Capital Structure: Trade-off

Theory
Session IV

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• MM’s proposition II assumes that increased
borrowings does not affect the interest rate
on firm’s debt.

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• Corporate tax laws favor debt financing over
equity financing.

3
• With corporate taxes, the value of the tax
shield is the value of a levered firm less value
of an unlevered firm.

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• The higher the corporate tax rate of a
business, the less debt the firm should have in
capital structure.
• Advantage of borrowing reduces, when
corporate tax rate & personal tax rate on
equity increases.

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 Costs and Benefits of Debt
• Benefits of Debt
- Tax Benefits
- Adds discipline to management
• Costs of Debt
- Bankruptcy Costs
- Agency Costs
- Loss of Future Flexibility

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 Tax Benefits of Debt
• When you borrow money, you are allowed to deduct interest
expenses from your income to arrive at taxable income. This
reduces your taxes.

• Other things being equal, the higher the tax rate, the more debt
the firm will have in its capital structure.

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 Debt adds discipline to
management
• Managers of a firm with no debt, and with high income and
cash flows each year, tend to become complacent. The
complacency can lead to inefficiency and investing in poor
projects. There is little or no cost borne by the managers
• Forcing such a firm to borrow money can be an antidote to the
complacency. The managers now have to ensure that the
investments they make will earn at least enough return to cover
the interest expenses. The cost of not doing so is bankruptcy
and the loss of such a job.

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 The cost of going bankrupt
Arises
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when a firm is not able to meet its obligations to debt-
holders.
• Direct costs: Legal Costs

• Indirect costs: Costs arising because people perceive firm to be

in financial trouble. These costs relate to the actions of
employees, customers, suppliers and shareholders.

Other things being equal, the greater the bankruptcy cost, the less
debt the firm can afford to use for any given level of debt.

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 Agency Costs

• The costs of managers not behaving in the best interests of

shareholders
• there may exist a conflict of interest among shareholders and
debt holders

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 Loss of future financing flexibility
• When a firm borrows up to its capacity, it loses the flexibility
of financing future projects with debt.
• Other things remaining equal, the more uncertain a firm is
about its future financing requirements and projects, the less
debt the firm will use for financing current projects.

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 Debt Ratios and Fundamentals
Marginal Tax Rate
Separation of ownership and
management
Variability of operating cash flows
Debt holders difficulty in monitoring
firm action
Need for flexibility
Cost and Benefit of Debt: Trade Off Theory
As marginal tax rate increases, debt
ratio increases
The greater the separation the higher
the debt ratio
As operating cash flows become
more variable, the bankruptcy risk
increases resulting in lower debt
ratios
the lower the debt ratio
The greater the need, the lower the
debt ratios
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 Trade-off Theory
• MM theory ignores bankruptcy (financial distress) costs, which
increases as more leverage is used.
Trade-off theory states that capital structure is based on a trade-off
between tax savings and distress costs of debt.
• Trade-off theory: costs and benefits of leverage.
• 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.

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• The possibility of bankruptcy is not a linear function of the
debt-to-equity ratio but rather increases at an increasing rate
beyond some threshold.
• As a result, expected cost of bankruptcy have a negative
effect on the value of firm.
• The Ko of a firm would decline as financial leverage was first
employed because of the net tax advantage of debt.
Gradually, the prospects of bankruptcy would become
increasingly important, causing ko to decrease at a decreasing
rate as financial leverage increased. As financial leverage
became extreme, the bankruptcy effect might more than
offset the tax effect, causing Ko of the firm to rise.
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L’Etoile du Nord Resorts is considering various levels of debt. At present it has
no debt, and a total market value of Rs 15 million. By undertaking financial
leverage, it believes that it can achieve a “net” corporate plus personal tax
advantage (a positive present value of tax-shield benefits) equal to 20 percent of
the market value of the debt. However, the company is concerned with
bankruptcy and agency cost as well as with lenders increasing their required rate
interest rate if the firm borrows too much. The company believes that it can
borrow up to Rs 5 million without incurring any of these additional costs.
However, each additional Rs 5 million increment in borrowing is expected to
result in these three costs being incurred. Moreover, these costs are expected to
increase at an increasing rate with financial leverage. The present value cost is
expected to be the following for various levels of debt:
 
Debt (in millions) Rs 5 Rs 10 Rs 15 Rs 20 Rs 25 Rs 30

Present value cost of Bankruptcy, 0 0.6 1.2 2 3.2 5

Agency, and increased interest rate (in millions)
 
Is there an optimal amount of debt for the company? If so, what is it?
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 2. Rebecca Isbell Optical Corporation is trying to determine an appropriate capital structure.
It knows that, as its financial leverage increases, its cost of borrowing will eventually
increase as will the required return on its stock. The company has made the following
estimates for various financial leverage ratios.

Debt divided Interest rate Required rate of return on

by on equity
(Debt+Equity) Borrowings Without With
(%) Bankruptcy Bankruptcy
costs (%) Costs (%)
0 - 10.0 10.0
0.10 8.0 10.5 10.5
0.20 8.0 11.0 11.25
0.30 8.5 11.5 12.0
0.40 9.0 12.25 13.0
0.50 10.0 13.25 14.5
0.60 11.0 14.5 16.25
0.70 12.5 16.0 18.5
0.80 15.0 18.0 21.0

a) At a tax rate of 50 percent, what is the weighted average cost of capital of the
company at various leverage ratios in the absence of bankruptcy costs?
With bankruptcy costs, what is the optimal capital structure?
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 Pecking Order Theory
•19 The “pecking order” theory is based on the assertion that
managers have more information about their firms than investors.
This disparity of information is referred to as asymmetric
information.
• The manner in which managers raise capital gives a signal of their
belief in their firm’s prospects to investors.
• Firms follow a specific financing order:
– First use internal funds.
– Then, issue new debt.
– Finally, and only as a last resort, issue new common stock.

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 Life Cycle Stages
• Start-up Stage: High operating risk, low sales and profitability
• Expansion Stage: High/moderate operating risk
• Growth Stage: Low/moderate operating risk, sales acceleration
and high profitability – Is it sufficient??
• Maturity Stage: Low/moderate operating risk, sharp growth in
sales and profitability
• Decline Stage: High operating risk, sales decline

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Life Cycle-Stages

Industry Analysis 21
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