CORPORATE

FINANCE
Chapter 16 Debt Policy

INSTRUCTOR: MEHNAZ KHAN

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 LEARNING OBJECTIVES
After studying this chapter, you should be able to:

• LO1 Show why capital structure does not affect firm value in perfect
capital markets (no taxes, no financial distress costs).
• LO2 Show why the tax system encourages debt finance and derive the
value of interest tax shields.
• LO3 Show how costs of distress can lead to an optimal capital structure
that involves a debt proportion that is greater than 0 but less than 1.

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NOTE ON CAPITAL STRUCTURE CHOICE:
• A firm’s mix of long term financing is known as its capital structure.

• Shareholders want to choose the mix of securities that maximize firm value.
• MM investigated effects of capital structure change:
MM proposition I: What happens to the value of the (entire) firm?
MM proposition II: What happens to the firm’s cost of equity?

• 3 Capital Market Scenarios considered:

1. Perfect market (no taxes, no financial distress costs)
2. Corporate taxes exist but no financial distress costs
3. Both corporate taxes and financial distress costs exist.

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16.1 HOW BORROWING AFFECTS VALUE OF FIRM
IN A PERFECT MARKET (FIRST SCENARIO):
• Think of a simple balance sheet with all entries expressed as current market values:

Assets Liabilities & Stockholders Equity

Value of cash flows from firm’s real assets and Market value of debt
operations
Market value of equity

Value of firm Value of firm

The right and left hand sides must equal. It does not matter what
the proportions are.

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 HOW BORROWING AFFECTS VALUE IN
A PERFECT MARKET: IT DOES NOT!
 Modigliani and Miller (MM)
◦ When there are no taxes and no financial distress costs, the
market value of a company does not depend on its capital
structure.
◦ The value of the firm cannot be increased by changing the
mix of debt and equity used to finance the company.
◦ Yogi Berra interpretation: You cannot increase the size of a
pizza by slicing it in different ways. (Yogi Berra asserted
otherwise!)

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HOW BORROWING AFFECTS EPS

• How Borrowing Affects Earnings Per Share

Example: The next few slides show the current position of River
Cruise company and the proposed new structure.
An illustration of EBIT-EPS analysis
Graph: X-axis is EBIT; Y-axis EPS
More debt makes the graph exhibit a lower vertical intercept and a
higher slope, i.e. Increasing debt results in a more volatile EPS

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3 EQUIPROBABLE MACROECONOMIC
STATES
(TABLE 16.1) PERPETUITY SITUATION; PLOWBACK OR RETENTION RATIO = 0.

Current position - River Cruises is entirely equity financed.

Data

Number of shares 100,000

Price per share $10

Market value of shares $1 ,000,000

Slump Normal Boom

Operating income EBIT $75,000 125,000 175,000

Earnings per share EPS $.75 1.25 1.75

Return on shares EPS/P 7.5% 12.5% 17.5%

Expected outcome

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HOW BORROWING AFFECTS VALUE IN A TAX-
FREE ECONOMY

Proposed structure – River Cruises issues $500,000 debt at 10%

and repurchases 50,000 shares at $10 each.
Data

Number of shares 50,000

Price per share $10

Market value of shares $500,000

Market Value of Debt $500,000

Value of firm = D+E= $500,000 + $500,000 = $1,000,000 (no change)

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HOW BORROWING AFFECTS VALUE IN A TAX-
FREE ECONOMY

Return to shareholders with $500,000 debt in capital structure.

EPS (also return on shares) now more volatile, wider range of variation
Slump Normal Boom

Operating income EBIT $75,000 125,000 175,000

Interest 10%($500,000) $50,000 50,000 50,000

Earnings to equity $25,000 75,000 125,000

Earnings per share EPS $.50 1.50 2.50

Return on shares 5% 15% 25%

Expected outcome

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HOW BORROWING AFFECTS VALUE IN A TAX-FREE ECONOMY

EPS at various operating income levels for all equity versus levered
capital structures

LO1
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 HOW BORROWING AFFECTS VALUE IN A PERFECT
MARKET
• Note: all the r variables are required rate of return
• MM Proposition I – also called the MM debt-irrelevance
proposition: the value of a firm is unaffected by its capital
structure.
• MM Proposition II – increase in financial leverage results in a
rise in the cost of equity due to volatility increase (Note T = 0)

D
rL  rU   rU  rdebt (1  T )
E
rU  rassets
rL  requity
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Chapter 16
HOW BORROWING AFFECTS VALUE IN A PERFECT
MARKET (FIRST SCENARIO)
• Debt and the Cost of Equity
• Debt has an explicit cost (the interest rate) and an implicit cost
(the increase in financial risk which causes shareholders to
demand a higher return).
• MM’s Proposition I: VL = VU
• MM’s Proposition II:
The required return on a firm’s equity increases as the firm’s debt
equity ratio increases according to the following: Note T = 0.

D
requity  rassets   rassets  rdebt (1  T)
LO1
E Chapter 16
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 HOW BORROWING AFFECTS VALUE IN A
TAX-FREE ECONOMY
• Restructuring does not affect operating income
• The operating risk, or business risk, of the firm is unchanged.
Associated with this is the unlevered cost of equity or
rassets

• However, with more debt in the capital structure, the EPS and return
on equity become more risky. The financial risk of the firm increases.

• 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.

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HOW BORROWING AFFECTS VALUE IN A
TAX-FREE ECONOMY
M&M’s proposition II with fixed interest rate on debt

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CAPITAL STRUCTURE WHEN CORPORATE
TAXES EXIST (SECOND SCENARIO)

• When we introduce taxes, debt financing has an important advantage:

• If the company pays tax, interest is a tax deductible expense, creating an interest tax
shield.
• Interest Tax Shield: Tax savings resulting from deductibility of interest payments.

• MM Proposition I: VL = VU + PV of interest tax shields

• MM Proposition II, T > 0:

D
requity  rassets   rassets  rdebt (1  T )
E

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 CAPITAL STRUCTURE AND CORPORATE
TAXES
• Interest is tax deductible. Thus, debt holders and equity holders
expect to receive a higher combined income when the firm is levered
because the firm’s tax liability is reduced due to interest tax shields.

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CAPITAL STRUCTURE AND CORPORATE
TAXES
• Notice from the previous slide, the combined debt and equity income
is $17,500 higher for the levered scenario.
• This is because interest payments are tax deductible so the annual
interest tax shield is the tax rate times the interest payment:
• .35 x $50,000 = $17,500

• If we assume the debt is permanent (perpetuity situation!), we can

find the present value of this annual cash flow stream by using the
PV perpetuity formula:

annual tax shield 17,500

PVtax shield    175,000
rdebt .10

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CAPITAL STRUCTURE AND CORPORATE
TAXES
Tax Shield calculation:

Annual tax shield = corporate tax rate x interest

= Tc x (rdebt x amount of debt)
= Tc x (rdebt x D)

PV of tax shield = annual tax shield / rdebt

= [Tc x (rdebt x D)] / rdebt
= Tc x D

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 CAPITAL STRUCTURE AND
CORPORATE TAXES
• MM’s Modified Proposition I
• In a world with corporate taxes but no financial distress costs, the
value of a firm increases with leverage.
• Such increase comes from the fact that there is a tax savings involved
with leverage.

Value of Levered Firm = Value of All-Equity Financed Firm + PV of Tax Shields

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CAPITAL STRUCTURE AND CORPORATE
TAXES(V ON VERTICAL AXIS, D ON HORIZONTAL AXIS)

• MM’s Modified Proposition I

Additional borrowing decreases corporate tax payments and
increases the cash flows available to lenders and
shareholders so value of firm increases.

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CAPITAL STRUCTURE WHEN CORPORATE
TAXES EXIST: SCENARIO 2

• MM’s Proposition II
• The required return on a firm’s equity increases as the firm’s
debt-equity ratio increases.
• The increased required ROE indicates the fact that there is some
increased level of risk that comes with leverage. (T > 0)

D
requity  rassets  1  TC rassets  rdebt 
E

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 CAPITAL STRUCTURE WHEN
CORPORATE TAXES EXIST: SCENARIO
2

• Corporate taxes and the Weighted Average Cost of Capital

• WACC declines (because Value of firm rises) as more debt is employed

• Once the tax benefit is recognized, the WACC formula becomes:

 D   E 
WACC  (1  Tc ) rdebt    requity  
D  E D  E

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CAPITAL STRUCTURE AND CORPORATE
TAXES
Changes in cost of capital with increased leverage when there are corporate taxes. The
after tax cost of debt is assumed to be constant. With increased borrowing the cost of
equity rises, but more slowly than in the no-tax case. The WACC declines (because V
rises) as the firm increases borrowing. WACC and V are inversely related. Caution:
WACC (blue) graph is a curve, not a line!

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MM PROPOSITIONS IN SCENARIO 3
(CORPORATE TAXES AND FINANCIAL
DISTRESS COSTS EXIST)
• Costs of Financial Distress: Costs arising from bankruptcy or
distorted business decisions before bankruptcy.
• MM Proposition I:
V of levered firm=Value of all equity financed + PV Interest Tax
Shields - PV Costs of Financial Distress

• The present value of the costs of financial distress depends on the

probability of distress and on the magnitude of the costs if distress occurs.

• MM Proposition II: Qualitative treatment as no formula exists!

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COSTS OF FINANCIAL DISTRESS
 The trade-off theory of capital structure. The market value initially
increases as debt increases (due to interest tax shield) but decreases as the
costs of financial distress become more important.

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