1. Capital Structure Theory
Perfect and Imperfect Capital Markets

2. Outline of the Topics
1 Capital Structure Choices 2 Capital Structure in Perfect Capital Markets 3 Debt and Taxes 4 The Costs of Bankruptcy and Financial Distress 5 Optimal Capital Structure: The Tradeoff Theory 6 Additional Consequences of Leverage: Agency Costs and Information 7 Capital Structure: Putting It All Together 2

3. Learning Objectives
Examine how capital structures vary across industries and companies
Understand why investment decisions, rather than financing decisions, fundamentally determine the value and cost of capital of a firm
Describe how leverage increases the risk of the firm’s equity
Demonstrate how debt can affect firm value through taxes and bankruptcy costs 3

4. Learning Objectives (cont’d)
Show how the optimal mix of debt and equity trades off the costs (including financial distress costs) and benefits (including the tax advantage) of debt
Analyze how debt can alter the incentives of managers to choose different projects and can be used as a signal to investors
Weigh the many costs and benefits to debt that a manager must balance when deciding how to finance the firm’s investments

5. Capital Structure Choices
The collection of securities a firm issues to raise capital from investors
Firms consider whether the securities issued:
Will receive a fair price in the market
Have tax consequences
Entail transactions costs
Change future investment opportunities 5

6. Capital Structure Choices
A firm’s debt-to-value ratio is the fraction of the firm’s total value that corresponds to debt
D / (E+D)
Capital structure choices often vary across industries and within industry 6

7. Figure 1 Debt-to-Value Ratio [D/(E + D)] for Select Industries

8. Figure 2 Capital Structures of Intel and ARM Holdings8

9. 2. Capital Structure in Perfect Capital Markets
A perfect capital market is a market in which:
Securities are fairly priced
No tax consequences or transactions costs
Investment cash flows are independent of financing choices 9

10. 2. Capital Structure in Perfect Capital Markets
Application: Financing a coffee shop that costs $24,000 to open
Expected cash flow is $34,500 at the end of one year (details in Table 16.1)
Given the risk, coffee shop should earn 15%
NPV of the project is -$24,000+$34,500/1.15 = $6,000
Finance with equity costing $30,000
Use some debt 10

11. 2. Capital Structure in Perfect Capital Markets
Choices:
Finance with equity costing $30,000
Use some debt (say, $15,000)
Leverage increases the cost of equity 11

12. 2. Capital Structure in Perfect Capital Markets
Modigliani and Miller (MM) with perfect capital markets
In an unlevered firm, cash flows to equity equal the free cash flows from the firm’s assets
In a levered firm, the same cash flows are divided between debt and equity holders
The total to all investors equals the free cash flows generated by the firm’s assets 12

13. Figure 3 Unlevered Versus Levered Cash Flows with Perfect Capital Markets13

14. 2. Capital Structure in Perfect Capital Markets
MM Proposition I:
In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure
VL= E + D =VU (Eq. 1) 14

15. Table 1 Returns to Equity in Different Scenarios with and Without Leverage15

16. Figure 4 Unlevered Versus Levered Returns with Perfect Capital Market16

17. Example 1- The Risk and Return of Levered Equity
Problem:
Suppose you borrow only $6,000 when financing your coffee shop.
According to Modigliani and Miller, what should the value of the equity be? What is the expected return?
Solution:
The value of the firm’s total cash flows does not change: it is still $30,000. Thus, if you borrow $6000, your firm’s equity will be worth $24,000.
To determine its expected return, we will compute the cash flows to equity under the two scenarios . The cash flows to equity are the cash flows of the firm net of the cash flows to debt (repayment of principal plus interest). 17

18. Example 1- The Risk and Return of Levered Equity
Solution:
The firm will owe debt holders
$6,000  1.05 = $6,300 in one year
Thus, the expected payoff to equity holders is
$34,500 – $6,300 = $28,200,
for a return of
$28,200 / $24,000 – 1 = 17.5% 18

19. Example 1- The Risk and Return of Levered Equity
Evaluate:
While the total value of the firm is unchanged, the firm’s equity in this case is more risky than it would be without debt, but less risky than if the firm borrowed $15,000
To illustrate, note that if demand is weak, the equity holders will receive $27,000 – $6,300 = $20,700, for a return of $20,700/$24,000 – 1 = – 13.75% 19

20. Example 1- The Risk and Return of Levered Equity
Solution (cont’d):
Compare this return to – 10% without leverage and – 25% if the firm borrowed $15,000. As a result, the expected return of the levered equity is higher in this case than for unlevered equity (17.5% versus 15%), but not as high as in the previous example (17.5% versus 25% with more leverage) 20

21. 2- Capital Structure in Perfect Capital Markets
Homemade leverage
Investors use leverage in their own portfolios to adjust firm’s leverage
A perfect substitute for firm leverage in perfect capital markets 21

22. 2- Capital Structure in Perfect Capital Markets
Leverage and the Cost of Capital
Weighted average cost of capital (pretax)
(Eq.2) 22

23. 2- Capital Structure in Perfect Capital Markets
MM Proposition II: The cost of capital of levered equity:
The Cost of Levered Equity
Cost of levered equity equals the cost of unlevered equity plus a premium proportional to the debt-equity ratio
(Eq.3) 23

24. Figure 5- WACC and Leverage with Perfect Capital Markets24

25. Figure 5- WACC and Leverage with Perfect Capital Markets (cont’d)25

26. Example 2- Computing the Equity Cost of Capital
Problem:
Suppose you borrow only $6,000 when financing your coffee shop. According to MM Proposition II, what will your firm’s equity cost of capital be?
Solution:
Because your firm’s assets have a market value of $30,000, by MM Proposition I the equity will have a market value of $24,000 = $30,000 – $6,000. We can use Eq to compute the cost of equity. We know the unlevered cost of equity is ru = 15%. We also know that rD is 5%.
The cost of equity is:
This result matches the expected return calculated in Example .1 where we also assumed debt of $6,000. The equity cost of capital should be the expected return of the equity holders. 26

27. 3- Debt and Taxes
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 27

28. 3- Debt and Taxes
Consider the impact of interest expenses on taxes paid by Safeway, Inc.
In 2012, Safeway had earnings before interest and taxes of $1.13 billion
Interest expenses of $300 million
Corporate tax rate is 35%
Compare Safeway’s actual net income with what it would have been without debt 28

29. Safeway’s Income with and without Leverage, 2012 ($ millions)
Total amount available to all investors is: 29

30. Interest Tax Shield = Corporate Tax Rate  Interest Payments
3- Debt and Taxes
Interest Tax Shield
The gain to investors from the tax deductibility of interest payments
Interest Tax Shield = Corporate Tax Rate  Interest Payments
(Eq. 4) 30

31. Example 3- Computing the Interest Tax Shield
Problem:
Shown below is the income statement for E.C. Builders (ECB). Given its marginal corporate tax rate of 35%, what is the amount of the interest tax shield for ECB in years 2010 through 2013?
ECB Income Statement ($million)
2010
2011
2012
2013
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
Income before tax
719
777
817
900
Taxes (35%)
-252
-272
-286
-315
Net Income
467
505
531
585 31

32. Example 3- Computing the Interest Tax Shield
Problem (cont’d):
ECB Income Statement ($million)
2010
2011
2012
2013
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
Income before tax
719
777
817
900
Taxes (35%)
-252
-272
-286
-315
Net Income
467
505
531
585 32

33. Example 3- Computing the Interest Tax Shield
Solution:
From Eq. 4, the interest tax shield is the tax rate of 35% multiplied by the interest payments in each year
Interest Tax Shield = Corporate Tax Rate  Interest Payments
($ million)
2010
2011
2012
2013
Interest expense 50 80
100
Interest tax shield (35% X interest expense)
17.5 28 35
By using debt, ECB 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. 33

34. 3- Debt and Taxes
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 34

35. Figure 6- The Cash Flows of the Unlevered and Levered Firm35

36. 3- Debt and Taxes
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 36

37. 3- Debt and Taxes 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
CFASSETS = CFDEBT +CFSTOCKHOLDERS
CF = Levered CF + I where I =Rd .D
CF = (EBIT - Rd .D)(1- TC)+ I= EBIT(1 - TC) + TC.Rd.D
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) or VL = VU + Tc. D (Eq. 5) 37

38. Example 4- Valuing the Interest Tax Shield
Problem:
Suppose ECB from borrows $2 billion by issuing 10-year bonds. ECB’s cost of debt is 6%, so it will need to pay $120 million in interest each year for the next 10 years, and then repay the principal of $2 billion in year 10. ECB’s marginal tax rate will remain 35% throughout this period. By how much does the interest tax shield increase the value of ECB?
In this case, the interest tax shield lasts for 10 years, so we can value it as a 10-year annuity. Because the tax savings are as risky as the debt that creates them, we can discount them at ECB’s cost of debt: 6%.
The interest tax shield each year is 35%  $120 million = $42 million. Valued as a 10-year annuity with a discount rate of 0.06, we have:
Because only interest is tax deductible, the final repayment of principal in year 10 is not deductible, so it does not contribute to the tax shield. 38

39. Example 4 Valuing the Interest Tax Shield
Evaluate:
We know that in perfect capital markets, financing transactions have an NPV of zero—the interest and principal repayment have exactly a present value of the amount of the bonds: $2 billion. However, the interest tax deductibility makes this a positive-NPV transaction for the firm. Because the government effectively subsidizes the payment of interest, issuing these bonds has an NPV of $309 million. 39

40. 3- Debt and Taxes 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 40

41. 3- Debt and Taxes Interest Tax Shield with Permanent Debt
As we know, the market value of debt must equal the present value of its future interest payments:
Market value of Debt = D = PV(Future Interest Payments)
(Eq. 6) 41

42. 3- Debt and Taxes Interest Tax Shield with Permanent Debt
If the firm’s marginal tax rate (TC) is constant, we have the following general formula:
Value of the Interest Tax Shield of Permanent Debt
PV(Interest Tax Shield)=PV(TC X Future Interest Payments)
=TC X PV(Future Interest Payments)
=TC X D
(Eq..7) 42

43. 3- Debt and Taxes Weighted Average Cost of Capital with Taxes
Another way to incorporate the benefit of the firm’s future interest tax shield
WACC = RA = (E/V)RE + (D/V)(1-T)RD
Eq..8 43

44. 3- Debt and 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 44

45. Figure 7- The WACC with and without Corporate Taxes45

46. 3- Debt and Taxes The Bottom Line
We can include the interest tax shield when assessing firm value by either:
Discounting free cash flow using the pretax WACC and adding the PV of future interest tax shields, or
Discounting free cash flow using the WACC (with taxes) 46

47. 4- The Costs of Bankruptcy and Financial Distress
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 47

48. 4- The Costs of Bankruptcy and 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 48

49. 4- The Costs of Bankruptcy and Financial Distress
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 49

50. 16.4 The Costs of Bankruptcy and Financial Distress
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 50

51. 4- The Costs of Bankruptcy and Financial Distress
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 51

52. 4- The Costs of Bankruptcy and Financial Distress
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 52

53. 5- Optimal Capital Structure: The Tradeoff 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:
(Eq ) 53

54. 5- Optimal Capital Structure: The Tradeoff Theory
Key qualitative factors determine the present value of financial distress costs:
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)
It increases with the volatility of a firm’s cash flows and asset values 54

55. 5- Optimal Capital Structure: The Tradeoff Theory
Key qualitative factors determine the present value of financial distress costs:
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 55

56. 5- Optimal Capital Structure: The Tradeoff Theory
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 56

57. Figure 8- Optimal Leverage with Taxes and Financial Distress Costs57

58. 5- Optimal Capital Structure: The Tradeoff Theory
The Tradeoff 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 58

59. 6- Additional Consequences of Leverage: Agency Costs and Information
costs that arise when there are conflicts of interest between stakeholders
Separation of ownership and control:
Managers may make decisions that:
Benefit themselves at investors’ expense
Reduce their effort
Spend excessively on perks
Engage in “empire building” 59

60. 6- Additional Consequences of Leverage: Agency Costs and Information
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 principle payments are required, debt reduces the funds available at management’s discretion to use wastefully 60

61. 6- Additional Consequences of Leverage: Agency Costs and Information
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 61

62. 6- Additional Consequences of Leverage: Agency Costs and Information
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 62

63. Figure 9- Optimal Leverage with Taxes, Financial Distress, and Agency Costs63

64. Optimal Leverage with Taxes, Financial Distress, and Agency Costs

65. Optimal Leverage with Taxes, Financial Distress, and Agency Costs

66. Putting All Together

67. Conclusions Case I – no taxes or bankruptcy costs
No optimal capital structure
Case II – corporate taxes but no bankruptcy costs
Optimal capital structure is almost 100% debt
Each additional dollar of debt increases the cash flow of the firm
Case III – corporate taxes and bankruptcy costs
Optimal capital structure is part debt and part equity
Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs
16-67

68. 6- Additional Consequences of Leverage: Agency Costs and Information
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 68

69. 6- Additional Consequences of Leverage: Agency Costs and Information
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 69

70. 6- Additional Consequences of Leverage: Agency Costs and Information
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 signaling theory of debt 70

71. 6- Additional Consequences of Leverage: Agency Costs and Information
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 71

72. 6- Additional Consequences of Leverage: Agency Costs and Information
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 72

73. 6- Additional Consequences of Leverage: Agency Costs and Information
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 73