R & D CORPORATE VALUATION, STANDARD RECAPITALIZATION STRATEGIES AND THE VALUE OF TAX SAVINGS IN TEXTBOOK VALUATION FORMULAS by B. SCHWETZLER* 2000/46/FIN * Professor, Chair of Financial Management, Leipzig Graduate School of Management (HHL), Jahnalle 59, D-04109 Leipzig, FRG Visiting Scholar, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France. A working paper in the INSEAD Working Paper Series is intended as a means whereby a faculty researcher’s thoughts and findings may be communicated to interested readers. The paper should be considered preliminary in nature and may require revision. Printed at INSEAD, Fontainebleau, France. Corporate Valuation, Standard Recapitalization Strategies and the Value of Tax Savings in Textbook Valuation Formulas Bernhard Schwetzler* * Professor, Chair of Financial Management, Leipzig Graduate School of Management (HHL), Jahnalle 59, D-04109 Leipzig, FRG Visting Scholar, INSEAD, Boulevard de Constance, 77305 Fontainebleau, CEDEX e-Mail: [email protected]; 2 Abstract Typically, in finance and valuation textbooks three different formulas, known as the weighted average cost of capital (WACC)-, the adjusted present value (APV)- and the flow to equity (FTE)- approach are proposed to calculate the present value of a levered firm. Recent results in research suggest that these formulas imply different types of recapitalization strategies, predetermining either absolute future debt levels or capital structures in future periods (D-strategy and L- strategy) leading to different tax shields and firm values if future firm values are uncertain. This paper will show that one of these two strategies attributed with riskless tax savings (the D-strategy) is not admissible in the expectations adaption regime necessary to apply risk adjusted CAPM-based rates of return on multiperiod uncertain cash flows. In contrast, the recapitalization strategy leading to riskier tax savings (L-strategy) is admissible. Standard valuation formulas that imply riskless tax savings thus overstate the tax benefits of debt financing. This result adds another possible explanation to the phenomenon that the effects of tax considerations upon capital structure decisions to be observed empirically are substantially smaller than suggested by standard corporate finance formulas. 3 1. Introduction Since the pathbreaking work of Modigliani and Miller (1963) financial researchers have been puzzled by the effects of debt-related tax savings upon optimal capital structure and firm value. Recent findings by Inselbag and Kaufold (1997) and Kruschwitz and Löffler (1998), building on earlier work of Miles and Ezzel (1981), suggest that the tax advantage attributed to debt financing depends on the debt policy, more precisely: on the recapitalization strategy of the firm, if future firm values are uncertain. - If companies predetermine absolute levels of outstanding debt for every future period the absolute amount of debt, interest payments and tax savings attributed to these savings are known with certainty. I will refer to this policy as the „D-policy“ henceforth. - Companies following an „L-Policy“ predetermine their capital structure (leverage) L (to be measured in market values) as debt-to-firm-value for every future period. Whenever future firm values are uncertain, future debt levels are uncertain too. The tax benefits attributed to debt under the L-policy are more risky and hence less valuable to investors than those under the D-policy.1 Since Fama (1977) and Myers and Turnbull (1977) it is well known that using a single period CAPM-based risk adjusted rate of return for multiperiod capital budgeting and valuation, as proposed in valuation and finance textbooks, requires a particular expectations adaption process. Market participants are assumed to adjust their expectations of future operating cash flows of the firm relatively to the deviation of the currently realized cash flow to its expected value. This revision of expectations puts future market values of the firm under the same risk as its operating cash flows. Using standard textbook formulas for valuation purposes implies risky future market values of the firm and thus makes the distinction between the two different debt policies an important issue in corporate valuation. In this paper the implications of the expectations adaption process for the two different policies outlined above are analyzed. It will be shown that the D-policy collides with the assumptions of the multiperiod revised expectations model. As expectations revisions may drive future firm values down and debtholders may face risk of default, their reaction will prevent the firm from maintaining a predetermined debt level under all circumstances. Debtholders may force the firm to repurchase debt or may charge higher rates of return. Future (expected) interest payments and the risk attributed to these payments thus cannot remain unchanged. Riskless interest payments and therefore riskless tax savings are not achievable under the expectations adaption regime assumed by standard valuation formulas. The L-policy does not collide with the revised expectations model, if debtholders choose the amount of debt in order to avoid default risk. As debt levels are assumed to be permanently 1 Note that it is the uncertainty about the level of debt outstanding that puts risk upon the tax benefits. The debt itself may still be riskless. 4 adjusted in accordance to changes in total firm value, debtholders may not face a change of default risk over time. As the amount of outstanding debt and the interest payments are certain only for the next period, the tax savings will be certain only for the next period, too. The expectations adaption process under the L-policy puts future debt levels following the next period under the same risk as the operating cash flows. Miles and Ezzel (1981) have shown that the risk adjusted rate of return for the unlevered firm is the correct rate for further discounting and for determining the present value of the tax benefit. For the purpose of corporate valuation disadvantages of debt financing (costs of financial distress, agency costs of debt) are rarely explicitly taken into account. The reason for this may be that financial theory offered only little guidance to practitioners in order to accurately quantify these effects. The possible differentiation between the two strategies imposes a considerable degree of uncertainty on corporate valuations in practice: The D-policy will lead to higher tax benefits and hence higher firm values, but is not admissible under the asssumend expectations adaption regime. The L-policy fits into the expectations adaption model but leads to lower firm values. As it is just the announcement of the future recapitalization policy that accounts for the difference in value, the differentiation between the two strategies may be expected to become a major issue of debate in price negotiations. The results of this paper add another argument to the discussion about the magnitude of tax effects upon optimal capital structure. If capital market participants recognize that a D-policy is not achievable within the expectations adaption framework markets use for valuation purposes they may not give too much credit on the announcement and promise of a company to follow this strategy. Capital markets might then perceive the L-strategy as more credible and thus will attribute less value to future tax benefits than implied by the standard valuation models that assume the D-policy to hold. If the announcement of different recapitalization strategies (as D- and L-policy) is assumed to be the only difference between a D- and an L- company under analysis, marginal and average disadvantages of debt financing as costs of financial distress and agency costs may, at best, only slightly differ for the two strategies. If bankruptcy costs and other disadvantages of debt are assumend to be independent from the announced debt recapitalization strategy, the L-policy leads to substantially lower optimal debt levels D* than the D-strategy (if perceived to be achievable): lower marginal tax benefits have to outweigh unchanged marginal disadvantages of debt. Maximum firm value at optimal debt level is higher for the D-firm than for the L-firm. If capital markets attribute lower values to future tax savings than the D-model implies, the standard valuation formulas used in finance theory overstate the value of the tax shield. Optimal debt levels based on the assumptions of riskless tax savings thus appear to be too high. The differentiation between the two recapitalization strategies and the non- achieveability of riskless tax savings implied by the standard valuation formulas thus might add another explanation to the phenomenon that empirically observed amounts of debt and leverage ratios are significantly lower than predicted by standard valuation models. 5 Related work concentrating on the risk of future debt and the magnitude of tax effects upon firm value in a multiperiod setting has been done by Lewellen and Emery (1986), Lewis (1990) and Berens and Cuny (1995). The model developed by Berens and Cuny optimizes corporate debt by outweighing marginal tax advantages of uncertain tax savings on corporate level against the marginal disadvantage of additional riskless tax payments on bondholder level. As they assume risk neutral investors and independent identically distributed future cash flows (pp. 1193) they ignore the expectations adaption process implied by the standard valuation