1. How much should a firm borrow?
“Everything that can be invented has been invented” - Charles D. Guell (U. S. Patent Office, 1899)

2. Debt and Taxes A Messy Subject - The Main Points
1) Debt provides a corporate tax shield. Most important for firms with high marginal tax rate.
2) The more a firm borrows, the less sure it is of being able to use tax shield.
Increasing leverage decreases marginal value of tax shields.
3) Equity investors get tax break relative to lenders. Capital gains can
be deferred. This may partially offset corporate tax shield.
4) Conclusion
a) Debt provides some net tax advantage for profitable firms.
b) Firms with tax-loss carryforwards or low marginal rates should have low debt ratios.

3. The Benefits of Debt Tax Shields
VALUE OF = VALUE IF PV TAX
FIRM EQUITY SHIELD
FINANCED
Implications:
Use as much debt as possible?
Profitable firms that can use tax shields should use debt.
Risky and unprofitable companies should borrow less.

4. Miller's Theory of Debt and Taxes
Corporate debt provides tax shields to borrowing companies. But, as more firms borrow, investors will receive more interest income. Then more corporate debt will increase personal taxes.
Overall, increases in corporate debt should stop when corporate tax shield savings equal personal tax losses.
This provides us no guidance for individual firms. It is describing an equilibrium level for total debt in the market and points out that overall debt usage should have limits.

5. The more companies borrow, the less likely they are to pay tax
Percent
Marginal personal tax lost 35
Marginal corporate tax gained
Aggregate debt

6. The more companies borrow, the less likely they are to easily meet their obligations.
More debt usage increases the probability of financial distress and going bankrupt.
Especially true for riskier firms.

7. Financial distress VALUE OF = VALUE IF + PV TAX - PV COST OF
FIRM EQUITY SHIELD DISTRESS
FINANCED
Costs of distress :
* Bankruptcy costs and costs of operating a company in distress
* Conflicts of interest between bondholder and stockholder and cost of writing debt contracts & monitoring compliance

8. Costs of financial distress reduce the optimal debt ratio
Firm Value
PV Costs Of Distress
PV Tax Shield
Value of levered firm
Debt Ratio
Optimum
A " Tradeoff " Theory

9. Financial Choices
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

10. Some tentative conclusions
1. Can the firm take advantage of market imperfections?
Look for opportunities to issue securities on favorable terms and for unsatisfied clientele.
Regard the financing decision as one of marketing and packaging the firm’s assets.
But in general, no magic in leverage.
2. There may be a tax advantage to debt for firms which are sure to pay taxes.
Firms that cannot use interest tax shields should borrow less.

11. Some tentative conclusions (cont.)
3. Stop borrowing when the expected costs of financial distress become excessive. Stop when these costs equal the benefits from tax shields.
The probability of financial distress depends on asset risk.
It is not just the probability of distress that matters, but the cost if distress occurs.

12. Two puzzles
1. Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues don’t significantly depress the stock price.
2. Why do some industry leaders use very little debt?
Why don’t they take advantage of tax shields from debt?

13. Why do successful companies often have little debt
Why do successful companies often have little debt? A Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need as much external financing.

14. Some implications Internal equity may be better than external equity.
Financial slack is valuable.
But, too much slack may lead to agency problems.
If external capital is required, debt is better.