1. Chapter 16: Limits to the Use of Debt
16.1 Costs of Financial Distress
16.2 Description of Costs
16.3 Can Costs of Debt Be Reduced?
16.4 Integration of Tax Effects and Financial Distress Costs
16.5 Shirking, Perquisites, and Bad Investments: A Note on Agency Cost of Equity
16.6 The Pecking-Order Theory
16.7 Growth and the Debt-Equity Ratio
16.8 Personal Taxes
16.9 How Firms Establish Capital Structure
16.10 Summary and Conclusions

2. M&M Assumptions Homogeneous expectations.
Homogeneous business risk classes.
Perpetual cash flows: V = CF/r.
Perfect capital markets
No market frictions:
corporate or personal taxes,
issue costs,
transactions costs,
costs of financial distress. 2

3. The Modigliani-Miller Capital Structure Propositions
NO TAX CASE:
Proposition I: VL = VU
Proposition II: rS = r0 +(B/S)(r0-rB)
WITH CORPORATE TAXES:
Proposition I: VL = VU + TCB
Proposition II: rS = r0 +(B/SL)(1- TC) (r0-rB) 3

4. MM Theory with Taxes Extensions VL = VU + TCB
implies firms should issue nearly all debt financing.
Extensions
personal taxes
financial distress costs 4

5. Costs of Financial Distress
Bankruptcy risk versus bankruptcy cost.
The possibility of bankruptcy has a negative effect on the value of the firm.
However, it is not the risk of bankruptcy itself that lowers value.
Rather it is the costs associated with bankruptcy.
It is the stockholders who bear these costs.

6. Costs of Financial Distress
Direct costs
Indirect costs
Financial distress costs result in an interior solution in the determination of optimal capital structure.
VL = VU + PV(tax savings)-PV(costs of financial distress) 8

7. Costs of Financial Distress
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business (e.g., lost sales)
Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward underinvestment
Selfish Strategy 3: Milking the property

8. 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.

9. 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

10. Selfish Stockholders Accept Negative NPV Project with Large Risks
Expected CF from the Gamble
To Bondholders = $300 × $0 = $30
To Stockholders = ($ $300) × $0 = $70
PV of Bonds Without the Gamble = $200
PV of Stocks Without the Gamble = $0
PV of Bonds With the Gamble = $30 / 1.5 = $20
PV of Stocks With the Gamble = $70 / 1.5 = $47

11. 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) so the stockholders will have to supply an additional $100 to finance the project
Required return is 10%
Should we accept or reject?

12. Selfish Stockholders Forego Positive NPV Project
Expected CF from the government sponsored project:
To Bondholder = $300
To Stockholder = ($350 - $300) = $50
PV of Bonds Without the Project = $200
PV of Stocks Without the Project = $0
PV of Bonds With the Project = $300 / 1.1 = $272.73
PV of Stocks with the project = $50 / $100 = -$54.55

13. Selfish Strategy 3: Milking the Property
Liquidating dividends
Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders.
Such tactics often violate bond indentures.
Increase perquisites to shareholders and/or management

14. Can Costs of Debt Be Reduced?
Protective Covenants
Debt Consolidation:
If we minimize the number of parties, contracting costs fall.

15. Protective Covenants Agreements to protect bondholders
Negative covenant: Thou shalt not:
Pay dividends beyond specified amount.
Sell more senior debt & amount of new debt is limited.
Refund existing bond issue with new bonds paying lower interest rate.
Buy another company’s bonds.
Positive covenant: Thou shall:
Use proceeds from sale of assets for other assets.
Allow redemption in event of merger or spinoff.
Maintain good condition of assets.
Provide audited financial information.

16. Integration of Tax Effects and Financial Distress Costs
There is a trade-off between the tax advantage of debt and the costs of financial distress.
It is difficult to express this with a precise and rigorous formula.

17. Integration of Tax Effects and Financial Distress Costs
Value of firm under MM with corporate taxes and debt
Value of firm (V)
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

18. The Pie Model Revisited
Taxes and bankruptcy costs can be viewed as just another claim on the cash flows of the firm.
Let G and L stand for payments to the government and bankruptcy lawyers, respectively.
VT = S + B + G + L
The essence of the M&M intuition is that VT depends on the cash flow of the firm; capital structure just slices the pie. S B G L

19. Pie Again VT = S + B + G + L = VM + VN
VM= marketed claims = debt and equity.
VN= non-marketed claims
= tax liabilities G plus other claimants L such as potential lawsuits or pension fund liabilities.
any change in the size of one piece of the pie must be offset by a change in the size of one or more of the other pieces.
the manager’s objective is to maximize the value of the marketed claims while minimizing the value of the non-marketed claims. 17

20. Example
1986:
Pennzoil was awarded $10.3 billion from Texaco by Texas courts because of Texaco’s interference with Pennzoil’s effort to acquire the assets of Getty Oil Co.
Texaco filed for Chapter 11 reorganization in attempt to shield the equity shareholders from this onerous non-marketed claim. 18

21. Free Cash Flow Hypothesis
An individual will work harder for a firm if he is one of the owners than if he is one of the “hired help”.
Who bears the burden of these agency costs?
While managers may have motive to partake in perquisites, they also need opportunity. Free cash flow provides this opportunity.
The free cash flow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.
The free cash flow hypothesis also argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.

22. The Pecking-Order Theory
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
Rule 1
Use internal financing first.
Rule 2
Issue debt next, equity last.
The pecking-order theory is at odds with the trade-off theory:
There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial slack

23. Growth and the Debt-Equity Ratio
Growth implies significant equity financing, even in a world with low bankruptcy costs.
Thus, high-growth firms will have lower debt ratios than low-growth firms.
Growth is an essential feature of the real world; as a result, 100% debt financing is sub-optimal.

24. Personal Taxes: The Miller Model
The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as:
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate

25. Personal Taxes: The Miller Model (cont.)
In the case where TB = TS, we return to M&M with only corporate tax:

26. Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes
VL = VU+TCB when TS =TB
Value of firm (V)
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS) VU
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VL < VU when (1-TB) < (1-TC)×(1-TS)
Debt (B)

27. Integration of Personal and Corporate Tax Effects and Financial Distress Costs and Agency Costs
Present value of financial distress costs
Value of firm under MM with corporate taxes and debt
Value of firm (V)
Present value of tax shield on debt
VL = VU + TCB
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
Agency Cost of Debt
Debt (B) B*
Optimal amount of debt

28. Managerial Recommendations
The tax benefit is only important if the firm has a large tax liability
Risk of financial distress
The greater the risk of financial distress, the less debt will be optimal for the firm
The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry

29. How Firms Establish Capital Structure
Most Corporations Have Low Debt-Asset Ratios.
Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up.
There are Differences in Capital Structure Across Industries.
There is evidence that firms behave as if they had a target Debt to Equity ratio.

30. Observed Capital Structure
Capital structure does differ by industries
Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc.
Lowest levels of debt
Drugs with 2.75% debt
Computers with 6.91% debt
Highest levels of debt
Steel with 55.84% debt
Department stores with 50.53% debt
See Table 13.5 in the book for more detail

31. Work the Web Example
You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Yahoo Marketguide
Click on the web surfer to go to the site
Choose a company and get a quote
Choose ratio comparisons

32. Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.
Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating income have high probability of experiencing financial distress.
Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

33. Example EXES is an all equity firm (1,000 shares) r0 = 20%
All earnings are paid as dividends.
TC=TS=TB=0
Expected Operating Income (EBIT)
Probability EBIT
0.1 $1,000
0.4 $2,000
0.5 $4,200
E(EBIT) = .1(1,000) + .4(2,000) + .5(4,200) = $3,000 21

34. Example, continued VU = SU = (EBIT)/r0 = $3,000/.2 = $15,000
a. What is the value of EXES Company?
VU = SU = (EBIT)/r0 = $3,000/.2 = $15,000
b. The president of EXES has decided that shareholders would be better off if the company had equal proportions of debt and equity. He proposes to issue $7,500 of debt at an interest rate of 10%. He will use the proceeds to repurchase 500 shares of common stock. 22

35. Example, continued. Since we are in a world with no taxes:
i. What will the new value of the firm be?
Since we are in a world with no taxes:
VL =VU= $15,000
ii. What will the value of EXES’s debt be?
B = $7,500
iii. What will the value of EXES’s equity be?
SL = VL-B = $15,000-$7,500 = $7,500 23

36. WACC= (7500/15000)(10%) + (7500/15000)(30%) = 20%= r0
Example, continued
c. Suppose the president’s proposal is implemented.
i. What is the required rate of return on equity?
rS = r0 +(B/S)(r0-rB) = .20+(7500/7500)( ) = 0.30 = 30%
ii. What is the firm’s overall required return?
WACC= (7500/15000)(10%) + (7500/15000)(30%) = 20%= r0 24

37. Example, continued Suppose the corporate tax rate is 40%.
i. What is the value of the firm?
VU = SU = (EBIT) (1- TC) / r0
= $3000(1-.4)/.2 = $9,000
VL= VU +TC B =$9, *$7,500 = $12,000 25

38. Example, continued.
Does the presence of taxes increase or decrease the value of the firm?
Taxes decrease the value of the firm because the government becomes a claimant on the firm’s assets.
How does the presence of bankruptcy costs change the effect of taxes on the value of the firm?
They will further lower the value of the firm.

39. Example, continued Suppose TB=40% and TS=0.
i. What is the value of EXES?
= $9,000 + [1-(1-.4)(1-0)/(1-.4)]($7,500) = $9,000
The debt no longer adds value. 26

40. VL= $9,000+[1-(1-.4)/(1-.55)]($7,500) = $6,500
Example, continued.
Under the Miller model, what will happen to the value of the firm as the tax on interest income rises? (TB=55%)
VL= $9,000+[1-(1-.4)/(1-.55)]($7,500) = $6,500

41. Summary and Conclusions
Costs of financial distress cause firms to restrain their issuance of debt.
Direct costs
Lawyers’ and accountants’ fees
Indirect Costs
Impaired ability to conduct business
Incentives to take on risky projects
Incentives to underinvest
Incentive to milk the property
Three techniques to reduce these costs are:
Protective covenants
Repurchase of debt prior to bankruptcy
Consolidation of debt

42. Summary and Conclusions
Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt.
Value of firm under MM with corporate taxes and debt
Value of firm (V)
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

43. Summary and Conclusions
If distributions to equity holders are taxed at a lower effective personal tax rate than interest, the tax advantage to debt at the corporate level is partially offset. In fact, the corporate advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB)
Present value of financial distress costs
Value of firm under MM with corporate taxes and debt
Value of firm (V)
Present value of tax shield on debt
VL = VU + TCB
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
Agency Cost of Debt
Debt (B) B*
Optimal amount of debt

44. Summary and Conclusions
Debt-to-equity ratios vary across industries.
Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.
Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating income have high probability of experiencing financial distress.

45. The Bottom Line
The validity of the MM propositions depend on the nature and degree of market imperfections.
Some market imperfections are important: corporate and personal taxes, agency costs, and other costs of financial distress.
There is a target debt-to-equity range for most firms.
A safe strategy is to stay close to the industry average since these firms represent the survivors. 20