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Capital Structure
Theories and Evidence – Imperfect World I

Burcu Esmer 1
What if the markets are not perfect?
• Valuation by parts
• Relax assumption 1: corporate tax
• Interest tax shield (Market value of balance sheet)
• Relax assumption 2: bankruptcy costs
• Relax assumption 3: agency problems

• If capital structure changes, what happens to the

cost of equity?
• Equity beta of levered firm contains two parts
• Unlevered asset beta
• “De-lever” vs. “Re-lever”

Overview of our approach
• Objectives:
• To examine the costs and benefits of leverage in an imperfect
• To understand how leverage influences value

• Approach: “Valuation by parts”

• Value of levered firm = Value of unlevered firm
+ Net value added by debt
• Note:
• Value of unlevered firm is obtained by discounting FCFs (and
Terminal Value) at the unlevered firm’s cost of capital, Ru
• Value added by debt is not same as value of debt

Why do we need valuation by part?
• Traditionally, we discount the FCFs (and terminal value)
at the levered firm’s WACC to get firm value.

 Rd  1  T 
WACC   Re 

• where Re is the levered firm’s cost of equity

• This direct method is difficult to handle when the leverage

• FCF does not change with leverage
• …but WACC does
• Unfortunately, it is difficult (not impossible) to figure out WACC after
change in leverage

• Valuation by parts makes it easier for us to see the

change in value due to change in leverage
Market Imperfection I: Corporate -Taxes
• Interest is a tax-deductible expense, while dividends are
• So with taxes, there is a relative advantage to using debt (or, a
disadvantage to using equity)
• How do we value this?
• Interest expense = Rd x D
• Interest tax shield = Rd x D x Tc
• Suppose interest tax shield is a perpetuity, then:

Value added by debt  dR c  DT
d c

• Example: a firm has a perpetual debt $1,000, and the tax rate is 35%, then the
PV of interest tax shield is $1,000×35%=$350

M&M Proposition 1 (with corporate
• The value of the levered firm is equal to the
value of the unlevered firm plus the present
value of the debt tax shield

VL  VU  D  Tc
• The value of the firm is linearly increasing in
• The optimal strategy? Maximize the usage of
debt… finance 100% (or 99.9999%) of the firm’s
capital needs with debt
M&M Prop 1 with Corporate

PV(Tax Shield)


Optimal D E  D/E 7
M&M with corporate taxes…
• Let V(L) and V(U) denote the values of the levered and
unlevered firms, respectively. Then:

V L   V U   Tc D
This formula is
difficult to derive;
Take it as given

Re  Ru  Ru  Rd 1  Tc 
WACC   Re   R d (1  T )
V V c
M&M Prop 2 with Corporate
withouttaxes :rE  ru  (ru  rD )
rE  ru  (ru  rD )(1  Tc )

without taxes : rD

Optimal D E  ! D/E 9
Example I: MM with taxes
• Dividend Airlines expects to generate an EBIT of
$153.85, in perpetuity (i.e., dividend payout
=1). Tax rate is 35%. Unlevered cost of capital is
• Questions:
• What is the firm value if it takes on $200 of debt at
10% interest?
• Ignore depreciation, NWC, capex
• What is equity value?
• What’s the cost of equity?
• What’s WACC?

Answer key to example I

Re and Corporate Taxes
• Corporate taxes reduce the financial risk of the firm
Re  Ru 
 
Ru  Rd 1  Tc 

• We can also express this in terms of s:

 e  u 
 
u   d 1  Tc 

( Because CAPM: Re = Rf + βe(Rm–Rf) )

• With corporate taxes, as the firm’s capital structure changes,

both cost of equity (Re) and WACC will change
• Note the crucial difference: Without taxes, in the MM world, WACC
always remained the same
Beta with Taxes
• If we consider taxes, the relationship between the
equity beta and asset beta is altered in the
expected manner

 E   u  (  u   D )(1  Tc )
Beta on the equity Beta if firm were all
of a firm with equity (Unlevered)
leverage a.k.a. Asset beta
(the Levered firm)

“Business” + “Financial” risk
assuming debt beta=0 (it is very common)

 D
BE  Bu 1  (1  t ) 
 E
 Bu  Bu (1  t )
Business Risk
Financial Risk

Example II
• A firm has a debt to equity ratio of 2/3. Its cost of equity is
15.2%, cost of debt is 4%, and tax rate is 35%. Assume that
the risk-free rate is 4%, and market risk premium is 8%.

• Suppose the firm repurchases stock and finances the

repurchase with debt, causing its debt to equity ratio to
change to 3/2:
• Compute the firm’s new equity beta and new cost of equity?
• What is the firm’s WACC before and after the change in capital

Solution steps
• First “de-lever” to obtain unlevered asset beta
using the current capital structure
• If betas are not given, derive using CAPM
• Next, lever it up to the target leverage ratio to
determine the new equity beta
• Calculate the new expected return on equity
• Using CAPM
• Then, calculate the new WACC under the target
leverage ratio

Answer key to Example II

Answer key to Example II cont.

M&M Summary
(No Bankruptcy)
• Proposition 1: Firm value (and shareholder value)
increases with debt

VL  VU  D  Tc
• Proposition 2: The cost of equity is increasing in debt-to-
equity, and the firm cost of equity is decreasing in debt-

Summary of the story so far
• In the MM world with taxes, as leverage increases:
• Cost of Re increases, but the increase is less
than in the perfect MM world
• WACC decreases, so firm value increases
• The reason firm value increases is because higher
the debt, higher is the interest tax shield
• Key assumption: No bankruptcy risk
• Therefore, WACC = Ru only if the firm has zero debt.
• So optimal capital structure is to have 100% debt

Have we found a money
• If we can do this for the first million in debt
financing, what about the tenth million? The
twentieth? The fiftieth?
• Can we reduce our investment to almost nothing
and make all of this cash?
• Obviously not… we aren’t picking up some aspect
of reality
• Possibilities:
• More complex corporate and personal tax system
• Other costs of debt… bankruptcy? Agency costs?

Market Imperfection II: Bankruptcy
• Let’s now add in the possibility of bankruptcy
• Debt increases the probability of financial distress and
• Bankruptcy has costs
• Other assumptions about perfect market remain

• Now we are taking both corporate taxes and

bankruptcy into account
• We could also take personal taxes into account by
changing our present value of tax shield calculation,
but let’s leave that out for simplicity’s sake

Advantages of Debt
• Reduces agency costs (Jensen, 1986)
• Debt creates obligations for firm
• A portion of cash from operations must go
toward repaying debt
• Management is less likely to overinvest and be
an “empire-builder”
• Tax shield created by interest expense
• After-tax cost of debt is low compared to
alternative forms of financing

Disadvantages of Debt
• Lack of future financing flexibility
• Debt can lock a firm into a particular
capital structure for a long period of time
• Lack of flexibility for using firm cash flows
• Agency cost (between lenders and owners)
• Bankruptcy Costs

Market Imperfection II: Bankruptcy Costs
• Debt can put pressure on the firm’s finances during bad
times (“financial distress”)
• because interest and principal payments (unlike dividend payments)
are legal obligations

• Bankruptcy: Legal transfer of ownership of firm’s assets to

debtholders in the event of a default
• Think of it as an extreme form of financial distress

• Two forms of bankruptcy in US:

• Chapter 11 (reorganization): Firm gets temporary respite from
creditors so that it can reorganize
• Chapter 7 (liquidation)

Bankruptcy Costs of Debt
• The expected cost has two components
• Probability of Bankruptcy
• Dollar Cost of Bankruptcy (direct and indirect costs)

Expected Bankruptcy Cost  Probabilit y of Bankruptcy

* Cost of Bankruptcy
• Example: If the estimated bankruptcy cost is $500 (mil), and the
probability of bankruptcy is 5%, then the expected bankruptcy cost is $500
×5% = $25 (mil)

• All else equal, the greater the bankruptcy cost and/or the
probability of bankruptcy implicit in the operating cash
flows of the firm, the less debt the firm can afford to use
1. Probability of Bankruptcy
• Likelihood a firm’s CF will be insufficient to meet its
promised debt obligations (interest and principal)
• Probability is a function of
• Size of operating cash flow (CF) relative to size of debt
• Higher operating CF can support more debt
• Higher operating CF implies lower probability of default
• Variance in operating CF
• More stable CF implies a lower default probability
• More volatile CF implies a higher default probability

2. Bankruptcy Costs
• There are both direct and indirect costs to bankruptcy (ultimately,
borne by shareholders)
• Direct costs: Legal and administrative
• Although large in absolute terms, usually not very big in proportion to
total value
• only 1% of market value 7 years prior (Warner (1977))
• In Macy’s 1992 Chapter 11 bankruptcy, at least $100 million (2 to 3 percent
of Macy’s value)
• Real Example: Orange County
• Indirect costs: Due to disruption of normal activities
• Lost sales, change in customer behavior
• Change in supplier behavior, like requiring up-front cash
payment for raw materials
• Difficulty obtaining new capital (higher cost)
• Firm could lose precious human capital
• Note: These can occur even before bankruptcy, when the firm
is in financial distress
e.g. of Direct Cost of Bankruptcy
Lawyers Set to Profit on Lehman
Weil Gotshal Asks Bankruptcy Court to Approve Record Quarterly Payout of $55 Million

Lehman Brothers Holdings Inc., which set a record as the largest company to file for bankruptcy
protection, is on course to yield one of the biggest bonanzas for lawyers.

New York-based Weil, Gotshal & Manges LLP earlier this week asked a federal bankruptcy judge in New
York to sign off on a $55.1 million payment for its work representing Lehman.

That marks the biggest quarterly fee request made by lawyers representing a bankrupt company,
according to Lynn LoPucki, a law professor at the University of California, Los Angeles, who runs a
bankruptcy-fee database. Mr. LoPucki estimates that Weil stands to bring in more than $200 million in fees
by the end of the case. That would exceed the next-highest debtor counsel fee, the $159 million that Weil
earned during the Enron bankruptcy.

Note: The lead lawyer is claiming 759 hours of work at $950 /hour for the 3 month period!
That means he claims he worked the equivalent of 7 days a week and 8.3333 hours a day
for the entire 90 days.

Enron spent total cost of $750m on legal and accounting fees!

Indirect Costs of Financial Distress
• While the indirect costs are difficult to measure accurately,
they are often much larger than the direct costs of
• Loss of Customers (e.g. Distressed airlines)
• Loss of Suppliers (e.g. Swiss Air)
• Loss of Employees
• Loss of Receivables (e.g. Enron)
• Fire Sale of Assets (study shows firms in distress sell their aircraft
15%-40% cheaper)
• Inefficient Liquidation (Eastern Airlines lost more than 50% of value
during banktruptcy)
• Costs to Creditors (e.g. Lehman – domino effect)
• It is estimated that the potential loss due to financial distress
is 10% to 20% of firm value (Andrade and Kaplan, 1998)

Indirect Costs of Bankruptcy
• The indirect costs of bankruptcy are higher for firms
that sell or produce:
• Long life durable goods that require replacement parts
• Cars: Renault, Daewoo
• Goods/services for which quality is an important attribute
• Airlines: Delta, US Air, United
• Products whose value depends on complementary products
supplied by other companies
• Computers: Apple vs Windows
• Products that require continuous service and support
• Copiers: Xerox
• High proportion of intangibles
• Tangible assets like land, machinery etc. can be liquidated/
redeployed easily.
• Intangible assets like human capital, brand value, R&D
capabilities is lost in the event of bankruptcy

Bankruptcy Cost
• We talked about bankruptcy cost previously
• Bankruptcy Cost = Bankruptcy Dollar Cost *
Probability of Bankruptcy
• The dollar cost of bankruptcy depends largely on
firm operations, not so much on capital structure
• The probability of bankruptcy is heavily dependent
on capital structure
• Increasing debt-to-equity implies higher probability of
• Therefore, bankruptcy cost is increasing in debt-to-
equity 32
Implications of
Bankruptcy Costs of Debt
• Implications for optimal capital structure:
• Firms with more volatile CF should have less debt
• Tech and Biotech firms
• A firm can hold more debt if it can match the CF of debt
and investments
• Commodity companies
• Firms protected by an external entity will tend to borrow
• Banks: FDIC
• Fannie Mae, Freddie Mac: Federal government
• Firms with illiquid assets tend to have less debt
• Assets cannot easily be separated from the business
• Firms producing assets requiring long-term service and
support tend to have less debt
M&M Proposition 1 with Corporate Taxes
and Bankruptcy Costs
VL  VU  PV ( tax shield)-PV(expected bankruptcy costs)
 VL  VU  D  Tc  PV(expected bankruptcy costs)

• The only difference from our previous equation is the

subtraction of the present value of expected
bankruptcy costs
• Since the probability of bankruptcy is increasing in
debt-to-equity, the PV of expected bankruptcy costs is
also increasing in debt-to-equity
• There is a trade-off between the tax advantage of
debt and the costs of financial distress.
M&M Prop 1 with Corporate
Taxes and Bankruptcy Costs
V PV(Exp Bankruptcy Costs)

PV(Tax Shield)


Optimal D D/E
E 35
Bankruptcy Costs and WACC
• In the perfect MM world, as leverage increases:
• Only Re increases, Rd is unchanged
• Overall, WACC and firm value are unchanged

• What happens when bankruptcy costs are the only

imperfection introduced into the MM world?
• As leverage increases:
• Rd increases due to higher expected bankruptcy costs
• Re also increases (just as in MM world)
• Overall, WACC also increases, and firm value falls

• Why does firm value fall?

• bankruptcy costs cause value added by debt to be negative

M&M Prop 2 with Corporate
Taxes and Bankruptcy Costs
At first, increasing
D/E decreases
% rE WACC b/c tax
outweighs the
increase in the
WACCL probability of
bankruptcy. But at
rD(1-t) some point, the
probability of
increases enough
to outweigh tax
* benefit.
Optimal D E
(min imizes WACC)
Optimal Leverage
(with bankruptcy costs and taxes)
• Corporate taxes and bankruptcy costs impact firm
value differently
• Bankruptcy costs lower firm value
• Interest tax shield increases firm value
• In a world with both bankruptcy costs and taxes, as
the firm adds debt:
• Firm value increases if PV of interest tax shield exceeds PV
of expected bankruptcy costs
• Firm value decreases if PV of interest tax shield is less
than PV of expected bankruptcy costs

• Optimal leverage is that leverage beyond which

costs of debt exceed its benefits