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18
HOW MUCH SHOULD A
CORPORATION BORROW?
Note: Debt to total capital ratio = D/(D + E), where D and E are book values
of long-term debt and equity.
18-3
TABLE 18.2 TAX-DEDUCTIBLE INTEREST
Note: Look at the difference in corporate tax paid. Interest tax shield =$28.
18-4
18-1 CORPORATE TAXES
If the interest tax shield is perpetual, its PV is:
Example Continued
($ 1,000 s) All Equity 1/2 Debt Total Cash Flow
EBIT 900 900 All equity = 585
Interest pmt 0 100
*1/2 debt = 620
Pretax income 900 800
Taxes @ 35% 315 280 (520 + 100)
Net cash flow 585 520
18-7
18-1 CORPORATE TAXES
Example:
Tax benefits = Interest x Tc = $100,000 x 0.35 =
$35,000
PV of tax benefits $35,000 in perpetuity at 5% =
$35,000/.05 = $700,000
Alternative calculation:
PV of tax shield = Debt xTc = $2,000,000 x .35
= $700,000.
18-8
18-1 CORPORATE TAXES
Example
All-equity value = 585/.05 = 11,700,000
PV tax shield = 700,000
Firm value of debt = 11,700,00 + 700,000 =
$12,400,000
18-9
TABLE 18.3 MARKET VALUE BALANCE
SHEETS
18-10
TABLE 18.4A J&J BALANCE SHEETS, ORIGINAL
POSITION
18-11
TABLE 18.4B J&J BALANCE SHEETS, BORROW $10
BILLION AND REPURCHASE SHARES
18-13
FIGURE 18.1 CAPITAL STRUCTURE WITH
CORPORATE AND PERSONAL TAXES
18-14
18-2 CORPORATE AND PERSONAL TAXES
Capital structure decision boils down to which
route is more beneficial to security holders, debt or
equity?
We calculate the Relative Advantage Formula
(RAF) of Debt vs. Equity
1- Tp
(1- T ) (1- T )
pE c
RAF > 1 = issue debt
RAF < 1 = issue equity
RAF = 1: indifferent, irrelevant
18-15
18-2 CORPORATE AND PERSONAL TAXES
Example
18-16
18-2 CORPORATE AND PERSONAL TAXES
In Malaysia, lets assume: Tc=25%,
Tp=15%, Tpe=10%
RAF of Debt vs. Equity:
RAF =
1 .15
1.26
1 .101 .25
So issue debt. But why are companies not
going for high leverage? Because high
leverage results in financial distress.
18-17
COSTS OF FINANCIAL DISTRESS
18-19
18-3 THE TRADE-OFF THEORY OF CAPITAL
STRUCTURE
18-20
18-3 COSTS OF FINANCIAL DISTRESS
Costs of
financial distress
Market Value of the Firm
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
18-22
FIGURE 18.4 PAYOUT TO ACE LIMITED
SECURITY HOLDERS
18-23
18-3 COSTS OF FINANCIAL DISTRESS
18-24
18-3 COSTS OF FINANCIAL DISTRESS
Circular File Company has $50 of one-year debt. Debt
is greater than firm market value.
18-25
18-3 COSTS OF FINANCIAL DISTRESS
Example 1: Risk shifting game. There is a project
costing $10 and having pay-off as follows:
18-27
18-3 COSTS OF FINANCIAL DISTRESS
Example 2: Second game: rejecting positive NPV project.
There is a safe project costing $10 to be financed by new
equity. It generates NPV = $5
18-29
18-4 PECKING ORDER THEORY OF CAPITAL
STRUCTURE
This is a theory of financing preference, proposed by
Myers and Majluf (1984)
Assume information asymmetry. Cost of financing
increases with information asymmetry
Firms have three sources of financing which are picked
based on the following order:
Internal funding will be used first
If external funding is required, debt is preferred to
equity
Equity financing is last
18-30
18-4 EMPIRICAL EVIDENCE ON CAPITAL
STRUCTURE
Stock-for-debt exchange (reducing
leverage) offers results in stock price falling
Debt-for-stock exchange (increasing
leverage) offers results in stock price rising
Issuing common stock drives down stock
prices as it signals overpricing of shares
Repurchases increase stock prices as it
signals underpricing of shares
18-31