Capital Structure, Debt and Taxes

Stephen Sapp
Fall 2020
Readings:
• Capital Structure Theory: A Current Perspective (casebook)
Assignment Questions:
1. What is capital structure? Why not finance a company entirely
with equity? Why not finance entirely with debt?
2. What is the trade-off theory of capital structure? What is the
pecking-order theory? Why do they matter?
3. What does the acronym FRICTO mean? Why is it useful?
4. Who were Modigliani and Miller? What was their contribution to
finance? Is it still relevant?
5. If a firm’s marginal tax rate is 35%, what happens to the WACC of
an all-equity firm as you add leverage?
6. What are the advantages of debt? What are the disadvantages?
How does it differ from equity? Preferred shares?
 Capital structure
• Definition: The different sources of capital used to finance the
acquisition and ongoing use or maintenance of a firm’s assets
(literally the structure of the capital the firm is using).
– Most common sources: debt, common equity, preferred
equity and hybrids.

• There are several theories that try to motivate what factors

influence a firm’s choice of capital structure.
• Most of the theories build on the fundamental issues identified
in the Nobel prize winning work of Modigliani and Miller.
– The theories discuss the trade-offs that are made when
companies choose debt or equity to finance their operations.

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 Modigliani & Miller (M&M)
• In an “ideal world” the firm’s choice of capital structure should not
impact firm value.
– Ideal world has no “death” (financial distress costs) nor “taxes”
– Nobel prize for the fundamental concepts
• Two famous propositions:
– Choice between debt and equity has no impact on market value
as it does not change the cashflows (“pizza proposition”)
– Cost of capital is unaffected by leverage; lower cost of debt
offset by higher cost of equity (“show me the money”)
• To get these propositions one must assume capital markets are
“perfect”
– No taxes, transaction costs, or costs of financial distress
– Is this realistic? What role is played by these assumptions?
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 M&M – role of assuming no taxes (1)

• Assume we have two firms that generate the same EBIT but
have different capital structures:
– Firm U (unlevered) is 100% equity
– Firm L (levered) is 50% equity and 50% debt
• Both firms pay out 100% of net income as dividends
• Cost of debt = 10%
• With efficient markets, M&M theorize firms paying out same
cash flows (dividends + interest exp) have same valuation
– Does not matter how you slice a pizza, it does not get
bigger!

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 Basic Issue

• In a Pizza Parlour, when Yogi Berra was asked if he wanted his

pizza cut into 6 or 8 slices he responded:
“Six, I don’t think I am hungry enough to eat eight”.
 Example 1: in an “Ideal World”
A firm has 100,000 shares valued at $10/share  Value of the firm’s
equity is $1 Million

Since it is all equity financed: how is the value of the firm impacted by
economic conditions?

• If the economy does well, the firm earns more and thus there is more
money that would flow to the shareholders/owners:

Poor Normal Great

Earnings $75K $100K $125K
EPS $0.75 $1.00 $1.25

• What if we have to use some of our earnings to pay back debt

holders?
 Example 1 (cont’d)
If ½ equity and ½ debt financed ($500K Equity, $500K Debt):

Poor Normal Great

Earnings $75K $100K $125K
Interest $50K $50K $50K
EPS $0.50 $1.00 $1.50

$25,000/50,000 shares

• We have to pay back our debtholders before anything goes to the

shareholders (Note: there are only 50,000 shares this time).

• This means we need a basic level of earnings to pay the interest

before shareholders get anything. Not great in “poor” conditions!

• There are fewer shareholders and more concentrated ownership, so it

really helps in the “great” case!
• What are the implications for LBOs? What would make an ideal
LBO candidate?
 Example 1 (cont’d)
Could I do this myself? As an investor - buy one share of the all equity
firm (for $10), borrow $10 and buy a second share.

Poor Normal Great

EPS $0.75 $1.00 $1.25
E from my 2 shares $1.50 $2.00 $2.50
Interest $1.00 $1.00 $1.00

EPS for 2 shares & $10 D

(artificial: ½, ½) $0.50 $1.00 $1.50

EPS for 1 share of ½, ½ $0.50 $1.00 $1.50

Same cost as ½ - ½ firm, and the same payout, so: Why pay someone
to add debt to a firm’s capital structure?
– By taking on debt I have not made the “pizza” any larger. I still get
the same amount of “pizza”.
 Example II
ASSUMPTIONS NO TAXES
EBIT ($m) $ 10.0
Your investment $ 100.0
Firm
Cost of debt 10.0% makes
Corporate tax rate 0.0% $10m EBIT
Dividend payout rate 100.0%

Firm U Firm L Firm L

Balance Sheet (no debt) (50/50) (75/25) Different
Debt ($m) 0 50 75 capital
Equity ($m) 100 50 25
Total Debt + Equity 100 100 100 structure
Income Statement
EBIT 10.0 10.0 10.0
Pay
Less: Interest expense 0.0 (5.0) (7.5) interest
Less: Taxes 0.0 0.0 0.0 expense
Net Income 10.0 5.0 2.5
Dividends 10.0 5.0 2.5
and
dividends
Levered 11
 Example II
Firm U Firm L Firm L
Balance Sheet (no debt) (50/50) (75/25)
Debt ($m) 0 50 75
Equity ($m) 100 50 25
Total Debt + Equity 100 100 100

Return on Investment
Your investment 100.0 100.0 100.0
Dividend income 10.0 5.0 2.5
Interest income 0.0 5.0 7.5
Total dividends + int exp 10.0 10.0 10.0
Return on Investment (ROI) 10.00% 10.00% 10.00%
Return on Equity (ROE) 10.00% 10.00% 10.00%

Weighted Average Cost of Capital

Cost of debt 9.0% 10.0% 11.0%
Cost of equity 12.5% 15.0% 17.0%
Tax rate 0.0% 0.0% 0.0%
WACC 12.5% 12.5% 12.5%
 No matter how you slice the pizza…
Unlevered firm Levered firm
($10m EBIT) ($10m EBIT)

Int Exp
$5.0m
Dividends
$10.0m
=
Dividends
$5.0m

Payout = $10.0m Payout = $10.0m

…It doesn’t make the payout any bigger. 13
 Leverage and WACC – no taxes
• Without taxes, WACC is independent of capital structure
choices (see Example II).
– In all cases, the cost of debt (kd) must be lower than the
cost of equity (ke). Why? In bankruptcy, debt has a higher
claim on assets so it is less risky. Common equity only has a
residual claim on a firm’s assets, so cost of equity is always
higher than cost of debt: ke > kd
– The cost of equity depends on the amount of leverage.
Increasing leverage raises firm risk, increasing the cost of
equity, offsetting any benefit from lower cost of debt,
leaving WACC unchanged.

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 Leverage and WACC – no taxes
ke = Cost
of equity
Cost (%)

ke
WACC

kd = Cost
kd of debt

Debt/Equity
 M&M With Taxes
• If the marginal tax rate is 35%, what happens to (i) net
income, and (ii) WACC of an unlevered firm as you add
leverage?
A. Net Income and WACC are higher
B. Net Income and WACC do not change
C. Net Income and WACC are lower
D. Net Income is lower and WACC is higher

Adding debt to an unlevered firm has two main effects:

• Adding debt increases interest expense. Allowing for firms to pay
taxes increases tax expense. Both lower Net Income.
• The after-tax cost of debt is lower due to the benefit of tax shields.
Adding debt to an unlevered firm lowers WACC.

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 M&M With Taxes
• A key benefit of debt is the deductibility of interest expense
before taxes.

• Unlike the model by M&M, the world we live in has death and
taxes…
– We focus on marginal tax rate (35%)
• Interest paid on debt is a tax-deductible expense
– “Government pays 35% of interest expense”
– Total payout to investors increases for a levered firm
• In a world with taxes, the value of the firm increases by the
present value of future expected tax shields

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 Example: M&M With Taxes
ASSUMPTIONS TAXES
EBIT ($m) $ 10.0
Your investment $ 100.0 Firm makes $10m EBIT
Cost of debt 10.0%
Corporate tax rate 35.0%
Dividend payout rate 100.0%

Firm U Firm L Firm L

Balance Sheet (no debt) (50/50) (75/25) Different capital
Debt ($m) 0 50 75
Equity ($m) 100 50 25 structure
Total Debt + Equity 100 100 100

Income Statement
EBIT 10.0 10.0 10.0
Pay interest
Less: Interest expense 0.0 (5.0) (7.5) expense and
Less: Taxes (3.5) (1.8) (0.9)
Net Income 6.5 3.3 1.6
taxes, then
Dividends 6.5 3.3 1.6 dividends
Weighted Average Cost of Capital
Cost of debt 9.0% 10.0% 11.0% …But WACC
Cost of equity 12.5% 15.0% 17.0%
Tax rate 35.0% 35.0% 35.0% decreases
WACC 12.5% 10.8% 9.6%
 With taxes, slice the pizza . . .
Levered firm
Unlevered firm ($1.0M EBIT)
($1.0M EBIT)
Int Expense
$5.0m
Dividends
$6.5m
= Dividends
$3.3m

Payout = $6.5m Payout = $8.3m

…and it becomes bigger. Why?

Because of taxes, the total payout is the same only
the distribution changed (debt gives less to gov’t)...
Unlevered firm Levered firm
($10m EBIT) ($10m EBIT)

Taxes Taxes
Int Exp
$3.5 M $1.75m
$5.0m
=
Dividends Dividends
$6.5 M $3.25m

Payout = $10.0m Payout = $10.0m

 M&M – no taxes vs. with taxes
ASSUMPTIONS NO TAXES TAXES
EBIT ($m) $ 10.0 $ 10.0
Your investment $ 100.0 $ 100.0
Cost of debt 10.0% 10.0%
Corporate tax rate 0.0% 35.0%
Dividend payout rate 100.0% 100.0%

Firm U Firm L Firm L Firm U Firm L Firm L

Balance Sheet (no debt) (50/50) (75/25) (no debt) (50/50) (75/25)
Debt ($m) 0 50 75 0 50 75
Equity ($m) 100 50 25 100 50 25
Total Debt + Equity 100 100 100 100 100 100

Income Statement
EBIT 10.0 10.0 10.0 10.0 10.0 10.0
Less: Interest expense 0.0 (5.0) (7.5) 0.0 (5.0) (7.5)
Less: Taxes 0.0 0.0 0.0 (3.5) (1.8) (0.9)
Net Income 10.0 5.0 2.5 6.5 3.3 1.6
Dividends 10.0 5.0 2.5 6.5 3.3 1.6

TOTAL PAYOUT
Interest expense 0.00 5.00 7.50 0.00 5.00 7.50
Plus: Taxes 0.00 0.00 0.00 3.50 1.75 0.88
Plus: Dividends 10.00 5.00 2.50 6.50 3.25 1.63
Total Payouts 10.00 10.00 10.00 10.00 10.00 10.00
 WACC and Tax Shields
• The value of an unlevered firm increases when leverage increases due
to the benefit of tax shields.
D E
WACC  k d (1  tax)  ke
(D  E) (D  E)

• Effect is driven by the decline in the WACC. How? The cost of debt is
tax-adjusted.
After-tax cost of debt < Pre-tax cost of debt
kd(1-tax) < kd
• But future tax shields are uncertain. They depend on:
(i) positive earnings
(ii) going-concern
(iii) changes to the marginal tax rate
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 Leverage and WACC – with taxes
ke = Cost
of equity
Cost (%)

ke
WACC

kd = Cost
kd of debt

Debt/Equity
 Other Theories
• Following the results of the Modigliani and Miller models,
researchers started to consider what the factors are that do
influence the attractiveness of debt or equity.
• We know that there are differences. MM just highlight some
of the factors that allow us to see the differences in debt
versus equity.
• Below we will talk about some of the different theories that
have been developed. Each provides different insights into
how managers may make their capital structure decisions.

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 Trade-off Theory

• The theory builds on M&M and says that firms trade-off

benefits of tax-shields vs. costs of financial distress (direct and
indirect costs)
– At low leverage levels, tax benefits outweigh bankruptcy costs.
– At high levels, bankruptcy costs outweigh tax benefits.
– An optimal capital structure exists that balances these costs and
benefits.
• Explains industry differences in debt use based on their risk
and cost of financial distress
• Studies find no link between tax shields and firm value
• Debt ratios remain stable even though marginal tax rates have
changed over time

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 Costs of Financial Distress
• Increasing leverage raises the risk of bankruptcy (i.e., the risk
of “death”) with the associated “costs of financial distress”
• The direct and indirect costs of bankruptcy are high, as much
as 25% of the firm’s value
– Direct costs: legal & administrative costs
– Indirect costs: management time, foregone investments,
loss of customers, problems with suppliers, retention of
employees, damage to brand, negative NPV activities
(“gambling for resurrection”). When a company is at risk
of bankruptcy, would you want to deal with them?

Value of firm decreases as

[Cost of distress x Probability of distress] increases
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 Costs of Financial Distress
– Indirect costs:
Example: during the Global Financial Crisis – The US
Government guaranteed US auto manufacturer warranties as
consumers were buying almost 50% fewer cars due to fears
about the warranties:
“due to fears that the companies won't be around to honor
the warranties on their vehicles. Bankruptcy fear was the
single biggest reason car shoppers avoided buying GM cars,
according to a survey conduced last fall by CNW Market
Research.”
– https://money.cnn.com/2009/03/30/news/economy/auto_warrantees/index.
htm?postversion=2009033014

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 Costs of Financial Distress

• Costs are lower for firms with:

– more fixed / tangible assets
– more stable cash flows
– fewer commitments to customers

• Costs are higher for firms with:

– intangible assets (i.e. patents, human capital)
– more growth opportunities
– tax-loss carry forwards

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 Tax shields vs. financial distress
Value of firm
with debt
Market value of firm

PV costs of
financial distress
PV of interest
tax shield Market Value
of firm
with debt

Value of
unlevered firm

optimal debt ratio

29 Debt-to-equity ratio
 Leverage and WACC – with Taxes
and Cost of Financial Distress
ke = Cost
of equity
Cost (%)

WACC
ke
costs of
financial distress

kd = Cost
of debt
kd

Optimal Capital Structure

Debt/Equity
 Pecking-Order Theory
• Firms have a ranking of sources of capital.
– The cheapest, fastest and easiest source of funds is internal
funds. They are the easiest and, arguably, least expensive
because you are your own creditor.
– If firms need to raise external capital they go to the next least
expensive source of capital. In most cases this means debt with
equity being last.

• Why internal first?

– Managers / owners have better information about firm’s
prospects (“asymmetric information”) so the cost is lower
– Sale of equity could mean (i) equity is over-valued, or (ii) firm is
doing badly  investors will view this as a bad sign so debt first
– Choice only clear when firm (i) has too much debt already, or (ii)
risky, uncertain business where borrowers will not lend
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 Evidence to support both

Trade-off Pecking-order
Theory Theory
Large companies have more More profitable firms borrow
leverage less
Firms with tangible assets Growth companies borrow
have more leverage less

Growth companies borrow Stock prices fall when firms

less announce stock offering
(avg 3%)
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 Other Factors Affecting Capital Structure

• Beyond these theories, there are many firm specific factors

which may influence the choice between equity and debt.
Trade-offs are summarized by the acronym FRICTO
– Flexibility (F): keeping your options open
– Risk (R): ability to meet fixed payments
– Income (I): impact on ROE and EPS
– Control (C): how it affects firm ownership
– Timing (T): the current market environment
– Other (O): issues specific to the firm

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 Agency Theory: Debt and Market Discipline
• Jensen & Meckling (JFE 1976) propose “Agency Theory”
– Managers (agents) act in their own best interests, not
necessarily interests of shareholders (principals)
– Managers with excess free cash flow spend it unwisely or
consume perquisites (e.g. corporate jets, compensation)
– Monitoring by Board and large shareholders is one
solution
• Jensen (AER 1986) proposes that debt can be used to
discipline managers who have excess free cash flow
– By taking on more debt, managers are forced to manage
costs and increase sales to meet interest payments, or risk
going bankrupt and losing their jobs
 Signaling Theory

• MM assumed that investors and managers have the same

information.
• But, managers often have better information. There is an
asymmetry of information with investors. Thus, they would:
– Sell stock if stock is overvalued.
– Sell bonds if stock is undervalued.
• Investors understand this, so view new stock sales as a credible
negative signal the stock is overvalued.
• Adding new debt conveys that the firm’s stock price is
undervalued. This is a credible signal because of the possibility
of bankruptcy.
• Implications for managers?

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 Traditional Approach

• Firms choose the capital structure to obtain the lowest

cost of capital.
• Initially, low-cost debt is the best to use to raise capital. It takes a
while before the cost of debt and equity start to increase so we can
use debt to replace more expensive equity financing and allow kc to
decline with more leverage.
• After a certain point increasing financial leverage and the
associated increase in ke and kd will more than offset
the benefits of lower cost debt financing.
• Thus, there is an optimal capital structure where kc is at
its lowest point leading to the firm’s total
value will be the largest (discounting at kc).
 Traditional Approach

ke with bankruptcy costs

Required Rate of Return

Premium
ke with no leverage for financial
on Equity (ke)

risk

ke without bankruptcy costs

Premium
for business
risk
Rf
Risk-free
rate

Financial Leverage (B / S)
 Windows of Opportunity
• The choice of capital structure is opportunistic.
– Managers try to “time the market” when issuing securities.
• They issue equity when the market is “high” and after big stock
price run ups.
• They issue debt when the stock market is “low” and when
interest rates are “low.”
• The issue short-term debt when the term structure is upward
sloping and long-term debt when it is relatively flat.
• This provides the lowest cost of capital

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 Timing and Flexibility

1. Timing
• As with the Windows of Opportunity theory, Managers try to
“time the market” when issuing securities.

2. Flexibility
• A decision today impacts the options open to the firm for future
financing options – thereby reducing flexibility.
• Consequently, firms consider future financing needs and make
the decision to issue debt or equity based on the impact on their
ability to access capital as necessary in the future.
• More debt limits financial flexibility
• More equity increases financial flexibility but with an increase in
the cost of capital
 Implications for Managers

• Avoid financial distress costs by maintaining excess borrowing

capacity, especially if the firm has:
– Volatile sales
– High operating leverage
– Many potential investment opportunities
– Less tangible assets
• Debt can lower the cost of capital, but it comes with both good
things (tax shield, agency monitoring) and bad (financial
distress).
• Markets and rating agencies are watching! Always consider the
impact of capital structure choices on lenders’ and rating
agencies’ attitudes
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 Summary
 Leverage increases value

 Too much leverage destroys it

 Optimum is hard to find

 Use FRICTO to evaluate

capital structure choices