McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Debt Policy

Changing a firm’s capital structure should not affect its value to shareholders.

This chapter analyzes several possible financing scenarios and provides an overview of the effects of taxes and costs of financial distress on a firm.

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Does Borrowing Affect Value?

A company’s choice of capital structure does not increase the value of the firm.

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MM’s Irrelevance Proposition

The value of a firm does not depend on its capital structure.

If this holds, can financial managers increase the value of the firm by changing the mix of securities used to

finance the company?

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MM’s Irrelevance Proposition

Assumptions of MM’s argument: “Well functioning” capital markets

Efficient capital markets

No taxes (therefore no distortion)

Ignore costs of financial distress

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MM’s Irrelevance PropositionExample: An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value?

Before Restructuring:

After Restructuring:

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How Borrowing Affects EPSCeteris paribus, borrowing will increase earnings per

share. However, this isn’t a source of value to shareholders.

Shareholders can easily replicate a firm’s

borrowing on their own if they choose.

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How Borrowing Affects Risk and Return

Debt financing does not affect the operating risk of the firm.

Debt financing does affect the financial risk of the firm.

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How Borrowing Affects Risk and Return

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Debt and the Cost of Equity

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Debt and the Cost of Equity: Example

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 30% of assets?

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MM’s Proposition II

Debt increases financial risk and causes shareholders to demand higher rates of return.

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Debt and TaxesDebt financing advantage: the interest that a firm pays

on debt is tax deductible.

Interest tax shield:

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Perpetual Tax Shield

If the tax shield is perpetual, then:

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Perpetual Tax Shield: Example

What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $12 million at an interest rate of 4% and a tax rate of 35%?

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Tax Shield and Shareholders’ Equity

When accounting for taxes, borrowing increases firm value and shareholders’ wealth.

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Taxes and WACCRecall that the WACC takes into account the required after-tax

rate of return

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Taxes and WACC: Example

What is the expected rate of return to shareholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio?

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Costs of Financial Distress

Investors factor the potential for future distress into their assessment of current value.

Overall Market Value =

Value if all equity financed

+ PV tax shield

– PV costs of financial distress

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Bankruptcy CostsIf there is a possibility of bankruptcy, the current market value of the firm is reduced by the present value of all court expenses.

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Financial Distress Without Bankruptcy

Even if a firm narrowly escapes bankruptcy, this does not mean that costs of financial distress are avoided.

Stockholders may be tempted to play games at the expense of creditors

Betting the Bank’s Money

Not Betting Your Own Money

Loan Covenant: Agreement between a firm and lender requiring the firm to fulfill certain conditions to safeguard the loan.

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Explaining Financing Choices

The Trade-off Theory• Debt levels are chosen to balance interest tax shields

against the costs of financial distress.

A Pecking Order Theory:• Firms prefer to issue debt rather than equity if internal

finance is insufficient.

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Financial Slack

Financial managers usually place a very high value on having financial slack.

Financial Slack: Ready access to cash or debt financing.

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Two Faces of Financial Slack Benefits

• Long run value rests more on capital investment and operating decisions than on financing.

• Most valuable to firms with positive-NPV growth opportunities

Drawbacks• Too much financial slack may lead to lazy management.• Managers may try to increase their own perks or engage in

empire-building.