Risk and Capital Strucure

 The Tradeoff Theory of Capital Structure

 Tax shields
 Modigliani Miller with taxes
 Personal income taxes
 Bankruptcy and Firm Value
 Limited Liability
 Historic Evolution
 Veil piercing
 Debt and Equity as options
 Applications
Taxes, Capital Structure and Firm Value
 If the company pays taxes, pre-tax cash flows are
distributed to :
 Shareholders
 Creditors
 The state
 Company value = value of flows distributed to
shareholders and creditors = after tax value
 Taxes depend on debt levels
 Therefore after tax value of the company depends on
debt levels

Michael Troege
Taxes and debt
 Umbrella SA pays 50% corporate taxes. The owner
wants to exchange 80% of equity by a 5% loan from his
own pocket.
Current Capital Structure Proposed Capital Structure
Assets Liabilities Assets Liabilities
100 100 Equity 100 20 Equity
0 Debt 80 Debt

Pre tax income: 10 Pre tax income: 10 – 4 = 6

Net income: 5 Net income: 3
Total cash to investor: 5 Total cash to investor: 7
Taxes: 5 Taxes: 3
 Debt increases the total amount of cash received by the
investor.
Michael Troege
Cash flows and tax shields
 We can write:
FCTFt  Tax Shields t  Free Cash to Equity t  Free Cash to Debt t

 We must adapt WACC if we still want the present value

of Free Cash to the Firm and Cash Flows to the different
types of investors to be equal

t 
FCTFt Free Cash to Equity Free Cash to Debt

t 0 (1  r ) t

1  rE  t

1  rD  t
WACC

With tax adjusted WACC!

Michael Troege
The Cash Flows of the Unlevered and Levered
Firm

Cash for
all
investors

 The figure assumes a 40% marginal corporate tax rate

Michael Troege
Modigliani Miller with taxes (1963)
 Proposition I (with taxes)
 Company Value increases with leverage
 Proposition II (with taxes)
 The cost of equity increases with leverage but at a slower
rate than without taxes
 Weighted average cost of captial
 Wacc decreases with leverage

 Note: The detailed relationship between leverage and

WACC depends on assumptions made about the future
debt levels. Several adjustment formulas are available.

Michael Troege
Corporate Tax Effects: Formulas for constant
debt levels (APV case)
 The exact values depend on capital structure policy, i.e.
future debt levels:
 Constant in absolute numbers
 Constant leverage at market values
 Denote by VL and VU the after-tax values
 Modigliani-Miller Prop. I: EV L  EV U   C D

D
 Modigliani-Miller Prop. II: r  r 
E
L U
E
E L
r
U
E 
 rD 1   C 
 D 
Modigliani-Miller Prop. III:WACC  r 1   

U C
 E
EV L 
  Michael Troege
Corporate Tax Effects
 Intuition: Government takes away a part of the pizza.
The tax slice is smaller with more debt finance (higher
leverage).

Two investments:
1. Buy a proportion k of equity in firm U
2. Buy a proportion k of equity and debt of firm L

Annual payoffs: Costs:

1. k EBIT(1-τC) k VEU
2. k (EBIT-rDVD)(1-τC) + k rDVD
= k EBIT(1-τC) + kτCrDVD k (VEL+VD)= k VFL
 C rDVD
Investments differ in PV by k  k CVD
rD
 VFL  VFU   CVD  VFU  PV(Tax Shield) Michael Troege
The Role of Leverage under Taxation
Firm Value VFL
(in million $)

Return Debt
(in %) rE L

WACC

rD

Leverage  Debt/Equi ty
Michael Troege
Conclusion
 “All else equal, considerations of the corporate income
tax should make debt finance more attractive.”
 Unprofitable investment projects can become profitable
for the levered firm.
 If the world worked as in the MM Theorem with taxes
the optimal financial structure would entail 100% debt
finance. Why do firms not take 100% debt?
 Reason:
 Personal taxes
 Bankcruptcy costs
 Agency costs

Michael Troege
Exercises
Exercise: Taxes and debt
 Umbrella SA is equity financed and has a pre-tax
income/Ebit of 10. The corporate tax rate is 50%, the
company’s cost of capital is 10%. The owner wants to
exchange 67% of equity with a 3% loan.
 Determine the annual tax shields of the levered

company.
 What is the present value of the tax shields

discounted at cost of debt?

 Determine the value of the levered company as sum

of the unlevered company’s value and the present

value of tax shields.
 Determine the levered company’s cost of equity and

WACC using the formulas given in class.

 Verify that you do indeed find the same equity and

firm value as before.

Michael Troege
Solution
 Value unlevered firm =50
 Debt level= 0,67*50=33
 Annual tax shields = Interest* tax rate=1*0,5
 Present value of tax shield 3%*0,5=1/0,03*0,5=16,6
 Value of the unlevered company=50
 Value of the levered company= 50+16=66
 Value of the levered equity=66-33=33
 Cost of equity levered company= 10%+33/33(10%-3%)
(1-0,5) =13,5%
 Wacc using formula=7,5%
 Wacc using weights =7,5%
 FCTF discounted at tax adjusted Wacc=5/0,075=66
Michael Troege
Exercise: Buyout Finance
 Company A has a stable pre tax cash/ EBIT flow of 10m
year without growth and no debt. It is privately owned,
management has 5% of equity. Corporate taxes are
50%, cost of captial is 10%. Now a Buyout Fund
acquires the equity and asks the company to take on
50m in Bank Debt at 8%. The excess cash of 50m is
paid out as special dividend. Management re-invests
the cahs they gained form the sale in the company. The
LBO fund sells the remaining shares are sold in an IPO
 What is the gain of the Buyout Fund?
 What is the percentage of shares held by management
after the LBO?

Michael Troege
Personal Income Taxes
Total Taxation includes Income Tax

Michael Troege
Individual Income Tax
 While the corporate income tax encourages debt
finance, the individual income tax serves to mitigate
this preference.
 Interest income:
 taxed at the individual level in the year it is earned. This
is known as taxing on an accrual basis. Further, interest
income is taxed at the individual’s full marginal tax rate.
 Equity income: dividends capital gains.
 Dividends are taxed when paid. In some countries the
tax on dividends is lower than the tax on interest.
 Capital gains are taxed when realized. This creates a
deferral advantage (since delaying reduces the PV of
tax bill).
Michael Troege
The Intuition

 Think about having $1 that you are free to label as

“interest” or “equity return” for tax purposes. What
label should you apply?
 You should label it debt when:
(1-TD) > (1-TC)(1-TE)
 You are indifferent between the label if:
(1-TD) = (1-TC)(1-TE)

Michael Troege
Example
 In 1981, the maximum individual income tax rate in the
US was 70% and the average effective tax rate on
capital gains was estimated to be 16%. The corporate
income tax rate was 46%. Using these figures, total
taxation of equity 1-(1-0.46)(1-0.16)=0.55 and total
taxation on debt 0.70
 Under this set of assumed rates, there would be a tax
disadvantage to debt finance.
 In reality many investors in debt are also tax exempt.

Michael Troege
Conclusion
 Various institutional features cause equity income to
face a lower effective tax rate than debt income at
the individual level.
 These differences mitigate the tax advantage to debt
finance at the corporate level. In fact, it is possible
for there to be a net disadvantage to debt finance.
 Historically, and under current tax law, there is a net
advantage to debt finance for a corporation in the top
bracket.

Michael Troege
Exercice: Taxes in France (2019)
 Is there a tax advantage for debt finance?
 Corporate tax 34,93%
 Tax in dividend income (High bracket) 35%
 Capital gains tax (impôt sur les plus values) 34.5%.=
capital gains tax at the rate of 19% plus 15.5% social
charges.
 Tax on interest income 27%

 Hence income from debt and equity is taxed at similar

rates at the investor level but income from debt is
untaxed at the corporate level.
 Interest has a clear tax advantage !
Michael Troege
Bankruptcy and Bankruptcy Costs
Bankruptcy in perfect markets
 In the Modigliani/Miller world
 bankruptcy simply means that there is not enough cash for
shareholders
 I this case creditors receive all the FCTF
 In the real world
 bankruptcy is a complicated court administered procedure
to resolve conflicts in case creditors cannot be paid in full
 In an efficient bankruptcy process the creditors become the
company ’s new owners
 They will typically not liquidate the company, but continue
to run the company.
 The company’s value should therefore be the same
independently if it is run by the old shareholders or the
creditors -> smililar to MM world

Michael Troege
 Exemple: Bankruptcy and Enterprise Value
 Startup SA will produce perpetual cash flows of 15 or 5,
with probabiltiy 50%, depending on the signature of an
important contract.
 Cost of Captial 10%:
 Without debt:
 Enterprise value is 100
 With debt of face value 75
Contract signed Contract not signed Average
Value Equity 75 Value Equity 0 Value Equity 37,5
Value Debt 75 Value Debt 50 Value Debt 62,5
Entreprise Value 150 Entreprise Value 50 Entreprise Value 100
 The expected value of the company didn ’t change!
Michael Troege
 Exemple: Bankruptcy and Enterprise Value
 In the case of bankruptcy 20 go to judges lawyers etc.
 Without debt:
 Enterprise Value 100
 With debt with a face value of 75

Contract signed Contract not signed Average

Value Equity 75 Value Equity 0 Value Equity 37,5
Value Debt 75 Value Debt 50-20=30 Value Debt 52,5
Entreprise Value 150 Entreprise Value 30 Entreprise Value 90

 Company value exactly decreases by the expected

bankruptcy costs.
Michael Troege
 Exemple: Bankruptcy and Enterprise Value
 In the case of bankruptcy half of the existing clients will
leave
 Without debt:
 Enterprise Value 100
 With debt with a face value of 75

Contract signed Contract not signed Average

Value Equity 75 Value Equity 0 Value Equity 37,5
Value Debt 75 Value Debt 50/2=25 Value Debt 50
Entreprise Value 150 Entreprise Value 25 Entreprise Value 87,5

 Company value exactly decreases by the expected

bankruptcy costs. Michael Troege
Conclusion
 Contrary to the assumptions of Modigliani and Miller, in
reality bankruptcy reduces the value of the firm
 direct transaction costs
 indirect costs: Lower expected future cash flows due to
the bankruptcy
 These expected additional future costs will reduce the
value of the levered company today
 Higher leverage makes bankruptcy more likely and
increases therefore expected bankruptcy costs
 Risky companies have higher bankruptcy probabilities
and therefore higher bankruptcy costs.
 Companies with a lot of intangibles will tend to lose more
value during bankruptcy.
Michael Troege
 Leverage and company value

Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal debt-to-
equity ratio (D/E)
Debt Michael Troege
Debt-to-Value Ratio [D/(E + D)] for Select
Industries

Debt levels are

determined by book
values, and equity
by market values.
The average debt
financing for all
U.S. stocks was
about 36%, but
note the large
differences by
industry.

Source: Reuters, 2005 cited after De

Marzo andBerk

Michael Troege
Tradeoff theory
 Can the optimal capital structure really be determined
as a tradeoff between bankruptcy costs and tax
shields?
 According to this theory which type of companies
should have low or high leverage?

 What about the identity of the shareholders?

 What about the number and identity of creditors?

Michael Troege
 Applications

 Tax Driven Financial Innovation

 « junk bonds »
 Pay-in-Kind Securities (PIK's)
 ARCN: adjustable rate convertible notes
 Strip Financing
Tax Motivated Financial Innovation

 Idea: Accept high bankruptcy risk in order to be able

to benefit from tax shields
 « junk bonds »
 LBO’s

 Idea: Allow tax deductibility of payments but reduce

probability or cost of bankruptcy.
 Pay-in-Kind Securities (PIK's)
 ARCN: adjustable rate convertible notes
 Strip Financing

Michael Troege
 Tax Motivated Financial Innovation
 Junk Bonds: Have high interest rates and therefore high
tax shields. Enable even risky companies to extract tax
shields

 Pay-in-Kind Securities (PIK's): Give issuer option to pay

interest in cash or in additional securities valued at par.
Zero coupon bonds give the corporation interest
deductions without forcing it to part with internal cash-
flow. There is no danger of bankruptcy (but the danger of
dilution of existing shareholders)

Michael Troege
The Tale of the ARCN
 ARCN: adjustable rate convertible notes
 Designed by Goldman Sachs to meet the "letter of
the law" as in regulations written by Treasury in 1982.
 Short-term convertible bond.
 Generally worth converting if value of stock did not
fall by more than 40% prior to maturity.
 Interest payments on ARCN's mimicked the dividend
for the corporation.
 Junior to any other class of debt.
 Treasury issued ruling in 1983 classifying ARCN's as
equity.

Michael Troege
Preferred Redeemable Increased Dividend
Equity Security - PRIDES
 First introduced by Merrill Lynch, PRIDES are synthetic
securities issued by special purpose vehicles (SPVs)
 The SPV is situated in an offshore jurisdiction and
financed with equity.
 The SPV then lends money at a fixed, tax-deductible
interest rate to the company.
 In addition the SPV enters in a forward contract to
purchase at the maturity of the loan equity in the
company for a price equal to the loan’s face value.
 Similar to ARCNs, PRIDES allow for a series of tax
deductible payments but generate little bankruptcy risk
as there is no reimbursement of the debt’s face value

Michael Troege
Strip Financing
 Strip Financing: Debt securities are held in equal
proportions by all outside equity holders. That is, debt
strips are stapled to equity.
 This aligns the interests of debt and equity.
 Allows firms to exploit tax advantage of debt at a lower
cost in terms of agency conflicts.

Michael Troege
Exercises
Exercise: Firm Value and risky debt
 A joint venture is supposed to deliver a cash flow of
either 60 or 160 with probability 50% at the end of the
year. The company will then be dissolved without
bankruptcy costs. Cost of capital is 10%
 What is the value of the joint venture today?
 Suppose that the firm is financed with 60 in debt. What
interest rate should the bank ask for to get on average the
risk free return of 5% on the risky loan?
 What should be the cost of equity of the levered company
according to the MM theorems?
 Calculate the weighted average cost of capital for the
levered company.
 Evaluate the company’s assets by discounting free cash
flow at the weighted average cost of capital.
Michael Troege
Solution
 Value: 110/1,1=100,
 In the case of bankruptcy the bank gets 60 otherwise it
gets (1+interest)*60. The interest of 10% yields an
average return of 5%

Michael Troege
Exercise: Firm Value and risky debt (cont.)
 Suppose now that in the case of bankruptcy the bank has
to pay 10 in order to liquidate the joint venture and get
some money back. What interest rate does the bank have
to ask for to get on average the risk free return of 5%?
 What is the risk adjusted cost of debt for the company?
 Calculate the weighted average cost of capital for the
levered company including bankruptcy costs.
 Suppose the company is paying taxes of 30%. Which
capital structure is cheaper: 100% equity or 60% debt?

Michael Troege
Exercise: Firm Value and risky debt (cont.)
 Surprisingly, the local savings bank has agreed to provide
credit at a 7% interest rate.
 What is the risk adjusted cost of debt for the company?
 Calculate the weighted average cost of capital for the
levered company and use it to evaluate the company
 What is the market value of debt assuming a 5%
expected yield?
 What is the market value of equity?

Michael Troege
Quizz: Leverage
 In a perfect MM world with taxes, what is the effect of
an increase in leverage on
 cost of equity,
 cost of capital
 value of the company?

 In a perfect MM world with taxes and bankruptcy costs,

what is the effect of an increase in leverage on
 cost of equity,
 cost of capital
 value of the company?

Michael Troege
Appendix: Levering/Unlevering Betas with tax
shields
 Value of Levered Firm = Value of Unlevered Firm + Tax
Shields = Equity + Debt
 EVL = VU + D × TC = E + D
 Remember: portfolio beta is weighted average of the
betas of the assets in the portfolio
 Beta of levered firm’s assets:

E D
βA  βE L  βD
ED ED
E D
 L
βE L  L
βD
EV EV

Michael Troege
Appendix: Levering/Unlevering Betas
(Continued)
 Alternatively: beta of levered firm’s assets using beta of
Unlevered Firm and beta of Tax Shields
VU tC D
βA  βE L  βD
VU  tC D VU  tC D
VU tC D
 βE L  βD
VL VL
 Combining the two expressions for βA:

E D VU tC D
βE L  βD  βE L  βD
VL VL VL VL

Michael Troege
Appendix: Levering/Unlevering Betas
(Continued)
 Multiply both sides by VL and replace VU with E + D –
tC D :

Eβ EL  Dβ D   E  D  tC D  β EU  tC Dβ D

 Deduct DβD from both sides and then divide by E:

D
β EL  β EU  1  tC  ( β EU  βD )
E
 Rearrange for βEU to obtain formula to un-lever beta:
D
 EL  1  tC    D
 EU  E
D
1  1  t C 
E Michael Troege
Limited Liability and the Option Theory
of Capital Structure

 Limited Liability
 Historic Evolution
 Veil piercing
 Debt and Equity as options

 Applications
Limited Liability
 Limited Liability implies that an investor in equity cannot
lose more than he has invested, even if he has wealth
outside the business.
 This is different from “de facto” limited liability which
arises because the shareholder has no additional
wealth
 Not a straightforward concept:
 Middle age in Europe: debtor’s prison
 Early limited liability concepts:
 Roman and early Islamic law: Have a slave running a
business
 17th century, joint stock charters with limited liability were
awarded as privilege to special companies such as the
East India Company. Michael Troege
Limited Liability
 General limited liability statues:
 French société commandite 1671
 Limited partnership statutes in different US states, first
enacted by New York in 1822
 UK: Limited liability act in 1855
 Limitations to limited liability:
 Veil piercing
 Action en comblement du passif

Michael Troege
 Debt, Equity and Enterprise Value with Limited
Liability
 Value as a function of asset value at the maturity of the
debt with face value FVD
Market Value
of Equity

Market Value of
Debt at Maturity

FVD = Face
Value of
Debt

D
Asset / Enterprise
Value
Without Limited
Liability value
becomes negative Michael Troege
Debt, Equity and Enterprise Value with Limited
Liability
 The value of equity is max(Assets-FVD, 0)
 The value of debt is min(Assets, FVD)
 Equity can be understood as a Call option on the
company’s assets with a strike price equal to the face
value of debt FVD
 Risky debt can be understood as a risk free asset with a
current value of PV(FVD) together with a short position
in a put option on the company’s assets with a strike
price equal to the face value of debt FVD.
 This is useful to
 Understand qualitatively how risk affects debt and equity
values
 Quantify the value of equity and debt in highly levered
companies Michael Troege
Limited Liability, Risk and Value of Debt and
Equity
 Limited liability and the option feature of capital
structure has direct implications:
 Debt value = Value of risk free debt – put
 This decreases with an increase in risk

 Equity value = value of call

 This increases with risk

 Hence shareholders will generally have incentives to

increase the risk of assets.

Michael Troege
Simple Example: Risk and Shareholder Value
 Farine SA today has a value of 100
 With a more aggressive corporate strategy the company
could achieve 50 or 150 (with prob. 50%) depending on
whether an important contract will be signed
 The company is financed with long term loans having a
face value of 70
 Determine for both strategies:
 Today ’s company value
 The value of equity
 The value of debt

Michael Troege
Risk and Shareholder Value
 Increasing the risk by keeping the expected company
value constant will increase shareholder value
 They gain from the upside
 No increased losses on the downside.
 On average their payoff will increase
 This increase in shareholder value comes from a
decrease in the value of debt due to the increase of
default risk.

Michael Troege
 Using the Black and Scholes formula to price
Debt, Equity with Limited Liability
 Value as a function of asset value

Market Value
of Equity

Market Value of
Debt before Maturity

Face Value
of Debt

Asset / Enterprise
Value
Without Limited
Liability value
becomes negative Michael Troege
The Put-Call equality for the firm’s capital
structure

 The following two strategies yield the same result:

 Owning the firm’s asset and a put with strike of FVD
 Owing a risk free bond and a call on the firm’s assets with
strike D.
 Therefore these strategies must have the same price:
Assets+ Put = PV(FVD) + Call
Assets = PV(FVD) - Put + Call

EV = D + E
 Reminder:
 the Call is equivalent to the firm’s equity
 Debt is equivalent to the the risk free bond and a short
position in the Put = PV(FVD) – Put = Assets - CallMichael Troege
The Black and Scholes formula
 The Black and Scholes model values European
options on non dividend paying stock.
 The value of a call option in the Black-Scholes model
can be written as a function of the following variables:
S = Current value of the underlying assets = EV
K = Strike price of the option = FVD
t = Life to expiration of the option
r = Riskless interest rate corresponding to the life of the option
2 = Volatility of the underlying asset

Michael Troege
The Black Scholes Model

 Value of Call

C= S N(d1) – K e- r t N(d²)

where, N is the cumulative Normal Distribution and

 
S  2
ln   + (r + )t
 K 2 d 2 = d1   t
d1 =
 t
Michael Troege
Application to valuation: A simple example
 Assume that you have a firm whose assets are currently
valued at $100 million and that the standard deviation in
this asset value is 40%.
 The face value of debt is $80 million (It is zero coupon
debt with 10 years left to maturity).
 The ten-year treasury bond rate is 10%,
 Questions:
 What is the value of the equity?
 What should the interest rate on debt be?

Michael Troege
Source: Damodaran
Model Parameters
 Value of the underlying asset = S = Value of the firm
= $ 100 million
 Exercise price = K = Face Value of outstanding debt
= $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10
years
 Volatility = Standard deviation in firm value = 0.4
 Riskless rate = r = Treasury bond rate corresponding
to option life = 10%

Michael Troege
Valuing Equity as a Call Option
 Based upon these inputs, the Black-Scholes model
provides the following value for the call:
d1 = 1.5994 N(d1) = 0.9451
d2 = 0.3345 N(d2) = 0.6310
 Value of the equity= call = 100 (0.9451) - 80 exp(-0.10)
(10) (0.6310) = $75.94 million
 Market value of the outstanding debt = $100 - $75.94 =
$24.06 million
 Appropriate interest rate on debt = ($ 80 / $24.06)^1/10
-1 = 12.77%

Michael Troege
The Effect of Catastrophic Drops in Value
 Assume now that a catastrophe wipes out half the value
of this firm (the value drops to $ 50 million), while the
face value of the debt remains at $ 80 million. What will
happen to the equity value of this firm?

 Possible answers:
 It will be worth nothing since the face value of debt
outstanding > Firm Value
 It will drop in value to $ 25.94 million [ $ 50 million -
market value of debt from previous page]
 It will be worth more than $ 25.94 million

Michael Troege
Valuing Equity in the Troubled Firm
 Value of the underlying asset = S = Value of the firm = $
50 million
 Exercise price = K = Face Value of outstanding debt = $
80 million
 Life of the option = t = Life of zero-coupon debt = 10
years
 Volatility = 0.4
 Riskless rate = r = Treasury bond rate corresponding to
option life = 10%

Michael Troege
The Value of Equity as an Option
 Based upon these inputs, the Black-Scholes model
provides the following value for the call:
d1 = 1.0515 N(d1) = 0.8534
d2 = -0.2135 N(d2) = 0.4155
 Value of the call = 50 (0.8534) - 80 exp(-0.10)(10)
(0.4155) = $30.44 million
 Value of the bond= $50 - $30.44 = $19.56 million
 When the value of the Assets drops by 50m, the equity
value only drops by $75.94 - $30.44 = $35,5m because
of the option characteristics of equity. The difference is
absorbed by a decrease in the value of debt
 This explains why often stock in firms, which are
essentially bankrupt, still have value.
Michael Troege
Options and Capital Structure: Implications
 Equity can have positive value (option value) even if the
current value of assets is lower than the value of debt
 The value of debt can be lower than face value even if
today assets have a higher value than debt
 The sum of both must still be the value of the assets:
value preservation!
 An increase in volatility of asset values will increase the
value of equity!

This can be seen from the Black Scholes formula but is
also directly intuitive:
 Higher risk will increase upside for shareholders but not
decrease downside which is capped by limited liability
 Higher risk will decrease debt values, therefore it must
increase equity values (value preservation!) Michael Troege
Some words on real option valuation
 Option theory is also used in a different context, to
evaluate strategic options and estimate the value of
flexibility
 Example 1 (starting option): A company buys a copper
mine with production costs of $3/lb. Current prices are at
$2.6/lb.
 Example 2 (waiting option): An investment is profitable at
current product prices, but may become unprofitable if
future prices go down. Should the company invest or
wait?

 Again the Black Scholes formula can be adapted to

these situations. In practice these tools are mostly used
for commodity investments. Michael Troege