2 - Chapter 15 (Super Abridged) - Presentation

Corporate Finance
Fifth Edition, Global Edition
Chapter 15
Debt and Taxes
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline
15.1 The Interest Tax Deduction
15.2 Valuing the Interest Tax Shield
15.3 Recapitalizing to Capture the Tax Shield
15.4 Personal Taxes
15.5 Optimal Capital Structure with Taxes

Learning Objectives (1 of 3)
• Explain the effect of interest payments on cash flows to
investors.
• Calculate the interest tax shield, given the corporate tax
rate and interest payments.
• Calculate the value of a levered firm.
• Calculate the weighted average cost of capital with
corporate taxes.
• Describe the effect of a leveraged recapitalization on the
value of equity.

• Describe the effect of personal taxes on the corporate tax
benefits of leverage.
• Given corporate and personal tax rates on equity and debt,
calculate the tax benefit of debt with personal taxes.
• Discuss why the optimal level of leverage from a tax-
saving perspective is the level at which interest equals
EBIT.

• Describe the relationship between the optimal fraction of
debt and the growth rate of the firm.
• Assess the apparent under-leveraging of corporations,
both domestically and internationally.

15.1 The Interest Tax Deduction (1 of 5)
• In Chapter 14, we found that the choice of debt versus equity financing does not affect
the value of the firm.
• While leverage increases the risk and cost of capital of the firm’s equity, the firm’s
weighted average cost of capital (WACC), total value, and share price are unaltered by a
change in leverage.
• That is, in a perfect capital market, a firm’s choice of capital structure is unimportant.
• If capital structure is unimportant, why do we see such consistent differences in capital

structures across firms and industries (for example auto and track manufactures have
higher debt ratios than biotechnology and drug companies)?. Why do managers
dedicate so much time, effort, and expense to capital structure choice?.
• Thus, if capital structure does matter, then it must stem from a market
imperfection. On this Chapter, we focus on one such imperfection: taxes.
• 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.
• Consider Macy’s, which had earnings before interest and
taxes (EBIT) 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.

Table 15.1 Macy’s Income with and
Without Leverage, Fiscal Year 2014
($ million)
Blank With Leverage Without Leverage

EBIT $2800 $2800
Interest expense −400 0
Income before tax 2400 2800
Taxes (35%) −840 −980
Net income $1560 $1820

• Macy’s debt obligations reduced the income available to
equity holders.
• But more importantly, the total amount available to all
investors (equity and debt holders) was higher with
leverage (1960-1820 = 140).
Blank With Leverage Without Leverage
Interest paid to debt holders 400 0
Income available to equity holders 1560 1820
Total available to all investors $1960 $1820

• 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, representing an increase of $140
million.
• It might seem odd that a firm can be better off with
leverage even though its earnings are lower. But recall
from Chapter 14 that the value of a firm is the total amount
it can raise from all investors, not just equity holders.
Because leverage allows the firm to pay out more in total
to its investors-including interest payments to debt holders-
it will be able to raise more total capital initially.
• Where does the additional $140 million come from?
• Interest Tax Shield
– The reduction in taxes paid due to the tax deductibility
of interest
Interest Tax Shield  Corporate Tax Rate  Interest Payments
 In Macy’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
The interest tax shield is the additional amount that a

firm would have paid in taxes if it did not have leverage.
Textbook Example 15.1 (1 of 2)
Computing the Interest Tax Shield
Problem
Shown below is the pro-forma forecasted income statement for D.F. Builders
(DF B), Given its marginal corporate tax rate of 25%, what is the amount of the
interest tax shield for DF B in year 2019 through 2022?
DFB Income statement ($ million) 2019 2020 2021 2022
Total sales $3369 $3706 $4077 $4432
Cost of sales −2359 −2584 −2867 −3116
Selling, general, and administrative expense −226 −248 −276 −299
Depreciation −22 −25 −27 −29
Operating income 762 849 907 988
Other income 7 8 10 12
EBIT 769 857 917 1000
Interest expense −50 −80 −100 −100
Income before tax 719 777 817 900
Taxes (35%) −180 −194 −204 −225
Net income $539 $583 $613 $675

Solution
From Eq.15.1, the interest tax shield is the tax rate of 25%
multiplied by the interest payments in each year:
($ million) 2012 2013 2014 2015
Interest expense −50 −80 −100 −100
Interest tax shield 12.5 20 25 25
(25% × interest expense)
Thus, the interest tax shield enabled DF B to pay an

additional $82.5 million (12.5+20+25+25) to its investors
over this period (all investors: debt and equity holders).

15.2 Valuing the Interest Tax Shield
• When a firm uses debt, the interest tax shield provides a
corporate tax benefit each year.
• To determine the benefit of leverage for the value of the
firm, we must compute the present value of the stream fo
future interest tax shields the firm will receive.

The Interest Tax Shield and Firm Value
(1 of 2)
• 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 
• Next Figure 15.1 illustrates this relationship..

Figure 15.1 The Cash Flows of the
Unlevered and Levered Firm
By increasing the cash flows paid to debt holders through interest payments,a firm
reduces the amount paid in taxes. Cash Flow paid to investors are shown in blue. The
increase in total cash flows paid to investors is the interest tax shield (or the difference
paid in taxes).
The Interest Tax Shield and Firm Value (2 of 2)
• Because the cash flow of the levered firm are equal to the sum of the
cash flows from the unlevered firm plus the interest tax shield, by the
Law of One Price, the same must be true for the present values of
these cash flows.
• So we have the following change to MM Proposition I in the presence of
taxes..
• MM Proposition I with Taxes

– The total value of the levered firm (VL) exceeds the
value of the firm without leverage (VU) due to the
present value of the tax savings from debt:
V L = V U + PV (Interest Tax Shield)
Clearly, there is an important tax advantage to use of debt financing.
But how large is this tax benefit? : to compute the increase in the firm’s total value associated with
the interest tax shield, we need to forecast how a firm’s debt-and therefore its interest payments-
will vary over time. Given a forecast of future interest payments, we can determine the interests
tax shield and compute its present value by discounting it at a rate corresponds to its risk.
Valuing the Interest Tax Shield Without Risk
Problem
Suppose DF B restructures its existing debt, and will instead
pay $80 million in interest each year for the next 10 years,
and then repay the principal of $1.6 billion in year 10. These
payments are risk free, and DF B’s marginal tax rate will
remain 25% throughout this period. If the risk-free interest
rate is 5%, by how much does the interest tax shield
increase the value of DF B?

Solution
In this case, the interest tax shield is 25% × $80 million =
$20 million each year for the next 10 years. Therefore, we
can value it as a 10-year annuity. Because the tax savings
are known and not risky, we can discount them at the 5%
risk-free rate:
1  1 
PV (Interest Tax Shield)  $20 million  1  
0.05  1.0510 
 $154 million
The final repayment of principal in year 10 is not deductible,

so it does not contribute to the tax shield.
4.5 Perpetuities and Annuities
Annuities
• When a constant cash flow will occur at regular intervals
for a finite number of N periods, it is called an annuity.
• Present Value of an Annuity

Present Value of an Annuity
The Interest Tax Shield with Permanent
Debt (1 of 4)
• In Example 15.2, we know with certainty the firm’s future
interest payments and associated tax savings. In practice,
this case is rare.
• 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 that the firm may default and fail to make an interest
payment.
– For simplicity, we will consider the special case in
which the above variables are kept constant. So by the
moment let’s consider the special case in which the
firm issues debt and plans to keep the dollar amount of
debt constant forever.
Debt (2 of 4)
• 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 (interest are rf x
D), and the tax shield can be valued as a perpetuity:
 c  Interest  c  (rf  D)
PV (Interest Tax Shield)  
rf rf
c  D
The above equation assumes the debt is risk-free and the risk-free
interest rate is constant
4.5 Perpetuities and Annuities (1 of 2)
• Annuities and Perpetuities:
• Two special types of cash flows streams
• Learning shortcuts for valuing them (very important when
we didn´t have financial calculators and computers… not
long ago…)
• Perpetuities
• When a constant cash flow will occur at regular intervals
forever it is called a perpetuity.
4.5 Perpetuities and Annuities (2 of 2)
The value of a perpetuity is simply the cash flow divided by the
interest rate.
Present Value of a Perpetuity
C
PV (C in perpetuity) =
r
Debt (3 of 4)
• 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)

Debt (4 of 4)
• If the firm’s marginal tax rate is constant, then
PV (Interest Tax Shield)  PV (τ c  Future Interest Payments)

 τ c  PV (Future Interest Payments)
 τc  D
This formula shows the magnitude of the interest tax shield. Given a 21%
corporate tax rate, it implies that for every $1 in new permanente debt that
the firm issues, the value of the firm increases by $0.21.

The Weighted Average Cost of Capital with Taxes
• With tax-deductible interest, the effective after-tax
borrowing rate is rD(1 − c).
• In Chapter 14, we showed that without taxes, the firm’s WACC was equal to its
unlevered cost of capital, which is the average return that the firm must pay to
its investors (equity holders and debt holders). The tax-deductibility of interest
payments, however, lowers the effective after-tax cost of debt to the firm. As
we discussed in Chapter 12, we can account for the benefit of the interest tax
shield by calculating the WACC using the effective after-tax cost of debt:
E D
rWacc  rE  rD (1  c ) (15.5)
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
The WACC is therefore lower than the pre-tax WACC or r U (unlevered cost of capital), which is
the average return paid to the firm’s investors. Thus, the higher the fim’s leverage, the more
the firm exploits the tax advantage of debt, and the lower its WACC.
Figure 15.2 illustrates the decline in the WACC with the firm’s leverage ratio
The WACC with and without Corporate Taxes
We compute the WACC as a function of the firm’s target debt-to-value ratio (D/(D+E) using Eq.15.5. As shown
in Figure 14.1, the firm’s unlevered cost of capital r U or pre-tax WACC is constant, reflecting the
required return of the firm’s investors based on the risk fo the firm’s assets. However the WACC, which
represents the after-tax cost to the firm, declines with leverage as the interest tax shield grows. The figure
assumes marginal corporate income tax rate of Ƭ C = 20%.
The Interest Tax Shield with a Target
Debt-Equity Ratio (1 of 2)
• Earlier we calculated the value of the tax shield assuming
the firm maintains a constant level of debt. In many cases
this assumption is unrealistic-rather than maintain a
constant level of debt, many firms target a specific debt-
equity ratio (D/E) instead. When a firm does so, the level of
its debt will grow (or shrink) with the size of the firm.
• As we will show formally in Chapter 18, when a firm
adjusts its leverage to maintain a target debt-equity ratio
(D/E), we can compute its value with leverage, VL, by
discounting its free cash flow using the weighted average
cost of capital (WACC).

The Interest Tax Shield with a Target
Debt-Equity Ratio (2 of 2)
• The value of the interest tax shield can be found by
comparing the value of the levered firm, VL, to the
unlevered value, VU ( the value of the free cash flow
discounted at the firm’s unlevered cost of capital or the
pretax WAC C, rU)

Valuing the Interest Tax Shield with a Target Debt-Equity
Ratio
Problem
Western Lumber Company expects to have free cash flow in
the coming year of $4.25 million, and its free cash flow is
expected to grow at a rate of 4% per year thereafter.
Western Lumber has an equity cost of capital of 10% and a
debt cost of capital of 6%, and it pays a corporate tax rate of
21%. If Western Lumber maintains a debt-equity ratio of
0.50, what is the value of its interest tax shield?

Solution
We can estimate the value of western Lumber’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 WAC C:
E D 1 0.5
Pre-tax WACC  rE  rD  10%  6%  8.67%
ED ED 1  0.5 1  0.5
Because western Lumber’s free cash flow is expected to grow at a

constant rate, we can value it as a constant growth perpetuity:
4.25
Vu   $91 million
8.67%  4%
To compute western Lumber’s levered value, we calculate its WAC C:

E D
WACC  rE  rD (1  c )
ED ED
1 0.5
 10%  6%(1  0.21)  8.25%
1.05 1  0.5
Thus, Western Lumber’s value including the interest tax

shield is
4.25
V 
L
 $100 million
8.25%  4%
The value of the interest tax shield is therefore

𝐿 𝑈
𝑃𝑉 ( Interest Tax Shield )=𝑉 −𝑉 =100 − 91=$ 9 million

15.3 Recapitalizing to Capture the Tax Shield
• When a firm makes a significant change to its capital structure, the
transaction is called a recapitalization (or simply a “recap”).
• In Chapter 14, we introduced a leverage recapitalization in which a firm issues a large
amount of debt and uses the proceeds to pay a special dividend or to repurchase
shares. They were popular when many firms found that these transactions could reduce
their tax payments.
• Let’s see how such a transaction might benefit current shareholders.

• Example: 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 21% tax rate.
• Management plans to borrow $100 million on a permanent basis
(leveraged recap) , and they will use the borrowed funds to repurchase
outstanding shares.
• Their expectation is that the tax savings from this transaction will boost Midco’s stock
price and benefit shareholders.
The Tax Benefit (1 of 3)
• Without leverage, Midco’s total market value is the value of
its unlevered equity
VU   20 million shares   $15 per 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)  c D  21%  $100 million  $21 million

• Thus the total value of the levered firm will be
– V L  V U  c D  $300 million  $21million  $321million
• This total value represents the combined value of the debt

and the equity after recapitalization.
• Because the value of the debt is $100 million, the value of
the equity is
E  V L  D  $321million  $100 million  $221million
While total value has increased, the value of equity dropped after
the recap (from 300 million to 221 million). How do shareholders
benefit from this transaction?.

• Although the value of the shares outstanding drops to
$221 million, don’t forget that shareholders will also
receive the $100 million that Midco will pay out through the
share repurchase.
• In total, they will receive the full $321 million, a gain of $21
million over the value of their shares without leverage.
• Let’s trace the details of the share repurchase and see
how it leads to an increase in the stock price.

The Share Repurchase (1 of 3)
• Assume Midco repurchases its shares at the current price
of $15 per share.
• The firm will repurchase 6.67 million shares.
$100 million
 6.67 million shares
$15 million / share
• It will then have 13.33 million shares outstanding.
20 million  6.67 million  13.33 million

• The total value of equity after the transaction is $221
million; therefore, the new share price is $16.575 per
share.
$221million
= $16.575
13.33 million /shares
• Shareholders who keep their shares earn a capital gain of

$1.575 per share.
$16.575  $15  $1.575

• The total gain to shareholders is $21 million.
– $1.575 / share  13.33 million shares  $21million
• In this case, the shareholders who remain after the recap

receive the benefit of the tax shield.
• However, you may have noticed something odd in the
previous calculations. We assumed that Midco was able to
repurchase the shares at the initial price of $15 per share,
and then demonstrated that the shares would be worth
$16.75 after the transaction.
• Why would shareholders agree to sell the shares for $15
when they are worth $16.75?
No Arbitrage Pricing (1 of 4)
• 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.
• But this activity would raise the share price above $15
even before the repurchase: once investors know the
recap will occur, the share price will rise immediately to a
level that reflects the $21 million value of interest tax shield
that the firm will receive.

• Realistically, the value of the Midco’s equity will rise
immediately from $300 million to $321 million after the
repurchase announcement.
• With 20 million shares outstanding, the share price will rise
to $16.05 per share.
$321 million
 $16.05 per share
20 million / shares
• Midco must offer at least this price to repurchase the shares.

• With a repurchase price of $16.05, the shareholders who
tender their shares and the shareholders who hold their
shares both gain $1.05 per share as a result of the
transaction.
$16.05  $15  $1.05

• The benefit of the interest tax shield goes to all 20 million
of the original shares outstanding for a total benefit of $21
million.
$1.05 per share  20 million shares  $21million
• 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.

Analyzing the Recap: The Market Value
Balance Sheet
• We can analyze the recapitalization using the market value
balance sheet, a tool we developed in Chapter 14. It states
that the total market value of a firm’s securities must equal
the total market of the firm’s assets.
• In the presence of corporate taxes, we must include the
interest tax shield as one of the firm’s assets.
• We analyze the leveraged recap by breaking this
transaction into steps, as shown in Table 15.2.

Table 15.2 Market Value Balance Sheet
for the Steps in Midco’s Leveraged
Recapitalization
Note that the share price rises at the announcement of the recap. This increase
in the share price is due solely to the present value of the (anticipated) interest
tax shield. Thus, even though leverage reduces the total market capitalization
of the firm’s equity, shareholders capture the benefits of the interest tax shield
upfront.
15.5 Optimal Capital Structure with
Taxes (1 of 3)
• In MM’s setting of perfect capital markets (Chapter 14) , firms could use any
combination of debt and equity to finance their investments without changing the
value of the firm. In effect, any capital structure was optimal.
• In this Chapter we have seen that taxes change that conclusion because
interest payments create a valuable tax shield.
• While this tax benefits somewhat offset by investors taxes (personal taxes), it is
likely that a substantial tax advantage to debt remains.
• Do Firms Prefer Debt?..do firms show a preference for debt in practice?

– Figure 15.5 makes clear that when firms raise new capital
from investors, they do so primarily by issuing debt.
– In fact, in most years, aggregate equity issues are
negative, meaning that on average, firms are reducing
the amount of equity outstanding by buying shares.

Figure 15.5 Net External Financing and Capital Expenditures by U.S.
Corporations, 1975–2017
Figure 15.5 illustrates the new issues of equity and debt by US corporations. For
equity, the figure shows the total amount of new equity issued, less the amount retired
through shares repurchases and acquisitions. For debt, it shows the total amount of
new borrowings less the amount of loans repaid.
Source: Federal Reserve, Flow of Funds Accounts of the United States, 2017.
Taxes (2 of 3)
• Do Firms Prefer Debt?
– While firms seem to prefer debt when raising external
funds, not all investment is externally funded.
– As Figure 15.5 shows, capital expenditures greatly
exceed firm’s external financing, implying that most
investment and growth is supported by internally
generated funds, such as retained earnings..
 Even though firms have not issued new equity, the
market value of equity has risen over time as firms
have grown (Figure 15.6).
 For the average firm, the result is that debt as a
fraction of firm value has varied in a range from 25%
to 50%.
Figure 15.6 Debt-to-Value Ratio [D/(E
+ D)] of U.S. Firms, 1975–2017
Although firms have primarily issued debt rather tan equity, the average
proportion of debt in their capital structures (D/D+E) has not increased due to
growth in value of existing equity.
Source: Compustat and Federal Reserve, Flow of Funds Accounts of the United States, 2017.

Taxes (3 of 3)
• Do Firms Prefer Debt?
– Aggregate date in Figure 15.6 masks two important tendencies:
first, the use of debt varies greatly by industry.
– Second, many firms retain large cash balances to reduce their
effective leverage.
– These patterns are revealed in Figure 15.7, which shows both
total and net debt as a fraction of firm enterprise value for a
number of industries and the overall market.
– Net debt is negative is a firm’s cash flow holdings exceed its
outstanding debt.
– Clearly, there are large differences: firms in growth industries like
biotechnology or high technology carry very little debt, while
airlines, automakers, utilities, real estate and financial firms have
high leverage ratios.

Figure 15.7 Debt-to-Enterprise Value
Ratio for Select Industries (1 of 2)
Source: Capital IQ, 2018.

Figure 15.7 Debt-to-Enterprise Value Ratio for Select Industries (2 of
2)
The median level of debt for all US stocks was about 17% of firm value, note the
large differences by industry.
Source: Capital IQ, 2018.
Lookign at that graph, these data raise important
questions….:
• If debt provides a tax advantage that lowers a firm’s

weighted average cost of capital and increases firm’s
value, why does debt make up less than half of capital
structure (debt+equity, D+E) of most firms?.
• And why does the leverage choice vary so much across

industries, with some firms having no net leverage?.
• To begin to answer these questions, let’s consider a bit

more carefully what the optimal capital structure is from a
tax perspective…

Limits to the Tax Benefit of Debt (1 of 7)
• 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 (in the limit, EBIT=total interests).
• In addition, starting in 2018, large corporations cannot
deduct interest exceeding 30% of their EBITDA (earnings
before interest, taxes, depreciation, and amortization, and
this limit drops to 30% of EBIT after 2021 (this limit applies
to firms with more than $25 million in revenue)
– This constraint may limit the amount of debt
needed as a tax shield.
• To determine the impact of these limitations on the optimal level of
leverage, compare the three leverages choices shown in Table 15.4
for a firm with EBIT (or EBITDA) equal to $1000 and a corporate tax
rate of Ʈc = 21%.
Table 15.4 Tax Savings with Different
Amounts of Leverage
Blank
No Moderate Excess
Blank Leverage Leverage Leverage
1 EBIT $1000 $1000 $1000
2 Interest expense 0 300 500
3 30% Income Limit 300 300 300
4 Interest Deduction (smaller of 2 and 3) 0 300 300
5 Taxable Income (1 – 4) 1000 700 700
6 Taxes (21% of 5) 210 147 147
7 Net income (1 – 2 – 6) 790 553 353
Tax savings from leverage $0 $63 $63

• From the previous slide:

– With no leverage, the firm receives no tax benefit.
– With moderate leverage, the firm saves $63 in taxes.
– With excess leverage, the interest payments exceed
the 30% income limit.
 In this case, the allowed interest deduction is
capped.
 Hence, once the 30% limit is reached, there is no
immediate tax shield from the excess leverage.

• The previous example illustrates that….

• The optimal level of leverage from a tax saving
perspective is the level such that interest equals the
income limit (30% of the 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.

• As Figure15.8 shows, if EBIT is known with certainty, an

interest payment equal to the income limit (30% EBIT)
maximizes the tax saving.
• 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.

Figure 15.8 Tax Savings for Different Levels of Interest
When EBIT is known with certainty, the tax savings is maximized if the interest expense is
equal to the limit of the EBIT (30%). When EBIT is uncertain, the tax savings declines for high
levels of interest because of the risk that the interest payment will be in excess of the limit of
EBIT.
• 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.

Growth and Debt (1 of 2)
• As we have seen in a tax-optimal capital structure, the
level of interest payments depends on the level of EBIT.
• What does this conclusion tell us about the optimal
fraction of debt in a firm’s capital structure?
• 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.
– That is, if the limit on the interest deduction is k x EBIT,
then
Interest  rD  Debt  k  EBIT or Debt  k  EBIT / rD

Growth and Debt (2 of 2)
• So, 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
 D 
the firm’s capital structure  (E + D)  will be lower, the
higher the firm’s growth rate.

The Low Leverage Puzzle (1 of 4)
• Do firms choose capital structures that fully exploit the tax
advantages of debt?
• The figure on the following slide (Figure 15.) reveals
important patterns:
- Firms have used debt to shield less than one third of their income
from taxes on average, and only about 50% in downturns (when
earnings tend to fall).
- Only about 10% of the time do firms have negative taxable income,
and thus would not benefit from an increased interest tax shield.
– 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 had far less leverage than our analysis of the interest
tax shield would predict.

Figure 15.9 Interest Payments as a Percentage of
EBIT and Percentage of Firms with Negative Pre-tax
Income, S&P 500 1975–2017
Source: Compustat.
• This low level of leverage is not unique to US firms. Table
15.5 shows international leverage levels
• 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 .

Table 15.5 International Leverage and
Tax Rates (1990)
Country D/(E + D) Net of Cash Interest/ C *
D/(E + D) EBIT
United states 28% 23% 41% 34.0% 34.0%
Japan 29% 17% 41% 37.5% 31.5%
Germany 23% 15% 31% 50.0% 3.3%
France 41% 28% 38% 37.0% 7.8%
Italy 46% 36% 55% 36.0% 18.6%
United 19% 11% 21% 35.0% 24.2%
Kingdom
Canada 35% 32% 65% 38.0% 28.9%
Source: R. Rajan and L. Zingales, “what Do We Know About Capital Structure? Some
Evidence from International Data,” Journal of Finance 50 (1995): 1421 − 1460. data is for
median firms and top marginal tax rates.
• Why are firms under-leveraged?.
• Either firms are content to pay more taxes than necessary rather than maximize shareholder
value, or there is more to the capital structure story that we have uncovered so far?
• It would appear that firms, on average, are under-leveraged. However,

it is hard to accept that most firms are acting sub-optimally.
– In reality, there is more to the capital structure story
than discussed so far.
• The consensus of so many managers in choosing low levels of leverage
suggests that debt financing has other costs that prevent firms from using
the interest tax shield fully.
• Talking to financial managers and they will quickly point out a key cost of
debt missing from our analysis: increasing the level of debt increases the
probability of bankruptcy. If bankruptcy is costly, these costs might offset
the tax advantages of debt financing (Chapter 16).
• Asides form taxes, another important difference between debt and equity
financing is that debt payments must be made to avoid bankruptcy,
whereas firms have no similar obligation to pay dividends or realize
capital gains.
• 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.
• We explore the role of financial bankruptcy costs and other
market imperfections in Chapter 16.

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?

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Corporate Finance

Fifth Edition, Global Edition

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• If capital structure is unimportant, why do we see such consistent differences in capital

• Corporations pay taxes on their profits after interest

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Blank With Leverage Without Leverage

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 In Macy’s case, the gain is equal to the reduction in

The interest tax shield is the additional amount that a

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Thus, the interest tax shield enabled DF B to pay an

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• The cash flows a levered firm pays to investors will be

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

• Next Figure 15.1 illustrates this relationship..

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• MM Proposition I with Taxes

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The final repayment of principal in year 10 is not deductible,

• Present Value of an Annuity

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Market Value of Debt = D = PV (Future Interest Payments)

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

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Because western Lumber’s free cash flow is expected to grow at a

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Thus, Western Lumber’s value including the interest tax

The value of the interest tax shield is therefore

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• Let’s see how such a transaction might benefit current shareholders.

VU   20 million shares   $15 per share   $300 million

PV (Interest Tax Shield)  c D  21%  $100 million  $21 million

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• This total value represents the combined value of the debt

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• Shareholders who keep their shares earn a capital gain of

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• In this case, the shareholders who remain after the recap

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• Midco must offer at least this price to repurchase the shares.

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• Do Firms Prefer Debt?..do firms show a preference for debt in practice?

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Source: Capital IQ, 2018.

• If debt provides a tax advantage that lowers a firm’s

• And why does the leverage choice vary so much across