Lecture 5 Ch16 2

Chapter Outline
16.3 Debt and Taxes

16.4 The Costs of Bankruptcy and Financial Distress
16.5 Optimal Capital Structure: The Trade-off Theory
16.6 Additional Consequences of Leverage: Agency
Costs and Information
16.7 Capital Structure: Putting It All Together
Copyright © 2023 Pearson Canada Inc. 16 - 1

16.3 Debt and Taxes (1 of 10)
• Market imperfections can create a role for the capital
structure.
– Corporate taxes:
▪ Corporations can deduct interest expenses.
▪ Reduces taxes paid
– Increases amount available to pay investors.
– Increases value of the corporation.

• Consider the impact of interest expenses on taxes
paid by Loblaw, Inc.
– In 2020, Loblaw had earnings before interest and taxes
of $2.365 billion
– Interest expenses of $742 million and corporate tax
rate of 26%
– We can compare Loblaw’s actual net income with what
it would have been without debt

• Interest Tax Shield
– The reduction in taxes paid due to the tax deductibility
of interest payments.
Interest Tax Shield = Corporate Tax Rate × Interest Payments

Example 16.3: Computing the Interest
Tax Shield (1 of 5)
• Shown below is the income statement for Delta Farm
Buildings (DFB). Given its marginal corporate tax rate
of 35%, what is the amount of the interest tax shield
for DFB in years 2020 through 2023?

Tax Shield (2 of 5)
1 DFB Income Statement ($ million) 2020 2021 2022 2023
2 Total sales $3369 $3706 $4077 $4432
3 Cost of sales −2359 −2584 −2867 −3116
4 Selling, general, and administrative expense −226 −248 −276 −299
5 Depreciation −22 −25 −27 −29
6 Operating income 762 849 907 988
7 Other income 7 8 10 12
9 EBIT 769 857 917 1000
10 Interest expense −50 −80 −100 −100
11 Income before tax 719 777 817 900
12 Taxes (35%) −252 −272 −286 −315
13 Net income $467 $505 $531 $585

Tax Shield (3 of 5)
• From Eq. 16.4, the interest tax shield is the tax rate of
35% multiplied by the interest payments in each year.

Tax Shield: Execute (4 of 5)
($ million) 2020 2021 2022 2023

Interest expense 50 80 100 100
Interest tax shield (35% × 17.5 28 35 35
interest expense)

Tax Shield: Evaluate (5 of 5)
• By using debt, DFB is able to reduce its taxable
income and therefore decrease its total tax payments
by $115.5 million over the four-year period. Thus, the
total amount of cash flows available to all investors
(debt holders and equity holders) is $115.5 million
higher over the four-year period.

• When a firm uses debt, the interest tax shield provides
a corporate tax benefit each year.
• To determine the benefit, compute the present value
of the stream of future interest tax shields.

• By increasing the cash flows paid to debt holders
through interest payments, a firm reduces the amount
paid in taxes.
• The increase in total cash flows paid to investors is
the interest tax shield.

• Value of the Interest Tax Shield
– Cash flows of the levered firm are equal to the sum of
the cash flows from the unlevered firm plus the interest
tax shield.
– By the Valuation Principle the same must be true for
the present values of these cash flows.

• Value of the Interest Tax Shield
– 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:
VL = VU + PV(Interest Tax Shield) (Eq. 16.5)

Example 16.4: Recapitalizing to Capture
the Tax Shield Problem
• Smart Industries has 210 million shares outstanding
with a market price of $23 per share and no debt.
Smart generates stable profits and pays a 25% tax
rate. Management plans to borrow $80 million on a
permanent basis and use the borrowed funds to
repurchase $80 million worth of their outstanding
shares. Their expectation is that the tax savings from
this transaction will benefit shareholders. Is this
expectation realistic?

the Tax Shield: Plan
• In this case, the debt is permanent so we can use
Equation 16.7 to value the interest tax shields. The
value of the levered firm is the value of the unlevered
company plus the present value of the tax shields,
and the value of equity equals the value of the levered
firm minus the company’s debt.

the Tax Shield: Execute (1 of 2)
• Without leverage, Smart total market value is the
value of its unlevered equity, which is the total value of
all 20 million shares:
• With leverage, Smart will reduce its annual tax

payments. If Smart borrows $80 million using
permanent debt, the present value of the firm’s
future tax savings is

the Tax Shield: Execute (2 of 2)
• Thus, the total value of the levered firm will be
• This total value represents the combined value of

the debt and the equity after the recapitalization.
Because the value of the debt is $100 million, the
value of the equity is

the Tax Shield: Evaluate
• While total firm value has increased, the value of
equity dropped after the recap. How do hare holders
benefit from this transaction? In addition to holding
$170 million worth of shares, shareholders will also
receive $80 million cash that Smart will pay out
through the share repurchase. In total, they will
receive $250 million, a gain of $20 million over the
value of their shares without leverage.

• Interest Tax Shield with Permanent Debt
– The level of future interest payments varies due to:
▪ Changes in the amount of debt outstanding,
▪ Changes in the interest rate on that debt,
▪ Changes in the firm’s marginal tax rate, and
▪ The risk that the firm may default and fail to make an
interest payment.

• Leverage and the WACC with Taxes
– Another way to incorporate the benefit of the firm’s
future interest tax shield
– Weighted Average Cost of Capital with Taxes

• The reduction in the WACC increases with the amount
of debt financing.
• The higher the firm’s leverage, the more the firm
exploits the tax advantage of debt, and the lower its
WACC.

16.4 The Costs of Bankruptcy and
Financial Distress (1 of 7)
• If increasing debt increases the value of the firm, why
not shift to 100% debt?
• With more debt, there is a greater chance that the firm
will default on its debt obligations.
• A firm that has trouble meeting its debt obligations is
in financial distress.

• Direct Costs of Bankruptcy
– Each country has a bankruptcy code designed to
provide an orderly process for settling a firm’s debts.
▪ However, the process is still complex, time-consuming,
and costly.
▪ Outside professionals are generally hired.
▪ The creditors may also incur costs during the process.
They often wait several years to receive payment.

• Direct Costs of Bankruptcy
– Average direct costs are 3% to 4% of the pre-
bankruptcy market value of total assets.
▪ Likely to be higher for firms with more complicated
business operations and for firms with larger numbers of
creditors.

• Indirect Costs of Financial Distress
– Difficult to measure accurately, and often much larger
than the direct costs of bankruptcy.
▪ Often occur because the firm may renege on both implicit
and explicit commitments and contracts.

– Estimated potential loss of 10% to 20% of value
– Many indirect costs may be incurred even if the firm is
not yet in financial distress, but simply faces a
significant possibility that it may occur in the future.

• Examples:
– Loss of customers:
▪ Customers may be unwilling to purchase products whose
value depends on future support or service from the firm.
– Loss of suppliers:
▪ Suppliers may be unwilling to provide a firm with
inventory if they fear they will not be paid

• Examples:
– Cost to employees:
▪ Most firms offer their employees explicit long-term
employment contracts.
▪ During bankruptcy these contracts and commitments are
often ignored and employees can be laid off
– Fire Sales of Assets:
▪ Companies in distress may be forced to sell assets
quickly.

16.5 Optimal Capital Structure: The
trade-off Theory (1 of 7)
• trade-off Theory:
– Total value of a levered firm equals the value of the firm
without leverage plus the present value of the tax
savings from debt, less the present value of financial
distress costs:

• Key factors determine the present value of financial
distress costs:
1) The probability of financial distress
▪ Depends on the likelihood that a firm will default.
▪ Increases with the amount of a firm’s liabilities (relative to
its assets).
▪ Increases with the volatility of a firm’s cash flows and
asset values.

• Key factors determine the present value of financial
distress costs:
2) The magnitude of the direct and indirect costs related
to financial distress that the firm will incur.
▪ Depend on the relative importance of the sources of
these costs and likely to vary by industry.

• As debt increases, tax benefits of debt increase until
interest expense exceeds EBIT.
• Probability of default, and hence present value of
financial distress costs, also increases.
• The optimal level of debt, D*, occurs when these the
value of the levered firm is maximized.
• D* will be lower for firms with higher costs of financial
distress.

• Costs of financial distress reduce the value of the
levered firm.
– Amount of the reduction increases with probability of
default, which increases with debt level.

• Trade-off Theory:
– Firms should increase their leverage until it reaches the
maximizing level.
– The tax savings that result from increasing leverage
are just offset by the increased probability of incurring
the costs of financial distress.
– With higher costs of financial distress, it is optimal for
the firm to choose lower leverage.

• The trade-off theory helps to resolve two important
facts about leverage:
– The presence of financial distress costs can explain
why firms choose debt levels that are too low to fully
exploit the interest tax shield.
– Differences in the magnitude of financial distress costs
and the volatility of cash flows can explain the
differences in the use of leverage across industries.

16.6 Additional Consequences of Leverage:
Agency Costs and Information (1 of 11)
• Agency costs:
– Costs that arise when there are conflicts of interest
between stakeholders.
• Managerial Entrenchment:
– Managers often own shares of the firm, but usually own
only a very small fraction of the outstanding shares.
– Shareholders have the power to fire managers.
▪ In practice, they rarely do so.

• Separation of ownership and control creates the
possibility of management entrenchment
– Managers may make decisions that:
▪ Benefit themselves at investors’ expense
▪ Reduce their effort
▪ Spend excessively on perks
▪ Engage in “empire building”

• If these decisions have negative NPV for the firm, they
are a form of agency cost.
– Debt provides incentives for managers to run the firm
efficiently:
▪ Ownership may remain more concentrated, improving
monitoring of management.
▪ Since interest and principal payments are required, debt
reduces the funds available at management’s discretion
to use wastefully.

• Equity-Debt Holder Conflicts
– A conflict of interest exists if investment decisions have
different consequences for the value of equity and the
value of debt.
▪ Most likely to occur when the risk of financial distress is
high
▪ Managers may take actions that benefit shareholders but
harm creditors and lower the total value of the firm

• Agency costs for a company in distress that will likely
default:
– Excessive risk-taking
▪ A risky project could save the firm even if the expected
outcome is so poor that it would normally be rejected.
– Under-investment problem
▪ Shareholders could decline new projects.
▪ Management could distribute as much as possible to the
shareholders before the bondholders take over.

• As debt increases, firm value increases
– Interest tax shield (TCD)
– Improvements in managerial incentives.
• If leverage is too high, firm value is reduced by
– Present value of financial distress costs
– Agency costs
• The optimal level of debt, D*, balances these benefits
and costs of leverage.

• Asymmetric information
– Managers’ information about the firm and its future
cash flows is likely to be superior to that of outside
investors.
– This may motivate managers to alter a firm’s capital
structure.

• Leverage as a Credible Signal
– Managers use leverage to convince investors that the
firm will grow, even if they cannot provide verifiable
details.
– The use of leverage as a way to signal good
information is known as the signalling theory of debt.

• Market Timing
– Managers sell new shares when they believe the stock
is overvalued, and rely on debt and retained earnings if
they believe the stock is undervalued.

• Adverse Selection and the Pecking Order Hypothesis
– Suppose managers issue equity when it is overpriced.
– Knowing this, investors will discount the price they are
willing to pay for the stock.
– Managers do not want to sell equity at a discount so
they may seek other forms of financing.

• The pecking order hypothesis states:
– Managers have a preference to fund investment using
retained earnings, followed by debt, and will only
choose to issue equity as a last resort.

Example 16.5: The Pecking Order of
Financing Alternatives
Axon Industries needs to raise $9.5 million for a new
investment project. If the firm issues one-year debt, it
may have to pay an interest rate of 8%, although Axon’s
managers believe that 6% would be a fair rate given the
level of risk. However, if the firm issues equity, they
believe the equity may be underpriced by 5%. What is
the cost to current shareholders of financing the project
out of retained earnings, debt, and equity?

Financing Alternatives: Plan
We can evaluate the financing alternatives by
comparing what the firm would have to pay to get the
financing versus what its managers believe it should
pay if the market had the same information they do.

Financing Alternatives: Execute (1 of 2)
If the firm spends $9.5 million out of retained earnings,
rather than paying that money out to shareholders as a
dividend, the cost of financing the project is $9.5 million.
Using one-year debt costs the firm $9.5 × (1.08) =
$10.26 million in one year, which has a present value
based on management’s view of the firm’s risk of
$10.26 ÷ (1.06) = $9.68 million.

Financing Alternatives: Execute (2 of 2)
If equity is underpriced by 5%, then to raise $9.5 million
the firm will need to issue shares that are actually worth
$10 million. (For example, if the firm’s shares are each
worth $50, but it sells them for 0.95 × $50 = $47.50 per
share, it will need to sell $9.5 million ÷ $47.50/share =
200,000 shares. These shares have a true value of
200,000 shares × $50/share = $10 million.)
Thus, the cost of financing the project with equity will be
$10 million.

Financing Alternatives: Evaluate
Comparing the three options, retained earnings are the
cheapest source of funds, followed by debt, and finally
by equity. The ranking reflects the effect of differences
in information between managers and investors that
result in a lemons problem when they issue new
securities, particularly when issuing new equity.

15.7 Capital Structure: Putting It All
Together (1 of 2)
• Use the interest tax shield if your firm has consistent
taxable income
• Balance tax benefits of debt against costs of financial
distress
• Consider short-term debt for external financing when
agency costs are significant.
• Increase leverage to signal confidence in the firm’s
ability to meet its debt obligations.

15.7 Capital Structure: Putting It All
Together (2 of 2)
• Be mindful that investors are aware that you have an
incentive to issue securities that you know are
overpriced
• Rely first on retained earnings, then debt, and finally
equity
• Do not change the firm’s capital structure unless it
departs significantly from the optimal level.

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Chapter Outline

16.3 Debt and Taxes

Copyright © 2023 Pearson Canada Inc. 16 - 1

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Interest Tax Shield = Corporate Tax Rate × Interest Payments

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4 Selling, general, and administrative expense −226 −248 −276 −299

5 Depreciation −22 −25 −27 −29

6 Operating income 762 849 907 988

9 EBIT 769 857 917 1000

10 Interest expense −50 −80 −100 −100

11 Income before tax 719 777 817 900

12 Taxes (35%) −252 −272 −286 −315

13 Net income $467 $505 $531 $585

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($ million) 2020 2021 2022 2023

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VL = VU + PV(Interest Tax Shield) (Eq. 16.5)

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• With leverage, Smart will reduce its annual tax

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• This total value represents the combined value of

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