Cash Dividends
Slide 1
Leverage and Capital Structure
A firm’s choice of how much debt it should have relative to equity is known as a capital structure decision.
A firm’s capital structure is really just a reflection of its borrowing policy. Should we borrow a lot of money,
or just a little?
In this module, we discuss the basic ideas underlying capital structures and how firms choose them. We
will ignore investment decisions and focus on the long-term financing, or capital structure, question.
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Capital Structure
• Capital structure = percent of debt and equity used to fund the firm’s assets – “Leverage” = use of debt in capital structure
• Capital restructuring = changing the amount of leverage without changing the firm’s assets ▪ Increase leverage by issuing debt and
repurchasing outstanding shares
▪ Decrease leverage by issuing new equity shares and retiring outstanding debt
Activities such as these that alter the firm’s existing capital structure are called capital restructurings.
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Capital Structure & Shareholder Wealth
• The primary goal of financial managers:
▪ Maximize stockholder wealth
• Maximizing shareholder wealth =
▪ Maximizing firm value
▪ Minimizing WACC
• Objective: Choose the capital structure that will minimize WACC and maximize stockholder wealth
WACC tells us that the firm’s overall cost of capital is a weighted average of the costs of the various
components of the firm’s capital structure. A primary reason for studying the WACC (WACC is the
discount rate appropriate for the firm’s overall cash flows) is that the value of the firm is maximized when
the WACC is minimized. When we described the WACC, we took the firm’s capital structure as given.
Thus, one important issue that we will want to explore in this module is what happens to the cost of capital
when we vary the amount of debt financing, or the debt-equity ratio.
We want to choose the firm’s optimal capital structure capital structure so that the WACC is minimized.
The “optimal” or “target” capital structure is that debt/equity mix that simultaneously (a) maximizes the
value of the firm, (b) minimizes the weighted average cost of capital, and (c) maximizes the market value
of the common stock.
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• How does leverage affect the EPS and ROE of a firm?
• When we increase the amount of debt financing, we increase the fixed interest expense.
• If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders.
• If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders.
• Leverage amplifies the variation in both EPS and ROE.
The Effect of Financial Leverage
When we increase the amount of debt financing, we increase the fixed interest expense. The more debt
financing a firm uses in its capital structure, the more financial leverage it employs. If we increase the
amount of debt in a restructuring, we are implicitly decreasing the amount of outstanding shares.
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• We will ignore the effect of taxes at this stage.
• What happens to EPS and ROE when we issue debt and buy back shares of stock?
Example: Financial Leverage, EPS and ROE – Part I
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Trans Am Corporation Example
Table 13.1
Current Proposed
Assets $8,000,000 $8,000,000
Debt $0 $4,000,000
Equity $8,000,000 $4,000,000
Debt/Equity Ratio 0.0 1.0
Share Price $20 $20
Shares Outstanding 400,000 200,000
Interest rate 10% 10%
The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms. Morris, is
considering a restructuring that would involve issuing debt and using the proceeds to buy back some of the
outstanding equity.
As shown, the firm’s assets have a market value of $8 million, and there are 400,000 shares outstanding.
Because Trans Am is an all-equity firm, the price per share is $20.
Proposed capital structure: no debt to 50-50 debt-equity mix.
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Trans Am Corp With and Without Debt
Table 13.2
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 0 0 0
Net Income $500,000 $1,000,000 $1,500,000
ROE 6.25% 12.50% 18.75%
EPS $1.25 $2.50 $3.75
Current Capital Structure: No Debt
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000 400,000 400,000
Net Income $100,000 $600,000 $1,100,000
ROE 2.50% 15.00% 27.50%
EPS $0.50 $3.00 $5.50
Proposed Capital Structure: Debt = $4 million
To investigate the impact of the proposed restructuring, we compare the firm’s current capital structure to
the proposed capital structure under three scenarios.
Corporate EBIT varies depending on the economic conditions.
With no debt (the current capital structure) and no taxes,
There are 400,000 shares outstanding.
The firm’s assets have a market value of $8 million (Equity).
With $4 million in debt (the proposed capital structure),
There are 200,000 shares outstanding.
The firm’s assets have a market value of $4 million (Equity).
Because the interest rate is 10 percent, the interest bill is $400,000.
EPS = NI/# of shares
ROE = NI/total Equity
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Leverage Effects
Variability in ROE – Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS – Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS increases when financial leverage is increased
The variability in both EPS and ROE is much larger under the proposed capital structure (due to
leverage).
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Break-Even EBIT
• If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders
• If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
• Find EBIT where EPS is the same under both the current and proposed capital structures (Break-even point).
The first line, labeled “No debt,” represents the case of no leverage. This line begins at the origin, indicating
that EPS would be zero if EBIT were zero. From there, every $400,000 increase in EBIT increases EPS by
$1 (because there are 400,000 shares outstanding).
The second line represents the proposed capital structure. Here, EPS is negative if EBIT is zero. This
follows because $400,000 of interest must be paid regardless of the firm’s profits. Since there are 200,000
shares in this case, EPS is −$2 per share as shown. Similarly, if EBIT were $400,000, EPS would be exactly
zero.
The important thing to notice in Figure 13.1 is that the slope of the line in this second case is steeper. In
fact, for every $400,000 increase in EBIT, EPS rises by $2, so the line is twice as steep.
This tells us that EPS is twice as sensitive to changes in EBIT because of the financial leverage employed.
Another observation to make in this figure is that the lines intersect. At that point, EPS is exactly the same
for both capital structures. To find this point, we can solve [EPS without debt = EPS with debt].
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Example: Break-Even EBIT EPS = for both Capital Structures
( )
$2.00 400,000
800,000 EPS
$800,000EBIT
800,000EBIT2EBIT
400,000EBIT 200,000
400,000 EBIT
200,000
400,000EBIT
400,000
EBIT
==
=
-=
-
=
- =
[EPS without debt = EPS with debt]
EPS = Net income / # of shares outstanding
With no debt (the current capital structure) and no taxes, there are 400,000 shares outstanding. With $4
million in debt (the proposed capital structure), there are 200,000 shares outstanding.
[(EBIT) / 400000] = [(EBIT – Interest) / 200000]
If EBIT is 800000, the firm has the same EPS regardless of TAC’s capital structure
.
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• Based on what we have seen so far, we can draw the following three conclusions: 1. The effect of financial leverage depends on the company’s
EBIT. When EBIT is relatively high, leverage is beneficial.
2. Under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS.
3. Shareholders are exposed to more risk under the proposed capital structure (with more leverage) because, in this case, the EPS and ROE are much more sensitive to changes in EBIT.
Corporate Borrowing Conclusions
Financial leverage increases ROE and EPS when EBIT is greater than the crossover (break-even) point.
The variability of EPS and ROE is increased as leverage increases.
Beyond the break-even point, EPS will be larger under the debt alternative, but with additional debt, the
firm will have additional financial risk that would increase the required return on its common stock. A
higher required return might offset the increase in EPS, resulting in a lower firm value despite the higher
EPS.
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Capital Structure Theory
• Modigliani and Miller (M&M) Theory of Capital Structure ▪ M&M Proposition I – firm value (The Pie Model)
▪ M&M Proposition II – WACC
• The value of the firm is determined by the cash flows to the firm and the risk of the firm’s assets
• Changing firm value ▪ Change the risk of the cash flows
▪ Change the cash flows
Our Trans Am example is based on a famous argument advanced by two Nobel laureates, Franco
Modigliani and Merton Miller. Franco Modigliani and Merton Miller published the first works attempting
to relate a firm’s capital structure with firm value.
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Capital Structure Theory Three Special Cases
• Case I – Assumptions – No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions – Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions – Corporate taxes, but no personal taxes
– Bankruptcy costs
You may wonder why we are even considering a situation in which taxes do not exist.
One way to get a good understanding of what is relevant to the capital structure decision is to start in a
“perfect” world and then relax assumptions as we go. By relaxing one assumption at a time, we can get a
better idea of the impact on the capital structure decision. This is the classic process of “model building” in
economics—start simple and add complexity one step at a time.
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Case I – Propositions I and II
• Proposition I
– The value of the firm is NOT affected by changes in the capital structure
– The cash flows of the firm do not change; therefore, value doesn’t change
• Proposition II
– The WACC of the firm is NOT affected by capital structure
– cost of equity depends on 3 factors: the required
return on the firm’s assets, the firm’s cost of debt and the firm’s debt-equity ratio
M&M Proposition I—without corporate taxes and bankruptcy costs, the firm cannot affect its value by
altering its capital structure.
M&M Proposition I states that the value of the firm (size of the pie) is not related to how the firm is financed
(how the pie is divided).
M&M Proposition II—a firm’s cost of equity capital is a positive linear function of its capital structure (still
assuming no taxes).
The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders
and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change; and we
haven’t changed the risk of existing cash flows, the value of the firm won’t change.
M&M Proposition II also states that the cost of equity depends on 3 factors: the required return on the firm’s
assets, the firm’s cost of debt and the firm’s debt-equity ratio.
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Case I - Equations
• WACC = RA = (E/V) x RE + (D/V) x RD
• RE = RA + (RA – RD) x (D/E)
RA = the “cost” of the firm’s business risk (i.e., the risk of the firm’s assets)
(RA – RD)(D/E) = the “cost” of the firm’s financial risk (i.e., the additional return required by stockholders to compensate for the risk of leverage)
This is the famous M&M Proposition II, which tells us that the cost of equity depends on three things: the
required rate of return on the firm’s assets, RA, the firm’s cost of debt, RD; and the firm’s debt equity
ratio, D/E.
As more debt is used, the return on equity increases, but the change in the proportion of debt versus
equity just offsets that increase, and the WACC does not change.
Business risk – the risk inherent in a firm’s operations. It depends on the systematic risk of the firm’s
assets and it determines the first component of the required return on equity, RA.
Financial risk – the extra risk to stockholders that results from debt financing. It determines the second
component of the required return on equity, (RA − RD)(D/E).
The main point with case I is that it doesn’t matter how we divide our cash flows between our
stockholders and bondholders; the cash flow of the firm doesn’t change. Because the cash flow doesn’t
change, and we haven’t changed the risk of existing cash flows, the value of the firm doesn’t change
Note that case I is a world without taxes. That is why the term (1 – TC) is not included in the WACC
equation.
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CASE 1 - M&M Propositions I & II Figure 16.3
The change in the capital structure weights (E/V and D/V) is exactly
offset by the change in the cost of equity (RE), so the WACC stays
the same.
Figure 13.3 summarizes our discussion thus far by plotting the cost of equity capital, RE, against the debt-
equity ratio. As shown, M&M Proposition II indicates that the cost of equity, RE, is given by a straight line
with a slope of (RA − RD). The y-intercept corresponds to a firm with a debt-equity ratio of zero, so RA =
RE in that case. Figure 13.3 shows that, as the firm raises its debt-equity ratio, the increase in leverage raises
the risk of the equity and therefore the required return, or cost of equity (RE). Notice in Figure 13.3 that the
WACC doesn’t depend on the debt-equity ratio; it’s the same no matter what the debt-equity ratio is.
Slide 17
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• Data
▪ Required return on assets = 16%; cost of debt = 10%; percent of debt = D/V = 45%
• What is the debt-to-equity ratio?
▪ D/E = (D/V) / (E/V) = (D/V) / (1 – D/V)
▪ D/E = (0.45) / (1 – 0.45) = 0.8182
• What is the cost of equity?
▪ RE = 16% + (16% - 10%)(.8182) = 20.91%
• Suppose instead that the cost of equity is 25%, what would the the debt-to- equity ratio then to be?
▪ 25% = 16% + (16% - 10%)(D/E)
▪ D/E = (25% - 16%) / (16% - 10%) = 1.5
Example: Case I
If the firm is financed with 45% debt, then it is financed with 55% equity. One way to compute the D/E
ratio is %debt / (1-%debt).
The second question is used to reinforce that RA does not change when the capital structure changes.
M&M Proposition I – without corporate taxes and bankruptcy costs, the firm cannot affect its value by
altering its capital structure.
You may not immediately see how to get the % of equity from the D/E ratio. Note that D+E = V. We are
looking at ratios, so the actual dollar amount of D and E is not important. All that matters is the relationship
between them.
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• How does financial leverage affect systematic risk?
• CAPM: RA = Rf + A(RM – Rf)
▪ Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets
• Proposition II
▪ Replace RA with the CAPM and assume that the debt is riskless (RD = Rf)
▪ RE = Rf + A(1+D/E)(RM – Rf)
The CAPM, the SML and Proposition II
According to Proposition II, RE = RA + (RA – RD)(D/E).
Intuitively, an increase in financial leverage should increase systematic risk since changes in interest rates
are a systematic risk factor and will have more impact the higher the financial leverage.
The assumption that debt is riskless is for simplicity and to illustrate that even if debt is default risk-free, it
still increases the variability of cash flows to the stockholders, and thus increases the systematic risk.
As more debt is used, the return on equity increases, but the change in the proportion of debt versus equity
just offsets that increase and the WACC does not change.
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• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
▪ E = A(1 + D/E)
• Therefore, the systematic risk of the stock depends on:
▪ Systematic risk of the assets, A, or “Business risk”
▪ Level of leverage, D/E, or “Financial risk”
Business Risk and Financial Risk
This result assumes that the debt is risk-free. The effect of leverage on financial risk will be even greater
if the debt is not default free.
Business risk – the risk inherent in a firm’s operations. It depends on the systematic risk of the firm’s
assets and it determines the first component of the required return on equity, RA.
Financial risk – the extra risk to stockholders that results from debt financing. It determines the second
component of the required return on equity, (RA − RD)(D/E).
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Case II – Corporate Taxes
• Interest on debt is tax deductible
• Therefore, when a firm adds debt, it reduces taxes, all else equal
• The reduction in taxes increases the cash flow of the firm
• The reduction in taxes reduces net income
• How should an increase in cash flows affect the value of the firm?
The U.S. government subsidizes corporate debt by making interest payments tax-deductible, which
reduces net income but increases cash flow.
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Case II - Example
Interest Tax Shield = 500 * 0.21 = $105 per year
• Eg. The levered firm has 6,250 in 8% debt. 21% corporate tax rate.
Unlevered Firm Levered Firm
EBIT 5,000 5,000
Interest 0 500
Taxable
Income
5,000 4,500
Taxes (21%) 1,050 945
Net Income 3,950 3,555
CFFA 3,950 4,055
Cash flow from assets is simply equal to EBIT – Taxes (depreciation expense is the same in either case, so
it will not affect CFFA on an incremental basis).
The levered firm has 6,250 in 8% debt, so the interest expense = .08(6,250) = 500
Tax saving equals to the interest payment ($500) multiplied by the corporate tax rate (21 percent): $500
X .21 = $105. What we are seeing is that the total cash flow to L (the levered firm) is $105 more.
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Interest Tax Shield
• Annual interest tax shield ▪ Tax rate times interest payment
▪ $6,250 in 8% debt = $500 in interest expense
▪ Annual tax shield = .21($500) = $105
• Present value of annual interest tax shield ▪ Assume perpetual debt
▪ PV = $105 / .08 = $1,312.50
▪ PV = D(RD)(TC) / RD = D*TC = $6,250(.21) = $1,312.50
The increase in cash flow in the example is exactly equal to the interest tax shield. The interest tax shield
is the tax savings arising from the tax deductibility of interest. It is the key benefit of borrowing over issuing
equity.
All else equal, a lower tax rate reduces the value of the tax shield. Thus, the recent Tax Cuts and Jobs Act,
which reduced corporate tax rates, may induce firms to reduce the amount of debt in their structure.
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• The value of the firm increases by the present value of the annual interest tax shield.
▪ Value of a levered firm (VL) =
Value of an unlevered firm (VU) + PV of interest tax shield
▪ Value of equity = Value of the firm – Value of debt
• Assuming perpetual cash flows
▪ VU = EBIT(1-T) / RU ▪ VL = VU + DTC
Case II – Proposition I
RU is the cost of capital for an unlevered firm = RA for an unlevered firm.
VU is just the PV of the expected future cash flow from assets for an unlevered firm.
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• Data
▪ EBIT = 25 million; Tax rate = 21%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%
• VU = 25(1-.21) / .12 = $164.58 million
• VL = 164.58 + 75(.21) = $180.33 million
• E = 180.33 – 75 = $105.33 million
Example: Case II – Proposition I
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M&M Proposition I with Taxes
Proposition I with taxes: The value of the leveraged firm (VL) is equal to the value of the unleveraged
firm (Vu) plus the present value of the interest tax shield.
Annual interest tax savings = D(RD)(TC)
We also assume perpetual cash flows to the firm. This is done for simplicity, but the ultimate result is the
same even if you use cash flows that change through time. If we assume perpetual debt, then the present
value of the interest tax savings = D(RD)(TC) ⁄ RD = DTC
Value of an unlevered firm, VU = EBIT(1 − TC)/RU, where RU is the cost of capital for an all equity firm.
Value of a levered firm, VL = VU + DTC
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• The WACC decreases as D/E increases because of the government subsidy on interest payments.
▪ RA = (E/V)RE + (D/V)(RD)(1-TC)
▪ RE = RU + (RU – RD)(D/E)(1-TC)
Case II – Proposition II
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Case II – Graph of Proposition II
As a firm increases its debt-equity ratio, WACC declines.
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• Now we add bankruptcy costs.
• As the D/E ratio increases, the probability of bankruptcy increases.
• This increased probability will increase the expected bankruptcy costs.
• At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost.
• At this point, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added.
Case III
Note that we are talking about “expected” in a statistical sense. If the firm goes bankrupt, it will have a
certain level of costs it will incur. If the firm is all equity, then the expected bankruptcy cost is 0 since the
probability of bankruptcy is 0. As the firm adds debt, the probability of incurring the bankruptcy costs
increases, and thus the expected bankruptcy cost increases.
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• Direct costs
▪ Legal and administrative costs
▪ Ultimately cause bondholders to incur additional losses
▪ Disincentive to debt financing
• Financial distress
▪ Significant problems in meeting debt obligations
▪ Firms that experience financial distress do not necessarily file for bankruptcy.
Bankruptcy Costs
The key disadvantage to the use of debt is bankruptcy costs.
Direct bankruptcy costs are the legal and administrative expenses. Generally, these costs are quantifiable,
measurable, and significant.
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Case III - Indirect Bankruptcy Costs
• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to measure and estimate
– Stockholders wish to avoid a formal bankruptcy
– Bondholders want to keep existing assets intact so they can at least receive that money
– Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business
– Lost sales, interrupted operations, and loss of valuable employees, low morale, inability to purchase goods on credit
Indirect bankruptcy costs (e.g., difficulties in hiring and retaining good people because the firm is in
financial difficulty) are hard to measure and generally take the form of forgone revenues, opportunity
costs, etc.
Financial distress costs – the direct and indirect costs of avoiding bankruptcy.
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Case III With Bankruptcy Costs
• D/E ratio → probability of bankruptcy
• probability → expected bankruptcy costs
• At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costs
• At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added
As the debt-equity ratio increases, the probability of bankruptcy increases.
As this probability increases, expected bankruptcy costs increase.
At some point, the advantages of debt are outweighed by the potential of bankruptcy.
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Optimal Capital Structure Figure 16.6
The Static theory of capital structure
Theory that a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly
equal to the cost that comes from the increased probability of financial distress.
-Firms borrow because tax shields are valuable
-Borrowing is constrained by the costs of financial distress
-The optimal capital structure balances the incremental benefits and costs of borrowing
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Figure 16.7
16-33
The optimal capital structure is the debt-equity mix that minimizes the WACC.
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Conclusions
• Case I – no taxes or bankruptcy costs
▪ No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
▪ Optimal capital structure = 100% debt
▪ Each additional dollar of debt increases the cash flow of the firm
• Case III – corporate taxes and bankruptcy costs
▪ Optimal capital structure is part debt and part equity
▪ Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs
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The Capital
Structure Question
Case I – No taxes or bankruptcy costs; firm value is unaffected by the choice of capital structure
Case II – Corporate taxes, no bankruptcy costs; firm value is maximized when the firm uses as much debt
as possible due to the interest tax shield
Case III – Corporate taxes and bankruptcy costs; firm value is maximized where the additional benefit from
the interest tax shield is just offset by the increase in expected bankruptcy costs—there is an optimal capital
structure
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Additional Managerial Recommendations
• Taxes
– The tax benefit is only important if the firm has a large tax liability
– Higher tax rate → greater incentive to use debt
• Risk of financial distress
– The greater the risk of financial distress, the less debt will be optimal for the firm
– The cost of financial distress varies across firms and industries
Taxes – tax shields are more important for firms with high marginal tax rates. While firms all face the same
21 percent federal tax rate beginning in 2018, other taxes (such as state taxes) create different effective tax
rates. The higher the effective tax rate, the greater the incentive to borrow.
Financial distress – the lower the risk (or cost) of distress, the more likely a firm is to borrow funds
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Figure 16.9
Cash Flow = Payments to stockholders (E) + Payments to creditors (D) + Payments to the government (G)
+ Payments to bankruptcy courts and lawyers (B) + Payments to all other claimants
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• Value of the firm = marketed claims + nonmarketed claims
▪ Marketed claims are the claims of stockholders and bondholders.
▪ Nonmarketed claims are the claims of the government and other potential stakeholders.
• The overall value of the firm is unaffected by changes in capital structure.
• The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions.
The Value of the Firm
Marketed claims – claims against cash flow that can be bought and sold (bonds, stock)
Nonmarketed claims – claims against cash flow that cannot be bought and sold (taxes)
VM = value of marketed claims
VN = value of nonmarketed claims
VT = value of all claims = VM + VN = E + D + G + B + …
Given the firm’s cash flows, the optimal capital structure is the one that maximizes VM or minimizes VN.
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• Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient
▪ Rule 1: Use internal financing first.
▪ Rule 2: Issue debt next, new equity last.
• The pecking-order theory is at odds with the tradeoff theory:
▪ There is no target D/E ratio.
▪ Profitable firms use less debt.
▪ Companies like financial slack.
The Pecking-Order Theory
Asymmetric information between buyers and sellers means that existing firm owners know more than
potential investors. The view is that existing owners will sell equity when it is overvalued, which is a
negative signal to investors. Thus, this is avoided at all costs, particularly since equity issuance is also
costly.
A. Internal Financing and the Pecking Order
Rules of the pecking order:
#1: Use internal financing first
#2: Issue debt next
#3: New equity last
B. Implications of the Pecking Order
The pecking-order theory is in contrast to the tradeoff theory in that:
-there is no target D/E ratio.
-profitable firms will use less debt.
-companies like financial slack.
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• Capital structure does differ by industry.
• Differences according to Cost of Capital 2010 Yearbook by Ibbotson Associates, Inc. ▪ Lowest levels of debt
• Drugs with 8.46% debt-to-equity
• Computer equipment with 10.02% debt-to-equity
▪ Highest levels of debt
• Cable television with 193.88% debt-to-equity
• Airlines with 177.19% debt-to-equity
Observed Capital Structure
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• Assuming perpetual cash flows in Case II - Proposition I, what is the value of the equity for a firm with following values?: ▪ EBIT = $50 million
▪ Tax rate = 21%
▪ Debt = $100 million
▪ Cost of debt = 9%
▪ Unlevered cost of capital = 12%
Comprehensive Problem
Section 16.11
VU = $50 million (1 - .21) / .12 = $329.17 million
VL = $329.17 million + $100 million (.21) = $408.17 million
E = VL – Debt = $408.17 million - $100 million = $308.17 million