Capital Structure

Limits to the Use of Debt

 Capital Structure: 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
• Prop 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
rS = r0 + ´(r0 - rB )
SL
 Capital Structure: With 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
• Prop 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
rS = r0 + ´(1 -TC ) ´(r0 - rB )
SL
 Example:1
Gibson, Inc., expects
perpetual earnings before
interest and taxes of $1.2
million per year. The firm's
pretax cost of debt is 8
percent per annum, and its
annual interest expense is
$200,000. Company
analysts estimate that the
unlevered cost of Gibson's
equity is 12 per­cent. Gibson
is subject to a 35 percent •
corporate tax rate.
a. What is the value of this
firm?
b. If there are no other costs,
what percentage of the
firm's capital structure
would be financed by debt? •
c. Is the conclusion in (b)
applicable to the real
world?
VL = VU + TCB
VU = [(EBIT)(1-TC)] / r0
= [($1,200,000)(1 - 0.35)] / 0.12
= $6,500,000
VL = V U + T C B
= $6,500,000 + (0.35)($2,500,000) = $7,375,000
If there are no other costs, increasing the
level of debt in a firm’s capital structure will
always increase the value of a firm. This
implies that every firm will want to be
financed entirely (100%) by debt if it wishes
to maximize its value.
This conclusion is not applicable in the real
world since it does not consider other costs
that might offset the benefit of increased
leverage. These costs will be discussed in
further detail later.
• In the MM model with corporate taxes
there is no limit to the increase in firm
value and equity value from the use of
financial leverage.
• Common sense tells us that companies
are not financed 100% by debt.
• What are some factors that hold back
financial manager from using financial
leverage?
• Debt provides tax benefits
• Interest and principal to be paid back in
time with certainty.
• If firm is unable to pay the debt
obligations, the ownership of asset is
transferred from stockholders to
bondholders
• When Equity = 0, Value of asset = Value of
Debt
 Bankruptcy costs
• As the D/E ratio increases, the probability of
bankruptcy increases
• This increased probability will increase the
expected bankruptcy costs
• At some point, the additional value of the
interest tax shield will be offset by the expected
bankruptcy cost
• At this point, the value of the firm will start to
decrease and the WACC will start to increase as
more debt is added
 Bankruptcy Costs
• Direct costs
– Legal and administrative costs
– Ultimately cause bondholders to incur
additional losses
• Financial distress
– Significant problems in meeting debt
obligations
– Most firms that experience financial distress
do not ultimately file for bankruptcy
 Indirect bankruptcy costs
• Larger than direct costs, but more difficult to
measure and estimate
• Stockholders wish to avoid a formal
bankruptcy filing
• Bondholders want to keep existing assets
intact so they can at least receive that money
• Assets lose value as management spends
time worrying about avoiding bankruptcy
instead of running the business
• Also have lost sales, interrupted operations
and loss of valuable employees
 Selfish Investment Strategies
• The selfish strategies represent agency costs
between bondholders and stockholders.
• These costs exist because stockholders enjoy
limited liability and full control.
• When a firm is in financial distress, investment
strategies that maximize firm value may no
longer maximize the value of stockholders.
We demonstrate these strategies using an
example.
 Balance Sheet
of a firm in distress
Assets BV MV Liabilities BV
MV
Cash 4000 3000 Bonds 4000 ?
Asset 4000 0000 Equity 4000 ?
Total 8000 3000 Total 8000 3000

The bonds mature tomorrow and bondholders should

receive 4000. Under the current conditions, the firm only
has 3000.

Therefore the company will be bankrupt and

bondholders will receive 3000 and stockholders will
receive nothing.
 Selfish Investment Strategy 1:
Incentive to Take Large Risks
• Suppose there is an investment that costs Rs.3000 with a
– 90% probability of a Rs.0 payoff and
– 10% probability of an immediate payoff of Rs.5,000.

• NPV = E(CF) / (l + r) – Initial investment

= [(.9)(Rs.0) + (.1)(Rs.5000)]/1.0 – Rs.3000 = –Rs.2500

• After investment in the project, the market value of the firm will fall
from Rs.3000 to Rs. 500.

• Under normal circumstances, this project should not be accepted

because it reduces the value of the firm.
 Selfish Investment Strategy 2:
Incentive toward Underinvestment
• Suppose the Company is presented with a government-
sponsored investment costing Rs.4000 and with an
current year payoff of Rs.4500.
• Given the low (zero) risk of the project, the required
return is only 10%.
• The NPV of this investment is Rs.4500/1.1 – Rs.4000 =
Rs. 91.
• This is a positive NPV project and should be accepted
under normal circumstances. However, this project costs
Rs.4000 and the firm only has Rs.3000.
• Should stockholders provide the additional Rs.1000
needed to take on the project?
 Selfish Investment Strategy 3:
Milking the Property
• Shareholders may attempt to capture
some of the firm’s value by paying out
extra dividends or higher salaries to
management in times of financial distress.
 Q1
• Fountain Corporation economists estimate that a good business
environment and a bad business environment are equally likely for the
coming year. The managers of Fountain must choose between two
mutually exclusive projects. Assume that the project Fountain chooses will
be the firm's only activity and that the firm will close one year from today.
Fountain is obligated to make a $500 payment to bondholders at the end
of the year. Assume the firm's stockholders are risk-neutral. Consider the
following information pertaining to the two projects. Applicable interest rare
is 10% p.a..

• What is the expected value of the firm if the low-risk project is

undertaken? What if the high-risk project is undertaken? Which of the two
strategies maximizes the expected value of the firm?
• What is the expected value of the firm's equity if the low-risk project is
undertaken? What if the high-risk project is undertaken?
• Which project do Fountain's stockholders prefer? Explain.

Fountain Corporation economists estimate that
a good business environment and a bad
business environment are equally likely for the
coming year. The managers of Fountain must
choose between two mutually exclusive
projects. Assume that the project Fountain
chooses will be the firm's only activity and that
the firm will close one year from today.
Fountain is obligated to make a $500 payment
to bondholders at the end of the year. Assume
the firm's stockholders are risk-neutral.
Consider the following information pertaining to
the two projects. Applicable interest rare is 10%
p.a..
What is the expected value of the firm if the
low-risk project is undertaken? What if the high-
risk project is undertaken? Which of the two
strategies maximizes the expected value of the
firm?
What is the expected value of the firm's equity
if the low-risk project is undertaken? What if the
high-risk project is undertaken?
Which project do Fountain's stockholders
prefer? Explain.
Q1
If the low-risk project is undertaken, value of the
firm is
(0.50)($500) + (0.50)($700) = $600
If the high-risk project is undertaken, the value of
the firm is
(0.50)($100) + (0.50)($800) = $450
The low-risk project maximizes the value of the
firm.
If the low-risk project is undertaken, the expected
value of the firm’s equity is
(0.50)($0) + (0.50)($100) = $100
If the high-risk project is undertaken, it is
(0.50)($0) + (0.50)($300) = $150
Risk-neutral investors prefer the strategy with
the highest expected value. Fountain’s
stockholders prefer the high-risk project since it
maximizes the expected value of the firm’s
equity.
 Market Value of Bonds?
• Assume the high risk project is undertaken
• Do you believe that bondholders will receive
$100 in a recession?
– The bondholders will hire lawyers
– The management will also hire lawyers
– Court fee and all expenses are to be paid by the
company
• After all expenses only $50 will remain and
bondholders will finally get $50.
• Cost of financial distress.
 The Value of the Firm

• The financial distress is costly for the firms and will bring
down value of the firm.

• The value of a levered firm is:

• VL = VU + PV(tax savings) – PV(costs of financial
distress).
 Integration of Tax Effects
and Financial Distress Costs
Value of firm (V) Value of firm under
Present value of tax MM with corporate
shield on debt taxes and 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
*
 Q2
Good Time Company is a regional chain department store. It will remain in
business for one more year. The probability of a boom year is 60 percent
and a recession is 40 percent It is projected that GoodTime will generate a
total cash flow of $250 million in a boom year and $100 million in a
recession. The firm's required debt payment at the end of the year is $150
million. The market value of Good Time's outstanding debt is $108.93
million. Assume a one-period model, risk neutrality, and an annual discount
rate of 12 percent for both the firm's debt and equity. Good Time pays no
taxes.

a. What is the value of the firm's equity?

b. What is the promised return on Good Time's debt?
c. What is the value of the firm?
d. How much would Good Time's debt be worth if there were no bankruptcy costs?
e. What payoff, after bankruptcy costs, do bondholders expect to receive in the
event of a recession?
f. What cost do bondholders expect Good Time to incur should bankruptcy arise at
the end of the year?
 Q2
Good Time Company is a regional
chain department store. It will remain
in business for one more year. The
probability of a boom year is 60
percent and a recession is 40
percent It is projected that GoodTime
will generate a total cash flow of
$250 million in a boom year and $100
million in a recession. The firm's
required debt payment at the end of
the year is $150 million. The market
value of Good Time's outstanding
debt is $108.93 million. Assume a
one-period model, risk neutrality, and
an annual discount rate of 12 percent
for both the firm's debt and equity.
Good Time pays no taxes.
a. What is the value of the firm's
equity?
b. What is the promised return on
Good Time's debt?
c. What is the value of the firm?
d. How much would Good Time's
debt be worth if there were no
bankruptcy costs?
e. What payoff, after bankruptcy
costs, do bondholders expect to
receive in the event of a
recession?
f. What cost do bondholders expect
Good Time to incur should
bankruptcy arise at the end of
the year?
The value of Good Time’s equity is:
{(0.60)($100 million) + (0.40)($0)} / 1.12
= $53.57 million
Promised Return on Debt
= (Face Value of Bond / Market Value of Bond) – 1
= ($150 million / $108.93 million) – 1
= 0.3770
The value of Good Time is: VL = B + S
= $108.93 million + $53.57 million
= $162.5 million
If no bankruptcy costs are priced, the value of debt is:
{(0.60)($150 million) + (0.40)($100)} / 1.1
= $116.07 million
Let X be the amount that bondholders expect to receive in
the event of a recession:
$108.93 million = {(0.60)($150 million) + (0.40)(X)} / 1.12
X = $80 million
Since the firm will generate $100 million of cash flow in the
event of a recession but the firm’s bondholders only
expect to receive a payment of $80 million,
Expected bankruptcy cost ($100 million - $80 million)
= $20 million
 Quiz
• XYZ Corporation will remain in business for one more year. The
companies' economists agree that the probability of a recession
next year is 20 percent and the probability of a continuation of the
current expansion is 80 percent. If the expansion continues, the firm
will generate earnings before interest and taxes (EBIT) of $3 million.
If a recession occurs, each firm will generate earnings before
interest and taxes (EBIT) of $0.8 million. XYZ's debt obligation
requires the firm to pay $ 1,XY0,000 at the end of the year. The firm
pays no taxes. Assume a one-period model, risk neutrality, and an
annual discount rate of (10 + X) percent.
• Assuming there are no costs of bankruptcy, what is the current
value of bond?
X= Unit place digit of your roll no
Y= Tenth place digit of your roll no.