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Chapter 17- Capital Structure in a Perfect Market

Perfect capital markets
 All securities are fairly priced
 No taxes or transaction costs
 Total cash flows of the firm’s projects are not affected by how the firm finances them
Capital structure- proportion of debt, equity and other securities that a firm has outstanding
Cost of capital = risk free interest rate + risk premium

Project financed using ONLY Equity

 Present value of its cash flows (no investment cost included)
NPV is value to the initial owners of the firm
Unlevered equity- equity in a firm with no debt
Risk of unlevered equity = risk of project (shareholders are earning an appropriate return for risk
they are taking)

Project financed using DEBT AND EQUITY

risk-free- project’s cash flow will always be enough to repay debt
Levered equity- equity in a firm that also has debt outstanding
With perfect capital markets, the total value of a firm should not depend on its capital
structure (total cash flows equal cash flows of project, thus same present value)
Equity is less valuable with leverage

Effect of leverage on risk and return

Leverages increases the risk of the equity of a firm (inappropriate to discount cash flows at
same rate as unlevered equity)
Levered equity- higher expected return to compensate for its increased risk

Systematic Risk and Risk Premiums for Debt, Unlevered Equity and Levered Equity
Debt’s return bears no systematic risk- risk premium is zero
MM Proposition I- In a perfect capital market, the total value of a firm is equal to the market
value of the total cash flows generated by its assets and is NOT affected by its choice of capital
Different choices of capital structure offer no benefit to investors
Homemade leverage- When investors use leverage in their own portfolio to adjust the leverage
choice made by the firm
The Market Value Balance Sheet
 Market value balance sheet (similar to accounting balance sheet)
o All assets and liabilities are included
o All values are current market values rather than historical costs
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
= 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑎𝑛𝑑 𝑂𝑡ℎ𝑒𝑟 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Leveraged Recapitalization – firm repurchases a significant percentage of its outstanding


Before Share Repurchase

*After borrowing (debt), market value of equity remains unchanged because both assets and
liabilities increase by the same amount
After Share Repurchase
Share repurchase- market value of equity decreases by the amount spent to repurchase
shares *share price is unchanged

Debt has a lower cost of capital than equity
Savings from the low expected return on debt (debt cost of capital) are exactly offset by a higher
equity cost of capital (no net savings)
Leverage and the Equity Cost of Capital
E+D = U = A
Total market value of the firm’s securities is equal to the market value of its assets, whether the
firm is unlevered or levered
𝑅𝑢 = 𝑅𝐸 + 𝑅
𝑅𝑢 = 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛, 𝑅𝐸 = 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑒𝑡𝑢𝑟𝑛 𝑅𝐷 = 𝑑𝑒𝑏𝑡 𝑟𝑒𝑡𝑢𝑟𝑛

𝑅𝐸 = 𝑅𝑈 + (𝑅 − 𝑅𝐷 )
𝐸 𝑢
𝑅𝑢 = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑑𝑢𝑒 𝑡𝑜 𝑎𝑠𝑠𝑒𝑡 ′ 𝑠 𝑟𝑖𝑠𝑘 𝑎𝑛𝑑 (𝑅 − 𝑅𝑑 )
𝐸 𝑢
= 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 𝑑𝑢𝑒 𝑡𝑜 𝑎𝑑𝑑𝑒𝑑 𝑟𝑖𝑠𝑘 𝑓𝑟𝑜𝑚 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒
*risk depends on the amount of leverage measured by debt to equity ratio

MM Proposition II
The cost of capital of levered equity increases with the firm’s market value debt-equity ratio
𝑟𝐸 = 𝑟𝑈 + (𝑟 − 𝑟𝑑 ), 𝑟𝐸 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑒𝑞𝑢𝑖𝑡𝑦

Capital Budgeting and the Weighted Average Cost of Capital

Pre-tax WACC = unlevered cost of capital
𝑟𝑤𝑎𝑐𝑐 = 𝑟𝐸 + 𝑟 , 𝑟𝑤𝑎𝑐𝑐 = 𝑟𝑢 = 𝑟𝑎
*in perfect capital markets, a firm’s WACC is independent of its capital structure and equal
to equity cost of capital if unlevered
Debt to value ratio – D/(E+D)
*even though debt and equity costs of capital both rise when leverage is high, more weight is
put on the lower-cost debt, the WACC remains constant
*although debt has a lower cost of capital than equity, leverage does not lower a firm’s WACC
Levered and Unlevered Betas
𝛽𝑈 = 𝛽𝐸 + 𝛽
Unlevered beta measures the market risk of the firm’s underlying assets (assess the cost of
capital for comparable investments)
𝛽𝐸 = 𝛽𝑢 + 𝐸 (𝛽𝑈 − 𝛽𝐷 ) firm’s equity beta also increase with leverage

Cash and the WACC

 Asset on B/S include any holdings of cash or risk-free securities
o Holding cash opposite effect of leverage on risk and return
o Cash = negative debt
 Measure leverage of the firm in term of its net debt = debt less holding of excess cash
or short-term investments
 E+D = Enterprise Value = Net Debt + Market Capitalization
 Net Debt = Debt – (Cash + Short Term Investments)

𝑟𝑢 = 𝑟𝑓 + 𝛽𝑈 (𝑟𝑚 − 𝑟𝑓 ), 𝑤ℎ𝑒𝑟𝑒 (𝑟𝑚 − 𝑟𝑓 )𝑖𝑠 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

Capital Structure Fallacy
Leverage and Earnings Per Share
 Leverage can increase a firm’s expected earnings per share (EPS)
o As long as securities are fairly priced these financial transactions have an NPV of
zero and offer no benefit to shareholders
o EPS of a levered firm is more volatile
 If EPS is higher due to additional risk, shareholders will demand a
higher return (offsets and price per share is unchanged)
 Dilution- an increase in the total number of shares that will divide a fixed amount of
earnings; often occurs when stock options are exercised, or convertible bonds are
o As long as the firm sells the new shares of equity at a fair price, there will be no
gain or loss to shareholders associated with the equity issue itself
Conservation of value principle- with perfect capital markets, financial transactions neither add
nor destroy value, but instead represent a repackaging of risk (and therefore return)
Total amount available to all investors was higher with leverage
Interest tax shield- gain to investors from the tax deductibility of interest payments
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 𝑡𝑜 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑤𝑖𝑡ℎ 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
= 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 𝑡𝑜 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑊𝑖𝑡ℎ𝑜𝑢𝑡 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑘𝑙𝑑
𝑉𝐿 = 𝑉𝑢 + 𝑃𝑉 (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)
The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt

The Interest Tax Shield and Permanent Debt

Permanent debt- firm issues short term debt and issues new debt when principal is due
 Fixed dollar amount of outstanding debt
𝑃𝑉 (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) = 𝑇𝑐 𝑥 𝐷
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 = 𝐷 = 𝑃𝑉( 𝐹𝑢𝑡𝑢𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠)

The Weighted Average Cost of Capital With Taxes

𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 = 𝑟(1 − 𝑇𝑐 ) 𝑟 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒, 𝑇𝐶 = 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
*tax deductibility of interest lowers the effective cost of debt financing for the firm

𝑟𝑤𝑎𝑐𝑐 = 𝑟𝐸 + 𝑟 (1 − 𝑇𝑐 ) 𝑊𝐴𝐶𝐶 (𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥)
𝑃𝑟𝑒 − 𝑇𝑎𝑥 𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 (1 − 𝑇𝐶 ) − 𝑟 𝑇
*higher the firm’s leverage, the greater that tax advantage of debt, the lower the WACC
The Interest Tax Shield with A Target Debt- Equity Ratio
 If target specific debt-equity ratio
o Level of debt will grow with the size of the firm
 Calculate its value with leverage VL by discounting its free cash flow using the WACC
o Interest tax shield can be found by comparing VL to VU , of the free cash flow
discounted at the firm’s unlevered cost of capital (pre-tax WACC)
Recapitalizing to Capture the Tax Shield
 Shareholders who remain after the recapitalization receive the benefit of the tax shield
o Capital gain = (new share price – old share price) x new number of shares
 No arbitrage pricing
o Investors could buy shares before the repurchase and sell these shares
immediately forward at a higher price
 However, once investors know recap will occur, share price will
immediately rise to a level that reflects the value of the interest tax shield
that the firm will receive
 When securities are fairly priced, the original shareholders of a firm capture the full
benefit of the interest tax shield from an increase in leverage
o Must include interest tax shield as part of the firm’s assets
 Personal taxes have the potential to offset some of the corporate tax benefits of leverage
 Interest income has been taxed more heavily than dividends or capital gains from equity
Effective Tax Advantage of Debt
(1 − 𝑇𝑐 )(1 − 𝑇𝑒 )
𝑇∗= 1−
1 − 𝑇𝑖
Valuing the Interest Tax Shield With Taxes
𝑉𝑙 = 𝑉𝑢 + 𝑇 ∗ 𝐷
 Personal tax disadvantage for debt causes the WACC to decline more slowly with
leverage than it otherwise would
Determining the Actual Tax Advantage of Debt
 Deferred the payment of capital gains taxes lowers the present value of the taxes, which
can be interpreted as a lower effective capital gains tax rate
 Investors with longer holding periods or with accrued losses faces a lower tax rate on
equity income, decreasing the effective tax advantage of debt
 A firm must consider the tax bracket of its typical debt holders to estimate 𝑇𝑖
o Tax bracket and holding period of equity holders to determine 𝑇𝑒
Tendency to use debt rather than equity is more pronounced
Firms seem to prefer debt when raising external funds
Capital expenditures > external financing implies that most investment and growth is supported
by internally generated funds e.g. retained earnings
Debt to value ratio is higher in times when the stock market is lower and the use of debt also
varies greatly by industry
Limits to the Tax Benefit of Debt
firm receives tax benefits only if it is paying taxes in the first place
tax savings for high levels of interest fall, possibly reducing the optimal level of the interest
Growth and Debt
Level of interest payments depends on the level of EBIT
The optimal proportion of debt in the firm’s capital structure (𝐸+𝐷) will be lower, the higher the
firm’s growth rate
Debt financing has other costs that prevent other firms from using the interest tax shield fully
Default and Bankruptcy in a Perfect Market
Default – firms fails to pay the interest/principal payments
 Debt holders are given certain rights to the assets of the firm
 Equity holders are not obligated to receive dividends
Bankruptcy and Capital Structure
There is no disadvantage to debt financing
Bankruptcy alone does not lead to a greater reduction in the total value to investors
Bankruptcy Law
Debt holders can take legal action against the firm to collect payment by seizing the firm’s assets
 Applies to businesses and individuals
 Smaller companies and liquidation is often the ending
 Proposal fails -> trustee appointed to oversee liquidation of the firm’s assets through an
o Proceeds from liquidation used to pay creditors
 Applies to firms that owe $5 million or more to creditors
 Plan of arrangement
o Stay- protection against its creditors
o Monitor- usually the auditor
 Company is not automatically forced to enter into bankruptcy but will likely do so under
BIA, either voluntarily or by petition from its creditors
o Liquidation is the likely outcome
Direct Costs of Bankruptcy
 Complex, time-consuming, and costly
 Direct costs of bankruptcy will reduce the value of the asset that the firm’s investors will
ultimately receive
 Workout
o When a financially distressed firm is successful at reorganizing outside of
Financial distress costs reduce the payments for the debt holders when the new product has failed
Debt holders will pay less for the debt initially (less than the market value of assets) in the case
of default
When securities are fairly priced, the original shareholders of a firm pay the present value of
the cost associated with bankruptcy and financial distress

Trade-off theory- the total value of a levered firm equals the value of the firm without leverage
plus the present value of the tax savings from debt, less the present value of the financial distress
𝑉𝐿 = 𝑉𝑈 + 𝑃𝑉( 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) − 𝑃𝑉( 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠 𝐶𝑜𝑠𝑡𝑠)

The Present Value of Financial Distress

 Probability of financial distress, magnitude of the costs of the firm in distress and the
appropriate discount rate for the distress costs
Ru = wacc + (D/E+D) rd TC