1. Corporate Finance
Lecture 8

2. Announcements 2nd quiz 2nd case : Boeing 7E7 Opens at midnight tonight
Valid for 48 hours
Closes at midnight of Thursday
2nd case : Boeing 7E7
Questions will be posted on May 8
Delivery deadline: May 13
Discussion: May 15

3. Topics covered MM proposition without tax MM proposition with tax
Cost of financial distress
Direct cost
Indirect cost
Reducing cost of debt
Integration of tax benefit and financial distress cost of debt

4. Modigliani and Miller (MM) Proposition (no taxes)
Proposition I
Firm value is not affected by leverage
VL = VU
Capital structure does not change firm value

5. Assumptions of the Modigliani-Miller Model
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes

6. EPS and ROE Under Both Capital Structures
All-Equity Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
Levered Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

7. Homemade Leverage: An Example
Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236

8. Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%
Buying 40 shares of a $50 stock, we get the same ROE as if we bought into a levered firm.
Our personal debt equity ratio is: 3 2
200 , 1 $
800 = S B

9. The MM Propositions II (No Taxes)
Proposition II
Leverage increases the risk and return to stockholders
rs = r0 + (B / SL) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity

10. The MM Proposition II (No Taxes)
The derivation is straightforward: S B
WACC r + =
set
Then r
WACC = r S B = + S B + by
sides
both
multiply r S B + = r S B + = ) ( B S r - + = r S B + =

11. MM Proposition II with No Corporate Taxes
Cost of capital: r (%) r0 rB rB S B
Debt-to-equity Ratio

12. The MM Proposition I (Corp. Taxes)1 (
receive
firm
levered a in rs
Shareholde C B T r
EBIT - B r
receive s
Bondholder B r T
EBIT C + - ) 1 ( is rs
stakeholde
all to
flow
cash
total
the
Thus,
The present value of this stream of cash flows is VL = + - B r T
EBIT C ) 1 ( B r T
EBIT C + - = ) 1 ( BT r T
EBIT C B + - = ) 1 (
The present value of the first term is VU
The present value of the second term is TCB B T V C U L + = \

13. The MM Proposition II (Corp. Taxes)
Start with M&M Proposition I with taxes: B T V C U L + =
Since B S V L + = B T V S C U + = Þ ) 1 ( C U T B S V - + =
The balance sheet of a levered firm can be written as
Vu=Value of unlevered firm
B=Debt
TcB=Tax shield
S=Equity

14. The MM Proposition II (Corp. Taxes)
The cash flows from each side of the balance sheet must equal: B C U S Br T r V Sr + = B r T S Br Sr C + - = )] 1 ( [
Divide both sides by S B C S r T + - = )] 1 ( [ ) ( 1 B C S r T - + =
Which reduces to

15. The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes
Cost of capital: r (%) r0 rB
Debt-to-equity ratio (B/S)

16. Total Cash Flow to Investors Under Each Capital Structure with Corp
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-Equity Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050
Total Cash Flow to S/H $650 $1,300 $1,950
Levered Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 8% )
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $ $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174

17. Tax effect of debt
In a world without taxes, debt does not affect firm value.
When there are corporate taxes, the firm value is positively related to its debt --Debt reduces the firm’s tax liability
With taxes, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

18. Total Cash Flow to Investors
All-equity firm Levered firm S G S G B
This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!

19. Costs of financial distress
Direct costs: Legal and administrative costs
Indirect costs:
Impaired ability to conduct business
Agency costs: conflicts between the shareholders and the debtholders
Incentive to take large risks
Incentive toward underinvestment
Milking the property

20. Balance Sheet for a Company in Distress
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300
Fixed Asset $400 $0 Equity $300
Total $600 $200 Total $600 $200
What happens if the firm is liquidated today?
$200 $0
The bondholders get $200; the shareholders get nothing.

21. Selfish Strategy 1: Take Large Risks
The Gamble Probability Payoff
Win Big 10% $1,000
Lose Big 90% $0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × $0 = $100
NPV = –$200 +
$100
(1.50)
NPV = –$133

22. Selfish Stockholders Accept Negative NPV Project with Large Risks
Expected CF from the Gamble
To Bondholders = $300 × $0 = $30
To Stockholders = ($1000 – $300) × $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble:
PV of Stocks With the Gamble:
Debtholder expropriation by shareholders
$20 =
$30
(1.50)
$47 =
$70
(1.50)

23. Selfish Strategy 2: Underinvestment
Consider a government-sponsored project that guarantees $350 in one period
Cost of investment is $300
the firm only has $200 now
the stockholders will have to supply an additional $100 to finance the project
Required return is 10%
NPV = –$300 +
$350
(1.10)
NPV = $18.18
Should we accept or reject?

24. Selfish Strategy 2: underinvestment
Firm
Debt
Equity
Without project PV
With project
CF at t=1

25. Selfish Strategy 2: Underinvestment
Firm
Debt
Equity
Without project PV
200
With project
CF at t=1
350
300 50
/1.1 =18.18
/1.1 =72.73
/1.1
=-54.55

26. Selfish Strategy 3: Milking the Property
Liquidating dividends
Increase perquisites to shareholders and/or management

27. Protective Covenants Agreements to protect bondholders
Negative covenant:
Pay dividends beyond specified amount.
Sell more senior debt & amount of new debt is limited.
Positive covenant:
Maintain good condition of assets.
Provide audited financial information.
Working capital requirement.

28. Integration of Tax Effects and Financial Distress Costs
Value of firm (V)
Value of firm under MM with corporate taxes and debt
Present value of tax shield on debt
VL = VU + TCB
Maximum firm value
Present value of financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Debt (B) B*
Optimal amount of debt

29. The Pie Model VT = S + B + G + L S Marketed claims: VM = S + B B
Nonmarketed claims: VN = G + L S B G L

30. Signaling
The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost.
Investors view debt as a signal of firm value.
A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.