Problem_Set__7_Solutions (1)

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Fin 401 Problem Set #7 Capital Structure Solutions 1. a. Haverhill Corporation has net income of $10 million per year on net sales of $100 million per year. It currently has no capital market debt but is considering a debt issue of $5 million. The interest rate on the debt would be 8%. Haverhill currently faces an effective tax rate of 35%. Assuming this debt is held in perpetuity, what would be the total value of the tax shield to Haverhill if it goes through with the debt issuance? t*D = 0.35 * 5 million = $1,750,000 b. If Haverhill has 5 million shares outstanding, by how much would this transaction increase the stock price, assuming this amount of debt will have a negligible effect on expected distress costs? $1.75 million / 5 million = $0.35/share 2. Firm XYZ has debt with a face (book) value of $150 million and 10 million shares outstanding. The debt is due tomorrow, but we don’t yet know what the value of the assets will be. The distribution of possible asset values tomorrow is shown in the table below. a. What is the market value of XYZ’s assets? Debt? Equity? What is XYZ’s stock price? The table below shows the payoff to equity and debt claimholders in each state. Debtholders get paid first (up to the 150 face value), and equity holders get the rest. Prob. 0.1 0.2 0.4 0.2 0.1 Asset Value 50 100 200 300 350 Prob. 0.1 0.2 0.4 0.2 0.1

Assets = 0.1*50 + 0.2*100 + 0.4*200 + 0.2*300 + 0.1*350 = 200 Debt = 0.1*50 + 0.2*100 + 0.7*150 = 130 Equity = 70 (Assets – Debt) Stock price = $7.00 ($70 million / 10 million) Notice that the market value of debt is less than the book value because of the default risk. This firm is in financial distress. b. Suppose XYZ wanted to sure up its balance sheet by issuing $100 million in new equity and holding the proceeds as cash, and imagine that it could do that by selling shares at the market price from part a. How would this equity issuance affect the market value balance sheet? (That is, re-calculate all of the values you calculated in part a.) The firm would now have an additional $100 million in cash, which would increase the asset value in each state by $100 million. It would have to issue an additional $100 million / $7 = 14.29 million shares in exchange for this new capital, so total shares would now by 24.29 million. Assets = 0.1*150 + 0.2*200 + 0.4*300 + 0.2*400 + 0.1*450 = 300 Debt = 1.0*150 = 150 Equity = 150 (Assets – Debt) Stock price = 150 / 24.29 = $6.18 c. Would shareholders want to do this equity issuance? No, shareholder wealth would fall from $7/share to $6.18/share. This transaction would benefit creditors (debt value increases from 130 to 150) at the expense of shareholders. This is an example of what is called debt overhang. Asset Value 50 100 200 300 350 Debt Value 50 100 150 150 150 Equity Value 0 0 50 150 200 Prob. 0.1 0.2 0.4 0.2 0.1 Asset Value 150 200 300 400 450 Debt Value 150 150 150 150 150 Equity Value 0 50 150 250 300 2

d. Suppose the firm has access to a very attractive project and that it could use the proceeds of the equity issuance from part b to fund this project (rather than holding them as cash). The project costs $100 million and pays off $100 million + X tomorrow in each possible outcome (X is the same for each outcome and represents the NPV of the project). How large would the NPV have to be for shareholders to want this equity issuance and investment to happen? Shareholders would not want to do the issuance and investment unless it increased the stock price above the current price of $7.00. The aggregate loss of shareholder wealth from the issuance is $0.82 * 24.29 million shares = $20 million (this is exactly the amount effectively transferred from shareholder pockets to creditor pockets). To make shareholders at least as well off, the project would need to have an NPV of at least $20 million. This is what we call an underinvestment problem and is the cost of debt overhang. The firm would choose to skip some positive NPV projects (those with NPV less than $20 million) because they would actually make shareholders worse off. If the firm had lower leverage (below 50 face value), it would take all positive NPV projects, as we’re used to thinking. We can verify this mathematically. The value of the assets and each claim is shown in the table: Assets = 0.1*(150+X) + 0.2*(200+X) + 0.4*(300+X) + 0.2*(400+X) + 0.1*(450+X) = 300+X Debt = 1.0*150 = 150 Equity = 150+X (Assets – Debt) Stock price = (150+X) / 24.29 >= $7.00 (shareholder’s need to be at least as well off). 150+X >= 170, so X >= 20. 3. Headquartered in Germany, SAP Ag is a leader in the enterprise application software business. Toyota Motor Corporation is the world’s largest car manufacturer. Which company do you think would bear heavier costs in the event of financial difficulties? Why? What does this imply for their respective capital structures? Prob. 0.1 0.2 0.4 0.2 0.1 Asset Value 150+X 200+X 300+X 400+X 450+X Debt Value 150 150 150 150 150 Equity Value X 50+X 150+X 250+X 350+X 3

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SAP AG, primarily a business software company, would likely face much higher distress costs than Toyota Motor Company because a much greater proportion of its assets is intangible. Moreover, many of the company’s most talented software people would probably leave if the company fell into distress, especially if a large part of the compensation is incentive based. (You could think about other items from the capital structure checklist here as well). For this reason, SAP AG should have the more conservative capital structure. This can be seen in the 2015 measures of leverage for the two firms: SAP is essentially an all-equity firm, while Toyota’s debt to assets ratio was around 50 percent. 4. The table below shows Net Income/Interest Expense, Total Liabilities/Total Book Assets, and Long-term Debt/Book Equity for Boeing and Adobe for fiscal year end 2016. What explains the differences in these firms’ leverage ratios? In terms of coverage ratios, the two firms are very similar. Each has plenty of income to pay its interest expense. Boeing exhibits higher financial leverage than Adobe Systems as measured by the second two measures, each of which is based on book values. Because the leverage ratios are based on book values, they are backward- looking and thus do not indicate Boeing’s ability to generate cash flows going forward. Boeing’s higher leverage ratios (combined with its similar coverage ratio) implies either that Boeing has lots of non-interest-bearing liabilities (e.g., Accounts Payable) or that Adobe generated relatively little net income (or both). Boeing’s principal businesses of aircraft manufacture and defense contracting call for large amounts of tangible assets, which typically bear lower liquidation costs (i.e., receive better liquidation prices) and can thus act as collateral. Meanwhile, Adobe’s most valuable assets are principally patented software, large market share, and skilled people. The difference in the companies’ leverage ratios presented above reflect the disparate nature of their businesses and the relative costs of financial distress each firm might encounter. Ratio Fiscal Year End 2016 Boeing Adobe Interest Coverage (EBIT/Interest) 22.8 21.2 Total Liabilities/Total Assets 0.99 0.42 Long-term Debt/Equity 11.71 0.26 4

5. Do the exercise in the Q5 spreadsheet on Learning Suite. a. The first two numbers suggest that Avon is highly levered, so levered that its liabilities exceed the accounting value of its assets in 2001 and 2002. The third number, on the other hand, shows substantial coverage of interest expense, indicating only modest financial leverage. Table 6.5 in the text suggests that interest coverage ratios in the observed range are consistent with bond ratings between A and AA. b. In 2001, EBIT could fall 91% ([10.7-1.0]/10.7). (That is, the TIE ratio could fall from 10.7 to 1.0, or 91%, and Avon could still cover interest payments.) The corresponding percentages for 2002 and 2003 are 93% ([15.0-1.0]/15.0) and 95%, respectively. (Alternatively, you can use the actual EBIT and interest expense numbers to arrive at the same answer.) c. Absent interest expense, Avon’s tax bill would be $313.3 million (.35 x $895 million). With the interest expense, the tax bill is $292.3 million (.35 x [$895 million -$60 million]). This is a reduction of $21.0 million for the year. Alternatively, the interest tax shield is $60 million * .35 = $21.0 million (that’s D*r*t, where D*r = $60 million.) d. 2001 2002 2003 Shareholders’ equity ($75) ($128) $371 Liabilities-to-assets ratio 1.02 1.04 0.90 Times-interest-earned ratio 10.7 15.0 21.3 2002 shareholders’ equity ($128) Reduction in equity due to $3,000 dividend -3,000 Revised shareholders’ equity -3,128 2002 assets $3,328 2002 liabilities 3,455 New debt 3,000 Total liabilities 6,455 Revised liabilities to assets ratio 1.94 2002 EBIT (income before tax + interest expense) $895 5

Increasing debt by $3 billion increases Avon's interest expense by $240 million (8% x $3 billion) and its interest tax shield by $84 million a year. This could increase Avon's equity by as much as $1 billion. (The present value of $84 million in perpetuity discounted at 8% is $1.05 billion [$84 million/.08]). Remember, paying a $3 billion dividend will obviously reduce the value of Avon's equity by $3 billion, but this is precisely offset by the $3 billion cash dividend. Offsetting the increased tax shield, of course, is the increased distress costs that accompany rising financial leverage. The decision to increase financial leverage must weigh this cost against the tax benefit. This is the subject of the following questions. e. Avon’s enterprise value is around $13 billion, while the book value of its assets is just over $3 billion, so liquidation could be very costly to creditors and owners. However, we need to assess the probability of financial distress and whether financial distress would necessarily lead to liquidation. My answer is probably not. Here you should think about some of the items from the “capital structure checklist”. Avon sells small ticket items, which probably means that their cash flows are not very volatile. (Indeed, past annual reports for Avon would help us confirm this. Sales have risen every year for the past 11 years, and operating profits have declined only twice over the same period, and by less than 1 percent in each instance.) These low levels of business risk suggest that Avon can safely support more debt than most businesses. In addition, Avon customers would be largely indifferent to any financial distress because Avon’s products require no service, spare parts, or maintenance. There also is no strong reason to expect the company’s sales force, suppliers, or competitors to significantly change their attitudes toward the company in the presence of financial distress. Finally, as a cosmetics company, it is likely that little of the company’s value comes from future investment options that might disappear in the event of financial distress, i.e., the need for external funds for investment doesn’t seem that important to the business strategy. On balance, it appears that the costs of financial distress to Avon, while not trivial, would be modest compared to many other firms. 2002 interest expense 60 Interest on new debt 240 Total interest expense 300 Revised times interest earned ratio 2.99 EBIT can fall 66.6% before interest coverage equals 1.0 ([2.99-1.0]/2.99). 6

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f. Avon had negative net worth as recently as 2002, suggesting to many an excessive reliance on debt financing. However, it has ample income to shield from taxes, modest business risk, and at most only moderate costs of financial distress. In quantitative terms, we observe that at the current capital structure, Avon could suffer declines in operating income of over 90% and still cover interest obligations; and even with an additional $3 billion of debt, it could still weather declines of over 60%. Given our expectations that Avon’s operation should be quite stable, this suggests that Avon could support additional debt. Furthermore, agency theory suggests that a higher debt level might sharpen management incentives to perform. Adding as much as $3 billion in debt would be aggressive but feasible for Avon, and in my judgment, it would create value for owners. 7