Capital Structure Theory and Applications

WEEK 12
MBAF 605: CORPORATE FINANCE

•INSTRUCTORS:
Dr. James Ntiamoah Doku,
Dr. Isaac Boadi,
Dr. Maryam Kriese &
Dr. Baah Boamah
Service Excellence
Capital Structure: Theory and
Applications
WEEK 12
Service Excellence
LEARNING OUTCOME
At the end of this segment, students should be able to:
•Understand Capital Structure Decisions in the light of:

– Proposition I without Taxes: Capital Structure Irrelevance
– Proposition II without taxes: Higher Financial Leverage and Cost of Equity
– Propositions I & II with Taxes: Taxes, Cost of capital and Value of Firm
•Understand the Theories of capital structure
•Determine optimal capital structure in practice
Service Excellence
Capital Structure: Theory and
Applications
4
 Capital Structure
 The relative proportions of debt, equity, and other
securities that a firm has outstanding
4
Financing a Firm with Equity
 You are considering an investment opportunity.
 For an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely.
5
Table 14.1 The Project Cash Flows
Financing a Firm with Equity (cont'd)
 The project cash flows depend on the overall economy
and thus contain market risk. As a result, you demand
a 10% risk premium over the current risk-free interest
rate of 5% to invest in this project.
 What is the NPV of this investment opportunity?
7
 The cost of capital for this project is 15%. The
expected cash flow in one year is
 ½($1400) + ½($900) = $1150.
 The NPV of the project is

$1150
NPV  $800   $800  $1000  $200.
1.15
8
 If you finance this project using only equity, how much
would you be willing to pay for the project?
$1150
PV (equity cash flows)   $1000
1.15
 If you can raise $1000 by selling equity in the firm, after
paying the investment cost of $800, you can keep the
remaining $200, the NPV of the project NPV, as a profit.
9
 Unlevered Equity
 Equity in a firm with no debt
 Because there is no debt, the cash flows of the

unlevered equity are equal to those of the project.
10
Table 14.2 Cash Flows and Returns for
Unlevered Equity
 Shareholder’s returns are either 40% or
–10%.
 The expected return on the unlevered equity is
 ½ (40%) + ½(–10%) = 15%.
 Because the cost of capital of the project is 15%,
shareholders are earning an appropriate return for the risk
they are taking.
12
Financing a Firm with Debt and Equity
 Suppose you decide to borrow $500 initially, in
addition to selling equity.
 Because the project’s cash flow will always be enough to
repay the debt, the debt is risk free, and you can borrow at
the risk-free interest rate of 5%. You will owe the debt
holders
 $500 × 1.05 = $525 in one year.
 Levered Equity
 Equity in a firm that also has debt outstanding
13
Financing a Firm
with Debt and Equity (cont'd)
 Given the firm’s $525 debt obligation, your
shareholders will receive only $875 ($1400 – $525 =
$875) if the economy is strong and $375 ($900 – $525
= $375) if the economy is weak.
14
Table 14.3 Values and Cash Flows for Debt and
Equity of the Levered Firm
Financing a Firm
 What price E should the levered equity sell for?
 Which is the best capital structure choice for the
entrepreneur?
16
Financing a Firm
 Modigliani and Miller argued that with perfect capital
markets, the total value of a firm should not depend
on its capital structure.
 They reasoned that the firm’s total cash flows still equal the
cash flows of the project and, therefore, have the same
present value.
17
Financing a Firm
 Because the cash flows of the debt and equity sum to
the cash flows of the project, by the Law of One Price
the combined values of debt and equity must be
$1000.
 Therefore, if the value of the debt is $500, the value of the
levered equity must be $500.
E= $1000 – $500 = $500.
18
Financing a Firm
 Because the cash flows of levered equity
are smaller than those of unlevered equity, levered
equity will sell for a lower price ($500 versus $1000).
 However, you are not worse off. You will still raise a total of
$1000 by issuing both debt and levered equity.
Consequently, you would be indifferent between these two
choices for the firm’s capital structure.
19
The Effect of Leverage on Risk and
Return
 Leverage increases the risk of the equity of a firm.
 Therefore, it is inappropriate to discount the cash flows of
levered equity at the same discount rate of 15% that you
used for unlevered equity. Investors in levered equity will
require a higher expected return to compensate for the
increased risk.
20
Table 14.4 Returns to Equity with and
without Leverage
The Effect of Leverage
on Risk and Return (cont'd)
 The returns to equity holders are very different with
and without leverage.
 Unlevered equity has a return of either 40% or
–10%, for an expected return of 15%.
 Levered equity has higher risk, with a return of either 75% or
–25%.
 To compensate for this risk, levered equity holders receive
a higher expected return of 25%.
22
 The relationship between risk and return can be
evaluated more formally by computing the sensitivity
of each security’s return to the systematic risk of the
economy.
23
Table 14.5 Systematic Risk and Risk Premiums for
Debt, Unlevered Equity, and Levered Equity
 Because the debt’s return bears no systematic risk, its
risk premium is zero.
 In this particular case, the levered equity has twice the
systematic risk of the unlevered equity and, as a
result, has twice the risk premium.
25
 In summary,
 In the case of perfect capital markets, if the firm is 100%
equity financed, the equity holders will require a 15%
expected return.
 If the firm is financed 50% with debt and 50% with equity,
the debt holders will receive a return of 5%, while the
levered equity holders will require an expected return of
25% (because of their increased risk).
26
 In summary,
 Leverage increases the risk of equity even when there is no
risk that the firm will default.
 Thus, while debt may be cheaper, its use raises the cost of
capital for equity. Considering both sources of capital
together, the firm’s average cost of capital with leverage is
the same as for the unlevered firm.
27
Example 14.1
Example 14.1 (cont'd)
Alternative Example 14.1
 Problem
 Suppose the entrepreneur borrows $700 when financing the
project. According to Modigliani and Miller, what should the
value of the equity be? What is the expected return?
30
Alternative Example 14.1 (cont'd)
 Solution
 Because the value of the firm’s total cash flows is still $1000, if
the firm borrows $700, its equity will be worth $300. The firm
will owe $700 × 1.05 = $735 in one year. Thus, if the economy is
strong, equity holders will receive $1400 − 735 = $665, for a
return of $665/$300 − 1 = 121.67%. If the economy is weak,
equity holders will receive $900 − $735 = $, for a return of
$165/$300 − 1 = −45.0%. The equity has an expected return of
1 1
(121.67%)  ( 45.0%)  38.33%
2 2
31
 Solution
 Note that the equity has a return sensitivity of 121.67% −
(−45.0%) = 166.67%, which is 166.67%/50% = 333.34% of the
sensitivity of unlevered equity. Its risk premium is 38.33% −
5%= 33.33%, which is approximately 333.34% of the risk
premium of the unlevered equity, so it is appropriate
compensation for the risk.
32
14.2 Modigliani-Miller I: Leverage, Arbitrage, and
Firm Value
 The Law of One Price implies that leverage will not
affect the total value of the firm.
 Instead, it merely changes the allocation of cash flows
between debt and equity, without altering the total cash
flows of the firm.
33
Firm Value (cont'd)
 Modigliani and Miller (MM) showed that this result holds more
generally under a set of conditions referred to as perfect capital
markets:
 Investors and firms can trade the same set of securities at competitive
market prices equal to the present value of their future cash flows.
 There are no taxes, transaction costs, or issuance costs associated with
security trading.
 A firm’s financing decisions do not change the cash flows generated by
its investments, nor do they reveal new information about them.
34
Firm Value (cont'd)
 MM Proposition I
 In a perfect capital market, the total value of a firm is equal
to the market value of the total cash flows generated by its
assets and is not affected by its choice of capital structure.
35
MM and the Law of One Price
 MM established their result with the
following argument:
 In the absence of taxes or other transaction costs, the total
cash flow paid out to all of a firm’s security holders is equal
to the total cash flow generated by the firm’s assets.
 Therefore, by the Law of One Price, the firm’s securities
and its assets must have the same total market value.
36
Homemade Leverage
 Homemade Leverage
 When investors use leverage in their own portfolios to adjust
the leverage choice made by the firm.
 MM demonstrated that if investors would prefer an

alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own and
achieve the same result.
37
Homemade Leverage (cont'd)
 Assume you use no leverage and create an all-equity
firm.
 An investor who would prefer to hold levered equity can do
so by using leverage in his own portfolio.
38
Table 14.6 Replicating Levered Equity
Using Homemade Leverage
 If the cash flows of the unlevered equity serve as
collateral for the margin loan (at the risk-free rate of
5%), then by using homemade leverage, the investor
has replicated the payoffs to the levered equity, as
illustrated in the previous slide, for a cost of $500.
 By the Law of One Price, the value of levered equity must
also be $500.
40
 Now assume you use debt, but the investor would
prefer to hold unlevered equity. The investor can re-
create the payoffs of unlevered equity by buying both
the debt and the equity of the firm. Combining the
cash flows of the two securities produces cash flows
identical to unlevered equity, for a total cost of $1000.
41
Table 14.7 Replicating Unlevered Equity
by Holding Debt and Equity
 In each case, your choice of capital structure does not
affect the opportunities available to investors.
 Investors can alter the leverage choice of the firm to suit
their personal tastes either by adding more leverage or by
reducing leverage.
 With perfect capital markets, different choices of capital
structure offer no benefit to investors and does not affect
the value of the firm.
43
Example 14.2
 Problem
 Suppose there are two firms, each with date 1 cash flows of
$1400 or $900 (as shown in Table 14.1). The firms are
identical except for their capital structure. One firm is
unlevered, and its equity has a market value of $1010. The
other firm has borrowed $500, and its equity has a market
value of $500. Does MM Proposition I hold? What arbitrage
opportunity is available using homemade leverage?
46
 Solution
 MM Proposition I states that the total value of each firm
should equal the value of its assets. Because these firms
hold identical assets, their total values should be the same.
However, the problem assumes the unlevered firm has a
total market value of $1010, whereas the levered firm has a
total market value of $500 (equity) + $500 (debt) = $1000.
Therefore, these prices violate MM Proposition I.
47
 Solution
 Because these two identical firms are trading for different
total prices, the Law of One Price is violated and an arbitrage
opportunity exists. To exploit it, we can buy the equity of the
levered firm for $500, and the debt of the levered firm for
$500, re-creating the equity of the unlevered firm by using
homemade leverage for a cost of only $500 + $500 = $1000.
We can then sell the equity of the unlevered firm for $1010
and enjoy an arbitrage profit of $10.
48
Date 0 Date 1: Cash Flows
Cash Flow Strong Weak
Economy Economy
Buy levered -$500 $875 $375
equity
Buy levered -$500 $525 $525
debt
Sell unlevered $1,010 $1,400 -$900
equity
Total cash flow $10 $0 $0
Note that the actions of arbitrageurs buying the levered firm’s equity
and debt and selling the unlevered firm’s equity will cause the price of
the levered firm’s equity to rise and the price of the unlevered firm’s
equity to fall until the firms’ values are equal.
49
The Market Value Balance Sheet
 Market Value Balance Sheet
 A balance sheet where:
 Allassets and liabilities of the firm are included (even
intangible assets such as reputation, brand name, or
human capital that are missing from a standard accounting
balance sheet).
 Allvalues are current market values rather than
historical costs.
 The total value of all securities issued by the firm must equal
the total value of the firm’s assets.
50
Table 14.8 The Market Value Balance
Sheet of the Firm
(cont'd)
 Using the market value balance sheet, the value of
equity is computed as follows:
Market Value of Equity 
Market Value of Assets  Market Value of Debt and Other Liabilities
52
Example 14.3
 Problem
 Assume that the social media app you developed has gone
viral and you decided to sell the company, which has $60
million in assets.
 You plan on splitting the firm into equity, debt, and warrants,
and you expect to sell $10 million in debt and $15 million in
warrants.
 What will the value of the equity be in a perfect capital
market?
55
 Solution
 According to MM Proposition I, the total value of all
securities issued should equal the value of the assets, or $60
million.
 Given that the debt is worth $10 million and the warrants
are worth $15 million, the value of the equity must be $35
million.
56
Application: A Leveraged
Recapitalization
 Leveraged Recapitalization
 When a firm uses borrowed funds to pay a large special
dividend or repurchase a significant amount of outstanding
shares
57
Recapitalization (cont'd)
 Example:
 Harrison Industries is currently an all-equity firm operating in
a perfect capital market, with 50 million shares outstanding
that are trading for $4 per share.
 Harrison plans to increase its leverage by borrowing $80
million and using the funds to repurchase 20 million of its
outstanding shares.
58
 Example
 This transaction can be viewed in two stages.
 First, Harrison sells debt to raise $80 million in cash.
 Second, Harrison uses the cash to repurchase shares.
59
Table 14.9 Market Value Balance Sheet after Each Stage of
Harrison’s Leveraged Recapitalization ($ millions)
 Example
 Initially, Harrison is an all-equity firm and the market value of
Harrison’s equity is $200 million (50 million shares × $4 per
share = $200 million) and equals the market value of its
existing assets.
61
 Example
 After borrowing, Harrison’s liabilities grow by $80 million,
which is also equal to the amount of cash the firm has raised.
Because both assets and liabilities increase by the same
amount, the market value of the equity remains unchanged.
62
 Example
 To conduct the share repurchase, Harrison spends the $80
million in borrowed cash to repurchase 20 million shares
($80 million ÷ $4 per share = 20 million shares).
 Because the firm’s assets decrease by $80 million and its
debt remains unchanged, the market value of the equity
must also fall by $80 million, from $200 million to $120
million, for assets and liabilities to remain balanced.
63
 Example
 The share price is unchanged.
 With 30 million shares remaining, the shares are worth $4
per share, just as before ($120 million ÷ 30 million shares =
$4 per share).
64
14.3 Modigliani-Miller II: Leverage, Risk, and the
Cost of Capital
 Leverage and the Equity Cost of Capital
 MM’s first proposition can be used to derive an
explicit relationship between leverage and the equity cost of
capital.
65
Cost of Capital (cont'd)
 E
 Market value of equity in a levered firm
 D
 Market value of debt in a levered firm
 U
 Market value of equity in an unlevered firm
 A
 Market value of the firm’s assets
66
 MM Proposition I states that
E  D  U  A.
 The total market value of the firm’s securities is equal to the
market value of its assets, whether the firm is unlevered or
levered.
67
 The cash flows from holding unlevered equity can be
replicated using homemade leverage by holding a portfolio
of the firm’s equity and debt.
68
 The return on unlevered equity (RU) is related to the returns
of levered equity (RE) and debt (RD):
E D
RE  RD  RU
E  D E  D
69
 Solving for RE:
D
RE  RU  ( RU  RD )

Risk without E     
leverage Additional risk
due to leverage
 The levered equity return equals the unlevered return, plus

a premium due to leverage.
 The amount of the premium depends on the amount of leverage,
measured by the firm’s market value debt-equity ratio, D/E.
70
 MM Proposition II:
 The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is
proportional to the market value debt-equity ratio.
 Cost of Capital of Levered Equity
D
rE  rU  (rU  rD )
E
71
 Recall from above:
 If the
firm is all-equity financed, the expected return on
unlevered equity is 15%.
 If thefirm is financed with $500 of debt, the expected
return of the debt is 5%.
72
 Therefore, according to MM Proposition II, the expected
return on equity for the levered firm is
500
rE  15%  (15%  5%)  25%
500
73
Example 14.4
 Problem
 Suppose the entrepreneur in Alternative Example 14.1
borrows only $700 when financing the project.
 Recall that the expected return on unlevered equity is 15%
and the risk-free rate is 5%.
 According to MM Proposition II, what will be the firm’s
equity cost of capital?
76
Alternative Example 14.4 (cont’d)
 Solution
 Because the firm’s assets have a market value of $1000, by
MM Proposition I the equity will have a market value of
$300. Then, using Eq. 14.5,
$700
rE  15%  15%  5%   38.33%
$300
 This result matches the expected return calculated in
Example 14.1.
77
Capital Budgeting and the
Weighted Average Cost of Capital
 If a firm is unlevered, all of the free cash
flows generated by its assets are paid out to its equity
holders.
 The market value, risk, and cost of capital for the firm’s
assets and its equity coincide and therefore
rU  rA
78
Capital Budgeting and the Weighted Average Cost
of Capital (cont'd)
 If a firm is levered, project rA is equal to the firm’s
weighted average cost of capital.
 Unlevered Cost of Capital (pretax WACC)
 Fraction of Firm Value   Equity   Fraction of Firm Value   Debt 

rwacc          
 Financed by Equity   Cost of Capital   Financed by Debt   Cost of Capital 
E D
 rE  rD
E  D E  D
rwacc  rU  rA
79
of Capital (cont'd)
 With perfect capital markets, a firm’s WACC is
independent of its capital structure and is equal to its
equity cost of capital if it is unlevered, which matches
the cost of capital of its assets.
 Debt-to-Value Ratio
 The fraction of a firm’s enterprise value that corresponds to
debt
80
Figure 14.1
WACC and
Leverage
with Perfect
Capital Markets
(a) Equity, debt, and weighted

average costs of capital for
different amounts of leverage.
The rate of increase of rD and
rE, and thus the shape of the
curves, depends on the
characteristics of the firm’s
cash flows.
(b) Calculating the WACC for
alternative capital structures.
Data in this table correspond
to the example in Section
14.1.
81
of Capital (cont'd)
 With no debt, the WACC is equal to the unlevered
equity cost of capital.
 As the firm borrows at the low cost of capital for debt,
its equity cost of capital rises. The net effect is that the
firm’s WACC is unchanged.
82
Example 14.5
 Problem
 Honeywell International Inc. (HON) has a market debt-equity
ratio of 0.5.
 Assume its current debt cost of capital is 6.5%, and its equity
cost of capital is 14%.
 If HON issues equity and uses the proceeds to repay its debt
and reduce its debt-equity ratio to 0.4, it will lower its debt
cost of capital to 5.75%.
85
 Problem
 With perfect capital markets, what effect will this transaction
have on HON’s equity cost of capital and WACC?
86
 Solution
 Current WACC
E D 2 1
rwacc  rE  rD  14%  6.5%  11.5%
ED ED 2 1 2 1
 New Cost of Equity
D
rE  rU  (rU  rD )  11.5%  0.4(11.5%  5.75%)  13.8%
E
87
 Solution
 New WACC
1 0.4
rNEWwacc  13.8%  5.75%  11.5%
1  0.4 1  0.4
 The cost of equity capital falls from 14% to 13.8%, while the
WACC is unchanged.
88
Computing the WACC
with Multiple Securities
 If the firm’s capital structure is made up of multiple
securities, then the WACC is calculated by computing
the weighted average cost of capital of all of the firm’s
securities.
89
Example 14.6
90
Levered and Unlevered Betas
 The effect of leverage on the risk of a firm’s securities
can also be expressed in terms of beta:
E D
U  E  D
E  D E  D
92
Levered and Unlevered Betas (cont'd)
 Unlevered Beta
 A measure of the risk of a firm as if it did not
have leverage, which is equivalent to the beta of the firm’s
assets.
 If you are trying to estimate the unlevered beta for an

investment project, you should base your estimate on
the unlevered betas of firms with comparable
investments.
93
Levered and Unlevered Betas (cont'd)
D
 E  U  ( U   D )
E
 Leverage amplifies the market risk of a firm’s assets,

βU, raising the market risk of its equity.
94
Example 14.7
Example 14.7 (cont’d)
Example 14.8
Example 14.8 (cont’d)
14.4 Capital Structure Fallacies
 Leverage and Earnings per Share
 Example
 LVI is currentlyan all-equity firm. It expects to generate
earnings before interest and taxes (EBIT) of $10 million
over the next year. Currently, LVI has 10 million shares
outstanding, and its stock is trading for a price of $7.50 per
share. LVI is considering changing its capital structure by
borrowing $15 million at an interest rate of 8% and using
the proceeds to repurchase 2 million shares at $7.50 per
share.
99
14.4 Capital Structure Fallacies (cont'd)
 Example
 Suppose LVI has no debt. Because there is no interest and
no taxes, LVI’s earnings would equal its EBIT and LVI’s
earnings per share without leverage would be
Earnings $10 million
EPS    $1
Number of Shares 10 million
100
 Example
 If LVI recapitalizes,
the new debt will obligate LVI to make
interest payments each year of $1.2 million/year.
 $15 million × 8% = $1.2 million
 As a result, LVI will have expected earnings after interest of
$8.8 million.
 Earnings = EBIT – Interest
 Earnings = $10 million – $1.2 million = $8.8 million
101
 Example
 Earnings per share rises to $1.10
 $8.8 million ÷ $8 million shares = $1.10
 LVI’s expected earnings per share increases with leverage.
102
 Example
 Are shareholders better off?
 NO! Although LVI’s expected EPS rises with leverage, the risk of its
EPS also increases. While EPS increases on average, this increase
is necessary to compensate shareholders for the additional risk
they are taking, so LVI’s share price does not increase as a result
of the transaction.
103
Figure 14.2 LVI Earnings per Share
with and without Leverage
104
Example 14.9
Equity Issuances and Dilution
 Dilution
 An increase in the total of shares that will divide a fixed
amount of earnings
 It is sometimes (incorrectly) argued that issuing equity

will dilute existing shareholders’ ownership, so debt
financing should be used instead.
107
Equity Issuances and Dilution (cont'd)
 Suppose Jet Sky Airlines (JSA) currently has no debt
and 500 million shares of stock outstanding, which is
currently trading at a price of $16.
 Last month the firm announced that it would expand
and the expansion will require the purchase of $1
billion of new planes, which will be financed by issuing
new equity.
108
 The current (prior to the issue) value of the the equity
and the assets of the firm is $8 billion.
 500 million shares × $16 per share = $8 billion
 Suppose JSA sells 62.5 million new shares

at the current price of $16 per share to raise the
additional $1 billion needed to purchase the planes.
109
110
 Results
 The market value of JSA’s assets grows because of the
additional $1 billion in cash the firm has raised.
 The number of shares increases.
 Although the number of shares has grown to 562.5 million,
the value per share is unchanged at $16 per share.
111
 As long as the firm sells the new shares of
equity at a fair price, there will be no gain or loss to
shareholders associated with the equity issue itself.
 Any gain or loss associated with the transaction will
result from the NPV of the investments the firm makes
with the funds raised.
112
14.5 MM: Beyond the Propositions
 Conservation of Value Principle for
Financial Markets
 With perfect capital markets, financial transactions neither
add nor destroy value, but instead represent a repackaging
of risk (and therefore return).
 This implies that any financial transaction that appears to
be a good deal may be exploiting some type of market
imperfection.
113
The Interest Tax Deduction
 Corporations pay taxes on their profits after interest
payments are deducted. Thus, interest expense
reduces the amount of corporate taxes. This creates
an incentive to use debt.
114
15.1 The Interest Tax Deduction (cont'd)
 Consider Macy’s which had earnings before interest
and taxes of approximately $2.8 billion in 2014 and
interest expenses of about $400 million. Macy’s
marginal corporate tax rate was 35%.
 As shown on the next slide, Macy’s net income in 2014
was lower with leverage than it would have been
without leverage.
115
Table 15.1 Macy’s Income with and
without Leverage, 2014 ($ millions)
116
 Macy’s debt obligations reduced the value of its
equity. But the total amount available to all investors
was higher with leverage.
117
 Without leverage, Macy’s was able to pay out $1820
million in total to its investors.
 With leverage, Macy’s was able to pay out $1960
million in total to its investors.
 Where does the additional $140 million
come from?
118
 Interest Tax Shield
 The reduction in taxes paid due to the tax deductibility of
interest
Interest Tax Shield  Corporate Tax Rate  Interest Payments
 InMacy’s case, the gain is equal to the reduction in taxes

with leverage: $980 million − $840 million = $140 million.
The interest payments provided a tax savings of 35% ×
$400 million = $140 million.
119
Example 15.1
 Problem
 For the most recent fiscal year, Texasfield had $5.35 million
in interest expense.
 If the firm’s marginal tax rate is 40%, what is the value of
the interest tax shield for Texasfield in the most recent
fiscal year?
122
 Solution
 The interest tax shield for the most recent fiscal year is
 $5.35 million × 40% = $2.14 million
15.2 Valuing the Interest Tax Shield
 When a firm uses debt, the interest tax shield provides
a corporate tax benefit each year.
 This benefit is the computed as the present value of
the stream of future interest tax shields the firm will
receive.
124
The Interest Tax Shield and Firm Value
 The cash flows a levered firm pays to investors will

be higher than they would be without leverage by
the amount of the interest tax shield.
 Cash Flows to Investors   Cash Flows to Investors 

      (Interest Tax Shield)
 with Leverage   without Leverage 
125
Figure 15.1 The Cash Flows of the
Unlevered and Levered Firm
The Interest Tax Shield
and Firm Value (cont'd)
 MM Proposition I with Taxes
 The total value of the levered firm exceeds the value of the
firm without leverage due to the present value of the tax
savings from debt.
L U
V  V  PV (Interest Tax Shield)
127
Example 15.2
128
 Problem
 Suppose ALCO plans to pay $60 million in interest each year
for the next eight years, and then repay the principal of $1
billion in year 8.
 These payments are risk free, and ALCO’s marginal tax rate
will remain 39% throughout this period.
 If the risk-free interest rate is 6%, by how much does the
interest tax shield increase the value of ALCO?
130
 Solution
 The annual interest tax shield is
 $1 billion × 6% × 39% = $23.4 million for eight years.
1 1
PV (Interest Tax Shield)  $23.4 million  (1  8
)
6% 1.06
 $145.31 million
with Permanent Debt
 Typically, the level of future interest payments is
uncertain due to changes in the marginal tax rate, the
amount of debt outstanding, the interest rate on that
debt, and the risk of the firm.
 For simplicity, we will consider the special case in which the
above variables are kept constant.
with Permanent Debt (cont'd)
 Suppose a firm borrows debt D and keeps the debt
permanently. If the firm’s marginal tax rate is c , and if
the debt is riskless with a risk-free interest rate rf , then
the interest tax shield each year is c × rf × D, and the
tax shield can be valued as a perpetuity.
 c  Interest  c  (rf  D)
PV (Interest Tax Shield)  
rf rf
 c  D
133
 If the debt is fairly priced, no arbitrage implies that its
market value must equal the present value of the future
interest payments.
Market Value of Debt  D  PV (Future Interest Payments)
134
 If the firm’s marginal tax rate is constant, then
PV (Interest Tax Shield)  PV ( c  Future Interest Payments)

  c  PV (Future Interest Payments)
 c  D
135
The Weighted Average Cost
of Capital with Taxes
 With tax-deductible interest, the effective after-tax
borrowing rate is r(1 − c) and the weighted average
cost of capital becomes
E D
rwacc  rE  rD (1   c )
E  D E  D
E D D
rwacc  rE  rD  rD c
E   D    E  D
 E   D 
Pretax WACC Reduction Due
to Interest Tax Shield
136
Figure 15.2 The WACC with and
without Corporate Taxes
137
with a Target Debt-Equity Ratio
 When a firm adjusts its leverage to maintain a target
debt-equity ratio, we can compute its value with
leverage, VL, by discounting its free cash flow using the
138
The Interest Tax Shield with a Target Debt-Equity
Ratio (cont'd)
 The value of the interest tax shield can be found by
comparing the value of the levered firm, VL, to the
unlevered value, VU, of the free cash flow discounted
at the firm’s unlevered cost of capital, the pretax
WACC.
139
Example 15.3
 Problem
 Harris Solutions expects to have free cash flow in the coming
year of $1.75 million, and its free cash flow is expected to
grow at a rate of 3.5% per year thereafter.
 Harris Solutions has an equity cost of capital of 12% and a
debt cost of capital of 7%, and it pays a corporate tax rate of
40%. If Harris Solutions maintains a debt-equity ratio of 2.5,
what is the value of its interest tax shield?
142
 Solution
 We can estimate the value of Harris Solution’s interest tax
shield by comparing its value with and without leverage. We
compute its unlevered value by discounting its free cash flow
at its pretax WACC:
E D
Pretax WACC = rE  rD
ED ED
 1   2.5 
 12%    7%  8.43%
 1  2.5   1  2.5 
143
 Solution
 Because Harris Solution’s free cash flow is expected to grow
at a constant rate, we can value it as a constant growth
perpetuity:
U $1.75 million
V   $35.50 million
8.43%  3.50%
144
 Solution
 To compute Harris Solution’s levered value, we calculate its
WACC:
E D
WACC = rE  rD (1   C )
ED ED
 1   2.5 
 12%    7%(1  .40)  6.43%
 1  2.5   1  2.5 
145
 Solution
 Thus, Harris Solution’s value including the interest tax shield
is
L $1.75 million
V   $59.73 million
6.43%  3.50%
The value of the interest tax shield is therefore:
PV(Interest Tax Shield) = VL - VU = $59.73 - $35.50 = $24.23
million
146
15.3 Recapitalizing to Capture
the Tax Shield
 Assume that Midco Industries wants to boost its stock
price. The company currently has 20 million shares
outstanding with a market price of $15 per share and
no debt. Midco has had consistently stable earnings
and pays a 35% tax rate. Management plans to borrow
$100 million on a permanent basis, and they will use
the borrowed funds to repurchase outstanding shares.
147
The Tax Benefit
 Without leverage
 VU = (20 million shares) × ($15/share) = $300 million
 If Midco borrows $100 million using permanent debt,

the present value of the firm’s future tax savings is
 PV(interest tax shield) = cD = 35% × $100 million = $35
million
148
The Tax Benefit (cont'd)
 Thus the total value of the levered firm will be
 VL = VU + cD = $300 million + $35 million = $335 million
 Because the value of the debt is $100 million, the

value of the equity is
 E = VL − D = $335 million − $100 million = $235 million
149
The Tax Benefit (cont'd)
 Although the value of the shares outstanding drops to
$235 million, shareholders will also receive the $100
million that Midco will pay out through the share
repurchase.
 In total, they will receive the full $335 million, a gain
of $35 million over the value of their shares without
leverage.
150
The Share Repurchase
 Assume Midco repurchases its shares at the current
price of $15/share. The firm will repurchase 6.67
million shares.
 $100 million ÷ $15/share = 6.67 million shares
 It will then have 13.33 million shares outstanding.

 20 million − 6.67 million = 13.33 million
151
The Share Repurchase (cont'd)
 The total value of equity is $235 million; therefore, the
new share price is $17.625/share.
 $235 million ÷ 13.33 million shares = $17.625
 Shareholders who keep their shares earn a capital gain

of $2.625 per share.
 $17.625 − $15 = $2.625
152
The Share Repurchase (cont'd)
 The total gain to shareholders is $35 million.
 $2.625/share × 13.33 million shares = $35 million
 If the shares are worth $17.625/share after the

repurchase, why would shareholders tender their
shares to Midco at $15/share?
153
No Arbitrage Pricing
 If investors could buy shares for $15 immediately
before the repurchase and sell these shares
immediately afterward at a higher price, this would
represent an arbitrage opportunity.
154
No Arbitrage Pricing (cont'd)
 Realistically, the value of the Midco’s equity will rise
immediately from $300 million to $335 million after
the repurchase announcement. With 20 million shares
outstanding, the share price will rise to $16.75 per
share.
 $335 million ÷ 20 million shares = $16.75 per share
155
 With a repurchase price of $16.75, the shareholders
who tender their shares and the shareholders who
hold their shares both gain $1.75 per share as a result
of the transaction.
 $16.75 − $15 = $1.75
156
 The benefit of the interest tax shield goes to all 20
million of the original shares outstanding for a total
benefit of $35 million.
 $1.75/share × 20 million shares = $35 million
 When securities are fairly priced, the original
shareholders of a firm capture the full benefit of the
interest tax shield from an increase in leverage.
157
Example 15.4
 Problem
 Suppose Midco still chooses to borrow $100 million, but only
wishes to repurchase $75 million worth of its shares. What
is the lowest price it could offer and expect shareholders to
tender their shares?
160
Shares Shares
 Solution Repurchase
Repurchased Remaining
New Share
Price Price
(millions) (millions)
PR R = 125/PR N = 20 - R Pn = 235/N
$13.50 5.56 14.44 $16.27
$13.75 5.45 14.55 $16.16
$14.00 5.36 14.64 $16.05
$14.25 5.26 14.74 $15.95
$14.50 5.17 14.83 $15.85
$14.75 5.08 14.92 $15.76
$15.00 5.00 15.00 $15.67
$15.25 4.92 15.08 $15.58
$15.50 $4.84 $15.16 $15.50
$15.75 4.76 15.24 $15.42
$16.00 4.69 15.31 $15.35
$16.25 4.62 15.38 $15.28
$16.50 4.55 15.45 $15.21
$16.75 4.48 15.52 $15.14
161
Analyzing the Recap:
 In the presence of corporate taxes, we must include
the interest tax shield as one of the firm’s assets.
162
Table 15.2 Market Value Balance Sheet for the Steps in
Midco’s Leveraged Recapitalization
15.4 Personal Taxes
 The cash flows to investors are typically taxed twice.
Once at the corporate level and then investors are
taxed again when they receive their interest or divided
payment.
164
15.4 Personal Taxes (cont'd)
 For individuals
 Interest payments received from debt are taxed as income.
 Equity investors also must pay taxes on dividends and capital
gains.
165
Including Personal Taxes
in the Interest Tax Shield
 The amount of money an investor will pay
for a security depends on the the cash flows the
investor will receive after all taxes have been paid.
 Personal taxes reduce the cash flows to investors and
can offset some of the corporate tax benefits of
leverage.
166
in the Interest Tax Shield (cont'd)
 The actual interest tax shield depends on both
corporate and personal taxes that are paid.
 To determine the true tax benefit of leverage, the
combined effect of both corporate and personal taxes
needs to be evaluated.
167
Figure 15.3 After-Tax Investor Cash Flows
Resulting from $1 in EBIT
Table 15.3 Top Federal Tax Rates in the
United States, 1971–2015
 In general, every $1 received after taxes by debt
holders from interest payments costs equity holders
$(1 − *) on an after-tax basis, where
Effective Tax Advantage of Debt
 (1   i )  (1   c ) (1   e ) (1   c ) (1   e )
   1
(1   i ) (1   i )
170
 (1   i )  (1   c ) (1   e ) (1   c ) (1   e )
  1
(1   i ) (1   i )
 When there are no personal taxes on debt income (i = 0) or

when the personal tax rates on debt and equity income are
the same (i = e), the formula reduces to * = c.
 When equity income is taxed less heavily (e is less than i),
then * is less than c.
171
Example 15.5
 Problem
 Given the following tax rates:
Average Personal
Corporate Tax Average Personal Tax
Year Tax Rate on Interest
Rate Rate on Equity Income
Income
1985 46% 35% 50%
1995 35% 34% 28%
2009 35% 15% 35%
 What is the effective tax advantage of debt for each of the years listed?
174
 Solution
 (1   c ) (1   e )
  1
(1   i )
 (1  0.46 ) (1  0.35)
 1985  1   29.8%
(1  0.50 )
 (1  0.35) (1  0.34 )
 1995  1   40.4%
(1  0.28 )
 (1  0.35 ) (1  0.15 )
 2009  1   15.0%
(1  0.35 )
175
Figure 15.4 The Effective Tax Advantage of Debt
with and without Personal Taxes, 1971–2015
Valuing the Interest Tax Shield
with Personal Taxes
 With personal taxes and permanent debt, the value of
the firm with leverage becomes
V L  V U   D
 If * is less than c, the benefit of leverage is reduced in the
presence of personal taxes.
177
with Personal Taxes (cont'd)
 Personal taxes have a similar effect on the firm’s
 However, we still compute the WACC as
E D
rwacc  rE  rD (1   c )
E  D E  D
178
with Personal Taxes (cont'd)
 With personal taxes, the firm’s equity and debt costs
of capital will adjust to compensate investors for their
respective tax burdens.
 The net result is that a personal tax disadvantage for
debt causes the WACC to decline more slowly with
leverage than it otherwise would.
179
Example 15.6
 Problem
 Estimate the value of Midco if it goes through with the $100
million recapitalization, accounting for personal taxes at their
1980 levels.
182
 Solution
 From example 15.5, we know in 1980 was 8.2%. Given
Midco’s current value of VU =$300 million, VL is estimated as
VU + D = $300 million + 8.2%($100 million) = $308.20. With
20 million original shares outstanding, the stock price would
increase by $8.2 million ÷20 million shares = $0.41 per share.
 In contrast, as shown in Example 15.6 in the text, at 2015
personal and corporate tax levels, the stock price would
increase by $0.75 per share.
183
Determining the Actual Tax
Advantage of Debt
 Several assumptions were made in estimating the
effective tax advantage of debt after taking personal
taxes into account that may need adjustment when
determining the actual tax benefit for a particular firm
or investor.
184
Advantage of Debt (cont'd)
 It was assumed that investors paid capital gains taxes
every year.
 However, capital gains taxes are paid only when the
investor sells the stock and realizes the gain. Deferring
the payment of capital gains taxes lowers the present
value of the taxes, which can be interpreted as a lower
effective capital gains tax rate.
185
 Investors with accrued losses that they can use to
offset gains face a zero effective capital gains tax rate.
 Thus, investors with longer holding periods or with
accrued losses face a lower tax rate on equity income,
decreasing the effective tax advantage of debt.
186
 It was also assumed that that shareholder gains from
additional earnings were evenly split between
dividends and capital gains.
 For firms with much higher or much lower
payout ratios, however, this average would not be
accurate.
187
 In addition, it was assumed that investors pay the top
marginal federal income tax rates.
 In reality, rates vary for individual investors, and many
investors face lower rates.
 At lower rates, the effects of personal taxes are
less substantial.
188
 Many investors face no personal taxes.
 For example, investments held in retirement savings
accounts or pension funds that are not subject to taxes
 For these investors, the effective tax advantage of debt is the
full corporate tax rate.
189
 The bottom line
 Calculating the effective tax advantage of debt accurately is
extremely difficult.
A firm must consider the tax bracket of its typical debt
holders, and the tax bracket and holding period of its
typical equity holders.
 The tax advantage of debt will vary across firms and from
investor to investor.
190
15.5 Optimal Capital Structure with
Taxes
 Do Firms Prefer Debt?
 When firms raise new capital from investors, they do so
primarily by issuing debt.
 In most years, aggregate equity issues are negative, meaning
that on average, firms are reducing the amount of equity
outstanding by buying shares.
191
15.5 Optimal Capital Structure
with Taxes (cont'd)
 While firms seem to prefer debt when raising external funds,
not all investment is externally funded.
 Most investment and growth is supported by internally
generated funds.
 Even though firms have not issued new equity, the market
value of equity has risen over time as firms have grown.
For the average firm, the result is that debt as a fraction of
firm value has varied in a range from 30%–45%.
192
15.5 Optimal Capital Structure
with Taxes (cont'd)
 The use of debt varies greatly by industry.
 Firms in growth industries like biotechnology or high
technology carry very little debt, while airlines, automakers,
utilities, and financial firms have high leverage ratios.
193
Limits to the Tax Benefit of Debt
 To receive the full tax benefits of leverage, a firm need
not use 100% debt financing, but the firm does need
to have taxable earnings.
 This constraint may limit the amount of debt needed as a tax
shield.
194
Table 15.4 Tax Savings with Different
Amounts of Leverage
195
Limits to the Tax Benefit of Debt (cont'd)
 From the previous slide:
 With no leverage, the firm receives no tax benefit.
 With high leverage, the firm saves $350 in taxes.
 With excess leverage, the firm has a net operating loss, and
there is no increase in the tax savings.
 Because the firm is already not paying taxes, there is no
immediate tax shield from the excess leverage.
196
 No corporate tax benefit arises from incurring interest
payments that exceed EBIT.
 Because interest payments constitute a tax
disadvantage at the investor level, investors will pay
higher personal taxes with excess leverage, making
them worse off.
197
 If the firm is not paying taxes, where c = 0, then the
tax disadvantage of excess leverage is
 (1   e ) e  i
 ex
 1    0
(1   i ) (1   i )
 Note: *ex is negative because (*e < i).
198
 The optimal level of leverage from a tax
saving perspective is the level such that interest equals
EBIT.
 At the optimal level of leverage, the firm shields all of its
taxable income, and it does not have any tax-disadvantaged
excess interest.
199
 However, it is unlikely that a firm can
predict its future EBIT (and the optimal
level of debt) precisely.
 If there is uncertainty regarding EBIT, then
there is a risk that interest will exceed EBIT.
As a result, the tax savings for high levels of
interest falls, possibly reducing the optimal level of the
interest payment.
200
Figure 15.8 Tax Savings for Different
Levels of Interest
 In general, as a firm’s interest expense approaches its
expected taxable earnings, the marginal tax advantage
of debt declines, limiting the amount of debt the firm
should use.
202
Growth and Debt
 Growth will affect the optimal leverage ratio.
 To avoid excess interest, a firm with positive earnings should
have a level of debt such that interest payments are below
its expected taxable earnings.
Interest  rD  Debt  EBIT or Debt  EBIT / rD
203
Growth and Debt (cont'd)
 From a tax perspective, the firm’s optimal level of debt
is proportional to its current earnings. However, the
value of the firm’s equity will depend on the growth
rate of earnings:
 The higher the growth rate, the higher the value of equity. As
a result, the optimal proportion of debt in the firm’s capital
structure [D/(E + D)] will be lower, the higher the firm’s
growth rate.
204
Other Tax Shields
 There are numerous provisions in the tax laws for
deductions and tax credits, such as depreciation,
investment tax credits, carryforwards of past
operating losses, etc.
 To the extent that a firm has other tax shields, its
taxable earnings will be reduced, and it will rely less
heavily on the interest tax shield.
205
The Low Leverage Puzzle
 The figure on the following slide reveals two
important patterns:
 Firms have used debt to shield a greater percentage of their
earnings from taxes in more recent years (mirroring the
increase in the effective tax advantage of debt).
 Firms have far less leverage than our analysis of the interest
tax shield would predict.
206
The Low Leverage Puzzle (cont'd)
 Firms worldwide have similar low proportions of debt
financing.
 Although the corporate tax codes are similar across all
countries in terms of the tax advantage of debt, personal tax
rates vary more significantly, leading to greater variation in
*.
207
Table 15.5 International Leverage and
Tax Rates (1990)
 It would appear that firms, on average, are under-
leveraged. However, it is hard to accept that most
firms are acting suboptimally.
 In reality, there is more to the capital structure story than
discussed so far.
209
 A key item missing from the analysis thus far is that
increasing the level of debt increases the probability
of bankruptcy.
 If bankruptcy is costly, these costs might offset the tax
advantages of debt financing.
210
Chapter Quiz
1. How do corporate taxes impact a firm’s value as
leverage changes?
2. How does leverage affect a firm’s weighted average
cost of capital?
3. How can shareholders benefit from a leveraged
recapitalization when it reduces the total value of
equity?
4. Under current tax law, why is there a personal tax
disadvantage of debt?
5. How does the growth rate of a firm affect the
optimal fraction of debt in the capital structure?
211
Chapter Quiz
1. How does the risk and cost of capital of levered

equity compare to that of unlevered equity? Which is
the superior capital structure choice in a perfect
capital market?
2. What is a market value balance sheet?
3. In a perfect capital market, how will a firm’s market
capitalization change if it borrows in order to
repurchase shares? How will its share price change?
212
Chapter Quiz
4. With perfect capital markets, as a firm increases its leverage,
how does its debt cost of capital change? Its equity cost of
capital? Its weighted average cost of capital?
5. If a change in leverage raises a firm’s earnings per share,
should this cause its share price to rise in a perfect market?
6. Consider the questions facing Dan Harris, CFO of EBS, at the
beginning of this chapter. What answers would you give based
on the Modigliani-Miller Propositions? On what
considerations should the capital structure decision be
based?
213
MM & BOTH TAXES AND BANKRUPTCY COST
 Now we add bankruptcy costs

 As the D/E ratio increases, the probability
of bankruptcy increases. This increased

probability will increase the expected
bankruptcy costs
214
Bankruptcy Costs (financial distress cost)
 Direct bankruptcy costs

 Legal and administrative costs
 Creditors will stop lending money to the firm.
 Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure and
estimate
 Also have lost sales, interrupted operations and loss of
valuable employees
215
Case
 At some point, the additional value of the interest tax

shield will be offset by the expected bankruptcy cost
 After this point, the value of the firm will start to
decrease and the WACC will start to increase as more

debt is added
216
217
Modigliani-Miller static Theory
 The graph shows MM’s tax benefit vs. bankruptcy

cost theory.
 With more debt, initially firm will benefit from tax
reduction.
 With high debt, the threat of financial distress
becomes severe.
 As financial conditions weaken, expected costs of
financial distress can be large enough to outweigh
the tax shield of debt financing.
 Optimal debt level is some trade-off point.
218
Asymmetric Information and Signaling
 Managers know the firm’s future prospects better than
investors.
 Managers would not issue additional equity if they
thought the current stock price was less than the true
value of the stock (given their inside information-
undervalue).
 Changing the capital structure to include more debt
conveys that the firm’s stock price is undervalued.
 This is a valid signal because of the possibility of
bankruptcy.
 Hence, investors often perceive an additional issuance of
stock as a negative signal, and the stock price falls.
219
Signaling Theory
220
 MM assumed that investors and managers have the

same information.
 But, managers often have better information. Thus,
they would:
 Sell stock if stock is overvalued.
 Sell bonds if stock is undervalued.
 Investors understand this, so view new stock sales as
a negative signal.
 Implications for managers?
220
Pecking Order Theory
221
 Firms use internally generated funds first, because

there are no flotation costs or negative signals.
 If more funds are needed, firms then issue debt
because it has lower flotation costs than equity
and not negative signals.
 If more funds are needed, firms then issue equity.
221
Debt Financing and Agency Costs
222
 One agency problem is that managers can use

corporate funds for non-value maximizing purposes.
 The use of financial leverage:
 Bonds “free cash flow.”
 Forces discipline on managers to avoid perks and non-
value adding acquisitions.
(More...)
222
Debt Financing and Agency Costs
223
 A second agency problem is the potential for

“underinvestment”.
 Debt increases risk of financial distress.
 Therefore, managers may avoid risky projects even if they
have positive NPVs.
223
Investment Opportunity Set and
224
Reserve Borrowing Capacity
 Firms with many investment opportunities should
maintain reserve borrowing capacity, especially if
they have problems with asymmetric information
(which would cause equity issues to be costly).
224
Market Timing Theory
225
 Managers try to “time the market” when issuing

securities.
 They issue equity when the market is “high” and
after big stock price run ups.
 They issue debt when the stock market is “low” and
when interest rates are “low.”
 The issue short-term debt when the term structure is
upward sloping and long-term debt when it is
relatively flat.
225
Implications for Managers
226
 Take advantage of tax benefits by issuing debt,

especially if the firm has:
 High tax rate
 Stable sales
 Low operating leverage
226
Implications for Managers (Continued)
227
 Avoid financial distress costs by maintaining excess

borrowing capacity, especially if the firm has:
 Volatile sales
 High operating leverage
 Many potential investment opportunities
 Special purpose assets (instead of general purpose assets
that make good collateral)
227
Implications for Managers (Continued)
228
 If manager has asymmetric information regarding

firm’s future prospects, then avoid issuing equity if
actual prospects are better than the market
perceives.
 Always consider the impact of capital structure
choices on lenders’ and rating agencies’ attitudes
228
Determining Optimal Capital Structure:
Example
229
 b = 1.0; rRF = 6%; RPM = 6%.

 Cost of equity using CAPM:
 rs = rRF +b (RPM)= 6% + 1(6%) = 12%
 Currently has no debt: wd = 0%.
 WACC = rs = 12%.
 Tax rate is T = 40%.
229
Current Value of Operations
230
 Expected FCF = $30 million.

 Firm expects zero growth: g = 0.
 Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.12 − 0)
Vop = $250 million.
230
Other Data for Valuation Analysis
231
 Company has no ST investments.

 Company has no preferred stock.
 10 milion shares outstanding
231
Current Valuation Analysis
Vop $250
+ ST Inv. 0
VTotal $250
− Debt 0
S $250
÷n 10
P $25.00
232
Investment bankers provided estimates of rd for
different capital structures.
233
wd 0% 20% 30% 40% 50%

rd 0.0% 8.0% 8.5% 10.0% 12.0%
If company recapitalizes, it will use proceeds from debt

issuance to repurchase stock.
233
The Cost of Equity at Different Levels of
Debt: Hamada’s Formula
234
 MM theory implies that beta changes with leverage.

 bU is the beta of a firm when it has no debt (the
unlevered beta)
 b = bU [1 + (1 - T)(wd/ws)]
234
The Cost of Equity for wd = 20%
235
 Use Hamada’s equation to find beta:

b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
 Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
235
The WACC for wd = 20%
236
 WACC = wd (1-T) rd + wce rs

 WACC =
0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
 WACC = 11.28%
 Repeat this for all capital structures under

consideration.
236
Beta, rs, and WACC
237
wd 0% 20% 30% 40% 50%

rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
The WACC is minimized for wd = 30%. This is the optimal

capital structure.
237
Corporate Value for wd = 20%
238
 Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.1128 − 0)
Vop = $265.96 million.
 Debt = DNew = wd Vop
Debt = 0.20(265.96) = $53.19 million.
 Equity = S = ws Vop
Equity = 0.80(265.96) = $212.77 million.
238
Value of Operations, Debt, and Equity
239
wd 0% 20% 30% 40% 50%

rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.00 $212.77 $190.74 $163.04 $131.58
Value of operations is maximized at wd = 30%.

239
Anatomy of a Recap: Before Issuing Debt
Before Debt
Vop $250
+ ST Inv. 0
VTotal $250
− Debt 0
S $250
÷n 10
P $25.00
Total shareholder
wealth: S + Cash $250
240
Issue Debt (wd = 20%), But Before
241
Repurchase
 WACC decreases to 11.28%.
 Vop increases to $265.9574.
 Firm temporarily has short-term investments of
$53.1915 (until it uses these funds to repurchase
stock).
 Debt is now $53.1915.
241
Anatomy of a Recap: After Debt, but
Before Repurchase
After Debt,
Before Debt Before Rep.
Vop $250 $265.96
+ ST Inv. 0 53.19
VTotal $250 $319.15
− Debt 0 53.19
S $250 $265.96
÷n 10 10
P $25.00 $26.60
Total shareholder
wealth: S + Cash $250 $265.96
242
After Issuing Debt, Before Repurchasing
Stock
243
 Stock price increases from $25.00 to $26.60.

 Wealth of shareholders (due to ownership of equity)
increases from $250 million to $265.96 million.
243
The Repurchase: No Effect on Stock Price
244
 The announcement of an intended repurchase might send a

signal that affects stock price, and the previous change in
capital structure affects stock price, but the repurchase itself
has no impact on stock price.
 If investors thought that the repurchase would increase the stock
price, they would all purchase stock the day before, which would drive
up its price.
 If investors thought that the repurchase would decrease the stock
price, they would all sell short the stock the day before, which would
drive down the stock price.
244
Remaining Number of Shares After
Repurchase
245
 DOld is amount of debt the firm initially has, DNew is

amount after issuing new debt.
 If all new debt is used to repurchase shares, then
total dollars used equals
 (DNew – DOld) = ($53.19 - $0) = $53.19.
 nPrior is number of shares before repurchase, nPost is
number after. Total shares remaining:
 nPost = nPrior – (DNew – DOld)/P
nPost = 10 – ($53.19/$26.60)
nPost = 8 million.
(Ignore rounding differences; see Ch15 Mini Case.xlsx for actual calculations).
245
Anatomy of a Recap: After Repurchase
After Debt,
Before Debt Before Rep. After Rep.
Vop $250 $265.96 $265.96
+ ST Inv. 0 53.19 0
VTotal $250 $319.15 $265.96
− Debt 0 53.19 53.19
S $250 $265.96 $212.77
÷n 10 10 8
P $25.00 $26.60 $26.60
Total shareholder
wealth: S + Cash $250 $265.96 $265.96
246
Key Points
247
 ST investments fall because they are used to

repurchase stock.
 Stock price is unchanged.
 Value of equity falls from $265.96 to $212.77
because firm no longer owns the ST investments.
 Wealth of shareholders remains at $265.96 because
shareholders now directly own the funds that were
held by firm in ST investments.
247
Intrinsic Stock Price Maximized at Optimal
Capital Structure
248
wd 0% 20% 30% 40% 50%

rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.00 $212.77 $190.74 $163.04 $131.58
n 10 8 7 6 5
P $25.00 $26.60 $27.25 $27.17 $26.32
248
Shortcuts
249
 The corporate valuation approach will always give

the correct answer, but there are some shortcuts for
finding S, P, and n.
 Shortcuts on next slides.
249
Calculating S, the Value of Equity after the
Recap
250
 S = (1 – wd) Vop
 At wd = 20%:
 S = (1 – 0.20) $265.96
 S = $212.77.
(Ignore rounding differences; see Ch16 Mini Case.xlsx for actual calculations).
250
Number of Shares after a Repurchase, nPost
251
 At wd = 20%:
 nPost = nPrior(VopNew−DNew)/(VopNew−DOld)
nPost = 10($265.96 −$53.19)/($265.96 −$0)
nPost = 8
251
Calculating PPost, the Stock Price after a
252
Recap
 At wd = 20%:
 PPost = (VopNew−DOld)/nPrior
nPost = ($265.96 −$0)/10
nPost = $26.60
252
Optimal Capital Structure
253
 wd = 30% gives:
 Highest corporate value
 Lowest WACC
 Highest stock price per share
 But wd = 40% is close. Optimal range is pretty flat.
253
What if L's debt is risky?
254
 If L's debt is risky then, by definition, management

might default on it. The decision to make a payment
on the debt or to default looks very much like the
decision whether to exercise a call option. So the
equity looks like an option.
254
Managerial Incentives
255
 When an investor buys a stock option, the riskiness

of the stock () is already determined. But a
manager can change a firm's  by changing the
assets the firm invests in. That means changing 
can change the value of the equity, even if it doesn't
change the expected cash flows:
255
Managerial Incentives
256
 So changing  can transfer wealth from bondholders

to stockholders by making the option value of the
stock worth more, which makes what is left, the debt
value, worth less.
256
Bait and Switch
257
 Managers who know this might tell debtholders they

are going to invest in one kind of asset, and, instead,
invest in riskier assets. This is called bait and switch
and bondholders will require higher interest rates for
firms that do this, or refuse to do business with
them.
257
How do companies manage the
258
maturity structure of their debt?
 Maturity matching
 Finance long-term assets with long-term debt
 Finance short-term assets with short-term debt.
 Information asymmetries: Firms with better future
prospects than expected by investors
 Issuing long-term debt will lock in a higher interest rate
than warranted by company’s prospect.
 So issue short-term debt (even though its rate is too high)
but refinance at appropriate rate when company’s
prospects are revealed.
258
Summary: No Taxes
 In a world of no taxes, the value of the firm is unaffected by
capital structure.
 This is M&M Proposition I:
VL = VU
 Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
 In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.
B
R S  R0   ( R0  R B )
SL
259
Summary: Taxes
 In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
 This is M&M Proposition I:
VL = VU + TC B
 Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
 In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.
B
R S  R0   (1  TC )  ( R 0  R B )
SL
260
Quick Quiz
 Why should stockholders care about maximizing firm

value rather than just the value of the equity?
 How does financial leverage affect firm value
without taxes? With taxes?
 What is homemade leverage?
261
End of Unit Quiz, Cont’d
262
1) Consider a project with free cash flows in one year of $137,022 or $188,017,
with each outcome being equally likely. The initial investment required for the
project is $100,655, and the project’s cost of capital is 20%. The risk-free interest
rate is 11%.
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment, the project is sold
to investors as an all-equity firm. The equity holders will receive the cash flows of
the project in one year.
How much money can be raised in this way—that is, what is the initial market
value of the unlevered equity?
 c. Suppose the initial $100,655 is instead raised by borrowing at the risk-free
interest rate. What are the cash flows of the levered equity, and what is its initial
value according to MM?
262
263
2) You are an entrepreneur starting a biotechnology firm. If your

research is successful, the technology can be sold for $30 million. If
your research is unsuccessful, it will be worth nothing. To fund your
research, you need to raise $2.1 million. Investors are willing to
provide you with $2.1 million in initial capital in exchange for 45% of
the unlevered equity in the firm.
a. What is the total market value of the firm without leverage?
b. Suppose you borrow $0.9 million. According to MM, what fraction
of the firm’s equity will
you need to sell to raise the additional $1.2 million you need?
c. What is the value of your share of the firm’s equity in cases (a)
and (b)?
263
264
3) Hardmon Enterprises is currently an all-equity firm with an expected

return of 12%. It is considering a leveraged recapitalization in which it would
borrow and repurchase existing shares.
a. Suppose Hardmon borrows to the point that its debt-equity ratio is 0.50.
With this amount of debt, the debt cost of capital is 5%. What will the
expected return of equity be after this transaction?
 b. Suppose instead Hardmon borrows to the point that its debt-equity ratio
is 1.50. With this amount of debt, Hardmon’s debt will be much riskier. As a
result, the debt cost of capital will be 7%. What will the expected return of
equity be in this case?
c. A senior manager argues that it is in the best interest of the shareholders
to choose the capital structure that leads to the highest expected return for
the stock. How would you respond to this argument?
264
265
4) Global Pistons (GP) has common stock with a market value of $470
million and debt with a value of $299 million. Investors expect a 13%
return on the stock and a 5% return on the debt. Assume perfect
capital markets.
a. Suppose GP issues $299 million of new stock to buy back the debt.
What is the expected return of the stock after this transaction?
b. Suppose instead GP issues $71 million of new debt to repurchase
stock.
i. If the risk of the debt does not change, what is the expected return
of the stock after this transaction?
ii. If the risk of the debt increases, would the expected return of the
stock be higher or lower than in part (i)?
265
266
5) Yerba Industries is an all-equity firm whose stock has a

beta of 0.70 and an expected return of 18.50%. Suppose
it issues new risk-free debt with a 6.50% yield and
repurchases 5% of its stock. Assume perfect capital
markets.
a. What is the beta of Yerba stock after this transaction?
b. What is the expected return of Yerba stock after this
transaction?
266
267
6) Jim Campbell is founder and CEO of Open Start, an innovative software

company. The company is all equity financed, with 100 million shares
outstanding. The shares are trading at a price of $1. Campbell currently owns
20 million shares. There are two possible states in one year. Either the new
version of their software is a hit, and the company will be worth $160 million,
or it will be a disappointment, in which case the value of the company will drop
to $75 million. The current risk free rate is 2%. Campbell is considering taking
the company private by repurchasing the rest of the outstanding equity by
issuing debt due in one year. Assume the debt is zero-coupon and will pay its
face value in one year.
a. What is the market value of the new debt that must be issued?
 b. Suppose Open Start issues risk-free debt with a face value of $75 million.
How much of its outstanding equity could it repurchase with the proceeds
from the debt? What fraction of the remaining equity would Jim still not own?
267
268
 c. Combine the fraction of the equity Jim does not own with the
risk-free debt. What are the payoffs of this combined portfolio?
What is the value of this portfolio?
 d. What face value of risky debt would have the same payoffs as
the portfolio in (c)?
 e. What is the yield on the risky debt in (d) that will be required to
take the company private?
 f. If the two outcomes are equally likely, what is OpenStart’s current
WACC (before the transaction)?
 g. What is Open Start’s debt and equity cost of capital after the
transaction? Show that the WACC is unchanged by the new
leverage.
268
269
7) Your firm currently has $116 million in debt outstanding with a 8% interest
rate. The terms of the loan require it to repay $29 million of the balance each
year. Suppose the marginal corporate tax rate is 30%, and that the interest tax
shields have the same risk as the loan. What is the present value of the interest
tax shields from this debt?
8) Arnell Industries has just issued $15 million in debt (at par). The firm will pay
interest only on this debt. Arnell’s marginal tax rate is expected to be 35% for
the foreseeable future.
 a. Suppose Arnell pays interest of 7% per year on its debt. What is its annual
interest tax shield?
b. What is the present value of the interest tax shield, assuming its risk is the
same as the loan?
c. Suppose instead that the interest rate on the debt is 6%. What is the present
value of the interest tax shield in this case?
269
270
9) Kurz Manufacturing is currently an all-equity firm with 27 million shares

outstanding and a stock price of $15 per share. Although investors currently
expect Kurz to remain an all-equity firm, Kurz plans to announce that it will
borrow $65 million and use the funds to repurchase shares. Kurz will pay interest
only on this debt, and it has no further plans to increase or decrease the amount
of debt. Kurz is subject to a 38% corporate tax rate.
 a. What is the market value of Kurz’s existing assets before the announcement?
b. What is the market value of Kurz’s assets (including any tax shields) just after
the debt is issued, but before the shares are repurchased?
c. What is Kurz’s share price just before the share repurchase? How many shares
will Kurz repurchase?
d. What are Kurz’s market value balance sheet and share price after the share
repurchase?
270
271
10) PMF, Inc. is equally likely to have EBIT this coming year of $7 million,
$13 million, or $19 million. Its corporate tax rate is 35%, and investors pay
a 15% tax rate on income from equity and a 40% tax rate on interest
income.
a. What is the effective tax advantage of debt if PMF has interest
expenses of $6 million this coming year?
b. What is the effective tax advantage of debt for interest expenses in
excess of $19 million? (Ignore carryforwards.)
c. What is the effective tax advantage of debt for interest expenses
between $7 million and $13 million? (Ignore carryforwards.)
d. What level of interest expense provides PMF with the greatest tax
benefit?
271
Costs of Financial Distress
 Bankruptcy risk versus bankruptcy cost

 The possibility of bankruptcy has a negative effect
on the value of the firm.
 However, it is not the risk of bankruptcy itself that
lowers value.
 Rather, it is the costs associated with bankruptcy.
 It is the stockholders who bear these costs.
272
Description of Financial Distress Costs
 Direct Costs
 Legal and administrative costs
 Indirect Costs
 Impaired ability to conduct business (e.g., lost sales)
 Agency Costs
 Selfish Strategy 1: Incentive to take large risks
 Selfish Strategy 2: Incentive toward underinvestment
 Selfish Strategy 3: Milking the property
273
Can Costs of Debt Be Reduced?
 Protective Covenants
 Negative covenant – limits actions the firm may take
 Positive covenant – specifies an action the firm agrees to
take
 Debt Consolidation:
 If we minimize the number of parties, contracting costs
fall.
274
Tax Effects and Financial Distress
 There is a trade-off between the tax advantage of
debt and the costs of financial distress.
 Trade-off Theory – suggest that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
 It is difficult to express this with a precise and
rigorous formula.
275
Tax Effects and Financial Distress
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCB
Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
0 Debt (B)
B *
Optimal amount of debt

276
The Pie Model Revisited
 Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
 Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
 VT = S + B + G + L
S
B
L G
 The essence of the M&M intuition is that VT depends on the

cash flow of the firm; capital structure just slices the pie.
277
Signaling
 The firm’s capital structure is optimized where the

marginal subsidy to debt equals the marginal cost.
 Investors view debt as a signal of firm value.
 Firms with low anticipated profits will take on a low level of
debt.
 Firms with high anticipated profits will take on a high level
of debt.
 A manager that takes on more debt than is optimal
in order to fool investors will pay the cost in the long
run.
278
Agency Cost of Equity
 An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
 While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
 The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
 The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
279
The Pecking-Order Theory
 Theory stating that firms prefer to issue debt rather than
equity if internal financing is insufficient.
 Rule 1
 Use internal financing first.
 Rule 2
 Issue debt next, new equity last.
 The pecking-order theory is at odds with the tradeoff
theory:
 There is no target D/E ratio.
 Profitable firms use less debt.
 Companies like financial slack.
280
Growth and the Debt-Equity Ratio
 Growth implies significant equity financing, even in a

world with low bankruptcy costs.
 Thus, high-growth firms will have lower debt ratios
than low-growth firms.
 Growth is an essential feature of the real world. As a
result, 100% debt financing is sub-optimal.
281
Personal Taxes
 Individuals, in addition to the corporation, must pay

taxes. Thus, personal taxes must be considered in
determining the optimal capital structure.
282
Personal Taxes
 Dividends face double taxation (firm and shareholder),

which suggests a stockholder receives the net amount:
 (1-TC) x (1-TS)
 Interest payments are only taxed at the individual level
since they are tax deductible by the corporation, so
the bondholder receives:
 (1-TB)
283
Personal Taxes
 The firm is indifferent between debt and equity

when:
(1-TC) x (1-TS) = (1-TB)
284
How Firms Establish Capital Structure
 Most corporations have low Debt-Asset ratios.
 Changes in financial leverage affect firm value.
 Stock price increases with leverage and vice-versa; this is
consistent with M&M with taxes.
 Another interpretation is that firms signal good news
when they lever up.
 There are differences in capital structure across
industries.
 There is evidence that firms behave as if they had a
target Debt-Equity ratio.
285
Factors in Target D/E Ratio
 Taxes
 Since interest is tax deductible, highly profitable firms should use
more debt (i.e., greater tax benefit).
 Types of Assets
 The costs of financial distress depend on the types of assets the
firm has.
 Firms with tangible assets that can easily be transferred are in a
better position than those with intangible assets that cannot easily
be transferred (e.g talented employees and growth opportunities).
 Uncertainty of Operating Income
 Even without debt, firms with uncertain operating income have a
high probability of experiencing financial distress.
 Pecking Order and Financial Slack
 Theory stating that firms prefer to issue debt rather than equity if
internal financing is insufficient.
286
Quick Quiz
 What are the direct and indirect costs of

bankruptcy?
 Define the “selfish” strategies stockholders may
employ in bankruptcy.
 Explain the tradeoff, signaling, agency cost, and
pecking order theories.
 What factors affect real-world debt levels?
287

Capital Structure Theory and Applications

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Capital Structure Theory and Applications

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WEEK 12

MBAF 605: CORPORATE FINANCE

•Understand Capital Structure Decisions in the light of:

 The NPV of the project is

 Because there is no debt, the cash flows of the

 MM demonstrated that if investors would prefer an

 The levered equity return equals the unlevered return, plus

 Fraction of Firm Value   Equity   Fraction of Firm Value   Debt 

(a) Equity, debt, and weighted

 New Cost of Equity

 If you are trying to estimate the unlevered beta for an

 Leverage amplifies the market risk of a firm’s assets,

 It is sometimes (incorrectly) argued that issuing equity

 Suppose JSA sells 62.5 million new shares

 InMacy’s case, the gain is equal to the reduction in taxes

 The cash flows a levered firm pays to investors will

 Cash Flows to Investors   Cash Flows to Investors 

PV (Interest Tax Shield)  PV ( c  Future Interest Payments)

 If Midco borrows $100 million using permanent debt,

 Because the value of the debt is $100 million, the

 It will then have 13.33 million shares outstanding.

 Shareholders who keep their shares earn a capital gain

 If the shares are worth $17.625/share after the

 When there are no personal taxes on debt income (i = 0) or

Interest  rD  Debt  EBIT or Debt  EBIT / rD

1. How does the risk and cost of capital of levered

 Now we add bankruptcy costs

of bankruptcy increases. This increased

 Direct bankruptcy costs

 At some point, the additional value of the interest tax

decrease and the WACC will start to increase as more

 The graph shows MM’s tax benefit vs. bankruptcy

 MM assumed that investors and managers have the

 Firms use internally generated funds first, because

 One agency problem is that managers can use

 A second agency problem is the potential for

 Managers try to “time the market” when issuing

 Take advantage of tax benefits by issuing debt,

 Avoid financial distress costs by maintaining excess

 If manager has asymmetric information regarding

 b = 1.0; rRF = 6%; RPM = 6%.

 Expected FCF = $30 million.

 Company has no ST investments.

wd 0% 20% 30% 40% 50%

If company recapitalizes, it will use proceeds from debt

 MM theory implies that beta changes with leverage.

 Use Hamada’s equation to find beta:

 WACC = wd (1-T) rd + wce rs

 Repeat this for all capital structures under

wd 0% 20% 30% 40% 50%

The WACC is minimized for wd = 30%. This is the optimal

wd 0% 20% 30% 40% 50%

Value of operations is maximized at wd = 30%.

 Stock price increases from $25.00 to $26.60.

 The announcement of an intended repurchase might send a

 DOld is amount of debt the firm initially has, DNew is

 ST investments fall because they are used to

wd 0% 20% 30% 40% 50%

 The corporate valuation approach will always give

 If L's debt is risky then, by definition, management

 When an investor buys a stock option, the riskiness

 So changing  can transfer wealth from bondholders

 Managers who know this might tell debtholders they