Mezzanine Capital in Europe

Contents

1 Introduction
1.1 Purpose and Structure of this Paper
1.2 History
1.3 Definition and Terms

2 Capital Structure Decision
2.1 Capital Structure Decision in Perfect Markets
2.1.1 The Traditional View
2.1.2 The Modernist View
2.2 The Concept of Leverage
2.2.1 The Total Leverage
2.2.2 The Operating Leverage
2.2.3 The Financial Leverage
2.2.3.1 Being Unlevered
2.2.3.2 Being Levered
2.2.4 The Traditional View Revisited
2.2.5 The Modernist View Revisited
2.2.5.1 M&M Proposition I
2.2.5.2 M&M Proposition II
2.3 Capital Structure Decision in an Imperfect World
2.3.1 Corporate Taxes
2.3.2 Corporate and Personal Taxes
2.3.3 Costs of Financial Distress
2.3.3.1 Direct Bankruptcy Costs
2.3.3.2 Indirect Bankruptcy Costs
2.3.4 Asymmetric Information
2.3.5 Agency Costs
2.3.5.1 Agency Costs of Debt
2.3.5.2 Agency Costs of Equity
2.3.6 Transaction Costs
2.4 Capital Structure and the Case for Convertibles

3 Valuation of Mezzanine Instruments
3.1 Black-Scholes Option Pricing Model
3.2 Valuation of a Convertible Bond

4 Summery on Capital Structure and the Valuation of Mezzanine Instruments

5 Basic Types of Mezzanine
5.1 Mezzanine Prototypes
5.1.1 Fixed or Floating-Rate Loans
5.1.2 Unsecured Loan Stock
5.1.3 Convertible Unsecured Loan Stock
5.1.4 Redeemable Preference Shares
5.1.5 Convertible Preference Shares
5.2 Characteristics of Equity
5.2.1 Advantages and Disadvantages of Equity
5.3 Characteristics of Debt
5.3.1 Coupons or Interest Payments
5.3.2 Principal Repayment
5.3.3 Security
5.3.3.1 Senior Mezzanine – Debt Mezzanine Capital
5.3.3.2 Junior Mezzanine – Equity Mezzanine Capital
5.3.4 Liquidity
5.3.5 Advantages and Disadvantages of Debt

6 Risk and Return of Mezzanine Instruments

7 Use of Mezzanine
7.1 When is Mezzanine Used
7.1.1 Early Stages
7.1.2 Expansion Stages
7.1.3 Post-IPO Stage
7.1.4 Public-to-Private Stage
7.2 Providers of Risk Capital
7.2.1 Friends and Family
7.2.2 Business Angels
7.2.3 Incubators
7.2.4 Early Stage Venture Capitalist
7.2.5 Venture Capitalists
7.2.6 Private Equity
7.2.7 Mezzanine Investors
7.2.8 Investment Banks
7.3 Amount of Mezzanine Used
7.4 Creating Extra Value with Mezzanine Finance
7.5 Use in Different Corporate Strategies
7.5.1 Growth Finance
7.5.1.1 Bridge-Finance
7.5.1.2 Pre-IPO
7.5.1.3 Product and Technology Development
7.5.2 Corporate Restructuring and Acquisitions
7.5.2.1 MBOs, MBIs and LBOs
7.5.2.2 Public-to-Private
7.5.2.3 Ownership Transition
7.5.2.4 Industry Consolidations
7.5.3 Refinancing
7.5.3.1 Turn Around or Bankruptcies

8 Mezzanine Capital in Practice
8.1 Financial Structure
8.1.1 Senior Debt
8.1.2 Mezzanine Finance
8.1.3 Equity
8.2 A Successful MBO with Mezzanine Capital
8.3 The Mezzanine Investment Process
8.3.1 Business-Plan
8.3.1.1 General Information
8.3.1.2 Financial Information
8.3.2 Letter of Intent
8.3.3 Due Diligence and Investment Memorandum
8.3.4 Contract and Investment
8.3.5 Monitoring
8.4 Investment Criteria
8.5 The Investor’s Exit
8.5.1 The Return
8.5.2 The Exit Route
8.5.2.1 Initial Public Offering
8.5.2.2 Trade Sale
8.5.2.3 Buy-Back
8.5.2.4 Secondary Purchase
8.5.2.5 Liquidation - Write Off

9 The European Mezzanine Landscape
9.1 The UK-Market
9.2 The “Rest of Europe”

10 Mezzanine in the Future

11 Conclusions

Literature

Abbreviations

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1 Introduction

1.1 Purpose and Structure of this Paper

In corporate finance two major decisions have to be made. One is the investment decision which means companies must decide which available opportunities they should invest in. The other one, the financing decision , also known as the capital structure decision , tries to answer the question of from where the money to finance investment projects should come.

Money can either be raised internally, through retained earnings, or externally. Mezzanine capital, as a special type of external finance, therefore falls into the area of the financing decision.

Although the use of mezzanine capital has increased in Europe in recent years, this special type of finance is still relatively unknown in some countries. Therefore, the purpose of my thesis is to familiarise the reader with this particular type of finance. It is structured in a way that it sequentially deals with the following questions:

- How did mezzanine develop?
- Can it offer an advantage compared to financing only with debt and equity?
- Which basic types of mezzanine instruments exist and how are they valued?
- When and where is mezzanine used?

At the end, an example of a management buy-out in which mezzanine is used is provided. This will give important insights into the practical use of multiples to structure the deal, the mezzanine investment process, the investment criteria and the various exit routes that exist.

The paper will be concluded with an overview on the European mezzanine landscape and on how recent stock market developments and the new Basel capital accord (Basel II) may impact the future of mezzanine capital.

Special terminology or important information that is used in the private equity area is written in bold letters if mentioned for the first time in the text.

1.2 History

The issue of a convertible promissory note to raise ^[1] funds to build a canal in the UK is believed to be the first mezzanine instrument. It was issued in 1798 by the “Company of proprietors to the Canal Navigation from Manchester to or near Ashton-under-Lyne and Oldham”.

However, the idea of converting debt into equity was already used after the War of Spanish Succession when in 1711 the British government had a heavy debt burden. As the debt was trading at a substantial discount it made the refinancing more difficult. A solution was found in creating a new body, the “South Sea Company”, whose newly issued shares were to be swapped for £9.5m of floating debt - thereby reducing the interest payments by three percent per annum.

In the 1980s a high rate of new product innovation, especially in financial markets, could be observed. Among the products innovated or revived during that decade were swaps, index options, mortgage bonds and mezzanine finance. The following reasons led to the particularly strong product development in the corporate finance market:

- Deregulation of the domestic financial markets in the major OECD countries.
- The lifting of controls over the flows of external capital movements in many countries.
- Liberalisation towards the internationalisation of securities markets and merger and acquisition (M&A) activity.
- Global monetary conditions with low interest rates and a revival of economic and corporate activity.

The above stated reasons in turn led to increased competition and the establishment of large financial conglomerates which mainly used tailor-made financial services to differentiate their products from those of competitors and also to fulfil their clients desires.

After the equity market crash in October 1987 the monetary banks of the largest economies, fearing a financial recession, reduced interest rates even further. Investments that appeared too expensive in risk-return profiles became profitable. The financial market reacted by placing more emphasis on the design of securities that resembled debt more than equity. But this also raised the price expectations of corporate sellers creating a gap between the total amount of a deal and the amount that could be financed with senior debt and equity.

The amount of senior debt banks would provide is limited to the company’s assets which are used as collateral and any additional injection of equity would further dilute the shareholders ownership structure.

1.3 Definition and Terms

Mezzanine products were designed to fill this gap. They are therefore often referred to as bridge finance . A broad definition of mezzanine finance that incorporates most of the mezzanine instruments is:

Mezzanine finance can be defined as a hybrid instrument in a firm’s capital structure that contains mixtures of both senior debt and equity.

Mezzanine capital acts as a third tier in a firm’s capital structure between senior debt and equity and can therefore be found as a separate layer. Being a separate layer it faces a different risk-return profile compared to debt and equity and therefore provides an alternative yield to investors.

The word mezzanine is French and originates from the Italian word mezzanino, a diminutive of mezzano “middle” which on the other hand stems from Latin medianus “Median” . It is commonly known in the building industry where it describes a low story between two others (usually between the ground and the first floor).^[2]

Figure 1, Capital Structure of a Levered Firm

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Source: [www - document], Invest Mezzanin, Scenarios & Structures , URL: http://www.investmezzanin.at, September 26, 2002.

Looking at Figure 1, it should be clear why the term mezzanine was incorporated into the economic language. It can be seen that the mezzanine layer forms a separate floor in the middle of a company’s capital structure.

Mezzanine capital is also known under the term subordinated debt . This arises from the servicing in case of financial distress. Senior debt has to be serviced first. Then subordinated debt can be serviced and the remainder accrues to the shareholders i.e. the providers of equity. Due to the fact that mezzanine is serviced after senior debt it its also referred to as junior debt .

Junior debt can be viewed in two ways. For equity providers this layer increases the leverage on ordinary shares but produces another stakeholder in the event of liquidation. For a bank that contributed senior debt, it is almost viewed as a further injection of equity.

As a result of the flexibility of mezzanine products their use allow a higher leverage compared to investments undertaken with only senior debt and equity. But do leverage and the combined characteristics of debt and equity built into a hybrid instrument offer any advantage at all?

2 Capital Structure Decision

The recent boom in the use of mezzanine capital seems to imply that it offers a superior risk-return profile compared to straight combinations of debt and equity. It either provides investors in mezzanine with a greater return for a given risk, or it involves a lower risk for a given return. By offering a superior risk adjusted return it should therefore lower a firm’s cost of capital and thereby increase the value of the company.

There has been a sizeable amount of research conducted by different economists into whether the capital structure would have any influence on the value of a company. Over the years different theories evolved. Some of them were amended because they failed empirical tests and/or received heavy criticism from others. Table 1 presents an overview of various theories developed.

Table 1, Theories of Capital Structure

1 Modigliani and Miller (1958): Leverage irrelevance with no taxes.
2 Modigliani and Miller (1963): Tax advantage of debt equal to TCB.
3 Miller (1977): Tax advantage based on marginal tax rates, including personal taxes.
4 Feldstein, Green, & Sheshinski (1979): Leverage is influenced by the full structure of tax effects and changes in the debt/equity ratio are influenced by risk premium effects as well.
5 Modigliani (1982): Leverage influenced by average tax rates and uncertainty.
6 Jensen and Meckling (1976): Optimal capital structure minimizes total agency costs.
7 DeAngelo and Masulis (1980): Optimal tradeoff between the marginal expected benefit of interest deductions plus other tax shields and the marginal expected cost of bankruptcy.
8 Ross (1977): Financial leverage and dividend policy used to signal future financial performance.
9 Myers and Majluf (1984): Information asymmetry and rational expectations signaling.
10 Ross (1985): With tax effects of DeAngelo and Masulis, a relationship between capital structure and beta measures of risk.
11 Jensen (1986): High debt ratios bond future cash payouts.
12 C. Smith (1986); Booth and R. Smith (1986): Certification role of investment bankers.

Source: Weston, Chung, Hoag, Mergers, Restructuring and Corporate Control , 1990, p. 112.

If a firm’s capital structure had no influence at all on the value of a company there would be no way the use of mezzanine finance, which is a hybrid form of debt and equity, could increase the value of an enterprise. It is therefore important to first study the theory of capital structure.

2.1 Capital Structure Decision in Perfect Markets

The concept of perfect markets rests on highly restrictive assumptions of how securities are traded, how information is passed on, and how decisions are made by individuals. They can be summarized as follows:

- Markets are frictionless, which means that there are no transaction costs, no taxes and no regulations .
- Information regarding securities is freely available, which is also known as “perfect information” .

In general two different positions evolved, a traditionalist and a modernist one.

2.1.1 The Traditional View

Traditionalists believe that there is an optimal set of securities that minimize the aggregate costs of capital which can be seen in Figure 2(a). At the minimal costs the firm value is maximised, because the lower the costs, ceteris paribus, the more investment projects will turn out with a positive net present value (NPV) . This is illustrated in Figure 2(b).

Figure 2, The Traditionalist’s View on Financing and Firm Value

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 306.

As a consequence, traditionalists view the financing decision as an essential one. Their position stems from general observations about a firm’s financing alternatives and is neither based upon an economic model nor an empirical validation.

2.1.2 The Modernist View

The modernist’s position was established by Franco Modigliani and Merton Miller in 1958. Each of them received the Nobel prize in economics for their revolutionary propositions and concepts which are commonly known as M&M propositions .

In perfect markets modernists regard the financing decision to be irrelevant. This would lead to the implication that the management should not waste its time on how to structure their finance. Rather, it should dedicate all of its efforts to the investment decision. Figure 3 shows that no matter how much debt or equity is used, the cost of capital and the firm value will not change.

Figure 3, The Modernist’s View on Financing and Firm Value

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 306.

As both views are based on financial leverage it is vital to understand the concept of leverage before continuing with the theory on capital structure.

2.2 The Concept of Leverage

In general science classes the principle of a physical leverage is introduced where a lever is an instrument that increases power. In finance leverage results from the use of fixed-cost assets or funds that have the power to magnify the returns to the firm’s owner. The leverage is a measure of elasticity and states how one variable affects another dependant one. There are three basic types of leverage which are best explained by looking at Figure 4.

Figure 4, General Income Statement Format and Types of Leverage

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Source: Gitman, Principles of Managerial Finance , 2000, p. 490.

2.2.1 The Total Leverage

Looking at either side of Figure 4 it can be seen that total leverage can be split up into the operational and the financial leverage.

2.2.2 The Operating Leverage

The static operating leverage measures the relationship between the earnings before interest and taxes (EBIT) , which is a descriptive label for the operating profit, and the company’s sales revenue. It results from the existence of fixed operating costs that can magnify the impact of changes in sales on the firm’s EBIT. If, due to cost reductions, the fixed operating costs are lowered, this will have a significant effect on the operating leverage.

2.2.3 The Financial Leverage

The relationship between the firm’s common stock earnings per share (EPS) and its EBIT is expressed by the static financial leverage. The use of fixed financial costs, such as debt, will magnify the effects of changes in EBIT on the firm’s EPS.

For the remainder of the paper when the word leverage, levered or unlevered, is mentioned it refers to the financial leverage.

2.2.3.1 Being Unlevered

A company that has no debt at all is unlevered. In such a firm the value and the risk of the assets will equal the value and the risk of the equity. Looking at the balance sheet the left side is comprised of the assets and because there is no debt at the right side it can be stated:

The unlevered firm:

Value of assets = Value of equity.

Example^[3] : An individual sets up a corporation to own and rent houses. His equity contribution of $100,000 is used to purchase the house. If the yearly cash flow was $18,000 then the return to the equity holder = Abbildung in dieser Leseprobe nicht enthalten = 0.18 or 18%.

2.2.3.2 Being Levered

If a company finances its assets with a combination of debt and equity it is called a levered firm and the value of the assets will equal the combined value of the debt and equity.

The levered firm:

Value of assets = Value of debt + Value of equity.

Because, as already stated in the introduction, debt holders have a prior claim on the company’s assets, providers of debt are in a less risky position compared to shareholders who are entitled to what is left after all the debt was serviced. As residual claimants, holders of equity face a higher risk.

It is important to understand, that the total risk of a company, which is the risk of the assets stays constant in this analysis and can only be changed by changing the assets. Financial leverage therefore does not change the overall risk, it will only partition it.

Example^[4] : With leverage, the individual could either stick to his initial contribution of equity of $100,000 and take out a loan of $100,000 which would enable him to buy two houses. Another possibility is to buy only one house with $50,000 of equity and debt and invest the remaining $50,000. Assuming that he bought two houses and that debt was issued at 10 percent, the yearly cash flows would be $36,000 minus $10,000 interest paid on the loan that he took out. In this case the return to the equity holder = Abbildung in dieser Leseprobe nicht enthalten = 0.26 or 26%.

Through the use of 50 percent debt the return to the individual increased from 18 to 26 percent. But if the rental market collapsed and the cash inflow was less than the interest payment of $10,000 the providers of debt could declare the individual bankrupt.

After the introduction of the concept of leverage the two differing views on capital structure theory are reviewed again.

2.2.4 The Traditional View Revisited

Traditionalists generally assume that companies construct their capital structures in order to offer a mix of securities to investors and lenders that will maximise the total value of the firm.

From Figure 5 it can be noted that, as small amounts of debt are considered to be risk free, both the return on debt rD and the return on equity rE do not rise significantly until large amounts of debt are used.

Figure 5, A Traditionalist’s View on Leverage and Expected Return

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 317.

Because debt is cheaper than equity, combining equity with reasonable amounts of debt should lead to the reduction of the overall cost of capital rA .

2.2.5 The Modernist View Revisited

Franco Modigliani and Merton Miller proved in their famous paper “Leverage irrelevance with no taxes” in 1958 that if two firms are identical except for their capital structures, an opportunity to earn arbitrage exists if the total values of the two firms are not the same.

By applying the law of one price, two financial products that are close substitutes and have the same payoff will have the same price after all arbitrage possibilities have been eliminated. Therefore, the actual choice between debt and equity is irrelevant in a world of perfect information, no taxation and efficient markets with zero transaction costs and leverage has no impact on the weighted average cost of capital (WACC) .

In efficient markets wealth cannot be increased by trading mispriced securities, and modernists believe that the major security markets are reasonably efficient. If however, mispricing existed, arbitragers would immediately enter the market, exploit the arbitrage opportunities and thereby force the prices to where they would equal the value of the firm’s assets.

2.2.5.1 M & M Proposition I

Modigliani and Miller demonstrated their theory on two firms that ^[5] generate the same stream of operating income but differ in their capital structure.

Firm U is unlevered and, as already mentioned above, the total value of its equity EU is the same as the total value of the firm VU . The Company L is levered and the value of its stock EL is therefore the value of the firm VL less its debt DL. If an investor invested one percent in U’s shares .01 VU he would be entitled to one percent of U’s profits:

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Result of Proposition I: VU = VL

If the values of the two companies differed, arbitrage would be possible.

Another way to show that capital structure is irrelevant is the homemade leverage argument which states that in perfect markets any decision on capital structure made by a company can be replicated or undone by the investor.

Table 2 provides an example of how this can be done. The two firms Boring, Inc. and Exciting, Inc. are exactly the same except for their capital structure. Boring, Inc. has no debt and an outstanding 1,000 shares of stock. Exciting, Inc. has $5,000 of debt which requires an interest payment of $500. and an outstanding 1,000 shares of stock.

Table 2, The Cash Flows and Values of Boring, Inc. and Exciting, Inc.

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 327.

If an individual wanted to invest $500 he could purchase 10 percent of the equity of Exiting, Inc., a levered firm. An equivalent alternative is to purchase 10 percent of the equity of Boring, Inc., which is unlevered, for $1,000 financing half of the amount by borrowing $500. This is illustrated in Panel A of Table 3. Using the homemade leverage both alternatives produce the same return.

Panel B illustrates the available alternatives to an investor who is purchasing 10 percent of Boring, Inc., which is unlevered, for $1,000. The equivalent way would be to invest $500 in Exiting, Inc., a levered firm, and lending $500 by buying bonds. Again both alternatives produce the same return and the process is called homemade unlevering .

Table 3, Homemade Leverage

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 330.

In this example the effect of risk on the required rate of return is temporarily ignored and it is assumed that the investor can borrow at the same interest rate as the company.

2.2.5.2 M&M Proposition II

As demonstrated in the examples above the capital structure decision^[6] is irrelevant in perfect markets and does not affect the return on the firm’s assets rA.

If an investor held all securities of a company, debt and equity, he would be entitled to all the firm’s operating income. His expected return on this portfolio would equal rA. The expected return on a portfolio is equal to the weighted average of the expected returns of the individual securities comprising the portfolio.

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If this formula is rearranged the expected return on the equity of a levered firm rE can be obtained:

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where:

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Proposition II states that the expected return on the equity of a levered firm increases in proportion with the debt/equity-ratio (D/E) , expressed in market values. This can be seen in Figure 6.

Figure 6, MM’s Proposition II, a Modernist’s View on Leverage and Expected Return

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Source: Brealey, Myers, Principles of Corporate Finance , 2000, p. 482.

At low levels of debt a firm’s bonds are viewed as risk-free and the expected return on the equity increases linearly with the D/E-ratio. As more debt is used, the risk of default increases and the bondholders will require a higher interest rate. When debt becomes risky the increase in rE slows down due to fact that equity holders have a limited liability and some of the risk is transferred to the debt holders, thereby making them worse off. As will be mentioned later, debt holders will protect themselves from being made worse off in various ways.

At first sight, proposition I which states that leverage has no effect on the shareholder’s wealth, contradicts proposition II, which states that by increasing the leverage shareholders can increase the expected return on equity. The answer to that puzzle is that any increase in expected return is exactly offset by an increase in risk and therefore in the shareholder’s required rate of return on their investment.

The beta of a firm’s assets, which is a measure of market risk, is the weighted average of the betas of the individual securities.

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Rearranging this expression leads to the beta of the equity of a levered firm βE:

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where:

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So far, the Modigliani-Miller theorem , that only holds in a perfect market, could not explain the existence of mezzanine products. It would be necessary to extend the analysis and consider the question of whether there is an optimal structure combining a mix of mezzanine, debt and equity.

According to Brealey and Myers^[7] “Proposition I is an extremely general result. It applies not just to the debt-equity trade-off but to any choice of financing instruments.” Therefore, the choices of long-term versus short-term, secured versus unsecured, senior versus subordinated, and convertible versus non-convertible should all have no effect on the overall value of the firm.

Grinblatt and Titman state in their book^[8] that risk and wealth transfer depends on weather new debt is subordinated or not to existing debt. They distinguish between two cases:

New Debt is Subordinated to Existing Debt

When debt is risky and the issue of new debt is junior to existing debt, i.e. subordinated, the new debt would require, as a consequence a higher interest rate than the senior debt. Under the assumptions of perfect markets using subordinated debt will leave shareholders indifferent to the changes in the capital structure.

New Debt is Not Subordinated to Existing Debt

If the new debt is not subordinated to the old debt, the new debt holders share the cash flows of the bankrupt firm with the senior debt holders. Therefore, the new debt issue can decrease the value of the existing debt. Again under perfect markets this loss to the old debt holders is offset by a gain to the equity holders, leaving the total value of the firm unchanged.

Both alternatives mentioned only transfer risk and do not change the overall value of the corporation.

2.3 Capital Structure Decision in an Imperfect World

In perfect capital markets there seems to be no theoretic evidence that capital structure will have an effect on the value of corporations and if debt policy were completely irrelevant then the observed debt ratios should vary randomly among different companies and industries. But rather than a random distribution of debt ratios a pattern of similar debt ratios in certain industries can be found.

Table 4 presents an overview of the debt ratios (total liabilities/total assets) and the times interest earned ratio (EBIT/interest) that can be found in selected industries. The times interest earned ratio is a measure of a firm’s ability to meet the fixed interest payments.

Table 4, Debt Ratios for Selected Industries and Lines of Business

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Source: Gitman, Princ iples of Managerial Finance , 2000, p. 506.

Significant differences can be seen in the data. For instance, the debt ratio for electronic computer manufacturers is 52.6 percent, whereas it is 78.4 percent for auto retailers.

Allowing for certain market imperfections might change the debt irrelevancy and offer some explanation for the use of hybrid financing instruments.

2.3.1 Corporate Taxes

As a general rule, income refers to taxable income less deductible expenses. Companies are allowed certain expenses to be deducted before they compute their taxes owed to the government. Interest payments are one of those tax-deductible expenses whereas dividends and retained earnings are not. There are also non-interest deductible expenses such as depreciation, amortization, expenses in research & development, etc.

Considering corporate income taxes the example on homemade leverage of Boring, Inc. and Exciting, Inc. mentioned in Table 2 would change as stated in Table 5. Since Exciting, Inc. has some debt included in its capital structure in can deduct the interest payments, thereby reducing its taxable income.

Table 5, Leverage with Corporate Income Taxes

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 347.

As can be seen in Table 6 homemade leverage no longer works and there is a preference for borrowing through a corporation.

Table 6, Homemade Leverage with Corporate Income Taxes

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Source: Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 347.

Using the homemade leverage leads to the loss of tax saving due to the deductibility of interest expenses. This extra gain is called the tax shield . Tax shields can be very valuable. Assuming that the risk of the tax shield is the same as the interest payments generating them, that the debt is permanent and that the earnings are enough to cover the interest expenses, the present value of a tax shield is:

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where:

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If the income does not cover the interest payments in a particular year, certain tax systems allow tax shields to be carried forward.

Modigliani-Miller state in their proposition I, that the value of a pie, i.e. the value of a firm, does not depend on how it is sliced. This is illustrated in the first pie of Figure 7. In the second pie a piece is removed for tax payments to the government. When more of the pie is allocated to the debt holders, less is allocated to the government, implying that the combined debt and equity slices, in which owners are interested, increase. Finally, the third pie has an additional slice taken off from the debt and equity holders which corresponds to the part that is wasted because of inefficiencies, lost opportunities or avoidable costs.

Figure 7, Slicing the Cash Flows of a Firm

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Source: Grinblatt, Titman, Financial Markets and Corporate Strategy , 1998, p. 490.

Modigliani and Miller corrected their theory in 1963 to reflect the impact on corporate income taxes: They changed their proposition I to:

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where:

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When taxes are introduced, the weighted average cost of capital formula has to be adapted for tax deductibility. The formula that was already used in the M&M Proposition II changes to the well known after-tax WACC formula:

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where:

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Again the return on the equity can be calculated by transforming the above equation:

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A graphical representation of the WACC and the debt/equity-ratio is given in Figure 8.

Figure 8, WACC Plotted Against the Debt/Equity-Ratio

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Source: Brealey, Myers, Principles of Corporate Finance , 2000, p. 553.

The after-tax WACC is less than the opportunity cost of capital r since the tax advantages of debt financing are now reflected in a lower discount rate. The variables in the formula refer to the firm as a whole.

If a particular project is financed in a different way, the ratios and variables have to be adjusted in order to get the correct figure. This is done first by unlevering and then relevering at the desired debt/equity-ratio. This, of course, changes the risk and therefore the required return on the equity.

Proposition I with taxes would imply that the optimal capital structure is one where 100 percent debt is used. This cannot be the goal of financial managers in any case as it would lead to bankruptcy. Allowing for further imperfections might solve the problem.

2.3.2 Corporate and Personal Taxes

In 1977, Merton Miller developed an alternative Model which, in addition to corporate taxes, included personal taxes. It is known as the Miller tax model . A firm’s capital structure determines whether operating income is paid out as interest or equity income. Equity income can arise in the form of dividends or capital gains. As mentioned above corporations can deduct tax payments. For that reason interest is only taxed at the personal level.

Commonly there are two different tax rates found for the individual’s equity and debt income. Miller argued that when personal taxes are introduced the overall objective is to minimize all taxes paid rather than solely corporate taxes.

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where:

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Miller concluded that the tax advantage to debt at the corporate level was exactly offset by the tax disadvantage to debt at the individual income tax level, such that capital structure returns to being irrelevant. This, of course, depends on the prevailing tax rates under every government.

Millers argument can be shown by setting Abbildung in dieser Leseprobe nicht enthalten. The result is that the formula above would reduce to VL = VU .

Many empirical studies have failed to determine the M&M or the Miller model as being correct. Reasons for this are that companies have a wide range of different parties who provide finance. Among these there might be tax-exempt pension funds, other corporations, millionaires, and people from the lower tax brackets. Minimising the overall taxes paid would require information about every party and accordingly their different treatment.

At the private level tax on capital gains has to be paid once the gain is realized. Smart investors will carefully choose the time to sell their stocks. Therefore, it is impossible for companies to optimise the taxes on capital gains of individuals.

At the corporate level both models assume constant perpetual tax shields which cannot be found in practice. No company can be sure that it will always be profitable and the amount of debt outstanding is always subject to changes. If, however tax shields can be carried forward, the firms at least lose the time value of money on the tax shield.

As mentioned at the beginning of this chapter there are also other non-interest tax shields such as accelerated write-offs, investments in intangible assets or contributions to the pension scheme, which also have to be taken into account.

The majority of financial managers and economists believe that there is a small advantage to corporate borrowing. However, there are still other imperfections which have not yet been considered.

2.3.3 Costs of Financial Distress

When companies have difficulties in meeting the interest payments of their debt providers they are in financial distress. This can sometimes lead to bankruptcy.

In general a bankruptcy is viewed as something bad. But because bankruptcy is the right of the shareholders to default, it is a very valuable option. Without it, shareholders would be personally liable for the debt of the firm.

A common misunderstanding is that people think of the lost value of a once healthy firm as the costs of bankruptcy. But due to the loss in value, which might have stemmed from various circumstances, bankruptcy is the final legal mechanism for allowing the creditors to take over control.

In perfect markets bankruptcy is assumed to be costless and very quick. In reality, of course, there are direct costs involved in bankruptcy and the legalities can take up some amount of time. Investors know that companies might encounter problems of financial distress and this is reflected in the market value of the company. The combined market value of a firm is therefore:

Value of the firm = VU + PVtax shield - PVcosts of financial distress

where:

VU = Value if all-equity financed.

The higher the leverage of a firm, the higher the present value of the tax shield but the higher also the probability of bankruptcy and therefore the present value of the costs of financial distress. This trade-off is shown in Figure 9.

Figure 9, Trade-off Theory of capital structure

illustration not visible in this excerpt

Source: Brealey, Myers, Principles of Corporate Finance , 2000, p. 511.

At low levels of debt the probability of financial distress is nearly irrelevant and the benefits from the tax shield dominate. At some point the probability of financial distress increases rapidly with additional borrowing. The optimal debt ratio is when the present value of tax savings, due to the additional borrowing, is offset by increases in the present value of costs of financial distress.

This theory is known as the trade-off theory of capital structure and was put forward by DeAngelo and Masulis in 1980: Their theory successfully explains some industry differences and avoids extreme predictions like the Modigliani-Miller model with taxes that suggested 100 percent debt.

The costs of distress vary with the type of the underlying assets. For instance, it is much easier to sell a hotel which cannot no longer make its mortgage repayments than to sell the assets of a high tech corporation where most of the value of the company was the technology, opportunities, and the human capital. In the new economy most of the assets are intangible and therefore are only valuable as part of a going concern.

This might explain why empirical research discovered that firms with largely intangible assets borrow less. Another reason is probably that banks are reluctant to borrow once companies cannot provide sufficient collateral.

In addition the trade-off theory explains what kind of companies go private in leveraged buy-outs (LBOs) . The target companies are usually mature, cash-cow businesses with a well established market position and therefore are able to digest large amounts of debt. One aspect it cannot explain is that some of the most successful businesses do not take on more debt and thereby give up valuable interest tax shields.

[...]

^[1] See Sturgess, Leen, Mezzanine Finance , 1991, pp. 1-4.

^[2] See Fowler, Fowler, The Concise Oxford Dictionary of Current English , 1995, p. 858.

^[3] Taken from Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 308.

^[4] Modified from Chambers, Nelson, Modern Corporate Finance: Theory and Practice , 1994, p. 309.

^[5] Taken from Brealey, Myers, Principles of Corporate Finance , 2000, pp. 475-476.

^[6] Taken from Brealey, Myers, Principles of Corporate Finance , 2000, p. 481.

^[7] See Brealey, Myers, Principles of Corporate Finance , 2000, p. 491.

^[8] See Grinblatt, Titman, Financial Markets and Corporate Strategy , 1998, p. 495.