1. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-1 Chapter 10 The Capital Structure Decision

2. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-2 l Debt and Value in a Tax Free Economy l Capital Structure and Corporate Taxes l Cost of Financial Distress l Explaining Financial Choices

3. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-3 M&M (Debt Policy Doesn’t Matter) l Modigliani & Miller When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

4. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-4 M&M (Debt Policy Doesn’t Matter) Assumptions l By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities l Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives

5. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-5 Example - River Cruises - All Equity Financed M&M (Debt Policy Doesn’t Matter)

6. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-6 Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

7. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-7 Example - River Cruises - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

8. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-8 Weighted Average Cost of Capital without taxes (traditional view) r DVDV rDrD Includes Bankruptcy Risk WACC

9. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-9 Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. C.S. & Corporate Taxes

10. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-10 Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? C.S. & Corporate Taxes

11. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-11 C.S. & Corporate Taxes All Equity1/2 Debt EBIT1,0001,000 Interest Pmt 0 100 Pretax Income1,000 900 Taxes @ 40% 400 360 Net Cash Flow$600$540 Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? Total Cash Flow All Equity = 600 *1/2 Debt = 640 (540 + 100)

12. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-12 Capital Structure PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 /.10 = $400 PV Tax Shield = D x Tc = 1000 x.4 = $400

13. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-13 Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 /.10 = 6,000 PV Tax Shield = 400 Firm Value with 1/2 Debt = $6,400

14. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-14 Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value =Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

15. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-15 Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Optimal amount of debt Maximum value of firm Financial Distress

16. ALL RIGHTS RESERVED No part of this document may be reproduced without written approval from Limkokwing University of Creative Technology 1-16 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.