Corporate Finance-II
EMBA
Winter Semester 2009
Lahore School of
Economics
Financial leverage & Capital
structure policy
Chapter-17
Financial leverage & Capital structure
policy
Learning Objectives
 Capital structure?
 Effect of Financial Leverage?
 M&M Propositions?
 Corporate Taxes & Capital Structure?
 Optimal Capital Structure?
 Bankruptcy Process & Costs?
The Capital Structure
Question
What is it?….
 How much Debt relative to Equity should a firm have?
 What should be the Borrowing policy?
Capital Structure
Restructuring..
If a firm wants to increase D/E ratio (increase borrowing)
What could it do…? (keeping its assets same)
Capital Structure
Restructuring..
If a firm wants to increase D/E ratio (increase borrowing)
What could it do…? (keeping its assets same)
Issue Bonds & use the cash proceeds to buy Shares!
Capital Structure
Restructuring..
If a firm wants to decrease D/E ratio (reduce borrowing)
What could it do…? (keeping its assets same)
Capital Structure
Restructuring..
If a firm wants to decrease D/E ratio (reduce borrowing)
What could it do…? (keeping its assets same)
Issue Stock & use the cash to pay off Debt!
Firm value & Stock Value –
An Example
The Market value of JJ Sprint company is $1000. The
company currently has no debt, & JJ Sprint’s 100
shares sell for $10 each. Further suppose that JJ
Sprint restructures itself by borrowing $500 & then
paying out the proceeds to shareholders as an extra
dividend of $5 per share.
Firm value & Stock Value –
An Example
Debt plus Dividend
No Debt
Debt
Equity
Firm Value
I
II
III
$0
$500
$500
$500
1000
750
500
250
1000
1250
1000
750
Debt plus Dividend
I
Equity Value reduction
II
III
-250
-500
-750
Dividends
500
+500
500
Net Effect
+250
0
-250
Firm Value & Stock Value
This means..
Change in the value of the firm is the same as the net
effect on the stockholders.
Financial Managers can try to find the Capital structure
that maximizes the value of the firm
Capital Structure
How should the firm approach this decision?..
 Maximization of shareholder value
 Maximization of Share price
Same as:
 Maximizing the whole value of the Firm!
Capital Structure & The cost
of Capital
Alternatively:
Firm should focus on Minimizing WACC. As, WACC is the
appropriate discount rate for the firm’s overall Cash flows.
Because values & discount rates move in opposite
directions:
Minimizing WACC should result in:
Maximizing Value!
Capital Structure & The cost
of Capital
And so..
Optimal Capital Structure (D/E ratio) represents lowest
possible WACC
Also called: TARGET Capital Structure
The effect of financial
leverage
Effects of Financial Leverage?..
 Financial Leverage refers to the extent to which a firm
relies on Debt.
 More Debt means MORE leverage
THE Effects of Financial
Leverage - Example
 We consider case of company X which has no debt & is
considering restructuring to include debt in its capital
structure.
 We look at DEBT & NO DEBT situations
 Taxes are ignored
THE Effects of Financial
Leverage - Example
Current
Assets
Proposed
$8,000,000
$8,000,000
0
4,000,000
8,000,000
4,000,000
0
1
Share Price
20
20
# of Shares
400,000
200,000
10%
10%
Debt
Equity
Debt-Equity Ratio
Interest Rate
THE Effects of Financial
Leverage - Example
Current Capital Structure: No Debt
Recession
EBIT
Normal
Expansion
$500,000
$1,000,000
$1,500,000
Interest
?
?
?
Net Income
?
?
?
ROE
?
?
?
EPS
?
?
?
THE Effects of Financial
Leverage - Example
Current Capital Structure: No Debt
Recession
EBIT
Normal
Expansion
$500,000
$1,000,000
$1,500,000
0
0
0
500,000
1,000,000
1,500,000
ROE
6.25%
12.5%
18.75%
EPS
1.25
2.50
3.75
Interest
Net Income
THE Effects of Financial
Leverage - Example
Current Capital Structure: Debt - $4 Million
Recession
EBIT
Normal
Expansion
$500,000
$1,000,000
$1,500,000
Interest
?
?
?
Net Income
?
?
?
ROE
?
?
?
EPS
?
?
?
THE Effects of Financial
Leverage - Example
Current Capital Structure: Debt - $4 Million
Recession
EBIT
Normal
Expansion
$500,000
$1,000,000
$1,500,000
Interest
400,000
400,000
400,000
Net Income
100,000
600,000
1,100,000
ROE
2.50%
15.50%
27.50%
EPS
0.50
3.00
5.50
THE Effects of Financial
Leverage - Example
Leverage & EPS
EPS No Debt
EPS Debt
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Recession
Expected
Expansion
THE Effects of Financial
Leverage - Example
Leverage & ROE
ROE No Debt
ROE w /Debt
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Recession
Expected
Expansion
THE Effects of Financial
Leverage - Example
Leverage & Net Income
Net Income No Debt
Net Income w/Debt
$1,600,000
$1,400,000
$1,200,000
$1,000,000
$800,000
$600,000
$400,000
$200,000
$0
Recession
Expected
Expansion
EPS Becomes sensitive to Leverage
EPS & EBIT Slopes (Leverage)
EPS No debt
5
EPS w /debt
Debt Advantage
4
3
EPS
2
Debt disadvantage
1
0
-1 0
400000
800000
-2
-3
EBIT
1200000
THE Effects of Financial
Leverage - Example
Finding the BE point..
With NO Debt…
EPS = EBIT/400,000 shares
With DEBT
EPS = (EBIT-$400,000 / 200,000 shares)
Break even point is the point where EBIT is such that EPS
under both scenarios is same:
Break Even EBIT = ?
THE Effects of Financial
Leverage - Example
Finding the BE point..
With NO Debt:
EPS = EBIT/400,000 shares
With DEBT:
EPS = (EBIT-$400,000 / 200,000 shares)
Break even point is the point where EBIT is such that EPS
under both scenarios is same:
EBIT = 800,000 & EPS = $2
This is the indifference point
Capital Structure & Break
Even Point
Leverage is …
Beneficial if EBIT is ABOVE Break-even EBIT
&
Not beneficial if EBIT is BELOW Break-even EBIT
Capital Structure & Break-even
point - Example
Suppose ABL has decided to increase its D/E ratio. It wants
to increase Debt from Rs 1,500,000 to 10,000,000. The
interest rate on this will be 16%. ABL has 750,000 shares
outstanding which sell for Rs 85. If the restructuring
increases the ROE. Calculate the indifference point or BE
point for ABL!
Capital Structure & Break-even
point - Example
Step 1:
Calculate Interest Expense under both
scenarios:
Interest expense current capital structure:
= Debt * Interest Rate
= 1500000*0.16
= 240000
Interest Expense NEW Capital Structure:
= Debt * Interest Rate
= 10000000 x .16
= 1600000
Capital Structure & Break-even
point - Example
Step 2: Calculate No. of shares outstanding under both
scenarios
Total # of shares under Current Capital structure = 750,000
# of shares repurchased under New Capital structure:
= Increase in Debt / Price per share
= (10M – 1.5M)/85
= 100,000
Total # of shares outstanding under new capital structure
= Already Outstanding Shares – Shares Repurchased
= 750,000 – 100,000
= 650,000
Capital Structure & Break-even
point - Example
Step 3: Getting Break-even EBIT
Break-even point is the point where EPS under both
scenarios is equal:
EPS WITH Current Capital Structure:
= (EBIT – 240,000)/750,000
EPS with NEW capital Structure:
= (EBIT – 1.6mm)/650,000
Capital Structure & Break-even
point - Example
Step 3: Getting Break-even EBIT
Break-even point is the point where EPS under both
scenarios is equal:
Break-even EBIT:
(EBIT-240000)/750,000 = (EBIT – 1.6M)/650,000
EBIT – 1.6M = 650000/750000 x (EBIT – 240000)
EBIT – 1.6M = (0.866 EBIT) – 207840
0.134 EBIT = 1.6M – 207840
EBIT
= 10,389,254
Capital Structure & Break-even
point - Example
Verifying EPS:
If EBIT is 10,389,254 then using equations we get:
No Debt:
EPS = (10389254 - 240000)/750,000 = 13.53
Debt:
EPS = (10389254 – 1.6M)/650,000 = 13.52
Capital Structure
Leverage Conclusions..
Capital Structure
Leverage Conclusions..
1. Effect of Leverage depends on EBIT.
When EBIT is high, leverage is beneficial
2.
3.
Leverage increases returns (indicated by ROE & EPS)
Risk increases with Leverage (variability of ER’s)
Corporate Borrowing &
Home Made Leverage
Home Made Leverage:
The use of personal borrowings to change the overall
amount of financial leverage to which the individual is
exposed.
Home Made Leverage Example
Proposed Capital Structure
Recession
EPS
Earnings for 100 shares
Expected
Expansion
0.50
3.00
5.50
50
300
550
Net Cost = 100 shares * $20 = $2000
Original Capital Structure & home made Leverage
EPS
1.25
2.50
3.75
Earnings for 200 shares
250
500
750
Less: Interest @ 10%
200
200
200
Net Cost = (200 shares *20) – Amount Borrowed = 2000
Corporate Borrowing & Home
Made Leverage
1. Home Made Leverage simply means, the investors can
replicate the firm’s capital structure by using the same
D/E ratio’s.
2. And investors can adjust their D/E to get different payoffs.
Thus, this implies…
The firm’s choice of capital structure does not matter!
Therefore,
The stock price should not be affected by capital
structure, although the payoff’s do.
ASSIGNEMENT # 4 (5Quetsions)
Q1: XYZ Corp has no debt outstanding & a total Market Value
of $150,000, EBIT is projected to be $15,000, if economic
conditions are normal. If there is strong Expansion in the
economy, then EBIT will be 30% higher. If there is
recession, then EBIT will be 60% lower. XYZ is
considering a $60,000 debt issue with a 5% interest rate.
The proceeds will be used to repurchase shares of stock.
There are currently 2500 shares of stock outstanding.
Ignore taxes for this problem.
A) Calculate EPS under each of the three economic scenarios
before any debt is issued. Also, calculate the percentage
change in EPS when the economy expands or enters a
recession.
B) Repeat Part (a) assuming that XYZ goes through with recapitalization. What do you observe?
Q#1 (Continued)
C)
D)
E)
F)
Repeat part (a) & (b) assuming XYZ Corp has a tax
rate of 35%.
Suppose XYZ Corp has a Market to Book ratio of 1.
Calculate ROE under each of the three economic
scenarios before any debt is issued. Also, calculate
percentage change in ROE for economic Expansions
& Recession assuming No taxes.
Repeat Part (D) assuming the firm goes through
recapitalization.
Repeat part (D) & (E) assuming the firm has a tax
rate of 35%.
Q#2
Break – EVEN EBIT
A)
B)
C)
Malang Fabric Manufacturing is comparing two
different capital structures, an all equity plan (Plan
I) & a levered plan (Plan II). Under Plan I, Malang
would have 150,000 shares of stock outstanding.
Under Plan II there would be 60,000 shares of stock
outstanding & 15 million Rupees in Debt
outstanding. The interest rate on debt is 10% and
there are no taxes.
If EBIT is 2million Rupees which plan will result in
the higher EPS?
If EBIT is 7million Rupees, which plan will result in
the higher EPS?
What is the Break – Even EBIT?
Q#3
Break – Even EBIT with Taxes
A)
Shantou Beverage is comparing two different capital
structures. Plan I would result in 1,100 shares of
stock outstanding 17 million yaun in Debt. Plan II
would result in 900 shares of stock & 28 million
yaun in Debt. Interest rate is 10%.
Ignoring taxes, compare both these plans to an all
equity plan assuming that EBIT will be 10 million
yaun. The all – Equity plan would result in 1,400
shares of stock outstanding. Which of these plans
has the Highest EPS? The lowest?
Q#3 Continued
B)
C)
D)
In part (A), what are the Break – even levels of EBIT
for each plan as compared to that for all – equity
plan? Is one higher than the other?
Ignoring taxes, when will EPS be identical for Plans
I & II.
Repeat Parts (A), (B) & (C) assuming that the
corporate tax rate is 40%.
Q#4 Home Made Leverage
Valencia Items, a prominent consumer products firm
is debating whether or not to convert its all equity
capital structure to one that is 40% debt. Currently,
there are 2,000 shares outstanding and the price per
share is 70 Euros. EBIT is expected to remain at
16,000 Euros per year forever. The interest rate on
new debt is 10% & there are no Taxes.
A) Ms. Aznar, a shareholder of the firm owned 100 shares
of stock. What is her Cash flow under the current
capital structure? Assume that she keeps all 100 of
her shares.
Q#4 Continued
B) Suppose Valencia does convert, but Ms Aznar prefers
the current all Equity capital structure. Show how she
could unlever her shares of stock to recreate the
original capital structure.
C) Suppose Valencia does not convert, but Ms Aznar
prefers a capital Structure that is 70% Debt. Show
how she could lever her shares of stock to recreate
the original capital Structure.
Q#5 Home Made leverage
ABC Co. & XYZ Co. are identical firms in all respects
except for their capital structure. ABC is all-equity
financed with $600,000 in stock. XYZ uses both stock
& perpetual Debt; its stock is worth $400,000 & the
interest rate on its debt is 9%. Both firms expect EBIT
to be $75,000. Ignore Taxes.
A) Maichin owns $30,000 worth of XYZ’s stock. What
rate of return is she expecting?
B) Show how Maichin could generate exactly the same
cash flows & rate of return by investing in ABC & using
home Made leverage.
Financial leverage & Capital structure
policy
Learning Objectives
 Capital structure?
 Effect of Financial Leverage?
 M&M Propositions?
 Corporate Taxes & Capital Structure?
 Optimal Capital Structure?
 Bankruptcy Process & Costs?
Capital Structure & the cost
of Equity Capital
M&M Proposition I with no Taxes
What we have just discovered regarding Capital Structure
& the firm’s value through home-made leverage is
proposed by Franco & Merton as the M&M proposition I
which states:
The Value of the Firm is Independent of its
capital structure
Or
It is irrelevant how a firm chooses its financing
M&M Proposition IThe Pie Model
M &M Pie
Stocks
M&M Pie
Bonds
Stocks, 30%
Bonds, 70%
Bonds,
30%
Stocks
Stocks,
70%
Bonds
The cost of Equity &
Financial Leverage
M&M Proposition II with no taxes

Although Firm’s value may not change,

D/E is certainly affected…
The cost of Equity &
Financial Leverage
M&M Proposition II with no taxes

WACC = (E/V) x Re + (D/V) x Rd

If we re-arrange for cost of equity –Re- we get:
Re = WACC + (WACC-Rd)*(D/E)
Or
Re = Ra + (Ra-Rd)*(D/E)
This is M&M Proposition II!
(Ra = WACC)
The cost of Equity &
Financial Leverage
M&M Proposition II with no taxes
Re = Ra + (Ra-Rd)*(D/E)
(Ra = WACC)
It says cost of Equity depends on 3 things:

Ra = required return on Firm’s assets

Rd = Firm’s cost of Debt

D/E = Firm’s debt/equity ratio
Cost of equity & wacc: m&m
Proposition I & II WITHOUT
taxes
Required
Return
Re (cost of equity)
WACC
Ra
Rd (cost of debt)
D/E (debt to equity ratio)
The cost of Equity &
Financial Leverage
M&M Proposition II without Taxes
Point to Note:
WACC does not depend on the D/E ratio
Another way to look at M&M II is:

The firm’s overall Cost of Capital (WACC) is unaffected by its
Capital Structure

As debt increases, cost of equity also increases to offset
lower debt cost!
So the WACC stays the same!
Assumptions used in M&M II
Capital markets are perfect
•Markets are frictionless.
•Perfect competition in product and securities markets.
•Information efficiency.
•Agents are perfectly rational and maximize utility.
There are no costs to bankruptcy
All cash flow streams are perpetuities and no growth is
allowed.
Managers always maximize shareholders’ wealth
•(imply no agency costs)
Homemade leverage is a perfect substitute
M&M Proposition without
taxes Evidence on Capital Structure
1) More profitable firms tend to use less leverage.
2) High-growth firms borrow less than mature firms do.
3) Firms’ asset base influence capital structure choice.
4) Stock market generally views leverage-increasing events
positively.
5) Tax deductibility of interest gives firms an incentive to use
debt.
M&M II Without Taxes Example
Company X has WACC of 12%. It can borrow at 8%. If X
chooses a capital structure of 80% Equity & 20% debt.
Calculate the cost of equity?
 If X changes to 50% equity & 50% debt, what is cost of
equity?
 What happens to WACC given different Capital Structures?
M&M II WITHOUT TaxesExample
Company X has WACC of 12%. It can borrow at 8%. If X
chooses a capital structure of 80% Equity & 20% debt.
Calculate the cost of equity?
Step 1: Get cost of equity, Re
Re = Ra + (Ra-Rd)*(D/E)
= 12% + (12-8%)*(.25)
= 13%
M&M II WITHOUT TAXESExample
Company X has WACC of 12%. It can borrow at 8%. If X
chooses a capital structure of 80% Equity & 20% debt.
If X changes to 50% equity & 50% debt, what is cost of
equity?
Re = Ra + (Ra-Rd)*(D/E)
= 12% + (12-8)*(1)
= 16%
M&M II WITHOUT TAXESExample
Company X has WACC of 12%. It can borrow at 8%. If X
chooses a capital structure of 80% Equity & 20% debt.
What happens to WACC given different Capital Structures?
Step 2: Get WACC for both cases (80/20 & 50/50)
WACC (80/20) = (.8*13%) + (.2*8%)
= 12%
WACC (50/50)
= (.5*16%) + (.5*8%)
= 12%
NOTE: WACC does not change with change in Capital
Structure!
M&M Proposition II –
Business & Financial Risk
Total systematic risk of firm’s equity has two parts:

Business Risk
Equity risk which comes from the nature of firm’s operating
activities

Financial Risk
Equity risk which comes from the capital structure choice
M&M Proposition II –
Business & Financial Risk
According to M&M II with No Taxes, there are two types of
Risks inherent in cost of equity:

Business Risk
Depends on the nature of the business & is compensated through
Ra (WACC)

Financial Risk
Depends on debt financing & is compensated through
[(Ra – Rd)*D/E] - zero for all equity company
M&M Proposition II –
Business & Financial Risk
Point to Note:
A Firm’s Cost of Equity increases as debt
increases
…purely because of financial risk portion–
NOT business risk
Financial leverage & Capital structure
policy
Learning Objectives
 Capital structure?
 Effect of Financial Leverage?
 M&M Propositions?
 Corporate Taxes & Capital Structure?
 Optimal Capital Structure?
 Bankruptcy Process & Costs?
M&M Proposition I & II
WITH CORPORATE TAXES
Features of Debt:
1. Interest is tax deductible (good)
2. Failure to pay debt causes bankruptcy (not good)
We look at taxes first…
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
We look at 2 firms…
Firm E (equity) & D (debt)
1. Same LHS of balance sheet = same assets
2. D has issued $1000 worth of perpetual Bonds at 8%
3. Interest bill is $80 per year forever
4. Tax rate is 30%
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Firm E
EBIT
Firm D
1,000
1,000
0
80
1000
960
Taxes (30%)
300
276
Net Income
700
644
Interest
EBT
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Cash flow
from Assets
Firm E
$1,000
Firm D
$1,000
Taxes
300
276
Total
700
724
EBIT
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Cash flow
To Stockholders
Firm E
$700
Firm D
$644
To Bondholders
0
80
700
724
Total
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
We Observe…

Debt firm D will earn $24 extra every year.
This means…

Debt firm’s value is more than E by PV of $24 Perpetuity
So.. Risk of this additional $24?

Since this Tax shield is derived from interest, therefore, the
risk is same as that of debt…

Which means, it’s discount rate is same 8% as debt.
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
M&M Proposition I & Taxes
Value of Tax Shield…

PV of tax shield = PV of Tax Benefit (Perpetuity):

PV of tax shield = 24/ .08
= (.30 * 1000 *.08)/.08
= (0.30*1000)
= 300

PV of interest tax shield = (T*D*Rd) / Rd
=T*D
M&M Proposition I & Corporate
Taxes
Putting it together…
We have seen,
Value of Firm D (Vd) > value of Firm E (Ve) by PV of Tax shield
In other words…
Vd
= Ve + (T*D)
Lets look at an interpretation…
M&M I with taxes
Firm’s value increases with Debt due to Interest Tax Shield
(slope = T)
Value of the
firm
Value of firm with Debt
Value No Debt
Ve=value w/no debt
Total Debt
M&M PROPOSITION I with taxes
This means…
Value of Firm goes UP by the tax rate T..
For every $1 additional Debt, Value of Firm increases by $0.3
Or
The NPV per dollar of Debt is $0.3
Therefore:
Higher debt results in lower WACC (since the Mkt value is
higher)
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Firm E
EBIT
Firm D
1,000
1,000
0
80
1000
960
Taxes (30%)
300
276
Net Income
700
644
Interest
EBT
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Suppose that cost of capital (Unlevered) for Firm E is
10%. Firm E’s cash flows is $700 every year forever &
since it has no debt then, appropriate Discount Rate is
10%. Then,
Value of Firm E
Value of Firm D
= NI / Ra
= 700/ 0.10
= 7,000
=?
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Suppose that cost of capital (Unlevered) for Firm E is
10%. Firm E’s cash flows is $700 every year forever &
since it has no debt then, appropriate Discount Rate is
10%. Then,
Value of Firm E
Value of Firm D
= NI / Ra
= 700/ 0.10
= 7,000
= Vu + (T*D)
= 7,000 +( 0.30*1000)
= 7,300
M&M PROPOSITION I with taxes
Conclusion:
Debt Increases Value of Firm due to Tax shield!
So….

The more Debt, the better

A Firm should maximize borrowing
M&M II with corporate
Taxes - Preview
M&M Proposition II without Taxes:
WACC = (E/V) x Re + (D/V) x Rd
Re = Ra + (Ra-Rd)*(D/E)
If, we introduce taxes, then?
(Ra = WACC)
M&M II with corporate
Taxes - Preview
M&M Proposition II without Taxes:
WACC = (E/V) x Re + (D/V) x Rd
Re = Ra + (Ra-Rd)*(D/E)
(Ra = WACC for unlevered firm)
If, we introduce taxes, then:
WACC = (E/V) x Re + (D/V)*Rd*(1-T)
Re = Ra + (Ra – Rd)*(1-T)*(D/E)
(Ra = WACC for unlevered firm)
M&M Proposition II
WITH CORPORATE TAXES –
Example
We look at 2 firms…
Firm E (equity) & D (debt)
1. Same LHS of balance sheet = same assets
2. D has issued $1000 worth of perpetual Bonds at 8%
3. Interest bill is $80 per year forever
4. Tax rate is 30%, Cost of Capital for Firm E = 10%
5.
Value of Firm E = 7,000 & Value of Firm D = 7,300
6. Re for Firm L = ?
7. WACC for Firm L = ?
M&M Proposition II
WITH CORPORATE TAXES –
Example
ReL = Ra + (Ra – Rd)*(1-T)*(D/E)
= 10% + (10 – 8%)*(1-0.30)*(1000/6300)
= 10.22%
WACCL
= [(E/V) *Re] + [(D/V)*Rd*(1-T)]
= [(6300/7300)*10.22%] + [(1000/7300)*8*(0.70)]
= 9.6%
M&M Proposition II
WITH CORPORATE TAXES
Re
Re = 10.22%
Ra = 10%
WACC = 9.6%
WACC
Rd*(1-t)
Rd = 5.6%
D/E = 1000/6,300
Debt-Equity Ratio
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
You are given following information about XYZ co. :
EBIT
= $151.52
T
= 0.34
D
= 500
Ru
= 0.20
The cost of debt capital is 10%. What is the value of XYZ’s
Equity? What is the cost of Equity Capital for XYZ? What is
the WACC?
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Step 1: Calculate Value of the firm if it had NO Debt:
Vu = EBIT(1 – T) / Ru
= $500
Step 2: Calculate Value of the Firm with Debt:
VL = Vu + (T*D)
= 500 + (0.34*500)
= 670
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Step 3: Calculate Value of Equity:
E = VL – D
= 670 – 500
= 170
Step 4: Calculate Cost of Equity:
ReL = Ra + (Ra – Rd)*(1-T)*(D/E)
= 0.2 + (0.2 – 0.1)*(1-0.34)*(500/170)
= 39.4%
M&M Proposition I & II
WITH CORPORATE TAXES –
Example
Step 5: Calculate WACC
WACC
= (E/V) x Re + (D/V)*Rd*(1-T)
= [(170/670)*39.4%] + [(500/670)*10%*(1-0.34)]
= 14.92%
Bankruptcy Costs
What is Bankruptcy?…
Bankruptcy Costs
What is Bankruptcy?…
As the Debt-Equity Ratio rises, so too does the probability
that the firm will be unable to pay its bondholders what was
promised to them.
When this happens, ownership of the firm’s Asset is
ultimately transferred from the stock holders to Bondholders.
A firm becomes Bankrupt when the Value of its Assets equal
the Value of its Debt.
Bankruptcy Costs - drivers

Stockholders: try to avoid bankruptcy while in control

Bondholders: want bankruptcy to get their money
This makes both groups fight…
Disrupting operations of the business & reducing the value
of sales & assets!
Bankruptcy Costs
Three types of Bankruptcy Costs…

Direct bankruptcy costs

Indirect bankruptcy costs
Bankruptcy Costs – Direct
Bankruptcy Costs
Direct bankruptcy costs…

When value of Assets = Debt
Means…

Equity = 0, and firm is economically bankrupt!
The administrative costs associated with the legal process of
turning assets to bondholders
Bankruptcy Costs –
Indirect Bankruptcy Costs
Indirect bankruptcy costs…

When a firm has significant problems in meeting debt
obligations, it is in financial distress
The costs associated with AVOIDING a bankruptcy filing.
NOTE: Costs associated with bankruptcy exceed tax-related
gains from leverage
Optimal Capital Structure

Good Points (Low D/E)
Tax shield adds value
Probability of Bankruptcy is low
Benefit of Debt outweighs costs (at low D/E)

Bad points (High D/E)
Possibility of financial distress increased
Benefit of Debt offset by Financial distress costs!

Optimal Cap Structure obviously is b/w these 2 extremes