Ross 7e Ch16

16-0
CHAPTER
16
Capital Structure: Limits

to the Use of Debt
McGraw-Hill/Irwin
Corporate Finance, 7/e
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
16-1
Chapter Outline
16.1
Costs of Financial Distress
16.2
Description of Costs
16.3
Can Costs of Debt Be Reduced?
16.4
Integration of Tax Effects and Financial Distress Costs
16.5
Signaling
16.6
Shirking, Perquisites, and Bad Investments:

A Note on Agency Cost of Equity
16.7
The Pecking-Order Theory
16.8
Growth and the Debt-Equity Ratio
16.9
Personal Taxes
16.10
How Firms Establish Capital Structure
16.11
Summary and Conclusions
McGraw-Hill/Irwin
16-2
16.1 Costs of Financial Distress

Bankruptcy risk versus bankruptcy cost.
The possibility of bankruptcy has a negative
effect on the value of the firm.
However, it is not the risk of bankruptcy itself

that lowers value.
Rather it is the costs associated with bankruptcy.
It is the stockholders who bear these costs.
McGraw-Hill/Irwin
16-3
16.2 Description of Costs

Direct Costs
Legal and administrative costs (tend to be a small
percentage of firm value).
Indirect Costs
Impaired ability to conduct business (e.g., lost sales)
Agency Costs
Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward underinvestment
Selfish Strategy 3: Milking the property
McGraw-Hill/Irwin
16-4
Balance Sheet for a Company in Distress

Assets
Cash
Fixed Asset
Total
BV MV
$200 $200
$400
$0
$600 $200
Liabilities
LT bonds
Equity
Total
BV MV
$300 $200
$0
$300
$600 $200
What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.
McGraw-Hill/Irwin
16-5
Selfish Strategy 1: Take Large Risks

The Gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Cost of investment is $200 (all the firms cash)

Required return is 50%
Expected CF from the Gamble = $1000 0.10 + $0 = $100
$100
NPV = $200 +
(1.10)
NPV = $133
McGraw-Hill/Irwin
16-6
Selfish Stockholders Accept Negative NPV Project

with Large Risks
Expected CF from the Gamble
To Bondholders = $300 0.10 + $0 = $30
To Stockholders = ($1000 $300) 0.10 + $0 = $70
PV of Bonds Without the Gamble = $200

PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble: $20 =
$30
(1.50)
PV of Stocks With the Gamble: $47 =
$70
(1.50)
McGraw-Hill/Irwin
16-7
Selfish Strategy 2: Underinvestment

Consider a government-sponsored project that
guarantees $350 in one period
Cost of investment is $300 (the firm only has $200 now)
so the stockholders will have to supply an additional
$100 to finance the project
Required return is 10%
NPV = $300 +
$350
(1.10)
NPV = $18.18
Should we accept or reject?
McGraw-Hill/Irwin
16-8
Selfish Stockholders Forego

Positive NPV Project
Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
PV of Bonds With the Project:
PV of Stocks With the Project:

McGraw-Hill/Irwin
$272.73 =
$300
(1.10)
$50
$100
$54.55 =
(1.10)
16-9
Selfish Strategy 3: Milking the Property

Liquidating dividends
Suppose our firm paid out a $200 dividend to the
shareholders. This leaves the firm insolvent, with
nothing for the bondholders, but plenty for the former
shareholders.
Such tactics often violate bond indentures.
Increase perquisites to shareholders and/or

management
McGraw-Hill/Irwin
16-10
16.3 Can Costs of Debt Be Reduced?

Protective Covenants
Debt Consolidation:
If we minimize the number of parties, contracting
costs fall.
McGraw-Hill/Irwin
16-11
Protective Covenants
Agreements to protect bondholders
Negative covenant: Thou shalt not:
Pay dividends beyond specified amount.
Sell more senior debt & amount of new debt is limited.
Refund existing bond issue with new bonds paying lower
interest rate.
Buy another companys bonds.
Positive covenant: Thou shall:
Use proceeds from sale of assets for other assets.
Allow redemption in event of merger or spinoff.
Maintain good condition of assets.
Provide audited financial information.
McGraw-Hill/Irwin
16-12
16.4 Integration of Tax Effects

and Financial Distress Costs
There is a trade-off between the tax advantage of
debt and the costs of financial distress.
It is difficult to express this with a precise and
rigorous formula.
McGraw-Hill/Irwin
16-13
Integration of Tax Effects

and Financial Distress Costs
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)

Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm

VU = Value of firm with no debt
0
McGraw-Hill/Irwin
Debt (B)
B*
Optimal amount of debt

16-14
The Pie Model Revisited

Taxes and bankruptcy costs can be viewed as just another claim
on the cash flows of the firm.
Let G and L stand for payments to the government and bankruptcy
lawyers, respectively.
VT = S + B + G + L
S
B
L
The essence of the M&M intuition is that VT depends on the cash

flow of the firm; capital structure just slices the pie.
McGraw-Hill/Irwin
16-15
16.5 Signaling
The firms capital structure is optimized where the
marginal subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value.
Firms with low anticipated profits will take on a low level of
debt.
Firms with high anticipated profits will take on high levels of
debt.
A manager that takes on more debt than is optimal in

order to fool investors will pay the cost in the long run.
McGraw-Hill/Irwin
16-16
16.6 Shirking, Perquisites, and Bad Investments:

The Agency Cost of Equity
An individual will work harder for a firm if he is one of the
owners than if he is one of the hired help.
Who bears the burden of these agency costs?
While managers may have motive to partake in perquisites, they
also need opportunity. Free cash flow provides this opportunity.
The free cash flow hypothesis says that an increase in dividends
should benefit the stockholders by reducing the ability of
managers to pursue wasteful activities.
The free cash flow hypothesis also argues that an increase in debt
will reduce the ability of managers to pursue wasteful activities
more effectively than dividend increases.
McGraw-Hill/Irwin
16-17
16.7 The Pecking-Order Theory

Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
Rule 1
Use internal financing first.
Rule 2
Issue debt next, equity last.
The pecking-order Theory is at odds with the trade-off

theory:
There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial slack
McGraw-Hill/Irwin
16-18
16.8 Growth and the Debt-Equity Ratio

Growth implies significant equity financing, even
in a world with low bankruptcy costs.
Thus, high-growth firms will have lower debt
ratios than low-growth firms.
Growth is an essential feature of the real world;
as a result, 100% debt financing is sub-optimal.
McGraw-Hill/Irwin
16-19
16.9 Personal Taxes: The Miller Model

The Miller Model shows that the value of a
levered firm can be expressed in terms of an
unlevered firm as:
(1 -TC ) (1 -TS )
VL =VU + 1 B
1 -TB
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
McGraw-Hill/Irwin
16-20
Personal Taxes: The Miller Model

The derivation is straightforward:
Shareholders in a levered firm receive
( EBIT - rB B) (1 -TC ) (1 -TS )
Bondholders receive
rB B (1 -TB )
Thus, the total cash flow to all stakeholders is
( EBIT - rB B ) (1 -TC ) (1 -TS ) + rB B (1 -TB )
This can be rewritten as
(1 -TC ) (1 -TS )
EBIT (1 -TC ) (1 -TS ) + rB B (1 -TB ) 1
1 -TB
McGraw-Hill/Irwin
16-21
Personal Taxes: The Miller Model (cont.)

The total cash flow to all stakeholders in the levered
firm is:
(1 -TC ) (1 -TS )
+
EBIT (1 TC ) (1 TS ) rB B (1 TB ) 1
The first term is the cash

flow of an unlevered firm
after all taxes.
1 -TB
A bond is worth B. It promises to

pay rBB(1- TB) after taxes. Thus
the value of the second term is:
(1 - TC ) (1 - TS )
B 1
The value of the sum of these
1
T
B
two terms must be VL

(1 -TC ) (1 -TS )
\VL = VU + 1 B
1 -TB
Its value = VU.
McGraw-Hill/Irwin
16-22
Personal Taxes: The Miller Model (cont.)

Thus the Miller Model shows that the value of a
levered firm can be expressed in terms of an
unlevered firm as:
(1 -TC ) (1 -TS )
VL =VU + 1 B
1 -TB
In the case where TB = TS, we return to M&M

with only corporate tax:
VL =VU +TC B
McGraw-Hill/Irwin
16-23
Effect of Financial Leverage on Firm Value with Both

Corporate and Personal Taxes
(1 -TC ) (1 -TS )
VL = VU + 1 B
1 -TB
VL = VU+TCB when TS =TB
VU
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)(1-TS)
VL =VU
when (1-TB) = (1-TC)(1-TS)
VL < VU when (1-TB) < (1-TC)(1-TS)

Debt (B)
McGraw-Hill/Irwin
16-24
Integration of Personal and Corporate Tax Effects and

Financial Distress Costs and Agency Costs
Present value of
Value of firm (V)

shield on debt
Value of firm under

MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)(1-TS)
Maximum
firm value

Agency Cost of Equity
Agency Cost of Debt
Debt (B)
B* Optimal amount of debt
McGraw-Hill/Irwin
16-25
16.10 How Firms Establish Capital Structure

Most Corporations Have Low Debt-Asset Ratios.
Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and vice-versa;
this is consistent with M&M with taxes.
Another interpretation is that firms signal good news when
they lever up.
There are Differences in Capital Structure Across

Industries.
There is evidence that firms behave as if they had a
target Debt to Equity ratio.
McGraw-Hill/Irwin
16-26
Factors in Target D/E Ratio

Taxes
If corporate tax rates are higher than bondholder tax rates, there
is an advantage to debt.
Types of Assets
The costs of financial distress depend on the types of assets the
firm has.
Uncertainty of Operating Income

Even without debt, firms with uncertain operating income have
high probability of experiencing financial distress.
Pecking Order and Financial Slack

Theory stating that firms prefer to issue debt rather than equity
if internal finance is insufficient.
McGraw-Hill/Irwin
16-27
16.11 Summary and Conclusions

Costs of financial distress cause firms to restrain their
issuance of debt.
Direct costs
Lawyers and accountants fees
Indirect Costs
Impaired ability to conduct business
Incentives to take on risky projects
Incentives to underinvest
Incentive to milk the property
Three techniques to reduce these costs are:

Protective covenants
Repurchase of debt prior to bankruptcy
Consolidation of debt
McGraw-Hill/Irwin
16-28

Because costs of financial distress can be reduced but not
eliminated, firms will not finance entirely with debt.
Value of firm (V)

shield on debt
Maximum
firm value
0
McGraw-Hill/Irwin
Value of firm under

MM with corporate
taxes and debt
VL = VU + TCB
Present value of
B*
Debt (B)
16-29

If distributions to equity holders are taxed at a lower effective personal tax rate
than interest, the tax advantage to debt at the corporate level is partially offset.
In fact, the corporate advantage to debt is eliminated if (1-TC) (1-TS) = (1-TB)
Value of firm (V)
Present value of

shield on debt
Value of firm under

MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB when TS < TB

but (1-TB) > (1-TC)(1-TS)
Maximum
firm value

Agency Cost of Equity
0
McGraw-Hill/Irwin
Agency Cost of Debt
B*
Debt (B)
16-30

Debt-to-equity ratios vary across industries.
Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates, there is an
advantage to debt.
Types of Assets
The costs of financial distress depend on the types of assets the firm
has.
Uncertainty of Operating Income

Even without debt, firms with uncertain operating income have high
probability of experiencing financial distress.
McGraw-Hill/Irwin

Ross 7e Ch16

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16-0

Capital Structure: Limits

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Costs of Financial Distress

Can Costs of Debt Be Reduced?

Integration of Tax Effects and Financial Distress Costs

Shirking, Perquisites, and Bad Investments:

The Pecking-Order Theory

Growth and the Debt-Equity Ratio

How Firms Establish Capital Structure

Summary and Conclusions

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.1 Costs of Financial Distress

However, it is not the risk of bankruptcy itself

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.2 Description of Costs

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Balance Sheet for a Company in Distress

What happens if the firm is liquidated today?

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Selfish Strategy 1: Take Large Risks

Cost of investment is $200 (all the firms cash)

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Selfish Stockholders Accept Negative NPV Project

PV of Bonds Without the Gamble = $200

PV of Stocks With the Gamble: $47 =

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Selfish Strategy 2: Underinvestment

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Selfish Stockholders Forego

PV of Stocks With the Project:

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Selfish Strategy 3: Milking the Property

Increase perquisites to shareholders and/or

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.3 Can Costs of Debt Be Reduced?

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.4 Integration of Tax Effects

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Integration of Tax Effects

Value of firm (V)

V = Actual value of firm

Optimal amount of debt

The Pie Model Revisited

The essence of the M&M intuition is that VT depends on the cash

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

A manager that takes on more debt than is optimal in

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.6 Shirking, Perquisites, and Bad Investments:

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.7 The Pecking-Order Theory

The pecking-order Theory is at odds with the trade-off

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.8 Growth and the Debt-Equity Ratio

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

16.9 Personal Taxes: The Miller Model

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Personal Taxes: The Miller Model

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

Personal Taxes: The Miller Model (cont.)

The first term is the cash

A bond is worth B. It promises to

two terms must be VL