Download Bankruptcy and Miller Channels

Miller Channels Model
Tax-class clienteles,
equilibrium,
and capital structure.
Review item
 Explain
why an increase in leverage
doesn’t affect the value of a firm in a
world without taxes or threat of
bankruptcy.
Answer
 Homemade
leverage gives the investor
the same effects as leverage in the firm.
 Homemade leverage is costless.
 Therefore investors won’t pay extra for
leverage in the firm.
Recapitulation
 Started
with VU = VL
 Corporate taxes
 Financial distress
Value, VL
Cost of
Financial
Distress
Value of the firm
Vu
B
Indirect costs of financial
distress
 Lost
sales, delayed collection, slow
deliveries.
 Managers take large risks.
 Investors won’t support good projects.
 Equity “milks the property.”
Against-the-Wall Mart
Assets
Cash
Fixed Asset
Total
BV
200
400
600
MV
200
0
200
Liabilities
LT bonds
Equity
Total
BV
300
300
600
What happens if the firm is liquidated today?
LT Bonds = 200.
Equity
= 0.
MV
?
?
200
Managers take bad risks
Cost = $200 (all the firm’s cash)
The gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Required return is 50%
Expected CF from the gamble = $1000 x 0.10 + $0 = $100
NPV = - $200 + $100 / 1.5 = -$133 BAD PROJECT
Equity accepts the bad risk






Expected CF to debt (bondholders)
= 300 x 0.10 + 0 = 30
Expected CF to equity (shareholders)
= (1000 - 300) x 0.10 + 0 = 70
PV of bonds without the gamble = 200
PV of stocks without the gamble = 0
PV of bonds with the gamble = $30 / 1.5 = $20
PV of stocks with the gamble = $70 / 1.5 = $47
The market won’t invest in
good projects.
 Government
sponsored project
t=0
t=1
-300
+350
 Required return is 10%
 NPV = -$300 + $350 / 1.1 = $18.18
 GOOD PROJECT
 But … the firm only has $200 now.
Equity passes, debt passes
•
•
•
New bondholders contribute the 100 by
buying more bonds. They are owed 100
or ¼ of the firm’s debt.
When the firm gets 350, the new
bondholders collect ¼*350 = 87.5. They
lose.
New shareholders contribute the 100:
They get 50 / 1.1 - 100 = -54.55
Summary of failure to contribute
Neither
new equity nor new debt will
contribute. Markets fail.
Note: old debt would contribute if it
could do so in a coordinated manner.
There is an externality element.
 One purpose of bankruptcy is to
coordinate the interests of debt.
Milking the Property
 Liquidating
dividends ...
 are often illegal …
 or restricted by bond indenture.
 Other tactics to siphon money.
 Perks, compensation to
management.
 Sweetheart deals with shell
companies
Optimal Debt and Value
Present value of
financial distress costs
Value of firm (V)
Present value of tax
shield on debt
VL=VU+TCB= Value of firm under
MM with corporate
taxes and debt
Maximum
firm value
V=Actual value of firm
VU=Value of firm with no debt
Debt (B)
0
B*
Optimal amount of debt
The final word on capital
structure


Miller channels model.
Restores MMI with important
differences
What's been left out so far?
 Investor
taxes.
 Supply and demand.
Financial officers as marketers
… or arbitragers.
 They
package EBIT into either the debt
channel or the equity channel,
 depending on which has more value.
Taxes in the debt channel
Only TB, investor tax rate on bond income
Taxes in the equity channel
 TC
the corporate tax rate
 TS investor tax rate on stock income
 Stock income is partially or largely tax
shielded:
unrealized capital gains
net capital gains
Channels
Debt
channel
$ of operating
cash flows
Equity
channel
Corporate
taxes
TC
Personal
taxes
TB
1-TB
TS
(1-TC)(1-TS)
Clienteles for the channels
Dependent
on tax rates
which differ among investors
Clienteles for the debt channel
1-TB > (1-TC)(1-TS)
Low income investors (Low TB and TS )
Pension funds (TB = TS = 0)
IRA's (low TB, TS, because deferred)
Non profit organizations
Clienteles for the equity
channel
 1-TB
< (1-TC)(1-TS)
 High income investors (high TB, low TS )
 Corporations (low TS on dividends)
Equilibrium of demand
 The
debt clientele demands debt.
 The equity clientele demands equity.
 But at what prices?
Miller: Tax-class clienteles
Value as
Debt
Value as
equity
V* = 1/RS
V* = 1/RB
as
debt
as equity
Operating C.F.’s of
the whole economy
Meaning of the Miller
channels model.
 Economy-wide
debt-equity ratio is
determinate.
 For each firm, debt-equity ratio does not
affect value.
Tax reform and leveraged
buyouts in the late 1980's



Tax reform of 1986
Raised TC, which favors bonds
Raised TS, which also favors bonds
Value as
debt
Value as
equity
tax reform
increased
debt
Operating C.F.’s of
the whole economy
...
Increase in demand for bonds
 Raises
economy-wide debt
 Rewards debt-for-equity swaps
 and leveraged buyouts.
Value as
debt
Value as
equity
tax cut
increased
equity
Operating C.F.’s of
the whole economy
...
Summary
Value is unaffected by leverage,
except when tax laws have changed
or something else affects the demands of
clienteles.
Review item
In
a world with corporate taxes,
VL=VU+TCB. Why?
Answer: Present value of tax
shield
Debt
and other assets are perpetuities.
Let rB be the market rate for the bonds.
Interest payments of BrB each year
generate a tax shield of TCBrB
Present value of this perpetuity is found
by dividing by rB. Result is TCB.