capital Structure and Corporate Taxes
Debt cheaper than Equity?
o ROD is lower than ROE BUT when raising Debt ROE
The real benefit if Debt is the Tax Shield creation:
Financial Policy matters because it affects the firms tax bill.
Different financial transactions are taxed differently.
For a corporation:
o Interest payments are considered a business expense are tax exempt for the firm Tax savings
on Debt;
o Dividends and Retained Earnings are taxed Tax costs on Equity.
Claim: Debt increases the value of a firm by reducing the tax burden.
Example
XYZ Inc. generates a safe $100M annual perpetuity.
o Assume risk-free rate of 10%.
2 different Capital Structures:
1. 100% debt: perpetual $100 interests
2. 100% Equity: perpetual $100 dividend or capital gains

Intuition
MM still holds The pie is unaffected by the capital structure:
o
o Problem: The Government now gets a Slice too;
Financial Policy affects the size of Governments slice!
Interest payments being tax deductible the PV of the IRS slice can be reduced by using debt rather than
equity.

Tax Savings from Debt


Taxes for Unlevered firm t * EBIT
Taxes for Levered firm t * (EBIT interest)
Interest tax shield t * interest

If Debt is a perpetuity

( )

Valuing the Tax Shield
Firm A has a perpetual before-tax, expected annual Cash Flow X:
o It is 100% equity financed;
o With required rate of return k.

( ) ()

( )

( )

Firm B is identical but maintains debt with value D:
o It thus pays a perpetual expected interest i:

( )( ) () ( )

The cash *lows differ by the tax shield t*i.

Apply value additively:
o

We already know:
(

) ()
( )

o The Tax Shields capitalized: ( ) ()
(

) () () ( )
( )

In Summary
The contribution of debt to firms value is the tax shields PV:
( ) ( ) , -
Where: , -
o
o ( )

Raising debt does not create value:
o i.e., you cant create value by borrowing and sitting on the excess cash.
It creates value relative to raising the same amount in equity!
Value is created by the tax shield when you:
o Finance an investment with debt rather than equity
o Undertake a recapitalization:
i.e., a financial transaction in which some equity is retired and replaced with debt.
3.2. The Tax cost of Excess Cash
Excess Cash:
o Not useful to run operations sometimes hard to pin down;
o Invested in financial assets hopefully.
o Its like negative debt for the company:

Comes with a negative tax shield!
Remarks:
Note that: retained earnings are taxed the higher the retained earnings, the higher the tax loss
Solution: use the money for Investment Opportunities Pay Dividends
Example
XYZ has $100M excess cash on a bank account at 10% interest;
Every year:
o XYZ receives $10M interest from the bank Pays 40% tax ($ 4M)
o XYZs shareholders get a $6M dividend (pre-personal tax)
If XYZ did distribute the $100M to its shareholders (e.g. in a share repurchase) for them to deposit directly
in the bank:
o They would receive the $10 interest payment from the bank (pre-personal tax).

Pie theory gets you to ask the right question: How does this financing choice affect the tax
authoritys slice of the corporate pie?
o It is standard to use for the capitalization of debts tax break.

Remarks/ Cautions:
Not all firms face full marginal tax rate definitely not OK for non-tax-paying companies.
Personal taxes vs. corporate taxes.
3.3. The Tax-Loss Carry Forward (TLCF)
Many firms with TLCF continue to make losses fail to take advantage of the debt tax shield.
TLCF can be carried backward/forward for 3/5 years.
o If paid taxes in the last 3 years TLCF can be used to get a refund.
o If cannot return to profitability in 5 years TLCF expire unutilized.
o Even if eventually utilized need to incorporate time value of money.
More TLCF Less Debt
Exercise: Recapitalizing to Capture the Tax Shield
Problem:
Assume that Midco Industries wants to boost its stock price:
o The company currently has 20 million shares outstanding with a market price of $15 per share and
no debt.
o Midco has had consistently stable earnings, and pays a 35% tax rate.
o Management plans to borrow $100 million on a permanent basis and they will use the borrowed
funds to repurchase outstanding shares.

Tax Benefit without leverage:

Tax Benefit with leverage:

( )

o Although the value of the shares outstanding drops to $235 million shareholders will also receive
the $100 million that Midco will pay out through the share repurchase.
o In total, they will receive the full $335 million a gain of $35 million over the value of their shares
without leverage.
Shares repurchase:
o Midco repurchase the shares at the Market price of $15:

New price per Share:

Total Gain for shareholders:

o
Problem:
If the shares are worth $17.625/share after the repurchase why would shareholders tender their shares
to Midco at $15/share?
No Arbitrage Pricing
If investors could buy shares for $15 immediately before the repurchase they could sell these shares
immediately afterward at a higher price this would represent an arbitrage opportunity.
Realistically, the value of the Midcos equity will rise immediately from $300 million to $335 million after
the repurchase announcement.
With 20 million shares outstanding, the share price will rise to $16.75 per share:
o

,( )-

With a repurchase price of $16.75 the shareholders who tender their shares and the shareholders who
hold their shares both gain $1.75 per share as a result of the transaction:
o

The benefit of the interest tax shield goes to all 20 million of the original shares outstanding for a total
benefit of $35 million:
o

When securities are fairly priced the original shareholders of a firm capture the full benefit of
the interest tax shield from an increase in leverage!
Conclusion remarks:
Shareholders have incentives to keep their shares when of a Shares Repurchase:
1. Less Shares Outstanding Each share is worth more
2. Buybacks of shares create value to the firm It creates a Tax Shield by the use of Debt
Exercise
Suppose that Midco announces a price at which it will repurchase $100M worth of its shares;
Show that $16.75 is the lowest price it could offer and expect shareholders to tender their
shares;
How will the benefits be divided if Midco offers more than $16.75 per share?
Solution:
The value of Equity is equal to $235M Firms value:

3.4.1. Analyzing the Recap: The Market Value Balance Sheet
In the presence of corporate taxes we must include the interest tax shield as one of the firms assets!


3.5. Personal Taxes
Investors return from debt and equity are taxed differently!
Classical Tax Systems (e.g., US):
o Interest and dividends taxed as ordinary income
o Capital gains taxed at a lower rate.
o Capital gains can be deferred (contrary to dividends and interest).
Imputation Systems (e.g., most of Europe)
o Tax credit for recipients of dividends (= fraction of corporate tax on dividends) reduce the double
taxation of dividends.
Through the use of tax credits called "franking credits" or "imputed tax credits," the tax
authorities are notified that a company has already paid the required income tax on the
income it distributes as dividends. The shareholder then does not have to pay tax on the
dividend income.
For personal taxes equity dominates debt.


( )
( )
( ) {





Example
Consider:
o
o
o

Independent of issue dividends or retain the earnings:

Consider:
o
o
o

NOT Independent of issue dividends or retain the earnings:

(
( ) ( )
( )
)
Implications: Is leverage good?
Since taxes favor debt for most firms should all firms be 100% debt financed?
Why dont all firms lever up and save on corporate taxes?
Problem: The Costs of Financial Distress
3.6. The Dark Side of Debt: Cost of Financial Distress
Why dont all firms lever up and save on corporate taxes?
If taxes were the only issue (most) companies would be 100% Debt Financed!
o Common sense suggests otherwise:
o If the debt burden is too high, the company will have trouble paying!
The result: Financial Distress.
3.6.1. Financial Distress: Causes and Eects
Financial Distress: is when the Cash Flow is not sufficient to cover current obligations, which starts a
process of resolving the broken contract with creditors.
o Private renegotiation or workout.
o Bankruptcy supervised by court.

It is important not to confuse the causes and effects off financial distress when identifying the potential
costs of financial distress!
Only those costs that would not arise outside financial distress should be counted:
o Firms in financial distress perform poorly Cause or effect?
o Financial distress sometimes results in partial or complete liquidation of the firms assets:
would these not occur otherwise?

Destroyed value in Financial Distress:
o Lawsuits;
o Losses on bidding the remaining assets;
o Reputational costs;
o Investors liquidating assets.
Another Irrelevant Result
Assume:
o No administrative costs of financial distress;
o Frictionless bargaining between the different claimholders.
Financial distress has no effect on operating decisions no effect on firm value.
Proof:
o Financial Distress simply states that current cash flows are insufficient to service the debt.
o Cash Flows themselves do not change because of Financial Distress.
Since Value is determined by Cash Flows Financial Distress per se does not affect value.
Like M&M this is not a literal statement about the real world.
But it provides a useful benchmark:
o What are the Transaction Costs in Financial Restructuring?
o What is preventing claimholders from reaching a mutually beneficial agreement?
It also warns against hasty conclusions:
Only those costs that would not arise outside Financial Distress should be counted:
o The fact that Firms in Financial Distress often have falling sales bad operating and poor financial
performance is usually the cause not an effect of financial distress.
3.6.2. Costs of Financial Distress
Direct Bankruptcy Costs:
o Legal expenses, advisory fees, lost time, etc.
o Also opportunity costs:
Example: time spent dealing with creditors.
Direct costs represent (on average):
o Some 2-5% of total Firms value for large companies, and;
o Up to 20-25% for small ones.
o BUT this needs to be weighted by the bankruptcy probability!
Overall, expected direct costs tend to be small.
Indirect Costs of Financial Distress:
o Debt overhang: Inability to raise funds to undertake new investments:
Forced to pass up valuable investment projects;
Competitors may take this opportunity to be aggressive.
o Scare off customers and suppliers;
o Agency costs of Financial Distress.
Practical Implications
Companies with low expected distress costs should load up on debt to get tax benefits.
Companies with high expected distress costs should be more conservative.
Expected Distress Costs
All substance lies in having an idea of what industry and company traits lead to potentially high expected
distress costs:
( ) ( )
Probability of Distress:
o Volatile Cash Flows;
o Industry change;
o Macro shocks;
o Technology change;
o Start-up vs. mature business.

o Firm A and B have the same () but they have different ():
In some periods CF (B) was lower than I (interests to the debt) Incurred on a probability of
default!
Distress Costs:
o Need external funds to invest in CAPX or market share;
o Financially strong competitors;
o Customers or suppliers care about your financial position;
Example: because of implicit warranties or speciffic investments;
o Assets cannot be easily redeployed.

Remarks on Financial Distress
Evaluating if a company should incur on debt
Ex ante cost of financial distress:
o Need for external financing Future profits? Debt ratio?;
o Do costumers and suppliers care about distress Unless otherwise stated say NO;
o Competitive threat if pinched for cash Is market competitive Depends;
o Agency costs of financial distress if there is high excess cash say YES;
Ex post costs of financial distress:
o Are assets hard to redeploy Strong brand name? Facilities and Inventories are industry specific?
4. Capital Structure 3
4.1. Indirect Costs of Financial Distress
High Leverage distorts decision making process:
o May prevent some good, and new, investments;
o May encourage some new, and bad, investments;
Existence of conflicts between shareholders and credit-holders.
Other agency costs of financial distress.
4.2. Debt Overhang
XYZs assets in place (with idiosyncratic risk) worth:

Without Debt:
o XYZ has an investment project:
Today: Investment outlay $15M
Next year: Safe return $22M
o With 10% risk-free rate, XYZ should undertake the project:

Now with Debt with a Face Value of $35M:

o XYZs shareholders will not fund the project (e.g. by cutting todays dividend payment) because:

,() () -


Explaining what is happening:
Shareholders would:
o Incur the full investment cost: - $15M
o Receive only part of the return (22 only in the good state)
Existing creditors would:
o Incur none of the investment cost
o Still receive part of the return (22 in the bad state)
o In ths case the Book-Value of Debt is different from the market value of Debt:


(

( )

So, existing risky debt acts as a tax on investment!

What if the probability of the bad state is 2/3 instead of 1/2?
o The creditor grab part of the return even more often.
o The tax of investment is increased.
o The shareholders are even less inclined to invest.
o Companies find it increasingly difficult to invest as financial distress becomes more likely.
4.2.1. How can Debt Overhang be solved?
New equity issue?
New debt issue?
Financial restructuring?
o Outside bankruptcy
o Under a formal bankruptcy procedure
New Equity Issue
Suppose you raise outside equity.
New shareholders must break even:
o They may be paying the investment cost
o But only because they receive a fair payment for it
This means someone else is de facto incurring the cost the existing shareholders!
o So, they will refuse again.
Firms in financial distress may be unable to raise funds from new investors because most of the
benefits would go to the firms existing creditors.
Financial Restructuring
In principle, restructuring could avoid the inefficiency:
o Debt for equity exchange;
o Debt forgiveness or rescheduling;
Say creditors reduce the face value to $24M:
Conditionally on the firm raising new equity to fund the project.


What are the results of Financial Restructuring?
Recall our assumption: Can discount all at same rate 10%.
Compared to no restructuring (and no investment):
o Shareholders get incremental cash flow of:

The will go ahead with the restructuring deal because:

,() () -


o Creditors are also better-off because they get:


( )


When evaluating financial distress costs, account for the possibility of (mutually beneficial) financial restructuring.
In practice, perfect restructuring is not always possible.
But you should ask: What are limits to restructuring?
o Banks vs. bonds
It is easier to restructure if there are bank loans instead of corp. bods;
o Few vs. many banks
It is easier to restructure if there are few banks instead of many banks;
o Bank relationship vs. arms length finance
o Simple vs. complex debt structure
Recall especially Seniority and Debt convenants(clausules prreventing firms to take actions
that will affect negatively existing debt.
Ex. number of classes with different seniority, maturity, security, .
Bankrupcty
This analysis has implications which are recognized in the Bankruptcy Law.
o Bankruptcy under Chapter 11 of the Bankruptcy Code:
Provides a formal framework for financial restructuring
Debtor in Possession: Under control by the court, the company can issue debt senior to
existing claims despite covenants.
Preventive measures of Debt Overhang
Firms which are likely to enter financial distress should avoid too much debt
o If you cannot avoid leverage structure your liabilities so that they are easy to restructure if
needed:
Active management of liabilities;
Bank debt;
Few banks
8.3. Excessive Risk-taking: Risk Shifting
XYZ has debt with face value $50M due next year:
o Liquidating the firms assets today would yield $40M
o Continuing for another year will yield one of the following:
With probability the firm rebounds and is worth $60M;
With probability the value declines to $10M.
The firm should be liquidated (assuming 10% rate):

,() () -


What would XYZs shareholders decide?
If they liquidate today they get nothing.
If they wait for another year they get:
o 60 - 50 = $10M with probability
o 0 otherwise

This is better than nothing.
How to explain these effects?
Continuing is a bad gamble (NPV<0) shareholders are essentially gambling with the creditors money.
Firms will tend to liquidate assets too late and remain in business for too long.
o More generally firms in distress will adopt excessively risky strategies to go for broke.
Option Pricing for Debt vs. Equity
Equity can be considered as a call option: * +
Debt can be considered as a put option: * +
Remember that the strike price for both is the

4.4. The Checklist
Taxes:
o Does the company benefit from debt tax shield?
Expected Distress Costs
o Cash flow volatility and potential for increase
o Need for external funds for investment
o Competitive threat if pinched for cash
o Customers care about distress
o Hard to redeploy assets
Example

Explains capital structure differences at broad level:
o Electric and Gas (43.2%) and Computer Software (3.5%).
o In general, industries with more volatile cash flows tend to have lower leverage.
Probably not so good at explaining small difference in debt ratios:
o Between Food Production (22.9%) and Manufacturing Equipment (19.1%).
Other factors, such as sustainable growth, are also important.
Recall the tension in Cullum between product market goals (fast growth) and financial goals (modest
leverage).
o Fast growing companies reluctant to issue equity end up with debt ratios greater than the
target implied by the checklist.
o Slowly growing companies reluctant to buy back equity or increase dividends end up with debt
ratios below the target implied by the checklist.
Fast growth companies that stray too far from the target with excessive leverage will infer in risk of
financial distress.
Ultimately, must have a consistent product market strategy and financial strategy.


-0.5
0.5
1.5
2.5
3.5
4.5
EV<D Debt Value EV>D
Debt
Equity
8.6. Example of UST Case Study Analysis
Agency problems

Debt Overhang and Risk-shifting arise when there is Financial Distress!
o Debt overhang arises especially on the scenario of investment opportunities
o Risk shifting must consider how easy it is to increase risk!
For Conglomerates:
o High leverage is optimal diversification of business may be good for creditholders s it
smoothers the CF making Debt payments more certain
5. Hybrid securities and estimation of the cost of debt
5.1. Introduction
MCI in 1980s
Telecom AT&T dominates the Industry but the limited by threat of re-regulation
Opening of the market to competition
Huge fixed costs, very high Capex
Need for massive advertising campaign
Lots of uncertainty: New market
o Regulation?
o Technology?
In the Long-Term:
o Oligopoly + Slow steady growth High profits
MCI needs to invest or die Needs access to capital markets!



Excess cash of $500M Need $3.3B over next 4 years
More if start-up hits bad times
Contrast with AT&T:
o Plant capacity + Generate cash


Agency
Problems
Debt Agency
Problem
Debt
Overhang
Risk-shifting
Managerial
Discussion
Current Capital Structure on the Industrys companies

MCIs Leverage ratio = 55% (37% with Cash)
Competitors: Less leverage + Less risky
o AT&T overstated as just raised $2B
o IBM low
o GTE similar to MCI, but larger and more tangible assets
Target Capital Structure: The Checklist
Expected Distress Costs: Potentially Enormous
o Lots of short-run Uncertainty
o If MCI finds itself unable to raise funds its dead meat.
o Rivals would seize the opportunity to get rid of MCI by outspending it into the ground
See AT&Ts deep pocket!
Taxes benefits from Leverage: Small

o Provision for taxes - Increase in deferred taxes.

Bottom Line: More equity is needed!
Possible problems of raising Equity:
Dilution: however in theory its not a damage for the shareholders they can buy the new shares and, thus,
do not suffer this effect
With asymmetric information: the market can react negatively and consider the stock over-priced!
Transaction costs: the costs associate with raising equity!
Possible problems of raising Equity:
Debt issues vs. Market issues
Debt issues: possibly good news because the company has a liability it must pay!
Market issues: bad news for the market it may mean that the company cannot issue money through debt
usually the markets are the last choice because its more expensive!
Hybrid securities: it can be considered to be in the middle because there will be a liability at a certain point!
5.2. Financing Choices
Straight Debt:
o $50m in 1980 15% interest, 20-year maturity.
o $210m in 1982 12.875% interest, 20-year maturity.
Common stock: no straight equity offering
o $26m in 1979, common stock
o Plus 5-year warrant with conversion price of $1.25 (stock price at issue: $0.875)
Warrant: similar to call options on common stocks.
o The holder of a warrant has the right (but not the obligation) to buy common stock at a pre-specified
price.
o Warrants usually have an expiration date (usually longer than call options) and are usually American
type options: can be exercised anytime up to expiration.
o Main difference with call option is from issuer point of view:
One important difference between calls and warrants is that exercise of a warrant requires
the firm to issue a new share of stock- the total number of shares outstanding increases
WILL CAUSE DILUTION!
Warrants result in a cash flow to the firm when the warrant holder pays the exercise price;

Convertible (+ callable) preferred stock:
o $63m in 1979, conversion price $5 (stock price at issue: $3.25)
o $46m in 1980, conversion price $9 (stock price at issue: 6$)
o Callable Bonds: are corporate bonds with call provisions which conveys a call option to the issuer,
where the exercise price is equal to the price at which the bond can be repurchased;
Are essentially a sale of a straight bond (a bond with no option features such as call-ability or
convertibility) to the investor and the concurrent issuance of a call option by the investor on
the bond-issuing firm;

Convertibles: it is like a hybrid security between equity and debt which gives the owner the opportunity to
change from debt to a long call option on firms equity.
Preferred stock: before a dividend can be paid on the common shares, must be paid of preferred ones.
o Pays a fixed amount of income each year, like a Perpuity;
o Doesnt convey voting power;
o The firm retains discretion to make the dividend payments, however, the preferred dividends are
usually cumulative;
o Are treated as bonds when it comes to taxes- not tax-deductible expenses for the firm.
Convertible preferred stock: the holder has the right to convert the preferred shares into a fixed number of
common shares, usually any time after a pre-specified date.
o If so, the holder gives up the fixed-income coming from the preferred stock to benefit from
(common) stock price increase.
o When exercised, new shares of common stocks are issued CAUSES DILUTION!
5.2.1. Conversion and Callability
Convertible (+ callable) bonds:
o $98m in 1981 10.25%, 20-year maturity and conversion price of $12.825 (stock price at issue:
$10.87)
o $246m in 1982 10%, 20-year maturity and conversion price of $22.5 (stock price at issue: $18.5)
o $393m in 1983 7.75%, 20-year maturity and conversion price of $55 (stock price at issue: $43.5)
o Convertible bonds: very similar to convertible preferred stock except that expiration date (bond
maturity), and debt like features:
Seniority, tax-deductibility of interest (but enters in rating evaluations).

o If there are dividends it would affect the price but not the Conversion ratio because will not
change the FV!
Conversion value:
o Value of option if exercised today;
o A convertible can never trade below its conversion value.
Conversion strategy:
o Investors are generally better off not converting voluntarily (unless the stock pays high
dividends)
o American option Leave option open (unless the underlying asset pays large dividends).
Example
MCIs last convertible debt:
Issue says Investors can convert one $1,000 face value bond into 18.18 shares
o Conversion ratio: of 18.18
o Reported as conversion price of:

.

If stock price rises to $60
If stock price goes below $55 the bonds value remains $1000, above its conversion value.
Always evaluate the Conversion Value vs. the Face Value of the bond:

5.2.2. Forced Conversion
Most convertibles are also callable (by the issuer) investors can be forced to convert if the issuer calls
the bond.
Notes:
o Cannot force conversion if stock price is too low.
o Forced conversion only if conversion value exceeds call price.
Example:
The MCIs last convertible issue had the feature that if the common stock price traded at more than 25% of
conversion price for 30 days then MCI could call the unconverted bonds at 110% of their issue value.
Best for bondholders to convert as if common price exceeds 68.75 they can get $1250 by converting
while they get $1,110 if not.
When the bond is called, investors will choose to convert it.
5.2.3. Call protection period
The issuer cannot call the bond for a certain period:
o Usually 1 or 2 years
All else equal, longer call-protection period:
o Convertible more attractive to investors
o Lower coupon rate.
MCI managed to call 5 out of 6 issues.
5.3. Reasons for issuing Convertibles
Compared to straight Equity:
o Owners might be unwilling to issue equity if current stock prices are too low;.
Additionally, issuing new stock might actually cause stock prices to be too low:
o Dilution effect
o Signaling effect.:
Wayne English, MCIs CFO: Issuing more common stocks would knock the props out from
under the stock
Issuing convertible is like issuing new equity in case stock price goes up.
Convertibles as back-door equity: gets equity into the capital structure while avoiding the price hit
associated with a direct stock issue.



Compared to straight Debt:
Debt-holders now share a bit of the upturn:
o If company does well they convert in common stock at advantageous price.
o In exchange of participating in upturn they accept lower interest rates in the first place.
o The more valuable the option (the lower the conversion price or the call protection period) the
lower the coupon required
Convertible as cheap debt?
o Might be important to match liabilities and returns.
5.4. Hybrid Instruments
Hybrid instruments: may be attractive as a means of mitigating financing problems associated with
information asymmetry.
o Ex: convertible debt
Evidence:
o Less negative price reaction than equity issues.
o Typical issuer of convertible debt has: relatively high R&D, high debt, volatile cash-flows, high
market-to-book ratio.
o High-tech growth company is a classic example.
The Role of Information Sensitivity: Example
XYZs assets in place are subject to idiosyncratic risk:
o With probability :
PV = $150m or;
PV = $50m
New investment project:
o Discount rate: 10%
o Investment outlay: $12m
o Safe return next year: $22m
PV = 22/1.1 = $20m


Suppose XYZ has no cash and cannot issue debt, because of high costs of financial distress
Suppose true asset value is $150m.
Absent information asymmetry, XYZ could raise:
o $12m by selling

()
of its equity (after issue).
()

)

Suppose XYZ has 1m shares outstanding:
o It can issue 76,000 shares because:

)
()

o New share price:

)
(

)



Assume that:
o Today managers know the true value of XYZs to be $170m
o Today, the market does not know the value of XYZ
o But next year, it will realize that it is $170m.
XYZ can issue $12m worth of convertible debt
o convertible (by investors) with all bonds being convertible into a total 76,000 shares.
o callable (by XYZ) at face value
o interest rate set so that can raise 12m together!

When the information becomes known, XYZ can force conversion because:
o If investors do not convert they get $12m
o If they get in total 76,000 shares worth $158= $12,008M.
Altogether, as under symmetric information, XYZ has:
o Raised $12m
o Issued 76,000 shares
This would not be true with a straight equity issue!
Convertible and Risk Taking: Example
ABCs assets in place are subject to idiosyncratic risk:
This also depends on choice between two strategies to operate those assets:
o A risky strategy:
With probability 1/2:
V = $150m or;
V = $50m
o A safer strategy:
With probability 1/3:
V = $150m or;
V = $50m or;
V=$120m.
For simplicity, ignore discounting.
The safer strategy maximizes value.
Suppose management chooses strategy preferred by shareholders.
Suppose first existing debt due of D=$100m

Payoff to equity-holders if:
o Risky strategy:
With probability 1/2, V = $(150-100)M or V = $0m if assets value is $0.
o Safe strategy:
With probability 1/3, V = $(150-100)m if asset value is $150m; with prob. 1/3 they get
$(120-100); and with prob. 1/3 they get $0m.

Straight debt will induce choice of risky strategy.
Debt-holders can therefore expect on average $75m.
Risk


D E

Prob=1/2 150

100 50
Prob. Prob=1/2 50

50 0

Safer


D E

Prob=1/3 150

100 50
Prob. Prob=1/3 120

100 20

Prob=1/3 50

50 0


Agency problem Shareholders prefer Risky option and Credit-holders prefer the Safes option!
With Convertible bond
Consider now convertible bond with face value of $90m but with option to convert for 66% of common
stock:
[

()]
, () -
When do bondholders convert?
If 2/3 of stock worth more than $90m: true if V assets is $150m.

Payoff to equity-holders if:
o risky strategy:
With probability :
V = 33%*150=$50M or V = $0M if assets worth $0.
o safe strategy:
With probability 1/3:
V = 33%*150=$50M
V= (120-90)=$30m
V = $0m if assets worth $0.
On average, safe strategy returns more to equity-holders if risky strategy undertaken.
Debt-holders can therefore expect on average $80m so that they prefer the convertible to straight debt.
Risk


D E

Prob=1/2 150

2/3*150 = 100 > 90 -> Convert! 150-100 = 50
Prob. Prob=1/2 50

2/3*50 = 33,33 < 50 -> Do not convert! 0

Safer

D E

Prob=1/3 150

2/3*150 = 100 > 90 -> Convert! 150-100 = 50
Prob. Prob=1/3 120

2/3*120 = 80 < 90 -> DO not onvert! 120-90 = 30

Prob=1/3 50

2/3*50 = 33,33 < 50 -> Do not convert! 0



Now both Debt and Equity holders prefer the safer project!
5.5. Estimating the Cost of Debt
Equity as a Call Option (long):
o A share of stock can be thought of as a call option on the assets of the firm with a strike price
equal to the value of debt outstanding.
o If the firms value does not exceed the value of debt outstanding at the end of the period the firm
must declare bankruptcy and the equity holders receive nothing.
o If the value exceeds the value of debt outstanding the equity holders get whatever is left once the
debt has been repaid.

Debt holders can be viewed as owners of the firm having sold a call option with a strike price equal to the
required debt payment:
o Can be viewed as owners of the firm having sold a call option with a strike price equal to the
required debt payment.
o If the value of the firm exceeds the required debt payment the call will be exercised the debt
holders will therefore receive the strike price and give up the firm.
o If the value of the firm does not exceed the required debt payment the call will be worthless
the firm will declare bankruptcy, and the debt holders will be entitled to the firms assets.

Debt can also be viewed as a portfolio of riskless debt and a short position in a put option on the firms
assets with a strike price equal to the required debt payment (SHORT PUT):
o When the firms assets are worth less than the required debt payment the owner of the put
option will exercise the option and receive the difference between the required debt payment and
the firms asset value.
This leaves the debt holder with just the assets of the firm.
o If the firms value is greater than the required debt payment the debt holder only receives the
required debt payment.

There is also another way to view corporate debt: as a portfolio of risk-free debt and a short position in a
put option on the firms assets with a strike price equal to the required debt payment:


5.5.1. Credit Default Swaps
Credit default swap: the buyer pays a premium to the seller (often in the form of periodic payments) and
receives a payment from the seller to make up for the loss if the underlying bond defaults
Rearranging:

Example on the Cost of Debt: Calculating the Yield on New Corporate Debt
Problem
As of September 2012, Google (ticker: GOOG) had no debt. Suppose the firms managers consider recapitalizing the
firm by issuing zero-coupon debt with a face value of $163.5 billion due in January of 2014, and using the proceeds
to pay a special dividend. Suppose too that Google had 327 million shares outstanding, trading at $700.77 per share,
implying a market value of $229.2 billion. The risk-free rate over this horizon is 0.25%.
Using the call option quotes in Figure 20.10, estimate the credit spread Google would have to pay on the
debt assuming perfect capital markets.
Solution
o ( )
o
o
o ( )
o

1. Assuming perfect capital markets, the total value of Googles equity and debt should remain unchanged
after the recapitalization.
2. The $163.5 billion face value of the debt is equivalent to a claim of $163.5 billion/(327 million shares) =
$500 per share on Googles current assets:

()


3. Because Googles shareholders will only receive the value in excess of this debt claim, the value of
Googles equity after the recap is equivalent to the current value of a call option with a strike price of
$500.
4. From the quotes in Figure 20.10, such a call option has a value of approximately $222.05 per share (using
the average of the bid and ask quotes).

5. Multiplying by Googles total number of shares, we can estimate the total value of Googles equity after
the recap as $222.05 * 327 million shares = $72.6 billion.

( )
6. To estimate the value of the new debt, we can subtract the estimated equity value from Googles total
value of $229.2 billion; thus, the estimated debt value is 229.2 - 72.6 = $156.6 billion.

7. Because the debt matures 16 months from the date of the quotes, this value corresponds to a yield to
maturity of a:

(
()

8. Thus, Googles credit spread for the new debt issue would be about 3.29% - 0.25% = 3.04%.

5.6. Agency Conflicts
In addition to pricing, the option characterization of debt and equity securities provides a new
interpretation of agency conflicts.
o Because Equity is like a call option equity holders will benefit from risky investments.
o Debt is a short put option position so debt holders will be hurt by an increase in risk.
This can potentially lead to an overinvestment problem!
When the firm makes new investments that increase the value of its assets, the value of the put option
will decline:
o Since debt holders are short a put the value of the firms debt will increase so some fraction
of the increase in the value of assets will go to debt holders.
o This reduces equity holders incentive to invest possibly leading to a debt overhang (or
underinvestment) problem.
5.7. The Beta of Risky Debt
When the beta of debt is zero, then:

o Where E is the beta of equity and U is the beta of unlevered equity
o However, for companies with high debt-to-equity ratios the assumption that the beta of debt is
zero is unrealistic as these companies have a positive probability of bankruptcy.
When the beta of debt is not zero, then:

o Where A is the value of the firms assets, E is the value of equity and D is the value of debt!
o is the delta of Debt!
(

( )

( ) (

( ) .

Example: Computing the Beta of Debt
Problem
You would like to know the beta of debt for BB Industries.
The value of BBs outstanding equity is $40 million, and you have estimated its beta to be 1.2. However, you cannot
find enough market data to estimate the beta of its debt, so you decide to use the Black-Scholes formula to find an
approximate value for the debt beta.
BB has four-year zero-coupon debt outstanding with a face value of $100 million that currently trades for $75
million.
BB pays no dividends and reinvests all of its earnings. The four-year risk-free rate of interest is currently 5.13%.
What is the beta of BBs debt?
Solution
1. We can interpret BBs equity as a four-year call option on the firms assets with a strike price of $100
million. The present value of the strike price is $100 million/(1.0513)4 = $81.86 million.
()

2. The current market value of BBs assets is $40 + 75 = $115 million.

3. Therefore, the implied volatility of BBs assets is equal to the implied volatility of a call option whose price is
40 when the stock price is 115 and the present value of the strike price is 81.86:


4. Using trial and error, we find an implied volatility of about 25%. With this volatility, the delta of the call
option is:

(

)
[

ln (

()
)

( )

( ) (

( ) .

Agency problem
Leverage creates an asset substitution problem because the value of the equity call option increases with
the firms volatility Thus, equity holders may have an incentive to take excessive risk.
Example: Evaluating Potential Agency Costs
Problem
Consider BB Industries from Example 21.10.
Suppose BB can embark on a risky strategy that would increase the volatility of BBs assets from 25% to 35%.
Show that shareholders benefit from this risky strategy even if it has an NPV of -$5 million.
Alternatively, suppose BB tries to raise $100,000 from shareholders to invest in a new positive NPV project that
does not change the firms risk.
What minimum NPV is required for this investment to benefit shareholders?
Solution
1. Recall that we can interpret BBs equity as a four-year call option on the firms assets with a strike price of
$100 million. Given the current risk-free rate of 5.13%, asset value of $115 million, and asset volatility of
25%, the current value of the equity call option is $40 million, with = 0.824.
2. If BB follows the risky strategy, the value of its assets will fall to $115 - 5 = $110 million, and the volatility of
the assets will increase to 35%. Applying the Black-Scholes formula with these new parameters, we find the
value of the equity call option would increase to $42.5 million, or a $2.5 million gain for equity holders. Thus,
leverage may cause equity holders to support risky negative NPV decisions.

ln .

/ (

ln .

/ (

)


3. Second, suppose BB raises and invests I = $100,000 in a new project with . Then the value of the
firms assets will increase by $100,000 + V. Because represents the sensitivity of a call option to the
underlying asset value the value of equity will increase by approximately times this amount, and so
equity holders gain more than they invest if:

( )




4. Can rewrite it as:

/
5. Using the betas, we see that the investment benefits shareholders only if its profitability index exceeds (0.14
* 75)/(1.2 * 40) = 0.21875, so that the projects NPV must exceed $21,875.
6. Because equity holders may reject projects with a positive NPV below this amount, the debt overhang
induced by leverage may cause the firm to underinvest.