Session 3
Capital Structure Continued
FIN 625: Corporate Finance
Learning Objectives
LO 1: Explain the Modigliani-Miller Proposition I & II for
capital structure with corporate taxes.
LO 2: Explain and calculate the tax benefit of debt, and
explain the costs of debt, including direct costs and
indirect costs.
LO 3: Explain the trade-off theory of capital structure.
Outline
1.
2.
3.
4.
MM Propositions I & II (With Taxes)
Costs of Financial Distress
Tradeoff Theory of Capital Structure
The Bankruptcy Process
1. MM Propositions I & II (With Taxes)


One of the key assumptions behind the
irrelevance of capital structure is that
there are no corporate taxes. In this case,
debt does not have any advantage over
equity.
With corporate taxes, debt has an
important advantage over equity, which is
that it can reduce the taxes a corporation
has to pay.
All Equity
The Effect of Debt on a Firm’s Total
Cash Flows
EBIT
Interest
EBT
Taxes (Tc = 35%)
Levered
Total Cash Flow to S
EBIT
Interest ($8000 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S & B):
EBIT(1-Tc)+TCRBB
Recession
$1,000
0
$1,000
$350
Expected
$2,000
0
$2,000
$700
Expansion
$3,000
0
$3,000
$1,050
$650
$1,300
$1,950
Recession
$1,000
640
$360
$126
$234+640
$874
$650+$224
$874
Expected
$2,000
640
$1,360
$476
$884+$640
$1,524
$1,300+$224
$1,524
Expansion
$3,000
640
$2,360
$826
$1,534+$640
$2,174
$1,950+$224
$2,174
MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)


Firm value increases with leverage
VL = VU + T C B
Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is
offset by the interest tax shield
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity / return on asset
B is the value of debt
S is the value of levered equity
MM Proposition I (With Taxes)
The total cash flow to all stakeholders is
( EBIT  RB B)  (1  TC )  RB B
The present value of this stream of cash flows is VL
( EBIT  RB B)  (1  TC )  RB B 
 EBIT  (1  TC )  RB B  (1  TC )  RB B
 EBIT  (1  TC )  RB B  RB BTC  RB B
The present value of the first term is VU
The present value of the second term is TCB
VL  VU  TC B
MM Proposition II (With Taxes)
Start with M&M Proposition I with VL  VU  TC B
taxes:
Since VL  S  B  S  B  VU  TC B
VU  S  B (1  TC )
The cash flows from each side of the balance sheet must
equal:
SRS  BRB  VU R0  TC BRB
SRS  BRB  [ S  B (1  TC )]R0  TC RB B
Divide both sides by S
B
B
B
RS  RB  [1  (1  TC )]R0  TC RB
S
S
S
B
Which quickly reduces RS  R0   (1  TC )  ( R0  RB )
S
to
The Effect of Financial Leverage
Cost of capital: R
(%)
RS  R0 
RS  R0 
B
 ( R0  RB )
SL
B
 (1  TC )  ( R0  RB )
SL
R0
RB
Debt-to-equity
ratio (B/S)
Total Cash Flow to Investors
All-equity firm
S
G
Levered firm
S
G
B
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie “larger.”–the
government takes a smaller slice of the pie!
Summary: No Taxes




In a world of no taxes, the value of the firm is unaffected
by capital structure.
This is M&M Proposition I:
VL = VU
Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
RS  R0   ( R0  RB )
SL
Summary: Taxes




In a world of taxes, but no bankruptcy costs, the value
of the firm increases with leverage.
This is M&M Proposition I:
VL = VU + TC B
Proposition I holds because debt reduces the tax
payment for the firm, thus increasing firm value
compared with unlevered case.
In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
RS  R0   (1  TC )  ( R0  RB )
SL
2. Costs of Financial Distress
Independent Variables
Dependent Variable: S&P Credit Rating
Leverage
-2.544***
ROA
9.235***
Loss
-1.774***
Interest Coverage
0.005***
Firm Size
1.237***
Subordinated Debt
-0.983***
Capital Intensity
0.736***
Sample
3209 firm-years from 2001-2007



As shown (Bradley, Chen, Dallas, and Snyderwine (2008)), debt increases the
risk of financial default.
If financial distress is costless, then the increasing risk of default does not
cause any problem.
It is the combination of the increasing risk of financial distress and the
costs associated with financial distress that make leverage a problem.
Costs of Financial Distress

Direct Costs


Legal and administrative costs
Indirect Costs


Impaired ability to conduct business (e.g., lost
sales, lost reputation)
Agency Costs of Debt


Shareholders are more risk-tolerant than bondholders
and prefer riskier investment strategy than what is
optimal for bondholders.
Shareholders/managers can milk the firm properties
at the expense of bondholders (pay special
dividends).
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
S
B
L
G
Firm Value With Costs of Financial
Distress

Adding the costs of financial distress to a firm with
corporate taxes, the value of the firm is:
VL = VU + TC B – EC(Distress)
where EC is the expected costs.
Can Costs of Debt Be Reduced?

Protective Covenants

Restriction on dividend payment

Restriction on investment policy (rare)

Restriction on issuance of more senior debt
3. Tradeoff Theory of Capital Structure

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
rigorous formula.
Tradeoff Theory of Capital Structure
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Present value of
financial distress costs
Maximum
firm value
V = Actual value of firm
VU = Value of firm with no debt
0
Debt (B)
B*
Optimal amount of debt
4. The Bankruptcy Process

Liquidation
Chapter 7 of the Federal Bankruptcy Reform Act
of 1978
 Trustee takes over assets, sells them, and
distributes the proceeds (Absolute Priority Rule)


Reorganization
Chapter 11 of the Federal Bankruptcy Reform
Act of 1978
 Restructure the corporation with a provision to
repay creditors

Absolute Priority Rule
1. Administrative expenses
 2. Wages
 3. Pension plan
 4. Consumer claims
 5. Government tax claims
 6. Unsecured creditors
 7. Preferred stockholders
 8. Common stockholders

Readings

Chapter 14.5, Chapter 15