Chapter 12

Capital Structure: Theory And Taxes

Del Hawley FIN 634 Fall 2003

Overview Of Capital Structure Theory & Practice

The capital structure question: can the mix of debt and equity a firm issues affect its total market valuation? Has been a key issue in finance theory & practice since 1958 Capital Structure patterns observed worldwide Similarities & differences between US, other OECD countries The Agency Cost/Tax Trade-Off Theory of capital structure Not perfect, but works better than principal competitors Time wont allow examination of other two theories The Modigliani-Miller capital structure irrelevance propositions Perfect capital markets assumption underlying Proposition I Proposition IIs implications for corporate financial policy The impact of income taxes on the irrelevance propositions Corporate income tax: 100% debt is optimal Irrelevance perhaps rescued by personal taxes

Capital Structure Patterns Observed Worldwide

Capital structures have strong industry patterns, and these are the same around the world. High debt-to-equity industries: utilities, transport cos, and mature, capital-intensive manufacturing firms Low D/E industries: service firms, mining companies, most rapidly growing or technology-based manufacturing firms Implies an industry's optimal asset mix influences CSs chosen by firms in that industry anywhere

Market Value Debt Ratios, Selected U.S. Corporations, July 2002

Company Debt to total assets L-T debt to total capital Market to book ratio

Microsoft Intel
ExxonMobil Procter & Gamble Boeing Walt Disney American Electric Power Georgia Pacific

0 0
0.04 0.12 0.27 0.27 0.54 0.69

0 0
0.03 0.07 0.24 0.25 0.36 0.55

5.54 4.03
3.72 10.13 3.65 1.92 1.62 1.19

Delta Air Lines

General Motors

0.77
0.84

0.75
0.83

0.82
4.12

Leverage Ratios For G-7 And Selected Developing Countries, 1980-91

Total debt to total asset (Book value %) 58% 69 73 71 70 54 56 67 73 59 L-T debt to total L-T debt to total assets capital (Book value %) (Market value %) 37% 53 38 48 47 28 39 34 49 24 28% 29 23 41 46 35 35 35 64 11

Country United States Japan Germany France Italy United Kingdom Canada India South Korea Turkey

Source: Rajan and Zingales, What do We Know About Capital Structure: Some Evidence from International Data, Journal of Finance 50 (1995).

CS Patterns Observed Worldwide (Continued)

Leverage ratios are inversely related to the perceived costs of financial distress. Both across industries & across countries, the more costly is financial distress, the less debt will be used. Companies rich in collateralizeable assets have higher leverage than firms rich in growth options. Within industries, leverage is inversely related to profitability In all industries, the most profitable companies typically borrow the least, suggesting that CS at least partly residual Corporate & personal taxes influence capital structures, but they neither cause nor prevent corporate leverage. US corps used as much debt before 1913 as after Increased corporate tax rates yield increased debt usage Decreases in the personal tax rates on equity income yield decreased corporate debt usage.

Market-Value Leverage Ratios (Total Debt-toTotal Capital) For US Corporations, 1929-1993

%

50 45 40 35 30 25 20 15 10 5 0
1930 1940 1950 1960 1970 1980 1990

Capital Structure Patterns Observed Worldwide (Continued)

Existing S/Hs consider leverage-increasing events "good news" and leverage-decreasing events "bad news" Stock prices rise when leverage-increasing events announced, but fall for leverage-decreasing events. Corporations that are forced away from a preferred capital structure tend to return to that structure over time Has occurred frequently, particularly for US firms that have taken on large amounts of new debt to finance takeovers. More generally, corporations like to operate within target leverage zones, and will issue new equity when debt ratios get too high and will issue debt if they fall too low.

Theoretical Models Of Capital Structure

First important theoretical model in corporate finance was Modigliani & Millers (M&M) capital structure model in 1958 In frictionless capital markets, with no taxes or transactions costs, CS is irrelevant--doesnt affect valuation Todays best theoretical explanation for observed CS patterns is the Agency Cost/Tax Shield Trade-Off Model Assumes that observed CSs result from firms trading off the tax benefits of debt usage against the increasingly severe agency costs as debt ratios approach critical levels The Pecking Order Theory based on two key assumptions (1) managers are better informed about the investment opportunities faced by their firms than are outsiders; (2) managers act in the best interests of existing shareholders. Signaling Model of CS also assumes asymmetric information but managers use debt as a costly signal to differentiate their firms from weaker competitors

The M&M Capital Structure Model

Assumptions of the M&M Capital Structure Model All physical assets are owned by corporations; Frictionless Capital markets: no corporate or personal income taxes, securities are traded costlessly, no bankruptcy costs; Corporations can issue only risky equity and risk-free debt; Both individuals and corporations can borrow or lend at the risk-free interest rate; Investors have identical expectations about the future stream of corporate profits; There is no growth; all cash flow streams are perpetuities and All corps can be classified into one of several "equivalent return classes" with returns on shares of all firms proportional to, and perfectly correlated with, all other firms in that class. Seems absurdly unrealistic, but model very robust Only costless bankruptcy and no taxes are critical assumptions.

M&Ms Proposition I: Capital Structure Irrelevance

See Example Spreadsheet

Table C: Income Statements For Unleverco & Leverco With Corporate Income Taxes
Unleverco
Net operating income (NOI) Interest paid (rdD) Taxable income (NOI rdD) Corporate income tax (c = 0.35) Net Income (NI) Total income to private investors (Interest + net income=dividends) Value of tax shield each period (c x rdD) = (0.35 x Interest) $100,000 0 $100,000 (35,000) $65,000 $65,000 0

Leverco
$100,000 (30,000) $70,000 (24,500) $45,500 $75,500 $10,500