© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 12: Capital Structure Theory and Taxes Corporate Finance, 3e Graham, Smart, and Megginson

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  The term capital structure refers to the mix of debt and equity securities that a firm uses to finance its activities. 2 Capital Structure

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  The fundamental principle of financial leverage:  Substituting debt for equity increases expected returns to shareholders— measured by earnings per share or ROE—but also increases the risk of those returns. 3 Financial Leverage

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  When firms borrow money, we say that they use financial leverage.  A firm with debt on its balance sheet is a levered firm.  A firm that finances its operations entirely with equity is an unlevered firm.  Can be either positive or negative, depending on the returns a firm earns on the money it borrows. 4 Financial Leverage

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The Modigliani & Miller Propositions  Modigliani and Miller (M&M) argument: Capital structure decisions do not affect firm value.  Managers who operate in imperfect markets can see more clearly how market imperfections might lead them to choose one capital structure over another.  M&M’s argument rests on the principle of no arbitrage. 5

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 6 The M&M Capital Structure Model First model to show that capital structure decision may be irrelevant Assumes perfect markets, no taxes or transactions costs Key insight Firm value is determined by: Cash flows generated Underlying business risk Capital structure merely determines how cash flows and risks are allocated between bondholders and stockholders.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Assumptions of the M&M Capital Structure Model  Capital markets are perfect – neither firms nor investors pay taxes or transactions costs.  Investors can borrow and lend at the same rate that corporations can.  There are no information asymmetries. 7

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.  In perfect markets, a firm’s total market value equals the value of its assets and is independent of the firm’s capital structure.  The value of the assets equals the present value of the cash flows generated by the assets.  Proposition leads to the conclusion that a firm’s capital structure does not matter – popularly known as the “irrelevance proposition” 8 M&M Proposition I

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 9 M&M Proposition I Use arbitrage arguments to prove Proposition I. Proposition I: Market value of a firm is driven by two factors: cash flow and risk (determines the discount rate).

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Proposition II and the WACC  Though debt is less costly for firms to issue than equity, issuing debt causes the required return on the remaining equity to rise.  Based on the core finance principle that investors expect compensation for risk, shareholders of levered firms demand higher returns than do shareholders in all-equity companies. 10

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Proposition II and the WACC  Proposition II says that the expected return on a levered firm’s equity ( r l ) rises with the debt-to-equity ratio:  Proposition II rearranged is the WACC: 11

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The M&M Model with Corporate Taxes  Firms can treat interest payments to lenders as a tax-deductible business expense.  Dividend payments to shareholders receive no similar tax advantage.  Intuitively, this should lead to a tax advantage for debt, meaning that managers can increase firm value by issuing debt. 12

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. The M&M Model with Corporate and Personal Taxes  Miller: Debt’s tax advantage over equity at the corporate level might be partially or fully offset by a tax disadvantage at the individual level. 13

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bond Market Equilibrium with Corporate and Personal Taxes  Wouldn’t taxable investors also demand a higher interest rate to compensate them for taxes due?  Yes, but Miller explains that interest rates do not rise immediately for two reasons: 1. Some investors, such as endowments and pension funds, do not have to pay taxes on interest income. 2. Investors who do not enjoy this tax-exempt status can buy municipal bonds, which pay interest that is tax free. 14

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Nondebt Tax Shields (NDTS)  Companies with large amounts of depreciation, investment tax credits, R&D expenditures, and other nondebt tax shields should employ less debt financing than otherwise equivalent companies with fewer such shields. 15

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. How Taxes Should Affect Capital Structure 1. The higher the corporate income tax rate, T c, the higher will be the equilibrium leverage level economy-wide. An increase in T c should cause debt ratios to increase for most firms. 2. The higher the personal tax rate on equity- related investment income (dividends and capital gains), T ps, the higher will be the equilibrium leverage level. An increase in T ps should cause debt ratios to increase. 16

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. How Taxes Should Affect Capital Structure 3. The higher the personal tax rate on interest income, T pd, the lower will be the equilibrium leverage level. An increase in T pd should cause debt ratios to fall. 4. The more nondebt tax shields a company has, the lower will be the equilibrium leverage level. 17