Financial Management

FIN 455 - Lecture 13

Capital Structure Decisions –

Part I
IFM Chapter 15

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Topics Covered
 Business versus financial risk
 M&M Theory of Capital structure
 MM theory
 Zero taxes
 Corporate taxes
 Corporate and personal taxes
 Hamada’s Equation
 Capital Structure and financial distress
 Optimal structure

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The key questions of corporate finance

 Valuation: How do we distinguish between

good investment project and bad ones?

 Financing: How should we finance the

investment projects we choose to undertake?

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 Financing policy

 Real investment policies imply funding needs.

 But what is the best source of funds?
 Internal funds (i.e. cash)?
 External
 Debt (i.e. borrowing)?

 Equity (i.e. issuing stock)?

 Moreover, different kinds of…

 Internal funds (e.g. cash reserves, cutting dividends)
 Debt (e.g. bonds vs. banks)
 Equity (e.g. Venture Capital vs. Initial Public Offering)

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Capital structure
 Capital structure represents the mix of claims
against the firm’s assets and free cash flows
 Some characteristics of financial claims
 Payoff structure (e.g. fixed promised payment)
 Priority (debt paid before equity)
 Maturity
 Restrictive covenants
 Real investment policies imply funding needs.
 Voting rights
 Options (convertible securities, call provisions, etc..)

 We will focus on leverage (debt vs. equity) and how

it can affect the firm value
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The fundamental questions in

capital structure
 Is there an “optimal” capital structure, i.e.,
an optimal mix between debt and equity?
 More generally, can you add value on the
RHS of the balance by following a good
financial policy, or by changing the mix of
debt and equity?
 Miller and Modigliani said “NO” under a set
of assumptions.

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 How can capital structure
affect value?
∞ FCFt
V = ∑
t=1 (1 + WACC)t
WACC= wd (1-T) rd + were
The impact of capital structure on value depends
upon the effect of debt on:
WACC
FCF
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Business Risk and Financial Risk

 Business risk:
 Uncertainty in future EBIT.
 Depends on business factors such as competition,
operating leverage, etc.

 Financial risk:
 Additional business risk concentrated on common
stockholders when financial leverage is used.
 Depends on the amount of debt and preferred
stock financing.

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Capital Structure Theory with Miller

and Modigliani (1958)
Assumptions of the M&M World
1. Investment is given.
2. Perfect Capital Markets
a. No transactions costs
b. No taxes
c. Info. is costless to obtain, available to all.
3. Equal access
4. Homogeneous expectations
5. Riskless debt
6. Zero growth

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 MM’s “Irrelevance” Proposition I
Financing decisions are irrelevant for the value of the
firm
 Purely financial transactions do not change the cash
flows. They are zero NPV investments, thus they neither
increase or decrease the value of the firm.
 A firm cannot change the total value of its securities just
by splitting its cash flows into different streams.
 Firm value is determined by real assets, not by securities it
issues.
 Thus, the choice of capital structure is irrelevant as long as
investment is taken as given.
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“Pie” Theory I

AN EVERYDAY ANALOGY
It should cost no more to assemble a
chicken than to buy one whole.

VL = VU
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The Law of the Conservation of Value

 Proposition I tells us Firm Value is determined on the

left hand side of the balance sheet by real assets-not by
the proportions of debt and equity securities issued by
the firm.
 VL = VU
 The law also applies to the mix of debt securities issued by the firm.
The choice of long-term vs. short-term, secured vs. unsecured, senior
vs. subordinated, convertible vs. nonconvertible debt should have no
effect on firm value.
 The law implies that the choice is irrelevant, assuming
perfect capital markets and provided that the choice
does not affect the firm’s investment, borrowing and
operating policies.
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 Under MM I, Borrowing does not
affect Return on Invested Capital
MM showed that, in perfect capital markets, the company’s
borrowing decision does not affect either the firm’s operating
income or the total market value of its securities. Therefore, it
does not affect return on invested capital…
expected operating income
Expected return on assets  rA 
market value of all securities

Value of the firm  ( D  E )  rA  rD  D   rsL  E 

 D   E 
rA  WAAC   rD     rsL  
 DE  DE
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How Leverage Affects Equity Return:

…MM’s Proposition II
 The cost of equity to a levered firm is equal to cost of
equity of unlevered firm in the same risk class plus a
risk premium

rsL  rU 
D
rU  rD  rA = rU = rs
E
M&M II: If the value of the firm remains the
same, why return on equity increases linearly
with leverage (debt-equity ratio) ?

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How changing capital structure

affects betas?

B A  BU   B D     B sL   BsL  BU  E BU  BD 
 D  E D
 V   V
For a given beta
D of debt, equity
If debt is risk free : BsL  BU  BU beta increases
E
with leverage.

Market risk of a common stock of a levered firm =

business risk of its operating assets

+ financial risk of its capital structure.

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 M&M Proposition II WACC remains
constant as leverage
r increases and this is
consistent with M&M
rs I, since the company
cost of capital
should only depend
on the risk of its
assets.
rA = WACC

rD
D
Risk free debt Risky debt
E

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Take away from M&M with Zero

Taxes (1958)
Proposition I: VL = VU.

Proposition II: rsL = rsU + (rsU - rd)(D/E).

If we assume debt is risk free: rd = rf, Bd = 0

BU ( RM  R F )  BU RM  RF 
D
rsL  rF 
E
= Risk Free Rate + Business Risk Premium + Financial Risk Premium

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Take away from M&M with Zero

Taxes (cont’d)
 According to MM, borrowing increases expected
returns only because it increases risk.
 The increase of risk exactly offsets the increase in
expected returns leaving stockholders no better or
worse off.
 The firm’s overall market value is independent of
capital structure.

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 Trip to the Real World….
Industry Debt Ratio* (%)

Electric and Gas 43.2

Paper and Plastic 30.4
Food Production 22.9
Retailers 21.7
Equipment 19.1
Chemicals 17.3
Computer Software 3.5
Average over all industries 21.50%

Companies and industries vary in their capital structure

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What is Missing from the Simple

M & M Story?
 Taxes:
 Corporate taxes
 Personal taxes

 Costs of Financial distress

 No transaction costs for issuing debt or equity

 No asymmetric information about the firm’s
investments
 Capital structure does not influence managers’
investment decisions
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Capital Structure and Corporate Taxes

 Financial policy matters because it affects a

firm’s tax bill.
 Different financial transactions are taxed differently.
 For a corporation:
 Interest payments are considered a business
expense, and are tax exempt for the firm.
 Dividends and retained earnings are taxed.

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 Capital Structure & Corporate Taxes
Corporate tax deductibility of interest increases the total
distributed income to both bondholders and
shareholders.
Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

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Capital Structure & Corporate Taxes

-- Example (cont’d)
Example - You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is $900,000
before interest and taxes. The corporate tax rate is 35% You have the
option to exchange 1/2 of your equity position for 5% bonds with a
face value of $2,000,000. Should you do this and why?

($ 1,000 s) All Equity 1/2 Debt

EBIT 900 900
Total Cash Flow
Interest Pmt 0 100
Pretax Income 900 800 All Equity = 585
Taxes @ 35% 315 280
Net Cash Flow 585 520
*1/2 Debt = 620
Tax benefit: $620 - $585 = $35 (520 + 100)
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The PV of tax shield

Example (cont’d):
Tax benefit = amount of Debt x Interest rate x Tax Rate
= 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
PV Tax Shield = $2,000,000 x .35 = $700,000

D  RD  Tc
PV of Tax Shield   D  Tc
RD
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 M&M I with corporate tax…
Example (cont’d):
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield = 700,000
Firm Value with 1/2 Debt = $12,400,000

Value of Leveraged firm = Value of All Equity Firm

+ PV Tax Shield

VL = VU + TD
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MM relationship between firm value and

debt when corporate taxes are considered.

Value of Firm, V
VL = VU + TD
VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.

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The Cost of Equity at Different Levels of

Debt: Hamada’s Equation
 MM theory implies that beta changes with leverage.

 ßU is the beta of a firm when it has no debt (the

unlevered beta)
 ßsL = ßU [1 + (1 - T)(D/E)]

rsL  rF  BU ( RM  R F )  BU RM  R F (1  T )

D
E
= Risk Free Rate + Business Risk Premium + Financial Risk
Premium

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 Notes About the New Propositions
 When corporate taxes are added,
VL ≠ VU. VL increases as debt is added to the
capital structure, and the greater the debt
usage, the higher the value of the firm.

 rsL increases with leverage at a slower rate

when corporate taxes are considered.

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Personal Taxes
Investors’ return from debt and equity are
taxed differently
Classical Tax Systems
 Interest and dividends are taxed as ordinary
income.
 Capital gains are taxed at a lower rate.
 Capital gains can be deferred (contrary to
dividends and interest)
 Corporations have a 70% dividend exclusion
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Capital structure and personal &

corp. taxes -- Example

Interest Equity Income

Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corporate tax 1 0.65
Personal tax at Tp B = .35 and Tpe = .105 0.35 0.068
Income after all taxes $0.675 $0.582

Advantage to debt= $ .083

Capital structure determines whether operating

income is paid out as interest or equity income.
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 Corporate and Personal Taxes
…Miller’s Model

(1  TC )(1  TPE )
VL  VU  [1  ]D
1  TPB 
 TC = corporate tax rate.
 TPB = personal tax rate on debt income.
 TPE = personal tax rate on stock income.

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Miller’s Model with Corporate

and Personal Taxes… Example

Tc = 40%, TPB = 30%, and TPE = 12%.

(1  0.40)(1  0.12)
VL  VU  [1  ]D
1 0.30
 VU  (1  0.75)D
 VU  0.25D

Value rises with debt; each $1 increase in debt raises

L’s value by $0.25.
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Tax shield of debt matters,

…potentially quite a bit
“Pie” Theory II

Pie theory gets you to ask the right question: How does a
financing choice affect the IRS’ bite of the corporate pie?
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 Is debt policy still irrelevant with
Corporate and Personal Taxes?
Two special cases:

 if TPB = TPE, then the relative advantage

depends only on the corporate tax rate.

 If (1-TpB) = (1-TpE)(1-Tc) then debt policy is

irrelevant.

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Conclusions with Personal Taxes

 Use of debt financing remains
advantageous, but benefits are less than
under only corporate taxes.
 Implications: Is leverage good?
 Since taxes favor debt for most firms, should all
firms be 100% debt financed?
 Note: However, Miller argued that in equilibrium,
the tax rates of marginal investors would adjust
until there was no advantage to debt.
 What is missing?

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Cost of Financial Distress

… Costs arising from bankruptcy or distorted business
decisions before bankruptcy.
 Financial distress without bankruptcy: Financial distress
occurs when promises to creditors are broken or
honored with difficulty. Financial distress includes
failure to pay interest or principal or both. Financial
distress can sometimes lead to bankruptcy.
 Evidence of bankruptcy costs:
 Eastern Airlines: $114 millions in professional fees
 Enron: $306 millions in consultants’ fees

 The mere threat of bankruptcy can be very costly

 Loss of suppliers
 Loss of valuable employees and inability to attract new
employees
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 Debt policy matters if debt is risky and
may cause Financial Distress
“Pie” Theory III

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Capital structure and costly

financial distress

Market Value = Value if all Equity Financed

+ PV Tax Shield
- PV Costs of Financial Distress

VL = VU + TD – PV (Cost of Financial Distress)

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Tradeoff between the tax benefits and the costs of distress

determines an optimal capital structure

Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
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 Static-tradeoff Theory of Capital
Structure
 There is a tradeoff between the tax benefits and the
costs of financial distress.
 This tradeoff determines the optimal capital structure.
 At moderate debt levels, the increase in risk is

small, so tax advantages dominate.

 At some point, the probability of financial distress

increases rapidly with additional borrowing.

 Also, if the firm can’t be sure of utilizing the tax

shield further, the tax advantage disappears.

 This is known as the static-tradeoff theory of capital
structure.
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Beyond M&M,
Theories of Capital Structure
 The static-tradeoff theory:
 taxes, costs of distress
 Pecking order approach.
 Asymmetric information: convey private information,
reduce adverse selection costs.
 Agency Costs:
 conflicts of interest between stakeholders.
 Corporate control contests:
 leverage influences the ability of firms to avoid hostile
takeovers.

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