Background

Two major decisions that concern managers include

determining:
Which projects create the most value
Which mix of sources of capital is best for financing the firms
investments
Too much debt is damaging because the firm will have difficulty
in servicing its debt
Too little debt is fiscally inefficient because of the tax
deductibility of interest expenses

How should a firm choose its debt/equity ratio?

This part examines how managers should combine debt
and equity financing to achieve an optimal or target
capital structure that maximizes the value of the firms
assets

Background

The Pie
The value of a firm is defined to be the sum
of the value of the firms debt and the
firms equity.
V = D+ E

If the goal of the firms

management is to
maximize the value of the
firm, then the firm should
pick the debt-equity ratio
that makes the pie as big
as possible.

Value of the Firm

3

The usual case

In general, changes in capital structure
benefit the stockholders if and only if the
value of the firm increases.
Thus, we will be focusing on how to
determine the optimal capital structure that
maximizes firm value.
Lets illustrate the effect of capital structure
on returns to shareholders

Financial leverage and firm value

Trans Am Corp. currently has no debt in its
capital structure. The firm is considering
issuing debt.
Hp: no corporate taxes and no financial
distress costs
CURRENT FUTURE
Assets

8,000$

8,000$

Debt

0$

4,000$

Equity

8,000$

4,000$

Interest rate

10%

10%

Market value per share

20$

20$

N shares outstanding

400

200

We consider the effect of a change in the capital

structure on the firms EPS and ROE for three possible
scenarios: recession, expected performance, boom.
5

Financial leverage and firm value

If scenarios expected and boom are more
likely, leverage is advantageous. If recession
is more likely, it is not good to raise debt.
CURRENT

Earnings

FUTURE

Recession

Expected

Boom

400$

1,200$

2,000$

Earnings before interest

Recession

Expected

Boom

400$

1,200$

2,000$

ROA

5%

15%

25%

5%

15%

25%

interest

-400$

-400$

-400$

Earnings after interest

400$

1,200$

2,000$

0$

800$

1,600$

ROE

5%

15%

25%

0%

20%

40%

EPS

1$

3$

5$

0$

4$

8$

400/8,000=5

800/4,000=20%

Financial leverage and firm value

The effect of financial leverage depends on the companys
earnings before interest.
The levered firm has fewer shares of stock outstanding.
Hence, any increase in EBI leads to a greater increase in EPS.

EPS

D#0
D=0

Advantage
to debt

Break-even
point

Earnings before
interest (EBI)

A risk-adverse investor
might prefer the allequity firm. A risk-neutral
investor might prefer
leverage.

Disadvanta
ge to debt
7

Which capital structure is better?

Imagine that shareholders issue debt along two
strategies:
A) Buy 100 shares of the levered equity
(cost=2,000$)
B) Buy 200 shares of the unlevered equity at 20$
per share using borrowed money (2,000$)+own
investment (2,000$).
Total cost of shares=200 x 20$=4,000$

Strategy A:
EPS_recession=0$ Earnings_rec=EPSx100 shares=0$
EPS_expected=4$ Earnings_exp=EPSx100 shares=400$
EPS_boom=8$
Earnings_boom=EPSx100
shares=800$
8

Which capital structure is better?

Strategy B:
EPS_recession=1$ Earnings_rec=EPSx200 shares=200$
EPS_expected=3$ Earnings_exp=EPSx200 shares=600$
EPS_boom=5$
Earnings_boom=EPSx200
shares=1000$
If you pay interest (10%) on debt:
Interest expense=0.10x2,000=200$ for all the three states
Earnings_rec=200-200=0$
Earnings_exp=600-200=400$
Earnings_boom=1000-200=800$
The payoff of the two strategies are the same and do not
affect shareholders welfare! (as far as the shareholder can
use borrowed money at the same interest rate applied on
the
firms debt.)

Modigliani and Miller (1958)

10

Modigliani and Miller (1958)

11

Modigliani and Miller I

12

Modigliani and Miller I

13

Modigliani and Miller I

14

Modigliani and Miller I

15

Modigliani and Miller II

re

DE
D
D
ru rd ru (ru rd )( )
E
E
E

MM Proposition II: The expected return on equity is positively

related to leverage because the risk to equity holders increases
with leverage.

16

Some algebra
rWACC

E
D
re
rd
DE
DE

rWACC ru
ru

E
D
re
rd
DE
DE

Levered firm
Unlevered
firm

multiply both sides by

DE
E
DE
D
DE
ru re

rd

E
DE
E
DE
E

DE
E

DE
D
ru re rd
E
E
re ru

D
(ru rd )
E
17

Modigliani and Miller II

In our previous
example:
0
8,000
UNLEVERED _ rWACC
10%
15% 15%
8,000
8,000

LEVERED _ rWACC
ru

4,000
4,000
10%
20% 15%
8,000
8,000

1,200
15% rWACC
8,000

Independently of the capital

structure rWACC is always the same!
18

Modigliani and Miller II

DE
D
D
re
ru rd ru (ru rd )( )
E
E
E

ru>rd

The cost of equity rises with leverage

because the risk to equity rises with
leverage.
19

An interpretation of MM
MM indicate that managers cannot change the value
of a firm by repackaging the firms securities
The size of the pie does not change, no matter how
stockholders and bondholders divide it
A firms capital structure is irrelevant

MM argue that the firms overall cost of capital

cannot be reduced as debt is substituted for equity,
even if debt is cheaper than equity.
As the firm adds debt, the remaining equity becomes
more risky and the cost of equity capital rises as a
result.
Hence, the increase in the cost of equity capital offsets
the higher proportion of the firm financed by low-cost
debt
Both the value of the firm and the firms overall cost of
capital are invariant to leverage
20

Corporate taxes
In the presence of corporate taxes, firm value is
positively related to its debt
In most countries interest (but not dividend)
r =10%
payments are tax deductible.
d

Debt=4,000,000$

Plan I= no debt

Plan II= debt

EBIT

1,000,000

1,000,000

Interest expense

400,000

Earnings before taxes

1,000,000

600,000

Taxes (35%)

350,000

210,000

Total Earnings

650,000

390,000

Total cash flow to both stockholders and bondholders

650,000

790,000

Debt-interest tax shield (DITS)=Tc * rdD

It is the amount of money saved because interest expenses are tax deductible
21

MMI and corporate taxes

VU

EBIT (1 TC )
ru

TC rd D
TC D
rd

Assumption: the CF expressed by DITS has the same risk as the interest
on debt

22

MMII and corporate taxes

D
r

(
1

T
)(
r

r
)(
)
MM II with corporate tax: e u
c
u
d
E
ru>rd

There is an incentive to issue debt because it allows to minimize

the cost of capital for the firm!

23

MM and corporate taxes

24

Personal taxes
Lets introduce personal taxes. We assume all
earnings are paid out as dividends. Dividends and
interests are taxed at the same rate 30%.
Plan I= no debt

Plan II= debt

Dividends

650,000

390,000

Personal taxes on dividends (30%)

(195,000)

(117,000)

Dividends after personal taxes

455,000

273,000

Interest expense

400,000

Personal taxes on interest (30%)

(120,000)

Interest expense after personal taxes

280,000

Total cash flow to both stockholders and bondholders

455,000

553,000

Plan I=corporate tax + personal tax on div=350,000+195,000=545,000$

Plan II=corporate tax + personal tax on div +personal tax on
interest=210,000+117,000+120,000=447,000$

Debt increases the value of the firm!

25

Personal taxes
Higher tax rate on interest than on dividends.
Personal tax rate on dividends is 10%. Personal
tax rate on interest is 50%.
Plan I= no debt

Plan II= debt

Dividends

650,000

390,000

Personal taxes on dividends (10%)

(65,000)

(39,000)

Dividends after personal taxes

585,000

351,000

Interest expense

400,000

Personal taxes on interest (50%)

(200,000)

Interest expense after personal taxes

200,000

Total cash flow to both stockholders and bondholders

585,000

551,000

Plan I=corporate tax + personal tax on div=350,000+65,000=415,000$

Plan II=corporate tax + personal tax on div +personal tax on
interest=210,000+39,000+200,000=449,000$

Debt does not increase the value of the firm!

26

Miller 1997: the effects of personal

taxes

27

Miller 1997: derivation

The value of the levered firm VL is the present value of its
expected after tax earnings which is partitioned into two
parts:
the shareholders
the debt holders.
The yearly cash flows to shareholders after corporate and
personal
( EBIT r taxation
D)(1 T )(are
1 Tgiven
) by:
d

pe

The yearly cash flows to bondholders are given by:

(1 T pd )rd D
Thus the total cash flow of all investors is:

( EBIT rd D)(1 Tc )(1 T pe ) (1 T pd )rd D

28

Miller 1997: derivation

( EBIT rd D)(1 Tc )(1 T pe ) (1 T pd )rd D
can be rewritten as:

(1 Tc )(1 Tpe )
EBIT (1 Tc )(1 Tpe ) (1 Tpd )rd D 1

(1 Tpd )

The first term is the cash flow from an unlevered firm after all
taxes and is equal to Vu. An individual buying a bond for D
receives
taxes:
(1 after
Tpd )rall
dD

(1 Tc )(1 Tpe )
Thus, the value of the second term must be:
D 1

(
1

T
)
pd

Therefore, the value of the levered firm must be:

(1 Tc )(1 Tpe )
VL VU D 1

(1 Tpd )

29

Miller 1997: the model

The value of a levered firm is:

(1 Tc )(1 T pe )

VL VU D 1

(
1

T
)

pd
VL VU Tc D
If we set Tpe T pd the formula
reduces to
WhenT pe T pd but (1 Tpd ) (1 Tc )(1 Tpe )

VL VU Tc D
When (1 Tpd ) (1 Tc )(1 Tpe )

The effect of debt

on firm value
depends on T*

VL VU
30

Miller 1997: the model

1

VL VU Tc D

VL VU Tc D

2 VL VU Tc D
3 VL VU
4 VL VU

1 Tpe T pd
2 Tpe Tpd

but

(1 Tpd ) (1 Tc )(1 Tpe )

3 (1 Tpd ) (1 Tc )(1 Tpe )

4 (1 Tpd ) (1 Tc )(1 Tpe )
31

Financial distress costs

Debt provides tax benefits to the firm but it puts pressure
because debt obligations have to be serviced.
Financial distress costs (in ultimum bankruptacy) can arise.

32

Static-trade off model

Trade-off between the tax benefit of increased leverage
PV(DITS) and expected financial distress costs.

The presence of financial distress costs can lower

the value of a firm.

33

Static-trade off model

V

At point D* (optimal amount of debt), the increase in the PV of FDC given from an additional $ of debt is equal
to the increase in the PV (DITS)
Beyond point D* financial distress costs increase faster than the tax shield, implying a reduction in firm value.

34

Static-trade off model

rWACC falls initially because of the tax advantage to debt. Beyond

the optimal level of debt it rises because of financial distress costs

35

Firm profitability and debt level

Firms with low anticipated profits (less valuable) will take
on a low level of debt
More valuable firms will take on more debt in order to
further reduce taxes from their greater earnings.
Debt signalling theory:
When firms expect their earnings to rise, they raise debt
This is interpreted as a signal of firm value stock prices
rise

Managers have incentives to fool the public:

If a firm has already an optimal level of debt, but managers
decide to raise debt to increase the stock price
Investors could think that the firm is more valuable than
what it really is and stock prices go up.
However, at some point the market will know that the firm
is not valuable and stock prices will fall at lower levels than
before the debt issuance.
36

Information structures

37

Principal-agent games and agency

cost

38

Moral Hazard

39

Costly control mechanisms

40

Agency cost of debt

41

Sources of debt-shareholders conflict

Shareholders are tempted to pursue selfish strategies when there
is a probability of bankruptacy:
Incentives to take large risks
Incentives towards underinvestment
Milking the property

Incentive to take large risks

Ex. A levered firm is considering two mutually-exclusive projects
(low-risk and high-risk). There are two equally likely states of the
economy (recession, boom). If recession hits, the firm will come
near to bankruptacy with the low-risk project and in bankruptacy
with the other. Bondholders are promised to be paid 100$,
shareholders are residual claimants.
If the low-risk project is taken:
Prob

Value firm

Stock

Bonds

Recession

0.5

100$

0$

100$

Boom

0.5

200$

100$

100$
42

Sources of debt-shareholders conflict

Expected value of the firm=0.5*100$+0.5*200$=150$
Expected value of the stock=0.5*0$+0.5*100$=50$
If the high-risk project is taken:
Prob

Value firm

Stock

Bonds

Recession

0.5

50$

0$

50$

Boom

0.5

240$

140$

100$

Expected value of the firm=0.5*50$+0.5*240$=145$

Expected value of the stock=0.5*0$+0.5*140$=70$
The high-risk project increases firm value in boom and decreases it in recession
The stockholders will receive anything in recession in both cases, so they have an
incentive to choose the high-risk project!

43

Sources of debt-shareholders conflict

Incentive towards underinvestment
Ex. A firm has a high probability to go in bankruptacy with a recession because its CFs
will be only 2,400$ and it has to service debt for 4,000$. It has the possibility to invest
in a new project, by raising new equity and avoiding bankruptacy in recession. The
project costs 1,000$ and brings 1,700$ in both states but its cost is entirely
contributed by stockholders

No project

Yes project

Boom

Recession

Boom

Recession

CFs

5,000 $

2,400$

6,700$

4,100$

Bondholder claim

4,000 $

2,400$

4,0000$

4,000$

Stockholder claim

1,000 $

0$

2,700$

100$

The all-equity firm always takes projects with positive NPV,

but the unlevered firm might deviate from this policy.
Milking the property
It means paying extra-dividends in time of financial distress, leaving
less in the firm to bondholders.
44

Bondholders defence against

stockholders

Negative covenants=limit actions that the company has to

take
Positive covenants=specify an action that a company agrees

45

Agency costs of external equity

Managers have the tendency to waste corporate

resources and this tendency is bigger if the firm can
generate cash flows
Free cash flow hp=debt reduces free-cash flow and so
boostes firm value
46

Pecking order model

Compared to previous theories:

it does not imply a target amount of
leverage. Only when debt capacity is
exhausted, the firm can turn to equity
Profitable firms generate cash internally
47