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EXECUTIVE SUMMARY I. Objective The 1980s were the decade of debt.

Numerous articles and commentators have discussed the growing use of debt by American nonfinancial corporations. These companies nearly doubled their debt from 1982 through 1988. Some questions were framed in terms of whether debt is excessive: What is the impact on firm value from the substitution of debt for equity? Is there a difference in the values of two firms that differ only in capital structure? Is there such a thing as an optimal capital structure that maximizes the market value of the firm? Determine if current debt levels are abnormally high? What is an appropriate level of debt? II. Analysis
To determine if the current debt levels are abnormally high and to begin to think in terms of what is an appropriate level of debt, we need some historical perspective on corporate debt level based on book value and debt ratios in terms of market values. Exhibit 1 shows book- and market-value ratios of long-term debt to total capital. The data shows that in some periods, book-value ratios exceed market value ratios; in other periods, it reverses. Focusing only on the book values, we can see the debt levels were high during the 1930s and declined in early 1940s. In 1970s, the trend becomes leveled off compared with the early periods. In terms of the market values, the debt-tocapital ratios were having fluctuation. Looking from both book- and market-value ratios, we can see that in 1986, the book value ratios of debt levels at an historical high point, market values were still lower than in the early 1970s. Long-term debt levels are apparently at relatively high levels both in terms of book- and market-values. From Exhibit 2 presents market-value-based estimates of debt-to-asset ratios for different industries over various time periods. The variability across industries is great; the variability over time is less. It means, there is no significant differentiation of market value in a certain period of time for every type of industries. Exhibit 3 and 4 show the distribution of market-value-based estimates of debt-tocapital ratios within two selected industries from 1988. Exhibit 3, the distribution

for retail stores that show a fairly uniformly distributed debt-to-capital ratios, which is between 5% and 40%. In Exhibit 4, the debt-of-capital ratios are less varied distributed compare to the retail stores, which is 40% to 50%. Two exceptions are for Delta and Pan Am which are having extreme ratios at 18% and 71%. From the historical perspective, we can conclude: First, capital structures do change over time, whether they are measured in terms of book- or market-value. In addition, industries differ. Some industries have relatively high debt ratios and others have low debt ratios. The differences make identifying how much debt is too much or what is an optimal capital structure very difficult. There are, however, some basic relationships that affect the capital-structure decision and, through it firm value. Business Risk and Debt Type of business is an important determinant of the use of debt. Debt in the form of interest is paid out from earnings before interest and taxes (EBIT), lines of business where the EBIT is highly variable should tend to use less debt.


Businesses with relatively high proportions of their total cost fixed tend to have high degrees of operating leverage. Small changes in their sales can have large impacts on EBIT. We would expect these firms to have relatively lower levels of debt. Financial Risk and Debt To understand the relationship of business risk to financial risk is the concept of financial leverage. Equity is paid after the fixed payment to the debt holders, the use of debt can drastically alter the volatility of what is left for the equity. The portion of income available to equity is net profit after tax (NPAT).


If a firm has no debt (i.e., interest costs are 0), the degree of financial leverage is 1. Unlike operating leverage, which to a large degree is dictated by the type of business the firm operates, the amount if financial leverage is a decision to be made by the firm.

Combining Operating and Financial Leverage The key to understanding the interaction of operating and financial leverage is to combine the two and relate percentage changes in sales to percentage in NPAT.

This concept of leverage both operating and financial, gives us some understanding of which firms can use debt, it really does not focus on why firms would want to do so. Corporate Taxes and Debt Most of the discussion concerning the use of debt by corporations has focused on the deductibility of interest in computing corporate taxes. To the extent that interest is tax deductible, debt can be substituted for equity and reduce the corporate tax due. Taxes and Firm Value 1. The No-Tax Case In 1959, Moldigliani and Miller (M&M) published their famous article on corporate taxes, firm value, and debt. They said that without corporate taxes, the debt-equity choice has no impact on firm value. Example: Two firms with identical operating characteristics and with the same EBIT equal to $100. Firm A is fully equity and firm B has a debt $40. EBIT firm A is 100% into their equity and firm B 40% into debt and 60% into firm equity. In the absence of taxes, as long as each can borrow at the same rate as firms, no difference exits in the value of an all-equity firm and the total value, equity plus debt, of a firm with leverage. 2. Corporate Taxes Only

The tax deductibility of interest payments changes the outcome of the preceding cases. When corporate taxes are introduced it caused a positive benefit to debt financing for value of the firm. The reason is debt interest payments reduce taxable income and reduce taxes. With debt there is more after-tax cash flow available to security holders (equity and debt) rather than without debt. Thus the value of the equity and debt securities combined is greater. In order to see the relationship between the value of an all-equity firm and a firm with leverage, we must break the total income of the levered firm into two parts. The relationship between the value of a levered firm and the value of an unlevered firm is:

3. Corporate Taxes and Personal Taxes

When we adding personal tax in calculation, it caused a negative benefit to the value of the firm rather than only corporate tax. It caused by interest payment debt as personal tax. Other Factors Affecting the Debt Decision 1. Bankruptcy Risk 2. Agency Cost III. Conclusion
Overall, taxes have an impact on the debt-equity choice of the firm. For corporate taxes, its potential for a significant value impact from the substitution of debt for equity. Personal taxes gives lessened impact to some extent but the tax deductibility of interest provides a strong incentive for the use of debt in order to minimize corporate taxes. Corporate Tax and Personal Tax will affect the firm value. While a value gain that we can calculate clearly arises because of the corporate tax shield, other, more qualitative, issues also play a role in the capital-structure decision. At this point, therefore, we cannot say with certainty

what the optimal capital structure is for a particular firm. We can say that the gains from the tax shield must be weighed against the cost of using debt.