______________________________________________ PRIVATE EQUITY in .NET

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54 ______________________________________________ PRIVATE EQUITY
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Tax deductibility of interest (debt is cheaper than equity; thus debt increases the firm's value and reduces its cost of capital) Raise capital from banks quickly Raising equity capital signals overvaluation so the firm issues debt, which signals optimism Easier to increase ROE (if investment earns more than the cost of debt) Also may have a desirable effect on EPS No dilution of voting control Incentive to management and a constraint of management Timing (common stock is depressed and capital is needed) Reduces the need for equity capital (using other people's money) A large amount of debt tends to discourage raiders Debt has lower issue costs than new equity If management wants to maximize shareholder value, it will tend to use some debt in the firm's capital structure The objective of the next sections of the chapter is to define the factors that limit the amount of debt issued by a firm, if the primary motivation for debt issuance is the income tax consideration and the primary goal is to maximize shareholder value
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TAX CONSIDERATIONS ____________________
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The substitution of debt for equity reduces the firm's cost of capital (assuming zero costs of financial distress) and increases the firm's value It can be readily shown that with zero investor taxes, zero agency costs, and zero costs of financial distress that
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56 ______________________________________________ PRIVATE EQUITY
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LIMITING THE USE OF DEBT ________________
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The list of factors limiting the amount of debt issued by a corporation in substitution of equity is long It includes: The probability of timely utilization of tax savings from the debt interest is less than one, reducing the incremental expected value from substituting $1 of debt for equity as additional debt is issued The expected costs of financial distress and bankruptcy Adding debt increases the incremental risk to shareholders The owners and/or managers fear loss of control because of the risk of bankruptcy Bankruptcy might prevent the firm from reaching a pot of gold The structure of investor taxes favor some equity Debt indenture provisions limit managerial actions Incremental debt limits the managerial and financial flexibility (the ability to take advantage of opportunities) An increase in debt leverage increases incremental cost of borrowing The debt increases the firm's Beta and the variance of EPS and ROE Management worries about the effects of too much debt on the stock price if the firm's leverage greatly exceeds that of comparable firms It is feared that the stock market will interpret the substitution of debt for equity negatively The changing of the capital structure may result in taxation of the equity investors accepting the debt in substitution for their equity securities Cash flows out of the firm paying the debt interest will restrict growth of the firm The economic characteristics of the firm's assets limit the amount of debt that can be supported All the above factors are relevant Not all decision makers will be concerned with a negative reaction by the market, but for some managers the market reaction is the primary consideration But usually management's objectives are more complex than the maximization of shareholder value
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Next, we consider how the economic characteristics of the firm's assets limit the amount of debt (issued in substitution for stock) that can be supported If debt were being issued to acquire new assets the analysis would be different
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HOW THE FIRM'S ASSETS DETERMINE THE MAXIMUM DEBT _____________________
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Assume equation (51) applies:
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VL = Vu + tB
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With maximum debt, VL = B and therefore: B = Vu + tB and solving for B:
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(51)
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For the example where Vu = $16,500,000 and t = 35, the value of B is:
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If more than $25,385,000 of debt is issued in substitution for stock there is a significant likelihood that the firm would not be able to pay the contractual debt payments This conclusion is based on the market's valuation of the unleveraged firm, thus includes the market's risk perceptions Let X be the firm's expected earnings before interest and taxes and equal to $3,807,750 The maximum debt can also be determined using the earnings expected to be generated by the assets If
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