Notes on Capital Structure

8/11/2019 Notes on Capital Structure

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Supplementary Notes:

Capital Structure

by Kyung Hwan Shim

University of New South Wales

Australian School of Business

School of Banking & Finance

for FINS 1613 S1 2011

May 14, 2011

These notes are preliminary and under development. They are made available for FINS 1613 S1 2011 students

only and may not be distributed or used without the authors written consent.

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Contents

1 Introduction 3

2 Financial Leverage 4

3 M&M Proposition I: Capital Structure Irrelevance 5

4 M&M Proposition II: Capital Structure Irrelevance 8

4.1 M&M Proposition II With Riskless Debt . . . . . . . . . . . . . . . . . . . . . . . . 8

4.2 M&M Proposition II with Riskless Debt: Betas . . . . . . . . . . . . . . . . . . . . 11

5 M&M I & II with Taxes: Riskless Debt and Tax Shields 12

6 M&M with Taxes & Cost of Financial Distress 17

6.1 Bankruptcy Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

6.2 Costs of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

6.3 Static Trade Off Theory: Tax Shield Gains vs. Bankruptcy & Distress Costs . . . 19

7 Optimal Capital Structure Policy: Empirical Evidence 22

7.1 Asset Type and Debt ratios: the Static Trade Off Explanation . . . . . . . . . . . 22

7.2 High Profit & Low Debt Ratio Firms: The Pecking Order Theory Explanation . . 23

8 Final Words on Capital Structure 23

8.1 Debt and Corporate Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

8.2 Other Things to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

9 Conclusions 24

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1 Introduction

A firms mix of debt and equity is what is called the firms capital structure. The capital structure

of a company determines how its operating cash flows will be split between equityholders and

debtholders. The cash flows of an all equity financed company belongs to the equity holders, while

a company that has both debt and equity will have its cash flows split between the debtholders

and equityholders. The debtholders will receive a relatively less risky portion of the cash flows,

while the equityholders collect the remainder.

A natural question that comes to mind is Is there an optimal choice of capital structure?

In other words, can one increase the value of a firm simply by choosing to finance the company

with an optimal mix of debt and equity. If the answer is No, then an investigative eye must

not observe a discernible difference in capital structure across firms. The capital structure offirms must vary randomly across companies because capital structure should not impact firm

value. However, if the answer is Yes and if optimal capital structure is dependant on firm

characteristics then firms observed capital structures must reflect their optimal targets and one

must observe a discernible difference in capital structure across firms.

The objective of this chapter is to explore for an answer. To this end, the most important

theories related to capital structure must be covered. To better understand firms capital structure

policies, we must first understand what are the circumstances when capital structure choices do

not matter. Only then can we begin to investigate circumstances when capital structure start

to matter. The backbone of much of what we know about firms financial leverage is based on

Modigliani & Miller Propositions. Much of what will be discussed in this chapter is related to

M&Ms propositions.

We will follow the same approach one would take to make a layered cake. It starts with

the foundations and each layer is placed until the cake is finished. Section two describes how

financial leverage affects the risk of the firms equity. Section three covers Modigliani and Millers

(M&M) First Capital Structure Irrelevance Proposition. The section shows that in perfect capital

markets capital structure choice is irrelevant. Section four covers M&Ms Second Capital Structure

Irrelevance Proposition, which is simply a corollary of the the first proposition. Next we will

investigate circumstances when the capital structure choices start to matter. Section five relaxes

M&M no tax assumption and revisits their propositions in a market with corporate taxes. Section

six adds another layer to the cake. M&Ms propositions are investigated when financial leverage


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can increase bankruptcy costs. Section seven discusses some empirical observations in capital

structure policy as evidenced in the cross section. Section eight concludes with some final remarks

and some factors managers may want to consider when making capital structure decisions.

2 Financial Leverage

Financial leverage is the degree to which a firm is committed to fixed charges related to interest

payments from the companys debt. Fixed charges, in contrast to variable charges, are charges to

profits that do not vary with the firms level of profits, sales or revenues. For a firm to turn out

positive earnings, its operating profits must be greater than its debt payment obligations. Firms

with a lot of financial leverage have high fixed charges related to heavy borrowing. For a firm that

has high financial leverage, its cash flows and earnings are likely to be very sensitive to changesin sales or revenues. That is because financial leverage magnifies the effect that fluctuations in

sales have on earnings. Firms with high financial leverage tend to perform relatively badly in a

slump but flourishes in a boom compared to firms with low financial leverage.

To understand financial leverage, consider a high financial leverage firm and a low financial

leverage firm. During good economic times, both firms experience high profits, but the low

leverage firm has to share corporate profits with more equityholders than the high leverage firm,

since the latter has fewer shareholders as some of the stakeholders are the creditors. Consequently,

the earnings per share of the high leverage firm will be greater than the low leverage firm.

The opposite would be the case during economic downturns. During economic downturns,

corporate profits are low for both the high and low leverage firms. However, the low leverage

firm does not have the high level of interest charges to contend with so its profits are likely to be

higher than a firm with high financial leverage. The end result is that the earnings per share and

dividend payments of high financial leverage firms experience higher highs and lower lows than

low leverage firms. Similarly, all else equal, the equity of high financial leverage firms tend to

have higher business risk than the equity of low financial leverage firms. The concept of financial

leverage and its effect on the risk of the equity of the firm will become more evident later when

we discuss Modigliani and Millers Propositions.

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3 M&M Proposition I: Capital Structure Irrelevance

An interesting concept of academic interest is the perfect capital market. In a perfect capital

market individuals and firms can costlessly trade securities without transaction costs, there are

no taxes, no bid-ask spreads, no differences in interest rate on borrowing and lending funds, and

information flows efficiently so no one has an informational advantage over the rest of the market.

A perfect capital market is a market where capital flows without any frictions. A perfect capital

market is considered to be an idealistic view of what efficient capital markets should strive to be.

While perfect capital market in its strictest definition does not exist in reality, the notion of a

perfect capital market is useful for researchers because it is a perfect experimental laboratory in

which new theories can be developed.

Modigliani & Miller (M&M) proposed that in perfect capital markets where there are notaxes, transaction costs and other imperfections investors can create homemade leverage

by trading securities. If investors can borrow or lend on same terms as corporations can an

assumption of perfect capital markets then investors can replicate the cash flow pattern of

investments in the equity of a firm with any amount of leverage. For example, if an investor

prefers leverage while he is invested in the stocks of an unlevered firm, then he can borrow an

amount that reflects the debt to equity ratio of a levered firm and use these funds to invest in

more stocks to create financial leverage in his investment portfolio. Similarly, an investor who is

originally invested in the equity of a levered firm, and prefers to have no exposure to financial

leverage, can simply sell some of his stock holdings and lend that amount to undo the leverage

that is inherent in his investment portfolio.

Since investors can create any level of leverage through their own financial portfolios, M&M

concluded that investors would not pay a premium for the securities of a firm that follows a

particular capital structure. M&M concluded that any two identical companies that only differ in

their capital structure policies should be priced equally in a perfect capital market. More formally,

M&Ms Capital Structure Irrelevance Proposition I states that

Value of Levered Firm =VL = VU= Value of Unlevered Firm

The next three examples illustrate how to create homemade leverage and motivates M&Ms

first proposition.

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Hackers Example: Hackers R Us is all equity financed and has 100,000 shares outstanding

valued at $10. Hackers can borrow at an interest rate of 5%. Hackers earns a perpetual before

interest operating cash flows of $200,000 and it operates in a taxless business environment. If you

own 500 shares of Hackers, and assuming that you can borrow or lend on same terms as Hackers

can, how can you replicate the cash flows of an investor who invested in 500 shares of Hackers if

Hackers were to be 25% financed with debt?

Answer: Hackers is currently valued at VU= 100, 000 $10 = $1M. If Hackers were to be

25% debt financed, it would have borrowed 25% $1M = $250, 000 at 5% and it would have

$250, 000/$10 = 25, 000 fewer shares outstanding. The per period cash flow of a portfolio that

invested in 500 shares of Hackers if it were levered would be

pdfL # of Shares=($200, 000 $250, 000 5%)

75, 000 500 = $1, 250

wherepdfLare the earnings per share of Hackers if it were 25% debt financed. To create homemade

leverage, you need to borrow some funds and use it to buy additional shares of the unlevered firm.

Denote x the number of additional shares purchased from the borrowed funds. To replicate the

cash flows of Hackers stocks if it were levered, the per period portfolio cash flow that borrows

and invests in the equity of the unlevered firm must equal to $1, 250

$1, 250 = pdfU # of Shares Interest on Borrowed Funds

= $200, 000

100, 000 (500 + x) x $10 5%

x = 166.6666666666

wherepdfUis the earnings per share of Hackers if it were unlevered.

To replicate the cash flows from holding 500 shares of Hackers if it were levered requires you

to borrow x $10 = 166.6666666666 $10 = $1, 666.666666666 in total. You will also have to

buy another x = 166.666666 shares of Hackers for a total holding of 500 +x = 666.666666666

shares.

Hackers Example Contd: How can you replicate the cash flows of an investor who invested

in 500 shares of Hackers if Hackers had a capital structure of 50% debt?

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Answer: If Hackers adopted a capital structure of 50% debt, it would have to convert

50% $1M= $500, 000 of equity into debt. Hackers would have to borrow $500, 000 at 5% and

repurchase $500, 000/$10 = 50, 000 shares leaving 50,000 shares outstanding. The per period cash

flow from a portfolio that invested in 500 shares of the levered firm would be

pdfL # of Shares=($200, 000 $500, 000 5%)

50, 000 500 = $1, 750

To create homemade leverage, you need to borrow some funds and use it to buy additional shares

of the unlevered firm. Denote x the number of additional shares purchased from the borrowed

funds. To replicate the cash flows of Hackers stocks if it were levered, the portfolio cash flow that

borrows and invests in the equity of the unlevered firm must equal to $1, 750

$1, 750 = pdfU No of Shares Interest on Borrowed Funds

= $200, 000

100, 000 (500 + x) x $10 5%

x = 500

To create homemade leverage equivalent to investing in Hackers shares if it were 50% debt

financed, you must borrowx $10 = 500 $10 = $5, 000 and purchasex = 500 additional shares

of Hackers.

Hackers Example Contd: Based on the answers from the previous examples, what con-

clusion do you make about optimal capital structure policy?

Answer: In a perfect capital market where investors can create homemade leverage, capital

structure does not matter. An investor can always replicate the cash flows of investing in the

equity of a levered firm simply by investing in the equity of an unlevered firm and borrowing.

Moreover, if an investor has a different preference for leverage exposure than his current leverage

exposure through his investment portfolio, he can simply borrow or lend a certain amount on his

own account to reflect his risk preference. Because investors do not need firms to borrow on their

behalf, investors would not pay a premium for the securities of a firm that follows a particular

capital structure.

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4 M&M Proposition II: Capital Structure Irrelevance

M&Ms First Capital Irrelevance Proposition says that identical firms that adopt different capital

structures should be valued equally in a perfect capital market. Though the proposition seems

like a very simple argument, much more insight can be attained from its corollaries. This section

discusses M&Ms Second Capital Structure Irrelevance proposition, first if the firms debt is

riskless and then if we allow the debt to become risky.

4.1 M&M Proposition II With Riskless Debt

While M&Ms Proposition I focuses on the firm values of levered and unlevered firms in perfect

capital markets, M&Ms proposition II relates a levered firms cost of equity to the cost of equity

of an identical unlevered firm and the firms financial leverage DE

.

An important corollary to M&Ms Proposition I is that the overall cost of capital of two

identical firms that differ only in their capital structure are the same. One way to rationalize this

corollary is to view the value of the firm as the present value of all of its future cash flows. Denote

Xthe perpetual cash flow of two identical firms that differ only in how their financed. The valueof the unlevered firm is given by

VU = X

WACCU

where W ACCU is the weighted average cost of capital for the unlevered company. Since M&M

Proposition I says that VU = VL, then XWACCU

= XWACCL

, and WACCU = WACCL, and one

arrives at the conclusion that

rA= rU =W ACCU =W ACCL= rD

DL

VL + rE

EL

VL (1)

where rA = rUdenotes the return on the firms real assets and it should equal the return on the

equity of an all equity financed firm, and the last equality is simply the formula for the W ACC

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for a levered company that does not pay any taxes. One can manipulate equation (1) to arrive at

rU = rD DLVL

+ rEELVL

rE

= rU

VL

EL r

D

DL

EL

= rUDL+ EL

EL rD

DLEL

= rU+DLEL

(rU rD)

The last equality is the much celebrated M&Ms Capital Structure Irrelevant Proposition

II.

We restate M&Ms Proposition II

rE

required rate of

return on equity

= rU

required rate of return

on real assets

+ D

E (rU rD)

required rate of return

due to financial leverage

(2)

Equation (2) shows that a levered equitys required rate of return comes from two sources: (i)

the required return from the assets of the company (or unlevered returns), and (ii) the required

return from exposure to financial leverage. M&Ms Prop I, coupled with M&Ms Prop. II, suggests

that while the WACC of the firm remains unchanged, rE increases in the DE

ratio. To further

understand the proposition, consider the firms W ACC

WACCL = rD DLVL

+ rEELVL

M&Ms Prop. II says that whilerE increases in the DE

ratio, DV

increases and EV

decreases in DE

ratio in proportions to make the levered firms overall cost of capital constant across any amount

of financial leverage. WhilerE increases in leverage, the required return on the total package ofthe securities of the firm remains unchanged.

M&Ms Prop. II is important because it provides us with a way to understand how investments

in levered stock returns must be compensated for their exposure to financial leverage. As discussed

earlier, financial leverage increases business risk for the equityholders. All else equal, the higher

the financial leverage of a stock, due to greater corporate borrowing, the greater the required rate

of return due to greater business risk exposure.

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0 0.5 1 1.5 2 2.5 3 3.5 4

0

0.05

0.1

0.15

0.2

0.25

D

E ratio

r

M&M Proposition II: rE=r

U+D/E(r

Ur

D)

rE

rD

rU

=WACC

But the WACC

stays constant

rD

The expected return on equity

rE increases linearly in

the DE

ratio.

Figure 1: M&M Proposition II: rE = rA = W ACC when DE

= 0, however rE increases linearlyin the D

E ratio while rA = W ACCremains constant; hence the result from M&M Prop. I that

VL= VU. The slope of the rEline is (rA rD).

Figure 1 provides a graphical illustration of M&M Proposition II. It shows that rE is linearly

increasing in the leverage ratio DE

. Initially, rE = rU when financial leverage DE

is zero. rE

increases linearly in the DE

ratio while W ACC remains constant. Note that the cost of debt rD

is constant because debt is assumed riskless and rD < rU. Increases in rEresulting from greater

financial leverage is exactly offset by a shift in weight toward rD. Equation (2) shows that as

financial leverage increases the equity holders command a higher rate of return due to increased

financial leverage. The required rate of equity return is equal to the required rate of return on

the real asset of the firm plus a premium related to the equitys exposure to financial leverage.

However, no matter how much the firm borrows, the required rate of return on the package of all

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the debt andequity (the overall firm) is unchanged.

The next examples illustrate M&M Propositions I and II.

Hackers Example Contd: What is Hackers overall cost of capital, cost of equity and firm

value if it were unlevered?

Answer: Since Hackers has 100,000 shares outstanding each priced at $10, the value of the

firm isVU= 100, 000$10 = $1 Million. Since Hackers generates a perpetual operating cash flow

of $200, 000, its rE=rU =W ACC is rE= XVU

= $200,000$1M = 20%.

Hackers Example Contd: If Hackers decides on one of the proposed capital restructuring

either 25% or 50% debt what would Hackers new rE, W ACCand firm value be under each

capital structure?

Answer: The following table summarizes the computations under each capital structure

choice

DV

DE

rE=rU+DE(rUrD) WACC=rU=rD

DLVL

+rEEVL

V = XWACC

0 0 .20 .20 200,000.2 = 1M

25% 25%75%

=13 .2+13(.2 .05) =.25 05 25% + .25 75% =.2

200,000.2 = 1M

50% 50%50%

= 1 .2+11(.2 .05) =.35 05 50% + .35 50% =.2 200,000

.2 = 1M

As it can be seen from the table, even though Hackers rE is increasing in the leverage ratio

DE

, itsW ACCand total firm value remain constant under different capital structure. This former

is M&Ms Prop. II and the latter is M&Ms Prop. I.

4.2 M&M Proposition II with Riskless Debt: Betas

It is instructive to express the levered returns in M&M Proposition II in beta form. Since the

expected levered return increases in the leverage ratio due to greater business risks, then the

levered beta should also increase in the leverage ratio. To see that the risk of a levered equity is

increasing in the DE

ratio, one can simply substitute in the CAPM equation into rE, rD and rU

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in equation (2) to arrive at the following result

rE = rU+D

E (rU rD)

rf+ E(rM rf) = rf+ A(rM rf) +D

E (rf+ A(rM rf) rf D(rM rf))

E(rM rf) = A(rM rf) +D

E (A D) (rM rf)

E

equity risk

= A

business risk

+ D

E (A D)

risk from financial leverage

(3)

where A is the beta of the firms real assets and A = U for an unlevered firm. Equation (3)

is the beta version equivalent to equation (2). The levered equity beta Eis linearly increasing

in the DE

ratio. Initially, E =A when DE

= 0; in other words, since the equityholders own the

entire firm, the equity holders bear all of the firms business and operational risk. The levered

betaEincreases linearly in the DE

ratio while the A remains constant. This implies that while

the risk of the equity increases because of financial leverage, the overall risk of the real assets of

the firm remains unchanged as the leverage ratio DE

increases. The latter interpretation is intuitive

because one tends to think of the operational risk of a firm to be related to the product markets

and the real assets of the firm, not to how the firm is financed.

5 M&M I & II with Taxes: Riskless Debt and Tax Shields

M&M Props. I and II assumed perfect capital markets. That includes the assumption that firms

do not pay corporate taxes. However, in taxable business environments the cost of debt is a

tax deductible expense for the firm. Interest on the firms debt, like depreciation claims, shields

operating profits from being taxed. This section modifies M&Ms proposition when companies

are subject to corporate taxes.

When looking at M&M propositions without taxes, the cost of debt was simply given as

the required rate of return on the debt, rD. Moreover, theWACC was the same for identical

firms that only differed in their capital structure. If corporate taxes are taken into consideration

in a taxable business environment, the effective cost of debt is lower by a factor (1 TC) (ie.

rD (1 TC)< rD), which leads to a lower W ACC as financial leverage increases.

M&M Proposition II with Taxes adjusts for this lower cost of debt when there are

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corporate taxes and its is given by

rE=rU+DLEL

(rU rD) (1 TC) (4)

where rU, as before, denotes the firms unlevered cost of capital, and TC denotes the corporate

tax rate. The WACC of the levered firm is given by

WACCL = rD DLVL

(1 TC) + rEELVL

(5)

0 0.5 1 1.5 2 2.5 3 3.5 4

0

0.05

0.1

0.15

0.2

0.25

D

E ratio

r

M&M II with Taxes: rE=r

U+D/E (1T

C)(r

Ur

D)

rE

rD(1T

C)

WACC

riskless debt

Unlevered cost of equity

rE=rU if D

E = 0

rE

With taxes, the WACCof the

firm is decreasing in the DE

ratio

because the tax shield gains lower the

overall cost of capital for the firm

Figure 2: M&M Proposition II with Taxes: InitiallyrE =rU =W ACC when DE

= 0. However,rE is increasing while the WACC is decreasing in the

DE

ratio. The slope of the rE line is(rU rD) (1 TC).

Figure 2 provides a graphical illustration of equations (4) and (5). The figure shows that

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initially rE = rU = WACC when DE

= 0. Furthermore, rE is increasing while WACC is

decreasing in the DE

ratio. The figure shows that the companys overall cost of capital is decreasing

in financial leverage because debt shield profits from being taxed, providing an advantage over

equity.

The Debt Tax Shield is the firms operating cash flows which was prevented from being taxed.

Effectively, debt results in larger cash flows being shared among the debt and equityholders be-

cause less of the firms cash flows is collected by the government in the form of taxes. Consequently,

the total firm value increases in the amount of debt. In a taxable environment, the debt is a source

of value creation.

To see this, assume that a company has a certain debt amount D that is to be maintained

with a cost ofrD. In each period, the operating profits of this firm will be prevented from being

taxed. The total tax shield gained each period is given by

Tax Shield =TC D rD

Assume furthermore that these tax shields have the same business risk as the firms debt. To

value this asset, one simply computes the present value of the tax shield by discounting them

with rD. Their present value is given by

PV of Tax Shields = TC D rD

rD=TCD

In a taxable business environment, the value of a levered firm is greater than the value of an

otherwise identical unlevered firm by the present value of its tax shields

VL= VU+ TC DL (6)

Equation (6) is known as M&Ms Proposition I with Taxes and a graphical illustration of

the proposition is shown in Figure 3. The figure plots the value function of the levered firm as

a function of D. Initially, VU = VL when D = 0. However, as indicated by equation (6), VL

is increasing in D as the interest tax shield becomes larger in the amount of financial leverage.

In presence of taxes, debt is preferred to equity and the propositions suggest that firms must be

financed with as much debt as possible.

The next example illustrates M&M propositions I and II when there are corporate taxes.

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0 5 10 15 208

9

10

11

12

13

14

15

16

17

18

D

V

M&M with Taxes: Firm Value in D

VL

=VU

+TC

D

VU

VU

TC

D

Figure 3: M&M Proposition I with Taxes: Initially, VU = VL when D = 0. However, VL isincreasing in D because of Tax Shield Gains.

Hackers Example Contd: If Hackers now operates in a taxable environment where the tax

rate is TC= 20%, what are Hackers new firm value, rEand new W ACCif Hackers is all equity

financed and if Hackers decides to adopt each of the proposed capital restructuring of 25% and

50% debt?

Answer: Since Hackers has 100,000 shares outstanding each priced at $10, the value of

the firm is VU = 100, 000 $10 = $1 Million if it were to be all equity financed. Since Hackers

generates a perpetual operating cash flow of $200, 000, its rE = rU = WACC is X(1TC)

VU=

$200,0000.8$1M

= 16%. The following table summarizes the computations for the firm values,rEand

the W ACCunder each proposed capital structure based on equations (4) and (5).

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DV

DE

rE=rU

+DE(rUrD) (1 TC)

WACC=rEELVL

+rDDLVL(1 TC)

V =X(1TC)WACC

0 0 .16 .16 $200,0000.8.16 = 1M

25% 25%75%

=13 .16+1

3

(.16

.05)

.8=.18933

.18933

75%+.05 .8 25% =.152

$200,0000.8

.152

= 1.052632M

50% 50%50%

= 1.16+11(.16 .05) .8

=.248

.24812

+.05 .812=.144

$200,0000.8.144

= 1.111111M

Alternatively, one could simply compute Hackers firm value under each capital structure using

equation (6), and deduce the WACC corresponding to each level of capital structure based on

the firm values and the operating cash flows. To this end, note that

DL= VL debt percentage of levered firm value

and

VL= VU+ DL TC

VL= VU+ VL debt percentage of levered firm value TC

VL=

VU1 debt percentage of levered firm value TC

The next table summarizes the computations

DV

DE

VL=VU+DLTC WACC=X(1T

C)

VL

0 0 1M $200,0000.81M =.16

25% 25%75%

=13VL = 1M+ VL25% 20%

= VL= 1.052632M

$200,0000.81.052632M =.152

50% 50%50%

= 1 VL = 1M+ VL50% 20%= VL= 1.111111M

$200,0000.81.111111M =.144

which gives results that are consistent with the results from the first table. As the exercise shows,

the value of the firm is increasing in leverage. Moreover, the W ACC is decreasing in leverage.

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6 M&M with Taxes & Cost of Financial Distress

The previous section investigated M&M propositions when companies are subject to corporate

taxes. All else equal, the value of the levered firm should be greater than the value of the unlevered

firm by the present value of the tax shields the debt generates. If there are corporate taxes, M&M

propositions seem to indicate that the optimal capital structure for all firms is to borrow as much

as possible.

However, the propositions discussed so far neglected bankruptcy costs. There are at least two

reasons to believe why a firm can not always increase firm value by increasing debt as much as

possible. First, the value creation from corporate debt is limited by the firms ability to generate

sufficient taxable income to take advantage of the tax shields. If a company has little profits,

having a large interest payment will not result in large tax shields. Consequently, increasing afirms debt beyond a certain level would not increase firm value, contradicting M&M Propositions.

Secondly, a direct consequence of increasing debt past a certain level is the increasing possi-

bility that the firm will default on its debt obligation. Bankruptcy and financial distress costs

can be quite substantial and they must be considered when making the optimal capital structure

choice. This section investigates how such costs impacts the optimal capital structure.

6.1 Bankruptcy Costs

Bankruptcy is a legal mechanism that allows the creditors of a company to take over the assets of

the firm if the firm is not able to repay its creditors. Bankruptcy Protection, on the other hand,

is a legal mechanism that allows the management and the shareholders of the firm to keep

operating the business as a going concern without having the assets of the firm seized by the

creditors.

The costs associated with bankruptcy are calledBankruptcy Costs. These are fees involved

in bankruptcy proceedings, such as lawyers and court fees. Bankruptcy costs are normally paid

by the creditors of the company because the assets of the firm is possessed by the debtholders

after lawyer and court fees are paid.

For a company that has borrowed, the total market value of the firm should reflect the costs

of possible bankruptcy in the future. Creditors foresee the possibility that bankruptcy can occur

when the firm holds excessive amounts of debt and they demand a higher yield on the loans.

Bankruptcy costs are usually about 1 to 5% of firm value for large companies, and sometimes

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greater than 25% of firm value for small firms.

6.2 Costs of Financial Distress

Another term closely related to (and more broadly defined than) bankruptcy cost is the Cost

of Financial Distress. Cost of financial distress are all costs and value destruction resulting

from distorted business decisions made by the management and the employees of the firm due to

firms financial insolvency, or fears of financial insolvency. Financial distress costs includes direct

bankruptcy costs and many of the indirect costs from fears that the firm will become bankrupt.

One source of financial distress costs is associated with the managements effort to prevent

bankruptcy. The management can engage in distorted business decision resulting from the possi-

bility of bankruptcy. Instead of focusing on running the business as usual, the management of a

distressed firm is likely to devote most of its time looking for ways to stay afloat. Even with good

intentions, the management of a distressed firm may be reluctance to liquidate the firm and pay

the creditors possibly leading to further value destruction. This is likely to happen to firms that

are in bankruptcy protection, or firms that foresee possible bankruptcy looming, when the firm

is allowed to operate for a prolonged period of time without any real prospects of successfully

emerging out of distress.

Distress costs can also sometimes result from debtholders that are reluctant to liquidate the

firm because they think that it is possible to nurse the company back to financial health. While

some companies can successfully emerge from bankruptcy, for most companies the longer they

are allowed to be operated without success, the larger are the financial distress costs.

Financial distress can also hurt the business of the company. For example, some companies

experience loss of customer loyalty, goodwill, company image, and brand name reputation when

the public learns of their financial troubles. Some distressed companies must pay their employees

a higher salary just to keep talents from leaving, while others end up losing their most talented

employees resulting in significant human capital losses. Distress also causes loss of credit and

liquidity from creditors and suppliers resulting in difficulties of running the business seamlessly.

Distressed companies also commonly run into trouble honouring contractual agreements with

suppliers and customers resulting in costly lawsuits. Lastly, and not exhaustively, distress costs

also lead to value destruction resulting from game playing between debtholders and equityholders

of the firm due to their conflicts of interest.1 In conclusion, it is not surprising that financial

1Value destruction from debtholder and equityholder conflicts will be discussed in the next section.

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distress costs can be many times larger than bankruptcy costs and they are by far the largest cost

associated with financial leverage.

Financial Distress Cost Example: AirWaves Airlines is a passenger air carrier that operates

in Australia and New Zealand. AirFresh AirScent is a hygiene product manufacturer that sells

soaps and deodorants in Australia and New Zealand. If both AirWaves and AirFresh are on

the verge of filing for bankruptcy and both have been under significant financial distress, which

companys firm value do you think will suffer the most due to financial distress?

Answer: Personal safety concerns is much higher for AirWaves than AirFresh. If AirWaves is

cash strapped, it is questionable if AirWaves will be able to upkeep proper maintenance on their

airplanes. Financial distress costs is likely to be much higher for AirWaves than for AirFresh from

losses in customer loyalty and business. Previous AirWaves customers are much more likely to fly

with another air carrier, but AirFreshs customers are still likely to continue using their products

if the quality of their products are unaffected by the bankruptcy filing.

6.3 Static Trade Off Theory: Tax Shield Gains vs. Bankruptcy & Distress

Costs

M&M Propositions I and II showed that in perfect capital markets, everything else equal, the

value of the levered firm must be equal to the value of the unlevered firm ( VL = VU) and there

is no optimal capital structure. When there are corporate taxes to contend with, then M&M

propositions suggest that firm value increases with financial leverage and firms should borrow

as much as possible. What about if there are costs of financial distress? How are the M&M

propositions modified to account for bankruptcy?

In presence of bankruptcy, M&Ms propositions suggest that firms have an optimal capitalstructure that maximizes the total value of the firm. The optimal capital structure is a balanced

trade off between the firm value gained from tax shields and the firm value loss from financial

distress costs. This is called theStatic Trade Off Theory of Capital Structure. The value

of a levered firm is given by

VL = VU+ PV of Tax Shields PV of Cost of Financial Distress (7)

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0 2 4 6 8 10 12 14 16

24

24.5

25

25.5

26

Debt

FirmValue

Static Trade Off Theory: Firm Value vs. Debt

0 2 4 6 8 10 12 14 160.094

0.095

0.096

0.097

0.098

0.099

0.10.101

0.102

D

E ratio

WACC

Static Trade Off Theory: WACC vs. D/E ratio

D

D

E

V is maximized when slope is zero

Optimal DE

ratio

WACC is minimizedwhen V is maximized

Optimal debt level

Figure 4: Static Trade Off Theory: Initially, VU =VL when DE= 0. However, VL is increasing inthe D

Eratio because of Tax Shield Gains but eventually it starts decreasing because the gains from

tax shields start to diminish and they are more than offset by the increase in financial distresscosts. The firm value maximizing amount of debt gives rise to the firmss lowest attainableWACC.

The top panel of Figure 4 plots equation (7) across increasing amount of debt D. As it can be

seen, when the firm is unlevered, its value is given by VU = X(1TC)

rU. If the debt level increases,

the firm value is initially increasing in debt due to larger tax shield gains, but eventually it starts

decreasing because the gains from tax shields start to diminish and they are more than offsetby the increase in financial distress costs. An optimal level of debtD achieves the highest firm

value.

The bottom panel of the figure shows that the optimal leverage ratio D

Ecorresponding to the

optimal debt level D is the one that minimizes the levered firms WACC. This result is not

surprising since the optimal value is achieved when the W ACC is the lowest (i.e. the firm value

and theW ACChave an inverse relationship, V = XWACC

). The minimum W ACCleverage gives

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the debt level that is consistent with the maximum firm value.

The figure also shows another important fact. The top panel of the figure shows that the

optimal level of debt is located exactly when the slope of the value function is zero. A slope of

zero means that a flat line can be balanced on the peak of the value function curve. Keeping in

mind that the slope of a function is the rise over the run of the function, a zero slope implies that

VLD

= 0

where denotes marginal change, $1 for example. Substituting equation (7) into the above

condition we arrive at the following result

VL

D = 0

(VU+ PV of Tax Shields PV of Cost of Financial Distress )

D = 0

VU+ PV of Tax Shields PV of Cost of Financial Distress

D = 0

PV of Tax Shields

D =

PV of Cost of Financial Distress

D (8)

where equation (8) accounts for the fact that VUD

= 0. The optimality condition in equation

(8) shows that the optimal amount of debt is attained when the firm value can not be increased

any further by changing the amount of debt. This optimality condition essentially says that the

optimal amount of debt in a firms capital structure is when the marginal gain in the present value

of tax shields is exactly offset by the marginal increase in the present value of distress costs from

a small increase in debt. A firm should increase or decrease financial leverage until the equality

in equation (8) is attained. The next example illustrates the point.

RightChoice Corp. Example: RightChoice Corp. always makes the right businessdecisions and it is highly profitable. Currently RightChoice is 30% and 70% debt and equity

financed, respectively and currently has a total market valuation of $50 M. If by increasing its

debt to equity ratio of DE

= 37 to 3.56.5 increases financial distress costs by about $2.5M and the

present value of tax shields by $3M, should RightChoice increase debt?

Answer: Because the marginal increase in the present value of tax shields is greater than the

marginal increase in distress costs, RightChoices right decision is to increase debt. RightChoices

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total market value will increase from $50M to $50.5M.

7 Optimal Capital Structure Policy: Empirical Evidence

The previous sections led us to conclude that capital structure choices matter a lot. For example,

M&M Proposition with Taxes indicate that highly profitable firms should utilize debt as much

as possible. However, the Trade Off Theory suggests that borrowing too much can lead to firm

value loss due to distress costs. The optimal capital structure is one that balances gains and

losses. Lastly, firm value destruction arising from conflicts of interest between equityholders and

debtholders seem to indicate that distress costs can arise intentionally if the management is willingto play games with debtholders money.

Armed with all of this information, can one explain the capital structure choices evidenced

empirically? As it turns out, many empirical facts on debt ratios across firms can indeed be

explained.

7.1 Asset Type and Debt ratios: the Static Trade Off Explanation

The trade off theory can explain why firms with mostly safe and tangible assets, such as utilities,

real estate and heavy manufacturing, tend to have higher debt ratios than firms with risky in-

tangible assets, such as high technology, pharmaceutical, advertising and consulting companies.

Financial distress costs for firms with mostly tangible real assets such as equipment, building,

machinery, production plants, properties and lands, are likely to be low since these assets dont

tend to lose value significantly due to their resale values. Financial distress costs are likely to

be much higher for firms whose operations are human capital intensive and dependant mostly

on intangible assets, such as copyrights and patents from research and development. In distress,

talented employees leave for higher pay in other companies and copyrights and patents are usually

disposed at substantial discounts. Consequently, firms with safer and tangible assets have a much

greater debt capacity than firms with riskier and intangible assets.

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7.2 High Profit & Low Debt Ratio Firms: The Pecking Order Theory Expla-

nation

The trade off theory can explain much of the capital structure choices made by firms. However,

there are still examples of companies that virtually have no debt and yet are some of the mostprofitable companies around. One would conclude that these companies are not fully utilizing tax

shelters by increasing debt.2 A possible explanation why some of the most profitable companies

borrow the least lies in the Pecking Order Hypothesis.

The pecking order theory says that highly profitable firms prefer to raise capital internally

through retained earnings, followed by issuing debt and, lastly, followed by issuing equity. The

main motivation behind the pecking order theory is that highly profitable firms prefer to grow

by investing in positive NPV projects through retained earnings instead of distributing earnings

to debtholders and shareholders through interest and dividend payments and later incurring

floatation costs to raise external capital. Regarding the preference for debt over equity, these

firms have little debt to begin with, so according to the trade off theory, the marginal gains in

tax shields from debt is greater than the marginal losses from distress costs.

8 Final Words on Capital Structure

8.1 Debt and Corporate Discipline

As an aside, debt has an additional benefit (other than tax shields). Debt has been used to

discipline management. With the right amount of debt, debt has the potential to keep the man-

agement on their toes, give motivation for lower management compensation and cut operational

costs, force management to make sound economic decisions ones that maximize the total value

of the firm and give the management less incentive to spend lavishly on such things as corpo-

rate jets, large executive offices, and dinning (and wining) with corporate clients, among other

perquisites.

8.2 Other Things to Consider

Lastly, some other points are made regarding capital structure decisions.

2Microsoft is a perfect example. Even though most of Microsofts assets are intangible human capital talents

and copyrights on software source codes Microsoft has a large corporate tax bill. Microsoft is so profitable that it

scores a high credit rating and should not have any problems raising debt capital. Companies like Microsoft could

substantially increase firm value by increasing debt and still avoid concerns of financial distress.

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i) Taxes: If the firm is in a tax paying position, the increase in leverage reduces the tax bill. If the

firm is expected to have negative profit, or if there were negative profits in the past (accumulated

losses), the company can make use of carry backs or carry forwards to shield taxes in periods of

high profits. These firms could do without increase in finance leverage.

ii) Risks: All else equal, distress is more likely for firms with high business risk. So these

companies should stay away from too much debt.

iii) Asset type: Distress costs are higher for firms with more intangible assets. These assets

tend to erode in value rapidly in case of default. These firms should borrow considerably less than

firms with more tangible assets.

iv) Financial Slack: Financial slack may be very important when it comes time to invest in

positive NPV projects in a competitive and timely manner. Moreover, external financing is more

quickly accessible when the firms debt is low and credit rating is high.

v) Tax Shelters: There are other tax shelters that are not related to debt. For example, depre-

ciation of depreciable assets is a tax shelter and lower taxes. Also, local governments sometimes

provide certain firms investment incentives so they can help improve the economic conditions of

a city or state. These companies are allowed to operate in a low tax environment for a prolonged

period of time. Other firms receive incentives from governments to invest in R&D by being al-

lowed to claim R&D investment costs as depreciable expenses. All of these factors can lead a

company not to borrow up to capacity.

9 Conclusions

The optimal capital structure choice for a firm should be firm specific. Firms differ in operations

leading to differences in how taxes and bankruptcy costs affect their firm value. In a market

without frictions and imperfections the mix of debt and equity is irrelevant. However, we live in

a world where managers need to balance the offsetting factors related to taxes and bankruptcy

costs. This chapter showed that the optimal mix of debt and equity for a firm is the mix that

maximizes its total firm value. Its without coincidence that the optimal debt to equity ratio is

the one what minimizes the firms overall cost of capital.

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