1. Advanced Corporate Finance FINA 7330
Capital Structure Issues and Financing
Lecture 07 and 08
Fall, 2009

2. The Theories of Capital Structure
Irrelevance
Static Tradeoff
Pecking Order

3. The Irrelevance Theorem
Perfect Capital Market Setting
No Taxes
No Contracting Costs
Costs of Financial Distress
Agency Costs
No Information Costs

4. Irrelevance Theorem LIABILITIES ASSETS DEBT 0 PVA $1,000,000
EQUITY 3,000,000
TOTAL $3,000,000
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000

5. Irrelevance Theorem ASSETS LIABILITIES PVA $1,000,000 DEBT 1,600,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 1,600,000
EQUITY 1,400,000
TOTAL $3,000,000

6. Tax Implications LIABILITIES ASSETS PVA $1,000,000 DEBT 0
EQUITY 2,100,000
TOTAL $2,100,000
ASSETS
PVA $1,000,000
PVGO ,000,000
- PV of Tax Liability 900,000
TOTAL $2,100,000

7. Tax Implications LIABILITIES ASSETS DEBT 1,600,000 PVA $1,000,000
EQUITY ,000
TOTAL $2,580,000
ASSETS
PVA $1,000,000
PVGO ,000,000
Less:
PV of Tax Liability 420,000
TOTAL $2,580,000

8. Stockholders’ Wealth Originally: $2,100,000 in Equity Interest
Now: ,000 in Equity Interest
$1,600,000 in Cash
2,580,000
Total Stockholders’ Wealth. Notice that Stockholders’ wealth increased by an amount equal to the Present Value of the Tax Shield on Debt.

9. The Static Tradeoff Theory
Benefits versus Costs of Leverage.
Benefits Costs
Taxes Financial Distress
Resolution of Agency Costs
Agency Costs Bondholder/Stockholder
Manager/Stockholder
Bankruptcy Costs
Direct and
Indirect
Information Costs

10. The Impact of Taxes on the Capital Structure Decisions
Firm Value = S Operating Cash Flow (t)
(1+ro)t
= Market Value of the Firms Liabilities (Including Equity)
Let OCF(t) = Operating Cash Flow at time t

11. With Taxes = S OCF(t) - Tax on operations = Market Value of the Firm
Firm Value for an equity financed firm
= S OCF(t) - Tax on operations
(1+ro)t
= Market Value of the Firm
= Market Value of Equity
= V(u)
We call this the
Value of the Unlevered Stream (Firm), or
the Asset Value of the Firm)

12. Example Everything is a perpetuity; Cash Revenue $1000
Cash Expense
Depreciation
Tax Rate = 32%
Cost of Capital = 10%
ATOCF = ( ) -.32*( )
{EBIT(1-t) + Depreciation} =
= 436
V(u) = $4,360
Where ATOCF is After Tax Operating Cash Flow

13. Example ATOCF = (1000-500) -.32*(1000-500-300)
{EBIT(1-t) + Depreciation} =
= 436
V(u) = $4,360
Where ATOCF is After Tax Operating Cash Flow

14. Leverage Effects
Now suppose the firm issues 2000 worth of perpetual debt, paying interest at 5%.
Then interest will be:
INT = .05*2000 = $100

15. Now lets consider the interest deductions
Cash Revenue $1000
Cash Expense
Depreciation
Interest
Tax Rate (t) = 32%
CF = ( ) -.32*( ) =
= = 468
Or:
= ATOCF + t*INT
= =

16. Now Discount CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT
ro rB
V = V(u) + t*B

17. Now Discount CF = ATOCF + Interest Tax Shield And V = ATOCF + t*INT
ro rB
V = V(u) + t*B
= 4, * 2,000
= $5,000

18. Value of Debt and Equity
Value of firm = $5,000
Value of Debt = $2,000
Value of Equity = $3,000
B/V = .4
E/V = .6

19. With Taxes
In general,
V(L) = V(u) Plus Present Value of Tax Shield on Debt.
V(L) = V(u) + (Corp. Tax Rate) * Debt,
in the special case when debt is thought of as perpetual, or is selling at par.

20. Graphically
Firm Value (V)
V = V(u) + Tc*B
V(u)
Debt

21. Cost of Capital
rS = ro + (ro-rB)B/S
WACC = ro r rB

22. Cost of Capital (After Tax)
rE = ro + (ro-rB)(1-t)B/S r
WACC = ro(1-t(B/V) ) rd

23. Weighted Average Cost of Capital
WACC is the discount rate we use to discount the firm’s after tax Operating Cash Flow: (ATOCF)
So in the example we just had:
WACC = ro(1-T(B/V) ) = 8.72%
= rE(E/V) + (1-T)rB(B/V), and
rE = ( )(1-.32)(.6) = 12.27%
WACC = .1227* *.05*.4 = 8.72%

24. Firm Value and the Tax Shield on Debt
Notice that the value of the firm is simply the ATOCF discounted by the WACC!
The greater is the amount of debt issued, the lower is the WACC, and thus the higher is the value of the firm.
By assumption, the ATOCF is unaffected by the firm’s capital structure.

25. Static Tradeoff Theorem
Costs of Financial Distress
Potential Bankruptcy Costs
Underinvestment
Risk Shifting
Agency Costs

26. General Approach
Assume:
No Taxes
Single period
Cost of Capital = 10%

27. Perfect Capital Market
Widgets International
Good State Bad State
Pure Equity 11 million million
Probability of each state is 50%
Stockholders’ Wealth
V = $6 million
E = $6 million

28. Bond and Stock Valuation
Suppose the firm issued 1 year Debt paying a 5% coupon and principal in the amount of $4 million.
What is the market value of this debt? It will depend on the required return to the debt. Suppose the required return (rB) is 5%
Then the value is B = E{Cash Flows}/1.05

29. Debt valuation What is the Yield to Maturity? (YTM)
What is the Expected Return?
This will require some work

30. Perfect Capital Markets
Let the Firm issue a bond paying $4 million in principal, 0.2 million in interest. (Coupon rate is 5%)
Widgets International
Good State Bad State Expected
Total million million
Debt million million
Equity million
Stockholders’ Wealth
V = $6 million
B = 3.2/(1.05) = $3.05
E = $6 - $3.05 = $ IF The Value of the Firm remains unchanged

31. Valuation of Equity
If the value of the firm is independent of capital structure,
rE = ro + (ro-rB)B/V
Therefore;
rE = (.05)(3.05/2.95) = = 15.17%
And:
E = 3.4/ = ???
Finally What is Stockholders’ Wealth?

32. Debt Valuation Yield to Maturity Coupon rate
Expected (required) return to Bonds

33. Widgets International
Bankruptcy Costs
Widgets International
Good State Bad State
Pure Equity 11 million million
Probability of each state is 50%
Stockholders’ Wealth
V = $6 million
E = $6 million

34. Direct Bankruptcy Costs
Typically amounts to 2% to 5% of the distressed value of the firm
Widgets International
Again assume the same leverage of a bond promising to pay 4.4 million
Good State Bad (Default)
Total million million Bankruptcy cost million
Net 11 million million

35. Impact of Bankruptcy Costs
Good State Bad (Default)
Total million million Bankruptcy cost million
Net 11 million million
Value million
Debt million
Equity million
Thus stockholders’ wealth declines by $50,000 (SHW = = 5.95 not 6)
Notice that it is the stockholders that pays the expected bankruptcy costs.