17RDP Master 160320

CORPORATE FINANCE
17. The Relevance of Debt Policy

José A. de Azevedo Pereira 2019 Gestão Financeira II 2
1. Main questions:
1.Why should the stockholders care about maximizing of the whole firm
value? Why not to focus in strategies aimed at maximizing shareholder
value (its own interests)?
2.What ratio of debt-to-equity maximizes shareholder’s interests

(creates more value for them)?
Since shareholders have residual claims over the company’s

assets, changes in capital structure benefit the stockholders if and
only if the value of the firm increases.

2. The Capital Structure Question
and the Pie Theory
V=D+E=B+S
3. The Capital Structure Question
and the Pie Theory
 As the market value of a firm is the sum of the value of
the corresponding debt and equity: V = D + E = B + S
• The main aim of the firm is to create value

for its stockholders,
•Consequently, the firm’s management team

E D
should choose the debt-to-equity ratio
capable of “maximizing the size of the pie”
(the global value of the company)
Value of the Firm

Example: Maximizing Firm Value vs Maximizing
Shareholder Interests
The market value of WMC, plc is £1,000. The company currently has
no debt, and each of WMC, plc 100 shares sells for £10. Suppose
that WMC, plc plans to borrow £500 and pay the £500 proceeds to
shareholders as an extra cash dividend of £5 per share. What will the
value of the firm be after the proposed restructuring?

Example: Maximizing Firm Value vs
Maximizing Shareholder Interests
Managers should choose the

Changes in capital structure capital structure that they
benefit the shareholders if and believe will have the highest
only if the value of the firm firm value because this capital
increases structure will be most beneficial
to the firm’s shareholders

3. EFFECT OF FINANCIAL LEVERAGE ON A
COMPETITIVE TAX-FREE ECONOMY
• Modigliani & Miller:

• When a firm pays no taxes and capital markets function
well, there is no difference if the firm borrows or individual
shareholders borrow
• Hence market value of company does not depend on
capital structure

• Assumptions:
• By issuing one security, instead of two, company
diminishes investor choice
• This fact does not reduce value if:
• Investors do not need choice
• Alternative securities are available
• Capital structure does not affect cash flow as there are:
• No taxes
• No bankruptcy costs
• No effect on management incentives
Example: The relationship between debt and
equity and its impact on firm value
Two firms generate the same stream of operating income and differ only in their
capital structure. Firm U is unlevered. Consequently the value of its equity, Eu, is the
same as the total value of the firm, Vu.
Firm L, is levered. The total value of its stock equals the value of the firm less the
value of the debt: EL = VL - DL.
An investor is now considering two alternatives to invest:
i) A conservative investment strategy, where two investment possibilities should
be taken into consideration:
a) To buy 1% of firm U’s shares;
b) To buy 1% of firm L’s shares and 1% of firm L’s debt.
ii) A riskier investment strategy, where the possibilities to consider are the
following:
a) To buy 1% of the shares in the levered firm;
b) To borrow an amount equivalent to 1% of DL and simultaneously to buy 1% of the
unlevered firm.

• M&M: Debt Policy Does Not Matter
• i) a conservative investment strategy
• a)
• b)
• Both alternatives offer the same payoff, 1% of the firm’s profits =>
the underlying cost must be the same (law of one price)
• M&M Debt Policy Does Not Matter:
• ii) a riskier investment strategy
• a)
• b)
• Again, both alternatives offer the same payoff, 1% of the firm’s profits
after interest => the underlying cost must be the same (law of one
price)
• That is to say that the investment 0,01(VU – DL) must be equal to 0,01
(VL – DL) => VU = VL.
No Magic in Financial Leverage
MM'S PROPOSITION I
If capital markets are doing their job,

firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a

chicken than to buy one whole.
Example: Financial Leverage and Firm Value
MacBeth Spot Removers is reviewing its capital structure. Its current position is shown
below in parallel with the expected financial performance under four different
scenarios:
The company as no leverage and all the operating income is paid as dividends to the
common stockholders.
The expected earnings and dividend per share are $1,50. The price of each share is
$10. Since, the firm expects to generate a level stream of earnings in perpetuity, the
expected return on the share is equal to the earnings/price ratio, 1,5/10,0 = 15%

Ms. MacBeth, the firm’s president, thinks that shareholders would be better off if the
company had equal proportions of debt and equity. She therefore proposes to issue
$5000 of debt at an interest rate of 10% and use the proceeds to buy 500 shares.
The analysis of the situation under different assumptions about operating income is
provided below:
She thinks that, since under the expected scenario the level of return to the
shareholders is going to be increased due to leverage, the proposed change in
capital structure will be a wise decision.
FIGURE 1: BORROWING INCREASES MACBETH’s EPS

3. EFFECT OF FINANCIAL LEVERAGE ON A COMPETITIVE
TAX-FREE ECONOMY
• Proposition 1
• Capital markets do their job
• Keep firms from increasing value by changing capital
structure
• Value is independent from debt ratio
• Example (image):
• Costs no more to assemble chicken than buy one

Will it be possible for individual shareholders to get a similar result in financial terms,
if they will be able to borrow at the same interest rate as MacBeth Spot Removers?
How?
Suppose that an investor borrows $10 and invests $20 in two unlevered MacBeth
shares. The end result under each one of the four scenarios will be the following:
This is exactly the same result (same payoffs) that would be obtained by the investor
if he had bought shares in the levered company. Consequently, a share in the
levered company must also sell for $10.
MM Proposition I: A Key Assumption
Individuals can
borrow as cheaply Is this realistic?
as corporations

MM Proposition I (No Taxes)
 Total market value of the firm (debt + equity) is
unaffected by the capital structure
 “Size of the pie is not a function of how you slice it”
 Firm’s value is determined by its real assets and
growth opportunities (elements in the first member of
the balance sheet), not by the securities it issues
and its relative sizes.
 Cost of capital is independent of capital structure

 Investors can create a levered or unlevered

position by adjusting the trading in their own
accounts
 Homemade leverage leads (by arbitrage) to the
conclusion that capital structure is irrelevant in
determining the market value of the firm:
VL = VU

The value of the

levered firm is the
same as the value of
the unlevered firm.
Proposition II and Macbeth

MM Proposition II (No Taxes)
rU = WACC
D
rE = rU + (rU − rD )
E
where:
rU is cost of capital of unlevered firm (all-equity)
rE is cost of equity (or required return on equity)
rD is cost of debt
E is market value of equity
D is market value of debt
WACC is weighted-average cost of capital
4. FINANCIAL RISK and EXPECTED RETURNS
Leverage and Returns:

It is possible to check out this formula for Macbeth Spot Removers.
a) Calculate rE = rA;
b) Calculate the expected return on equity if the firm goes ahead with its intention
to borrow;
c) What happens to the risk of Macbeth shares if it moves to equal debt-equity
proportions (analyze the impact of a drop in operating income from $1500 to
$500)

MM Proposition II
a)

MM and Proposition II
b)

c) Leverage and Risk Macbeth Shares

Example: Leverage and Cost of Equity

Lets consider a company with the following market-value balance sheet:
and an overall cost of capital of:

5. Financial Risk and Expected Returns
What would happen if the firm issued an additional 10% of debt and used the
cash to repurchase 10% of its equity (as a consequence rD will rise to 7,875%)?

5. Financial Risk and Expected Returns
Leverage and Risk:

Similarly to what happens with cash flows and returns, risk is shared between
debtholders and stockholders.
However, debtholders usually bear much less risk than shareholders (betas of large
firms are typically in the range of 0 to 0,2).
The beta of the portfolio constituted by each firm’s assets is just a weighted average of
the corresponding debt and equity betas:

6. Weighted-Average Cost of Capital
Weighted-Average Cost of Capital (WACC)

• Defining the weighted average cost of capital in normal

terms:
D E
WACC = rD + rE
D+E D+E
• In parallel, if we set rU = WACC (cost of capital is

independent of capital structure)
D E
rU = rD + rE
D+E D+E
 D D+E
rE =  rU − rD 
 D+E  E
D
E
Cost of capital
D
E
rU
D E
WACC = rD + rE
D+E D+E
rD rD
Debt-to-equity ratio D
E
FIGURE 17.2 PROPOSITION II and MM

FIGURE 17.3 WACC TRADITIONAL VIEW

Summary of MM Propositions I and II
without Taxes
Assumptions
Individuals
No and
No Taxes Transaction Corporations
Costs borrow at
Same rate

Summary of MM Propositions I
and II without Taxes
Proposition Proposition
I II
• VL = VU

Summary of MM Propositions I
and II without Taxes
Proposition I Proposition II
• Through homemade • The cost of equity rises
leverage individuals can with leverage because
either duplicate or undo the risk to equity rises
the effects of corporate with leverage
leverage

A senseless subsidy
Most Western economies sweeten the cost of borrowing. That is a bad
idea
THE field for the title of world’s worst economic distortion is a

crowded one. Fuel subsidies in the emerging world are one contender;
the implicit government guarantee that props up big banks another.
But it is a less noticed and more pervasive warping of the economic
fabric that is the most damaging. Despite the fact that the world is
mired in debt, governments make borrowing costs tax-deductible,
cheapening debt and encouraging borrowers to pile on more.
Tax breaks for debt come in two principal forms. Interest payments on
mortgages are tax-deductible for personal tax purposes in at least
some way in America and over a dozen European countries, including
Belgium, Italy, the Netherlands, Spain, Switzerland and most Nordic
states. And across the world firms can deduct interest payments to
debt-holders from their taxable earnings. In contrast the dividend
payments and retained profits that flow to shareholders are taxed in
most places.
The Economist, 16.05.2015

Corporate Taxes

Example : Taxes and Cash Flow
Having performed what he considered an appropriate risk-return analysis of the operational
characteristics of a project to produce widgets, Mr. Jacob Weinberg decided to create a start up
to implement it.
The firm’s long-term assets will have a value of 120000 euros and its short-term assets will have
a value of 80000 euros. The firm will face a corporate tax rate, tC, of 36,5 %. The corresponding
annual expected earnings before interest and taxes (EBIT) will reach 40000 euros per year. The
entire net earnings (after taxes) are going to be paid out as dividends.
However, Mr. Weinberg is still in doubt about the capital structure of the firm. He decided that, at
this stage, he would contribute with all the capital needed. Nevertheless, he is considering two
alternatives to deploy that capital: in alternative A, the firm will have an unlevered capital
structure (no debt). The equity will represented by 1000 shares. The cost of its equity will be
12,7%.
In contrast, in alternative B, the firm will have debt of 50000 euros. The (market) cost of debt, rD,
will be 10 %. Its capital will be represented by 750 shares.
What is:
a) The balance sheet of each one of the firms?
b) The price per share in each firm?
c) The total cash flow to shareholders and bondholders (at the moment all the cash
flow will revert to Mr. Weinberg, since originally he is going to provide all the capital
needed), in each alternative?
36,5% Tc 36,5%
A Description B Remark
120000 1. Long term assets 120000
Companies A and B are
80000 2. Short term assets 80000
similar in everything but
200000 3. Total assets 200000 their capital structures.
200000 4. Equity 150000
0 5. Debt 50000
1000 6. Number of shares 750
200 7. Price 200
12,7% 8. Cost of equity
9. Interest rate 10%
40000 10. EBIT 40000
0 11. Interest 5000
40000 12. EBT 35000
14600 13. Corporate Income Tax 12775
14. Net earnings = CF (to
25400 22225
shareholders)
15. Free CF to investors
25400 27225 1
(debtholders and shareholders)

Having performed what he considered an appropriate risk-return analysis of the operational
characteristics of a project to produce widgets, Mr. Jacob Weinberg decided to create a start up
to implement it.
The firm’s long term assets will have a value of 120000 euros and its short term assets will have
a value of 80000 euros. The firm will face a corporate tax rate, tC, of 36,5 %. The corresponding
annual expected earnings before interest and taxes (EBIT) will reach 40000 euros per year. The
entire net earnings (after taxes) are going to be paid out as dividends.
However, Mr. Weinberg is still in doubt about the capital structure of the firm. He decided that, at
this stage, he would contribute with all the capital needed. Nevertheless, he is considering two
alternatives to deploy that capital: in alternative A, the firm will have an unlevered capital
structure (no debt). The equity will represented by 1000 shares. The cost of its equity will be
20%.
In contrast, in alternative B, the firm will have debt of 50000 euros. The (market) cost of debt, rD,
will be 10 %. Its capital will be represented by 750 shares.
What is:
d) The (present) value of the tax shield?
e) The market value of the firm under each alternative? What will be the best solution,
in terms of capital structure?
Present Value of the Tax Shield
Interest rate Amount borrowed
Reduction in Corporate Taxes:
Corporate tax rate Interest paid
Assuming Cash Flows are Perpetual, Present Value of Tax Shield:

Value of Levered Firm
1−
MM Proposition I (Corporate Taxes):
× 1− × ×
= + = +

16. Free CF to investors (Annual
-1825 1825
Difference)
16. State bears 36,5% of the interest × ×
× 1 1825
= paid by company B
17. Present Value of Tax Shield
18250
[PV(TS)]
200000 18. Value of the firm 218250 !

MM Proposition II (Corporate Taxes):
" # 1 $ #
Given MM I under taxes, a levered form's market-value

balance sheet can be written as:
= %& '( & % ) ( * = -
$ = + ℎ % = .& /

Expected cash flow from the left-hand side:
) # + $
(Since assets are risky, their expected return is rA . Tax shield is created by debt, so its risk is the same and
the corresponding expected return is rD).
Expected cash flow to stockholders and bondholders (together):

-) " +
…a) is equal to b):

(Since all cash flows are paid out as dividends in a no-growth perpetuity model, the cash flows paid to bond
and stockholders are exactly equal to the global cash flows generated by the company)
!) " + = # + $

Dividing both sides of the previous equation by E and subtracting DrD provides the
following result:
) " = × # − 1− $ ×
Since VL equals VU + TC D = D + E => VU = E + (1 - TC) x D. Consequently, d) can

be rewritten in the following terms:
"2(45 6 )×
e) " =
"
× # − 1− $ ×
"
Amalgamating the terms involving (1-TC) x D/E leads to the general formula f):
() " = # + × 1− $ × # −

Personal Taxes: Basics
Assume an all-equity firm receives €1 of pretax earnings. If the

corporate tax rate is TC, the firm pays taxes TC, leaving itself with
earnings after taxes of 1 – TC.
Assume that this entire amount is distributed to the shareholders as
dividends. If the personal tax rate on share dividends is TPE, the
shareholders pay taxes of (1 – TC) × TPE, leaving them with (1 – TC) ×
(1 – TPE) after taxes.
Alternatively, imagine that the firm is financed with debt. Here, the
entire €1 of earnings will be paid out as interest because interest is
deductible at the corporate level. If the personal tax rate on interest is
TP, the bondholders pay taxes of TP, leaving them with 1 – TP after
taxes.
Until now we have ignored the amount of personal income tax (pit) that is going to paid by Mr.
Weinberg on the income provided by its investment. However, since there is no doubt that he is
going to be asked to pay taxes at personal level, that fact needs to be properly taken into
account.
A) Mr. Weinberg’s personal income tax bracket corresponds to a rate of 40%.
g) Having this fact in consideration what will be the value of the firm in each alternative? What
will be the best alternative?
h) What will be formulae that will provide the value of the tax shield, under these
circumstances?
B) Assuming now, that dividends are tax-free and interest is still taxed at 40%,
g) What will be the value of the firm in each alternative? What will be the best alternative?
Why?
h) Under which circumstances the use of equity (debt) might be preferable to the use of
equity?

19. Marginal Tax Rate (Personal
40% 40%
Income Tax)
20. Personal Income Tax related to
0 2000
debt revenue
10160 8890
equity revenue
22. Total Taxes paid by investors
10160 10890
(shareholders and debtholders)
23. Total amount of taxes paid at
24760 23665
firm and investor level
15240 24. Investors Net Revenue 16335
25. Tax Shield (after consideration
1095
of Personal Taxes)
26. Present Value of Tax Shield
18250
[PV(TS)]
200000 27. Value of the firm 218250 = + !

The Effect of Personal Taxes on Capital
Structure
Ignoring costs of financial distress, what is the firm’s optimal capital
structure if dividends and interest are taxed at the same personal
rate—that is, TPE = TP?
The firm should select the capital structure that gets the most cash
into the hands of its investors. This is tantamount to selecting a
capital structure that minimizes the total amount of taxes at both the
corporate and personal levels.
Beginning with €1 of pretax corporate earnings, shareholders receive
(1 – TC) x (1 – TPE), and bondholders receive 1 – TP. If TPE = TP,
bondholders receive more than shareholders. Thus, the firm should
issue debt, not equity.

The Effect of Personal Taxes on Capital
Structure
Under what conditions will the firm be indifferent between issuing
equity or debt?
1− $ × 1− 7" = 1− 7

Until now we have ignored the amount of personal income tax (pit) that is going to paid by Mr.
Weinberg on the income provided by its investment. However, since there is no doubt that he is
going to be asked to pay taxes at personal level, that fact needs to be properly taken into
account.
A) Mr. Weinberg’s personal income tax bracket corresponds to o rate of 40%.
g) Having this fact in consideration what will be the value of the firm in each alternative? What
will be the best alternative?
h) What will be formulae that will provide the value of the tax shield, under these
circumstances?
B) Assuming now, that dividends are tax-free and interest is still taxed at 40%,
g) What will be the value of the firm in each alternative? What will be the best alternative?
Why?
h) Under which circumstances the use of equity (debt) might be preferable to the use of
equity?

28. Marginal Tax Rate on Debt
40% Returns (Personal Income Tax on 40% 7
Interest - T P )
29. Marginal Tax Rate on Equity
0% Returns (Personal Income Tax on 0% 7"
Equity Income - T PE )
25400 30. Investors' Equity Income 22225
0 31. Personnal Tax on Equity Income 0
0 32. Investors' Debt Income 5000
0 2000
debt revenue
34. Tax Shield originated by debt 1825
35. Investors Net Tax Shield related to
-175
Debt
25400 36. Free CF to investors
25225
(bondholders and shareholders)
37. Net Tax Shield as a function of the
-175
difference between marginal tax rates
Alternative A 38. Best alternative (Max CF)

Example 15.4: MM with Corporate Taxes
Presently, PRN, SA is an unlevered firm. The company expects to

generate €125 in earnings before interest and taxes (EBIT), in
perpetuity.
The firm faces a corporate tax rate of 20%, which implies after-tax
earnings of €100. All earnings after tax are paid out as dividends.
The firm is considering the possibility of restructuring its capital
structure and using €100 of debt. The corresponding cost (debt
capital) is 10 percent.
Similar unlevered firms doing their business in the same industry face
currently a cost of equity capital of 20 percent.
What will be the new value of PRN, SA?

Example: MM with Corporate Taxes
× 1−
= + $
€100
= + 0,20 × €100
0,20
= €500 + €20 = 520

Expected Return and Leverage under
Taxes
 MM Proposition II (Corporate Taxes):
" = # + × 1− $ × # −

WACC and Corporate Taxes
=#$$ = " + 1− $

Share Prices and Leverage under
Corporate Taxes

WACC and Corporate Taxes

Summary of MM Propositions with Taxes
Assumptions
Corporations Individuals
are taxed at and
No transaction
the rate tC, on corporations
costs
earnings after borrow at
interest same rate

• VL = VU + tCD " = # + 1− # −
(for a firm with

perpetual debt)

• Because corporations can • The cost of equity rises
deduct interest payments with leverage because the
but not dividend payments, risk to equity rises with
corporate leverage lowers leverage
tax payments

17-4 FINAL WORD ON AFTER-TAX WEIGHTED-AVERAGE
COST of CAPITAL
• After-Tax WACC
• Tax benefit from interest-expense deductibility must
include cost of funds
• Tax benefit reduces effective cost of debt by factor of
marginal tax rate

COST of CAPITAL
• Union Pacific
• Firm has marginal tax rate of 35%
• Cost of equity 9.9%
• Pretax cost of debt 4.7%
• Market equity to value ratio is 84% (which implies that
market debt to value ratio is 16%)
• Given book-and-market value balance sheet what is tax-
adjusted WACC?

COST of CAPITAL
• Union Pacific
• WACC = (1 – .35) x 4.7% x .160 + 9.9 x .840 = 8.8%

FIGURE 17.4 UNION PACIFIC WACC

COST CAPITAL
• After-Tax WACC
• Kate’s Café has marginal tax rate of 35%
• Cost of equity 10.0% and pretax cost of debt 5.5%
• Given book- and market-value balance sheets, what is tax-
adjusted WACC?

COST CAPITAL
After-Tax WACC
Balance Sheet (Market Value, billions)

Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities

COST CAPITAL
• After-Tax WACC
• Debt ratio = (D/V) = 7.6/22.6 = .34 or 34%
• Equity ratio = (E/V) = 15/22.6 = .66 or 66%

COST CAPITAL
After-Tax WACC

Thank You

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CORPORATE FINANCE

17. The Relevance of Debt Policy

2.What ratio of debt-to-equity maximizes shareholder’s interests

Since shareholders have residual claims over the company’s

José A. de Azevedo Pereira 2019 Gestão Financeira II 3

• The main aim of the firm is to create value

•Consequently, the firm’s management team

Value of the Firm

José A. de Azevedo Pereira 2019 Gestão Financeira II 6

Managers should choose the

José A. de Azevedo Pereira 2019 Gestão Financeira II 7

• Modigliani & Miller:

José A. de Azevedo Pereira 2019 Gestão Financeira II 8

José A. de Azevedo Pereira 2019 Gestão Financeira II 10

If capital markets are doing their job,

V is independent of the debt ratio.

It should cost no more to assemble a

José A. de Azevedo Pereira 2019 Gestão Financeira II 14

José A. de Azevedo Pereira 2019 Gestão Financeira II 16

José A. de Azevedo Pereira 2019 Gestão Financeira II 17

José A. de Azevedo Pereira 2019 Gestão Financeira II 19

José A. de Azevedo Pereira 2019 Gestão Financeira II 20

 Investors can create a levered or unlevered

José A. de Azevedo Pereira 2019 Gestão Financeira II 21

The value of the

Proposition II and Macbeth

José A. de Azevedo Pereira 2019 Gestão Financeira II 23

Leverage and Returns:

José A. de Azevedo Pereira 2019 Gestão Financeira II 25

José A. de Azevedo Pereira 2019 Gestão Financeira II 26

José A. de Azevedo Pereira 2019 Gestão Financeira II 27

José A. de Azevedo Pereira 2019 Gestão Financeira II 28

José A. de Azevedo Pereira 2019 Gestão Financeira II 29

Leverage and Returns:

and an overall cost of capital of:

José A. de Azevedo Pereira 2019 Gestão Financeira II 30

José A. de Azevedo Pereira 2019 Gestão Financeira II 31

Leverage and Risk:

José A. de Azevedo Pereira 2019 Gestão Financeira II 32

Weighted-Average Cost of Capital (WACC)

José A. de Azevedo Pereira 2019 Gestão Financeira II 33

• Defining the weighted average cost of capital in normal

• In parallel, if we set rU = WACC (cost of capital is

José A. de Azevedo Pereira 2019 Gestão Financeira II 36

José A. de Azevedo Pereira 2019 Gestão Financeira II 37

José A. de Azevedo Pereira 2019 Gestão Financeira II 38

José A. de Azevedo Pereira 2019 Gestão Financeira II 39

José A. de Azevedo Pereira 2019 Gestão Financeira II 40

THE field for the title of world’s worst economic distortion is a

The Economist, 16.05.2015

José A. de Azevedo Pereira 2019 Gestão Financeira II 41

José A. de Azevedo Pereira 2019 Gestão Financeira II 42

José A. de Azevedo Pereira 2019 Gestão Financeira II 44

Interest rate Amount borrowed

Reduction in Corporate Taxes:

Corporate tax rate Interest paid

Assuming Cash Flows are Perpetual, Present Value of Tax Shield:

José A. de Azevedo Pereira 2019 Gestão Financeira II 46

MM Proposition I (Corporate Taxes):

José A. de Azevedo Pereira 2019 Gestão Financeira II 47

José A. de Azevedo Pereira 2019 Gestão Financeira II 48

Given MM I under taxes, a levered form's market-value