Samenvatting
Ondernemingsfinanciering & vermogensmarkten
Hoofdstuk 14
Investment project: I0 = CapEx + DNWC
Expected cash flows E(CFt) using all-equity fiction
Cost of capital, applicable to project (rp)
Project value = PV = STt=1 E(CFt)/(1+rp)t = current market value of additional cash flow stream
for the firm, only obtainable after paying the investment outlay I0
NPV = PV – I0
NPV is identical to increase in firm market value
Project discount rate (rp) = reflects risk embedded in the project cash flow (perceived by
capital market), only systematic part of risk is relevant (CAPM) measured by the beta-
coefficient, project risk not necessarily equal to that of existing projects in the firm
Rp = rf + [E(Rmkt) – rf] * bp
In determining expected cash flows, continue to use all-equity assumption, but firms usually
financed with equity and debt, included in NPV calculation? YES, but not in expected cash
flows, but in relevant cost of capital
rwacc = weighted average cost of capital
rE and rD are required returns by outside investors on equity and debt in company
Required returns rE and rD are affected by
Level of debt in company
Dividend policy
Tax credits
Bankruptcy and other financial distress
Inside information held by board members
Company’s excellent real projects exceed quality to make smart financial decisions à then
relevant expected cash flow definition should not include financial items such as interest
cost à all-equity fiction (rente en aflossing niet in free cash flow)
Unlevered equity = equity in a firm with no debt
Fair return = expected unlevered equity return
Debtholders have priority claim on cash flows; equity-holders = residual claim holders
Issue amount of levered equity is lower than with unlevered equity, but total financing
package still yields the same
MT will be indifferent between both packages
Levered equity cash flows not only smaller, but the spread in levered equity is higher; more
risky
Levered equity cash flow not discounted at the same discount rate; higher expected return
,Rwacc = is equal in both unlevered and levered financing packages
Drogreden: goedkoop vreemd vermogen aannemen is het beste, maar geeft duurder eigen
vermogen
EU= VU = VL = EL + D
No net present value to be created by choosing financing package = Proposition of
Modigliani & Miller
MM1 holds under conditions of a perfect capital market
Investors can trade same set of securities at competitive market prices equal to PV of
future cash flows
No taxes, transaction costs or issuance costs
Financing decisions do not change cash flows generated by investments, nor reveal
information
Leveraged recapitalization = company uses borrowed funds to (choosing completely
different financing package)
Pay large special dividend
Repurchase a significant amount of outstanding shares
MMI: A = U = E + D
MMII: E/(E+D)*rE + D/(E+D)*rD = rU
Rewritten:
Risky debt: fair pricing when chance of default
Hoofdstuk 15
Corporate taxation = vennootschapsbelasting
Interest payments are tax deductible
Vreemd vermogen à je betaalt interest
Eigen vermogen à dividend aan aandeelhouders (dit is niet aftrekbaar)
Although debt obligations reduce equity value, the total amount available to all investors is
higher with leverage. Difference between levered and unlevered = interest tax shield.
Interest tax shield = interest rate x market value of debt
Interest tax shield arises by the very existence of debt in the firm
The cash flow carries the same risk as the debt cash flow
Its value should therefore be obtained using the cost of debt capital
,The value of the levered firm is higher due to the present value of the interest tax shield à
discounted using the cost of debt capital: VL = VU + PV(interest tax shield)
= MM Proposition I with taxes
With tax-deductible interest, the firm effectively borrows at RD(1-taxrate)
This is the firm’s cost of debt capital after tax
Rwacc after-tax becomes: Rwacc= E/(E+D)*rE+ D/(E+D)*rD * (1-taxrate)
Leveraged recapitalization à tax-related value to be gained from using debt, firms could
exploit this by switching to a higher debt ratio.
Equilibrium repurchase price P’
R = number of shares repurchased= D/P’
N = number of remaining shares = N0 – R (N0 = pre-repurchase number of shares)
P’= EL/N (EL follows from VL = VU + TD and EL = VL – D)
Equilibrium pricing requires that EL + D = VL = (N+R)*P’ dus
P’= VL/(N+R) = VL/N0
à from finance theory thus far, we know that the interest tax shield will be claimed by
existing shareholders, so this is consistent with the equilibrium relationship for P’.
Dutch and US income tax systems are both based on the double taxation principle
Typically taxed twice: once when earned at corporate level and again on personal
level
Debt and equity investors pay income taxes on their share of the after-tax corporate
cash flow, reducing the net cash flow received
There might be a differential tax treatment between debt- and equity-related income
Market capitalization = waarde van het eigen vermogen
Taxable income = Net income / (1-tauc)
Additional debt = taxable income / r
Hoofdstuk 16
In success and failure state there is no difference between unlevered and levered firm value,
even when bankruptcy is possible: MM I still holds with risky debt in perfect capital markets
Bankruptcy code
Chapter 11: reorganization
Chapter 7: liquidation
Direct bankruptcy costs
Costly outside experts to assist bankruptcy process
Creditors may hire own experts
Assets sold lower in auction than going-concern values
Costs are leverage-related and reduce firm's value investors will eventually receive (3 to 4%
of total market value), firm may avoid bankruptcy by negiotiating to reorganize
, Prepackaged restart: bruikbare werknemers en profitable assets gaan mee naar "NewCo" en
"OldCo" wordt failliet verklaard
Indirect costs of financial distress
Loss of customers, suppliers, receivables
Tighter trade credit
"Fire sale" of assets to avoid bankruptcy
Increased cost of bank credit
Features of indirect costs
Losses to total firm value
Incremental losses associated with financial distress
Who bears financial distress costs?
Debt holders anticipate on distress costs, and they will get less in case of failure
Fair pricing implies debt holders pay less at time 0 than without these costs (difference
between firm value in good state and bad state)
Equity holders bear this discount, since firm has less money available for investments etc
Tradeoff theory = capital structure by trading off benefits of tax shields against cost of
distress
VL = VU + PV(interest tax shield) - PV(financial distress costs)
Determinants of financial distress costs
Probability
Magnitude of costs
Appropriate discount rate
Firms should attract as much debt such that marginal benefit equals marginal cost, this
explains why firms do not exploit the tax shield fully and industry-specific debt ratio
clustering occurs.
Conflicts of interest à we assumed that the firm always takes investment and financing
decisions in the best interest of all investors in the firm: equity holders and debt holders, if
there is a conflicting interest: existing equity holders are served
Management acting in the interest of equity holders, they can’t get any worse but have
slight chance of getting better, while debt holders have a chance of getting worse. Still
accept project: agency cost phenomenon, caused by too much debt and poor past
performance à in financial distress, equity holders prefer risky projects, since they only care
about the upside potential, even with a negative NPV à over-investment problem
Over-investment is a consequence of financing decisions in the past (too much debt) à
would not happen if the firm were unlevered or had small debt commitments
Debt holders anticipate this bad behavior and will value current debt accordingly, ultimately
fair/rational pricing causes equity holders to bear the value consequences.
