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The Capital Structure Decision

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Topics Covered

Debt and Value in a Tax Free Economy

Capital Structure and Corporate Taxes
Cost of Financial Distress
Explaining Financial Choices

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 15- 3

Value and Capital Structure

Assets Liabilities and Stockholder’s Equity

Value of cash flows from

Market value of debt
firm’s real assets and
operations Market value of equity

Value of Firm Value of Firm

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Average Book Debt Ratios

Industry Debt Ratio
Software and programming 0.07
Semiconductors 0.14
Business services 0.22
Biotech 0.28
Major drugs 0.36
Retail 0.37
Average 0.53
Airlines 0.59
Real estate operations 0.60
Food processing 0.62
Hotels and motels 0.63
Utilities 0.65
Forestry and wood products 0.67

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 15- 5

M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller

When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.

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M&M (Debt Policy Doesn’t Matter)

Assumptions
 By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
 Investors do not need choice, OR
 There are sufficient alternative securities
 Capital structure does not affect cash flows e.g...
No taxes
No bankruptcy costs
No effect on management incentives

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M&M (Debt Policy Doesn’t Matter)

Example - River Cruises - All Equity Financed
Data
Number of shares 100,000
Price per share $10
Market Value of Shares $ 1 million

Outcome State of the Economy

Slump Expected Boom
Operating Income $75,000 125,000 175,000
Earnings per share $.75 1.25 1.75
Return on shares 7.5% 12.5% 17.5%
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M&M (Debt Policy Doesn’t Matter)

Example Data
cont.
50% debt
Number of shares 50,000
Price per share $10
Market Value of Shares $ 500,000
Market value of debt $ 500,000

Outcome State of the Economy

Slump Expected Boom
Operating Income $75,000 125,000 175,000
Interest $50,000 50,000 50,000
Equity earnings $25,000 75,000 125,000
Earnings per share $.50 1.50 2.50
Return on shares 5% 15% 25%
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M&M (Debt Policy Doesn’t Matter)

Example - River Cruises - All Equity Financed
- Debt replicated by investors

Outcome State of the Economy

Slump Expected Boom
Earnings on two shares $1.50 2.50 3.50
LESS : Interest @ 10% $1.00 1.00 1.00
Net earnings on investment $.50 1.50 2.50
Return on $10 investment 5% 15% 25%

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Cost of Capital

D
requity  rassets  (rassets  rdebt )
E

 D   E 
WACC  (1  Tc )rdebt    requity  
DE DE

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Weighted Average Cost of Capital

rE

rA
rD
D
V
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 Weighted Average Cost of Capital
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without taxes (M&M view)

r
rE

WACC

rD
D
Includes Bankruptcy Risk V
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Weighted Average Cost of Capital

r
rE

WACC

rD
D
V
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C.S. & Corporate 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.

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 15- 15

C.S. & Corporate Taxes

Example - You own all the equity of Space Babies

Diaper Co.. The company has no debt. The
company’s annual cash flow is $1,000, before
interest and taxes. The corporate tax rate is 40%.
You have the option to exchange 1/2 of your equity
position for 10% bonds with a face value of $1,000.

Should you do this and why?

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C.S. & Corporate Taxes

Example - You own all the equity of Space Babies Diaper Co.. The company
has no debt. The company’s annual cash flow is $1,000, before interest
and taxes. The corporate tax rate is 40%. You have the option to
exchange 1/2 of your equity position for 10% bonds with a face value of
$1,000.
Should you do this and why?

All Equity 1/2 Debt

EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
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C.S. & Corporate Taxes

Example - You own all the equity of Space Babies Diaper Co.. The company
has no debt. The company’s annual cash flow is $1,000, before interest
and taxes. The corporate tax rate is 40%. You have the option to
exchange 1/2 of your equity position for 10% bonds with a face value of
$1,000.
Should you do this and why?

All Equity 1/2 Debt

EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
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Capital Structure
PV of Tax Shield =
D x rD x Tc
(assume perpetuity) = D x Tc
rD

Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400

PV Tax Shield = D x Tc = 1000 x .4 = $400

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Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield

Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400

Firm Value with 1/2 Debt = $6,400

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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

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Financial Distress
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 amount
of debt
Debt
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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.

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