Principles of

Chapter 10 Corporate Finance

Tenth Edition

How Much
Should a
Corporation
Borrow?
Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

10-2

Topics Covered
Corporate Taxes
Corporate and Personal Taxes
Cost of Financial Distress
Pecking Order of Financial Choices
 Capital Structure & Corporate 10-3

Taxes
Financial Risk - Risk to shareholders resulting
from the use of debt.
Financial Leverage - Increase in the variability
of shareholder returns that comes from the
use of debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

Capital Structure & Corporate 10-4

Taxes
The tax deductibility of interest increases the total
distributed income to both bondholders and
shareholders.
Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

 Capital Structure & Corporate 10-5

Taxes

28
PV (tax shield)   $350
.08
Interest payment  return on debt X amount borrowed
 rD  D

rcorporate tax rate X interest payment

PV (tax shield) 
expected return on debt
TC (rD  D)
  TC  D
rD

Capital Structure & Corporate 10-6

Taxes
Example - You own all the equity of Space
Babies Diaper Co. The company has no debt.
The company’s annual cash flow is $900,000
before interest and taxes. The corporate tax
rate is 35% You have the option to
exchange 1/2 of your equity position for 5%
bonds with a face value of $2,000,000.

Should you do this and why?

 Capital Structure & Corporate 10-7

Taxes
Example - You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is
$900,000 before interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your equity position for 5%
bonds with a face value of $2,000,000.
Should you do this and why?

($ 1,000 s) All Equity 1/2 Debt Total Cash Flow

EBIT 900 900 All Equity = 585
Interest Pmt 0 100
Pretax Income 900 800
*1/2 Debt = 620
Taxes @ 35% 315 280
(520 + 100)
Net Cash Flow 585 520

Capital Structure & Corporate 10-8

Taxes
PV of Tax Shield D x rD x Tc
= = D x Tc
rD
(assume perpetuity)

Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 =
$700,000

PV Tax Shield = $2,000,000 x .35 = $700,000

 Capital Structure & Corporate 10-9

Taxes
Firm Value =
Value of All Equity Firm + PV Tax Shield

Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield =
700,000
Firm Value with 1/2 Debt = $12,400,000

Capital Structure & Corporate 10-10

Taxes
Merck Balance Sheet, December 2008
(figures in $millions)

Book values
Net working capital 4,986.2 3,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 18,758.3 Equity
Total assets 32,877.0 32,877.0 Total value

Market values
Net working capital 4,986.2 3,943.3 Long-term debt
PV interest tax shield 1,380.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,928.3 Equity
Total assets 79,047.0 79,047.0 Total value
 Capital Structure & Corporate 10-11

Taxes
Merck Balance Sheet, December 2008 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)

Book values
Net working capital 4,986.2 4,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 17,758.3 Equity
Total assets 32,877.0 32,877.0 Total value

Market values
Net working capital 4,986.2 4,943.3 Long-term debt
PV interest tax shield 1,730.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,278.3 Equity
Total assets 79,397.0 79,397.0 Total value

10-12

C.S. & Taxes (Personal & Corp)

Operating Income
($1.00) Or paid out as
Paid out
as interest equity income

Corporate Tax None Tc

Income after $1.00 $1.00 – Tc

Corp Taxes

Personal Taxes Tp TpE (1.00-Tc)

.

Income after All $1.00 – Tp $1.00–Tc-TpE (1.00-

Taxes Tc) =(1.00-
TpE)(1.00-Tc)
To bondholders To stockholders
 10-13

C.S. & Taxes (Personal & Corp)

Relative Advantage Formula
( Debt vs Equity )

1-Tp
(1-TpE) (1-Tc)

Advantage
RAF > 1 Debt
RAF < 1 Equity

10-14

C.S. & Taxes (Personal & Corp)

Example

Interest Equity Income

Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corpotare tax 1 0.65
Personal tax at Tp = .35 and TpE = .125 0.35 0.081
Income after all taxes $0.650 $0.569

Advantage to debt= $ .081

 10-15

C.S. & Taxes (Personal & Corp)

Another Example

Interest Equity Income

Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corpotare tax 1 0.65
Personal tax at Tp = .35 and Tpe = .105 0.35 0.068
Income after all taxes $0.675 $0.582

Advantage to debt= $ .068

10-16

C.S. & Taxes (Personal & Corp)

Today’s RAF & Debt vs Equity

preference.
1-.33
RAF = = 1.23
(1-.16) (1-.35)

Why are companies not all debt?

 10-17

Capital Structure
Structure of Bond Yield Rates
r

Bond
Yield

D
E

10-18

WACC w/o taxes (traditional view)

r Includes Bankruptcy Risk

rE

WACC

rD
D
V
 10-19

Financial Distress
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.

10-20

Financial Distress
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield
- PV Costs of Financial
Distress
 10-21

Financial Distress
Maximum value of firm
Costs of
financial distress
Market Value of The Firm

PV of interest
tax shields
Value of levered
firm

Value of
unlevere
d
firm

Optimal amount
of debt
Debt

10-22

Default Payoff Scenarios

 10-23

Ace Limited Example

Total payoff to Ace Limited security holders. There is a
$200 bankruptcy cost in the event of default (shaded
area).

10-24

Conflicts of Interest
Circular File Company has $50 of 1-year
debt.

Circular File Company (Book Values)

Net W.C. 20 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets 100 100 Total liabilities
 10-25

Conflicts of Interest
Circular File Company has $50 of 1-year
debt.

Circular File Company (Market Values)

Net W.C. 20 25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities

 Why does the equity have any value ?

 Shareholders have an option -- they can
obtain the rights to the assets by paying off
the $50 debt.

10-26

Conflicts of Interest
Circular File Company has may invest $10
as follows.

Now Possible Payoffs Next Year

$120 (10% probability)
Invest $10
$0 (90% probability)

 Assume the NPV of the project is (-$2).

What is the effect on the market
values?
 10-27

Conflicts of Interest
Circular File Company value (post project)

Circular File Company (Market Values)

Net W.C. 10 20 Bonds outstanding
Fixed assets 18 8 Common stock
Total assets 28 28 Total liabilities

 Firm value falls by $2, but equity holder gains

$3

10-28

Conflicts of Interest
Circular File Company value (assumes a safe
project with NPV = $5)

Circular File Company (Market Values)

Net W.C. 20 33 Bonds outstanding
Fixed assets 25 12 Common stock
Total assets 45 45 Total liabilities

 While firm value rises, the lack of a high potential

payoff for shareholders causes a decrease in equity
value.
 10-29

Financial Distress Games

Cash In and Run

Playing for Time

Bait and Switch

10-30

Financial Choices
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings
and distress costs of debt.

Pecking Order Theory - Theory stating that

firms prefer to issue debt rather than equity if
internal finance is insufficient.
 10-31

Trade Off Theory & Prices

1. Stock-for-debt Stock price

exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices;

repurchase increases stock prices.
3. Issuing straight debt has a small negative
impact.

10-32

Issues and Stock Prices

 Why do security issues affect stock
price? The demand for a firm’s
securities ought to be flat.

 Any firm is a drop in the bucket.

 Plenty of close substitutes.
 Large debt issues don’t significantly
depress the stock price.
 10-33

Pecking Order Theory

Consider the following story:

The announcement of a stock issue drives down the

stock price because investors believe managers are more
likely to issue when shares are overpriced.

Therefore firms prefer internal finance since funds can

be raised without sending adverse signals.

If external finance is required, firms issue debt first and

equity as a last resort.

The most profitable firms borrow less not because

they have lower target debt ratios but because they don't
need external finance.

10-34

Pecking Order Theory

Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is
better. (There is less room for difference
in opinions about what debt is worth).
 10-35

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