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CH16 PPT

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Fundamentals of Corporate Finance
Fourth Edition, Global Edition
Chapter 16
Capital Structure
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Chapter Outline
16.1 Capital Structure Choices
16.2 Capital Structure in Perfect Capital Markets
16.3 Debt and Taxes
16.4 The Costs of Bankruptcy and Financial Distress
16.5 Optimal Capital Structure: The Tradeoff Theory
16.6 Additional Consequences of Leverage: Agency Costs
and Information
16.7 Capital Structure: Putting It All Together
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Learning Objectives (1 of 2)
• Examine how capital structures vary across industries and
companies
• Understand why investment decisions, rather than financing
decisions, fundamentally determine the value and cost of
capital of a firm
• Describe how leverage increases the risk of the firm’s equity
• Demonstrate how debt can affect firm value through taxes
and bankruptcy costs
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Learning Objectives (2 of 2)
• Show how the optimal mix of debt and equity trades off the
costs (including financial distress costs) and benefits
(including the tax advantage) of debt
• Analyze how debt can alter the incentives of managers to
choose different projects and can be used as a signal to
investors
• Weigh the many costs and benefits to debt that a manager
must balance when deciding how to finance the firm’s
investments
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16.1 Capital Structure Choices (1 of 2)
• Capital Structure
– The collection of securities a firm issues to raise capital
from investors
• Firms consider whether the securities issued:
–
–
–
–
Will receive a fair price in the market
Have tax consequences
Entail transactions costs
Change future investment opportunities
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16.1 Capital Structure Choices (2 of 2)
• Capital Structure Across Industries
– A firm’s debt−to−value ratio is the fraction of the firm’s
total value that corresponds to debt
D
E D
– Capital structure choices often vary across industries
and within industry
• Capital Structure Within Industries
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Figure 16.1 Debt−to−Value Ratio [D
Over (E + D)] for Select Industries
Source: Capital IQ, 2015.
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Figure 16.2 Capital Structures of Intel
and ARM Holdings
Source: Authors’ calculations from http://finance.google.com (April 2016).
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16.2 Capital Structure in Perfect
Capital Markets (1 of 9)
• A perfect capital market is a market in which:
– Securities are fairly priced
– No tax consequences or transactions costs
– Investment cash flows are independent of financing
choices
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16.2 Capital Structure in Perfect
Capital Markets (2 of 9)
• Application: Financing a coffee shop that costs $24,000 to
open
– Equity Financing
 Unlevered Equity
– Expected cash flow is $34,500 at the end of one year
– Given the risk, coffee shop should earn 15%
– NPV of the project is −$24,000+$34,500/1.15 = $6,000
– Levered Financing
 Levered Equity
– Leverage increases the cost of equity
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16.2 Capital Structure in Perfect
Capital Markets (3 of 9)
• Choices:
– Finance with only equity
– Finance with some equity and some debt
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Figure 16.3 Unlevered Versus Levered Cash
Flows with Perfect Capital Markets
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16.2 Capital Structure in Perfect
Capital Markets (4 of 9)
• Leverage and Firm Value
– Modigliani and Miller (MM) with perfect capital markets
 In an unlevered firm, cash flows to equity equal the free
cash flows from the firm’s assets
 In a levered firm, the same cash flows are divided
between debt and equity holders
 The total to all investors equals the free cash flows
generated by the firm’s assets
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16.2 Capital Structure in Perfect
Capital Markets (5 of 9)
• Leverage and Firm Value
– MM Proposition I:
 In a perfect capital market, the total value of a firm is
equal to the market value of the free cash flows
generated by its assets and is not affected by its choice
of capital structure
VL  E  D VU
(Eq. 16.1)
• The Effect of Leverage on Risk and Return
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Returns to Equity in Different
Scenarios with and Without Leverage
Table 16.1 Returns to Equity in Different Scenarios with and Without
Leverage
Coffee
Shop
Blank
Security
Cash
Flows
Demand
Free
Cash
Flows
Unlevered
Equity
Blank
Blank
Security
Returns
Debt
Levered
Equity
Unlevered
Equity
Blank
Blank
Debt
Levered
Equity
Weak
$27,000
$27,000
$15,750
$11,250
−10%
5%
−25%
Expected
$34,500
$34,500
$15,750
$18,750
15%
5%
25%
Strong
$42,000
$42,000
$15,750
$26,250
40%
5%
75%
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Figure 16.4 Unlevered Versus Levered
Returns with Perfect Capital Market
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Example 16.1 The Risk and Return of
Levered Equity (1 of 4)
Problem:
• Suppose you borrow only $6000 when financing your
coffee shop. According to Modigliani and Miller, what
should the value of the equity be? What is the expected
return?
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Example 16.1 The Risk and Return of
Levered Equity (2 of 4)
Solution:
Plan:
• The value of the firm’s total cash flows does not change: It
is still $30,000. Thus, if you borrow $6000, your firm’s equity
will be worth $24,000.
• To determine the equity’s expected return, we will compute
the cash flows to equity under the two scenarios.
• The cash flows to equity are the cash flows of the firm net of
the cash flows to debt (repayment of principal plus interest).
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Example 16.1 The Risk and Return of
Levered Equity (3 of 4)
Execute:
• The firm will owe debt holders
$6000 × 1.05 = $6300 in one year.
• Thus, the expected payoff to equity holders is
$34,500 − $6300 = $28,200,
for a return of
$28,200
 1  17.5%.
$24,000
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Example 16.1 The Risk and Return of
Levered Equity (4 of 4)
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity in this
case is more risky than it would be without debt, but less risky than if
the firm borrowed $15,000. To illustrate, note that if demand is weak,
the equity holders will receive $27,000 − $6300 = $20,700, for a
return of
$20,700
 1  13.75%.
$24,000
• Compare this return to −10% without leverage and −25% if the firm
borrowed $15,000. As a result, the expected return of the levered equity
is higher in this case than for unlevered equity (17.5% versus 15%), but
not as high as in the previous example (17.5% versus 25%).
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Example 16.1a The Risk and Return of
Levered Equity (1 of 5)
Problem:
• Suppose you borrow $25,000 when financing a coffee
shop which is valued at $75,000. As in Example 16.1a, you
expect to generate a cash flow of $75,000 at the end of the
year if demand is weak, $84,000 if demand is as expected
and $93,000 if demand is strong. Each scenario is equally
likely. The current risk−free interest rate is 4%, and there’s
an 8% risk premium for the risk of the assets.
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Example 16.1a The Risk and Return of
Levered Equity (2 of 5)
Problem:
• According to Modigliani and Miller, what should the value
of the equity be? What is the expected return?
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Example 16.1a The Risk and Return of
Levered Equity (3 of 5)
Solution:
Plan:
• The value of the firm’s total cash flows does not change: it
is still $75,000 (the expected $84,000 cash flow discounted
at 12%). Thus, if you borrow $25,000, your firm’s equity will
be worth $50,000.
• To determine its expected return, we will compute the cash
flows to equity under the two scenarios.
• The cash flows to equity are the cash flows of the firm net of
the cash flows to debt (repayment of principal plus interest).
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Example 16.1a The Risk and Return of
Levered Equity (4 of 5)
Execute:
• The firm will owe debt holders
$25,000 × 1.04 = $26,000 in one year.
• Thus, the expected payoff to equity holders is
$84,000 − $26,000 = $58,000,
for a return of
$58,000
 1  16%.
$50,000
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Example 16.1a The Risk and Return
of Levered Equity (5 of 5)
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity in this
case is more risky than it would be without debt, but less risky than if
the firm borrowed $50,000.
• To illustrate, if demand is weak, the equity holders will receive
$75,000 − $26,000 = $49,000, for a return of
$49,000
 1  2%.
$50,000
• If demand is strong, the equity holders will receive $93,000 − $26,000
= $67,000, for a return of
$67,000
 1  34%.
$50,000
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16.2 Capital Structure in Perfect
Capital Markets (6 of 9)
• Homemade Leverage
– Investors use leverage in their own portfolios to adjust
firm’s leverage
– A perfect substitute for firm leverage in perfect capital
markets
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16.2 Capital Structure in Perfect
Capital Markets (7 of 9)
• Leverage and the Cost of Capital
– Weighted average cost of capital (pretax WACC)
D
E
rU 
rD 
rE
DE
DE
(Eq. 16.2)
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16.2 Capital Structure in Perfect
Capital Markets (8 of 9)
• MM Proposition II: The cost of capital of levered
equity:
– The Cost of Levered Equity
D
rE  rU  (rU  rD )
E
(Eq. 16.3)
• Cost of levered equity equals the cost of unlevered
equity plus a premium proportional to the debt−equity
ratio
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Figure 16.5 WACC and Leverage with
Perfect Capital Markets (1 of 2)
Panel (a) Equity, Debt, and WACC for Different Amounts of
Leverage
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Figure 16.5 WACC and Leverage with
Perfect Capital Markets (2 of 2)
Panel (b) WACC Data for Alternative Capital Structures
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Example 16.2 Computing the Equity
Cost of Capital (1 of 4)
Problem:
• Suppose you borrow only $6000 when financing your
coffee shop. According to MM Proposition II, what will your
firm’s equity cost of capital be?
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Example 16.2 Computing the Equity
Cost of Capital (2 of 4)
Solution:
Plan:
• Because your firm’s assets have a market value of
$30,000, according to MM Proposition I the equity will have
a market value of $24,000 = $30,000 − $6000. We can use
Equation 16.3 to compute the cost of equity. We know the
unlevered cost of equity is ru = 15%. We also know that rD
is 5%.
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Example 16.2 Computing the Equity
Cost of Capital (3 of 4)
Execute:
6000
rE  15% 
(15%  5%)  17.5%
24,000
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Example 16.2 Computing the Equity
Cost of Capital (4 of 4)
Evaluate:
• This result matches the expected return calculated in
Example 16.1 where we also assumed debt of $6000. The
equity cost of capital should be the expected return of the
equity holders.
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Example 16.2a Computing the Equity
Cost of Capital (1 of 4)
Problem:
• Referring back to Example 16.1a, suppose you borrow
$25,000 when financing your coffee shop. According to
MM Proposition II, what will your firm’s equity cost of
capital be?
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Example 16.2a Computing the Equity
Cost of Capital (2 of 4)
Solution:
Plan:
• Because your firm’s assets have a market value of
$75,000, by MM Proposition I the equity will have a market
value of $50,000 = $75,000 − $25,000. We can use
Equation 16.3 to compute the cost of equity. We know the
unlevered cost of equity is ru = 12%. We also know that rD
is 4%.
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Example 16.2a Computing the Equity
Cost of Capital (3 of 4)
Execute:
$25,000
rE  12% 
(12%  4%)  16%
$50,000
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Example 16.2a Computing the Equity
Cost of Capital (4 of 4)
Evaluate:
• This result matches the expected return calculated in
Example 16.1a where we also assumed debt of $25,000.
The equity cost of capital should be the expected return of
the equity holders.
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16.2 Capital Structure in Perfect
Capital Markets (9 of 9)
• MM and the Real World
– Capital markets are not perfect in the real world
– How does this impact the Modigliani and Miller results?
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16.3 Debt and Taxes (1 of 13)
• The Interest Deduction and Firm Value
– Market imperfections can create a role for the capital
structure
 Corporate taxes:
– Corporations can deduct interest expenses
– Reduces taxes paid
• Increases amount available to pay investors
• Increases value of the corporation
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16.3 Debt and Taxes (2 of 13)
• The Interest Deduction and Firm Value
– Consider the impact of interest expenses on taxes paid
by Kroger, Inc.
 In 2015, Kroger had earnings before interest and taxes
of $3.58 billion
 Interest expenses of $480 million
 Corporate tax rate is 35%
 Compare Kroger’s actual net income with what it would
have been without debt
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Kroger’s Income with and without
Leverage, 2015 ($ millions)
Table 16.2 Kroger’s Income with and without Leverage, 2015 ($ millions)
Blank
With Leverage
EBIT
Without Leverage
$3580
$3580
Interest expense
−480
0
Income before tax
3100
3580
Taxes (35%)
−1085
−1253
Net income
$2015
$2327
Total amount available to all investors is:
Blank
With Leverage
Interest paid to debt holders
Income available to equity holders
Total available to all investors
Without Leverage
480
0
2015
2327
$2495
$2327
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16.3 Debt and Taxes (3 of 13)
• The Interest Tax Deduction and Firm Value
– The gain to investors from the tax deductibility of
interest payments
Interest Tax Shield = Corporate Tax Rate × Interest Payments
(Eq. 16.4)
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Example 16.3 Computing the Interest
Tax Shield (1 of 5)
Problem:
• Shown below is the income statement for E. C. Builders
(ECB). Given its marginal corporate tax rate of 35%, what
is the amount of the interest tax shield for ECB in years
2010 through 2013?
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Example 16.3 Computing the Interest
Tax Shield (2 of 5)
• Problem:
ECB Income Statement ($
million)
Total Sales
Cost of Sales
Selling, general, and administrative
expense
Depreciation
Operating income
Other income
EBIT
Interest expense
Income before tax
Taxes (35%)
Net Income
2010
2011
2012
2013
$3369
$3706
$4077
$4432
−2359
−2584
−2867
−3116
−226
−22
−248
−25
849
8
857
−80
−276
−27
907
10
917
−100
−299
−29
988
12
1000
−100
777
817
900
−272
−286
−315
$505
$531
$585
762
7
769
−50
719
−252
$467
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Example 16.3 Computing the Interest
Tax Shield (3 of 5)
Solution:
Plan:
• From Equation 16.4, the interest tax shield is the tax rate
of 35% multiplied by the interest payments in each year.
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Example 16.3 Computing the Interest
Tax Shield (4 of 5)
Execute:
($ million)
Interest expense
Interest tax shield (35% × interest
expense)
2010
2011
2012
2013
50
80
100
100
17.5
28
35
35
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Example 16.3 Computing the Interest
Tax Shield (5 of 5)
Evaluate:
• By using debt, ECB is able to reduce its taxable income
and therefore decrease its total tax payments by $115.5
million over the four-year period.
• Thus, the total amount of cash flows available to all
investors (debt holders and equity holders) is $115.5
million higher over the four-year period.
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Example 16.3a Computing the
Interest Tax Shield (1 of 5)
Problem:
• Shown on the next slide is the income statement for Dalton
Asphalt Painters (DAP). Given its marginal corporate tax
rate of 35%, what is the amount of the interest tax shield
for DAP in years 2014 through 2017?
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Example 16.3a Computing the
Interest Tax Shield (2 of 5)
• Problem:
DAP Income Statement ($ million)
Total Sales
Cost of Sales
2014
2752
−2215
2015
2890
−2326
2016
3236
−2605
2017
3625
−2917
Selling, general, and administrative
expense
Depreciation
Operating income
Other income
EBIT
Interest expense
Income before tax
Taxes (35%)
Net Income
−125
−10
402
5
407
−20
387
−135
252
−131
−11
422
2
424
−25
399
−140
259
−147
−12
473
1
474
−25
449
−157
292
−165
−13
529
7
536
−30
506
−177
329
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Example 16.3a Computing the
Interest Tax Shield (3 of 5)
Solution:
Plan:
• From Equation 16.4, the interest tax shield is the tax rate
of 35% multiplied by the interest payments in each year
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Example 16.3a Computing the
Interest Tax Shield (4 of 5)
Execute:
($ million)
Interest expense
Interest tax shield (35% × interest
expense)
2014
2015
2016
2017
20
25
25
30
7
8.75
8.75
10.5
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Example 16.3a Computing the
Interest Tax Shield (5 of 5)
Evaluate:
• By using debt, DAP is able to reduce its taxable income
and therefore decrease its total tax payments by $35
million over the four−year period.
• Thus the total amount of cash flows available to all
investors (debt holders and equity holders) is $35 million
higher over the four−year period.
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16.3 Debt and Taxes (4 of 13)
• Value of the Interest Tax Shield
– When a firm uses debt, the interest tax shield provides
a corporate tax benefit each year
– To determine the benefit, compute the present value of
the stream of future interest tax shields
 Cash Flows to Investors   Cash Flows to Investors 


  (Interest Tax Shield)
with
Leverage
without
Leverage

 

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Figure 16.6 The Cash Flows of the
Unlevered and Levered Firm
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16.3 Debt and Taxes (5 of 13)
• Value of the Interest Tax Shield
– By increasing the cash flows paid to debt holders
through interest payments, a firm reduces the amount
paid in taxes
– The increase in total cash flows paid to investors is the
interest tax shield
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16.3 Debt and Taxes (6 of 13)
• Value of the Interest Tax Shield
– Cash flows of the levered firm are equal to the sum of
the cash flows from the unlevered firm plus the interest
tax shield
– By the Valuation Principle the same must be true for
the present values of these cash flows
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16.3 Debt and Taxes (7 of 13)
• Value of the Interest Tax Shield
– MM Proposition I with taxes:
 The total value of the levered firm exceeds the value of
the firm without leverage due to the present value of the
tax savings from debt:
V L  V U  PV (Interest Tax Shield)
(Eq. 16.5)
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Example 16.4 Valuing the Interest Tax
Shield (1 of 4)
Problem:
• Suppose ECB from Example 16.3 borrows $2 billion by
issuing 10-year bonds.
• ECB’s cost of debt is 6%, so it will need to pay $120 million
in interest each year for the next 10 years, and then repay
the principal of $2 billion in year 10.
• ECB’s marginal tax rate will remain 35% throughout this
period. By how much does the interest tax shield increase
the value of ECB?
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Example 16.4 Valuing the Interest Tax
Shield (2 of 4)
Solution:
Plan:
• In this case, the interest tax shield lasts for 10 years, so we
can value it as a 10-year annuity. Because the tax savings
are as risky as the debt that creates them, we can discount
them at ECB’s cost of debt: 6%.
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Example 16.4 Valuing the Interest Tax
Shield (3 of 4)
Execute:
• The interest tax shield each year is 35% × $120 million =
$42 million. Valued as a 10-year annuity with a discount
rate of 0.06, we have:
PV (Interest Tax Shield)  $42 million 
1 
1 
1

 $309 million

10 
0.06  1.06 
• Because only interest is tax deductible, the final repayment
of principal in year 10 is not deductible, so it does not
contribute to the tax shield.
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Example 16.4 Valuing the Interest Tax
Shield (4 of 4)
Evaluate:
• We know that in perfect capital markets, financing
transactions have an NPV of zero—the interest and
principal repayment have a present value of exactly the
amount of the bonds: $2 billion.
• However, the interest tax deductibility makes this a
positive-NPV transaction for the firm. Because the
government effectively subsidizes the payment of interest,
issuing these bonds has an NPV of $309 million.
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Example 16.4a Valuing the Interest
Tax Shield (1 of 4)
Problem:
• Suppose DAP from Example 16.3a borrows $500 million
by issuing 20−year bonds.
• DAP’s cost of debt is 8%, so it will need to pay $40 million
in interest each year for the next 20 years, and then repay
the principal of $500 million in year 20. DAP’s marginal tax
rate will remain 35% throughout this period.
• By how much does the interest tax shield increase the
value of DAP?
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Example 16.4a Valuing the Interest
Tax Shield (2 of 4)
Solution:
Plan:
• In this case, the interest tax shield lasts for 20 years, so we
can value it as a 20−year annuity. Because the tax savings
are as risky as the debt that creates them, we can discount
them at DAP’s cost of debt: 8%.
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Example 16.4a Valuing the Interest
Tax Shield (3 of 4)
Execute:
• The interest tax shield each year is 35% × $40 million =
$14 million. Valued as a 20−year annuity with a discount
rate of 8%, we have:
PV (Interest Tax Shield)  $14 million 
1 
1 
1

 $137.45 million

20 
0.08  1.08 
• Because only interest is tax deductible, the final repayment
of principal in year 20 is not deductible, so it does not
contribute to the tax shield.
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Example 16.4a Valuing the Interest
Tax Shield (4 of 4)
Evaluate:
• We know that in perfect capital markets, financing
transactions have an NPV of zero—the interest and
principal repayment have exactly a present value of the
amount of the bonds: $500 million. However, the interest
tax deductibility makes this a positive−NPV transaction for
the firm.
• Because the government effectively subsidizes the
payment of interest, issuing these bonds has an NPV of
$137.45 million.
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16.3 Debt and Taxes (8 of 13)
• Interest Tax Shield with Permanent Debt
– The level of future interest payments varies due to:




Changes in the amount of debt outstanding,
Changes in the interest rate on that debt,
Changes in the firm’s marginal tax rate, and
The risk that the firm may default and fail to make an
interest payment
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16.3 Debt and Taxes (9 of 13)
• Interest Tax Shield with Permanent Debt
– As we learned in Chapter 6, the market value of debt
must equal the present value of its future interest
payments:
Market value of Debt = D = PV(Future Interest Payments)
(Eq. 16.6)
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16.3 Debt and Taxes (10 of 13)
• Interest Tax Shield with Permanent Debt
– If the firm’s marginal tax rate (TC) is constant, we have
the following general formula:
Value of the Interest Tax Shield of Permanent Debt
PV(Interest Tax Shield) = PV(TC × Future Interest Payments)
=TC × PV(Future Interest Payments)
=TC × D
(Eq. 16.7)
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16.3 Debt and Taxes (11 of 13)
• Leverage and the WACC with Taxes
– Another way to incorporate the benefit of the firm’s
future interest tax shield
– Weighted Average Cost of Capital with Taxes
rwacc  rE
E
D
 rD (1  TC )
E D
E D
(Eq. 16.8)
(Eq. 16.9)
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16.3 Debt and Taxes (12 of 13)
• Leverage and the WACC with Taxes
– The reduction in the WACC increases with the amount
of debt financing
– The higher the firm’s leverage, the more the firm
exploits the tax advantage of debt, and the lower its
WACC
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Figure 16.7 The WACC with and
without Corporate Taxes
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16.3 Debt and Taxes (13 of 13)
• The Bottom Line
– We can include the interest tax shield when assessing
firm value by either:
 Discounting free cash flow using the pretax WACC and
adding the PV of future interest tax shields, or
 Discounting free cash flow using the WACC (with taxes)
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16.4 The Costs of Bankruptcy and
Financial Distress (1 of 6)
• If increasing debt increases the value of the firm, why
not shift to 100% debt?
• With more debt, there is a greater chance that the firm
will default on its debt obligations
• A firm that has trouble meeting its debt obligations is
in financial distress
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16.4 The Costs of Bankruptcy and
Financial Distress (2 of 6)
• Direct Costs of Bankruptcy
– Each country has a bankruptcy code designed to
provide an orderly process for settling a firm’s debts
 However, the process is still complex, time−consuming,
and costly
 Outside professionals are generally hired
 The creditors may also incur costs during the process.
They often wait several years to receive payment
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16.4 The Costs of Bankruptcy and
Financial Distress (3 of 6)
• Direct Costs of Bankruptcy
 Average direct costs are 3% to 4% of the
pre−bankruptcy market value of total assets
– Likely to be higher for firms with more complicated
business operations and for firms with larger
numbers of creditors
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16.4 The Costs of Bankruptcy and
Financial Distress (4 of 6)
• Indirect Costs of Financial Distress
– Difficult to measure accurately, and often much larger
than the direct costs of bankruptcy
 Often occur because the firm may renege on both
implicit and explicit commitments and contracts
– Estimated potential loss of 10% to 20% of value
– Many indirect costs may be incurred even if the firm is
not yet in financial distress, but simply faces a
significant possibility that it may occur in the future
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16.4 The Costs of Bankruptcy and
Financial Distress (5 of 6)
• Examples:
– Loss of Customers:
 Customers may be unwilling to purchase products whose
value depends on future support or service from the firm
– Loss of Suppliers:
 Suppliers may be unwilling to provide a firm with
inventory if they fear they will not be paid
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16.4 The Costs of Bankruptcy and
Financial Distress (6 of 6)
• Examples:
– Cost to Employees:
 Most firms offer their employees explicit long− term
employment contracts
 During bankruptcy these contracts and commitments are
often ignored and employees can be laid off
– Fire Sales of Assets:
 Companies in distress may be forced to sell assets
quickly
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16.5 Optimal Capital Structure: The
Tradeoff Theory (1 of 4)
• Tradeoff Theory:
– Total value of a levered firm equals the value of the firm
without leverage plus the present value of the tax
savings from debt, less the present value of financial
distress costs:
V L  V U  PV (Interest Tax Shield)-PV (Financial Distress Costs)
(Eq. 16.10)
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16.5 Optimal Capital Structure: The
Tradeoff Theory (2 of 4)
• Difference Across Firms
– Key qualitative factors determine the present value of
financial distress costs:
 The probability of financial distress
– Depends on the likelihood that a firm will default
– Increases with the amount of a firm’s liabilities (relative to
its assets)
– It increases with the volatility of a firm’s cash flows and
asset values
 The magnitude of the direct and indirect costs related to
financial distress that the firm will incur
– Depend on the relative importance of the sources of these
costs and likely to vary by industry
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16.5 Optimal Capital Structure: The
Tradeoff Theory (3 of 4)
• Optimal Leverage
– As debt increases, tax benefits of debt increase until
interest expense exceeds EBIT
– Probability of default, and hence present value of
financial distress costs, also increases
– The optimal level of debt, D*, occurs when these the
value of the levered firm is maximized
– D* will be lower for firms with higher costs of financial
distress
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Figure 16.8 Optimal Leverage with
Taxes and Financial Distress Costs
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16.5 Optimal Capital Structure: The
Tradeoff Theory (4 of 4)
• The Tradeoff Theory helps to resolve two important
facts about leverage:
– The presence of financial distress costs can explain
why firms choose debt levels that are too low to fully
exploit the interest tax shield
– Differences in the magnitude of financial distress costs
and the volatility of cash flows can explain the
differences in the use of leverage across industries
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (1 of 9)
• Agency Costs:
– Costs that arise when there are conflicts of interest
between stakeholders
– Separation of ownership and control:
 Managers may make decisions that:
–
–
–
–
Benefit themselves at investors’ expense
Reduce their effort
Spend excessively on perks
Engage in “empire building”
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (2 of 9)
• Agency Costs
– Managerial Entrenchment
 Arising as a result of the separation of ownership and
control, in which managers may make decisions that
benefit themselves at investors’ expense.
 If these decisions have negative NPV for the firm, they are
a form of agency cost
– Debt provides incentives for managers to run the firm
efficiently:
• Ownership may remain more concentrated, improving
monitoring of management
• Since interest and principle payments are required, debt
reduces the funds available at management’s discretion to use
wastefully
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (3 of 9)
• Agency Costs
– Equity−Debt Holder Conflicts
 A conflict of interest exists if investment decisions have
different consequences for the value of equity and the
value of debt
– most likely to occur when the risk of financial distress is
high
– managers may take actions that benefit shareholders but
harm creditors and lower the total value of the firm
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (4 of 9)
• Agency Costs
– Equity−Debt Holder Conflicts
 Agency costs for a company in distress that will likely
default:
– Excessive Risk−Taking
• A risky project could save the firm even if the expected
outcome is so poor that it would normally be rejected
– Under−Investment Problem
• Shareholders could decline new projects.
• Management could distribute as much as possible to the
shareholders before the bondholders take over
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Figure 16.9 Optimal Leverage with Taxes,
Financial Distress, and Agency Costs
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (5 of 9)
• Agency Costs
– Equity−Debt Holder Conflicts
 As debt increases, firm value increases
– Interest tax shield (TCD)
– Improvements in managerial incentives.
 If leverage is too high, firm value is reduced by
– present value of financial distress costs
– agency costs
 The optimal level of debt, D*, balances these benefits
and costs of leverage
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (6 of 9)
• Debt and Information
– Asymmetric information
 Managers’ information about the firm and its future cash
flows is likely to be superior to that of outside investors
 This may motivate managers to alter a firm’s capital
structure
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (7 of 9)
• Debt and Information
– Leverage as a Credible Signal
 Managers use leverage to convince investors that the
firm will grow, even if they cannot provide verifiable
details
 The use of leverage as a way to signal good information
is known as the signaling theory of debt
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (8 of 9)
• Debt and Information
– Market Timing
 Managers sell new shares when they believe the stock is
overvalued, and rely on debt and retained earnings if
they believe the stock is undervalued
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16.6 Additional Consequences of Leverage:
Agency Costs and Information (9 of 9)
• Debt and Information
– Adverse Selection and the Pecking Order Hypothesis
 Suppose managers issue equity when it is overpriced
– Knowing this, investors will discount the price they are
willing to pay for the stock
– Managers do not want to sell equity at a discount so they
may seek other forms of financing
 The Pecking Order Hypothesis states:
– Managers have a preference to fund investment using
retained earnings, followed by debt, and will only choose
to issue equity as a last resort
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Example 16.5 The Pecking Order of
Financing Alternatives (1 of 5)
Problem:
• Axon Industries needs to raise $9.5 million for a new
investment project. If the firm issues one-year debt, it may
have to pay an interest rate of 8%, although Axon’s
managers believe that 6% would be a fair rate given the
level of risk.
• However, if the firm issues equity, the managers believe
the equity may be underpriced by 5%.
• What is the cost to current shareholders of financing the
project out of retained earnings, debt, and equity?
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Example 16.5 The Pecking Order of
Financing Alternatives (2 of 5)
Solution:
Plan:
• We can evaluate the financing alternatives by comparing
what the firm would have to pay to get the financing versus
what its managers believe it should pay if the market had
the same information they do.
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Example 16.5 The Pecking Order of
Financing Alternatives (3 of 5)
Execute:
• If the firm spends $9.5 million out of retained earnings,
rather than paying that money out to shareholders as a
dividend, the cost of financing the project is $9.5 million.
• Using one-year debt costs the firm $9.5 × (1.08) = $10.26
million in one year, which has a present value based on
management’s view of the firm’s risk of $10.26 ÷ (1.06) =
$9.68 million.
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Example 16.5 The Pecking Order of
Financing Alternatives (4 of 5)
Execute:
• If equity is underpriced by 5%, then to raise $9.5 million
the firm will need to issue shares that are actually worth
$10 million.
• (For example, if the firm’s shares are each worth $50, but it
sells them for 0.95 × $50 = $47.50 per share, it will need to
sell $9.5 million ÷ $47.50/share = 200,000 shares. These
shares have a true value of 200,000 shares × $50/share =
$10 million.) Thus, the cost of financing the project with
equity will be $10 million.
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Example 16.5 The Pecking Order of
Financing Alternatives (5 of 5)
Evaluate:
• Comparing the three options, retained earnings are the
cheapest source of funds, followed by debt, and finally by
equity. The ranking reflects the effect of differences in
information between managers and investors that result in
a lemons problem when they issue new securities, and
particularly when they issue new equity.
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Example 16.5a The Pecking Order of
Financing Alternatives (1 of 5)
Problem:
• Perspective Industries needs to raise $32 million for a new
investment project.
• If the firm issues one−year debt, it may have to pay an
interest rate of 5%, although Perspective’s managers
believe that 4% would be a fair rate given the level of risk.
However, if the firm issues equity, they believe the equity
may be underpriced by 7%.
• What is the cost to current shareholders of financing the
project out of retained earnings, debt, and equity?
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Example 16.5a The Pecking Order of
Financing Alternatives (2 of 5)
Solution:
Plan:
• We can evaluate the financing alternatives by comparing
what the firm would have to pay to get the financing versus
what its managers believe it should pay if the market had
the same information they do.
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Example 16.5a The Pecking Order of
Financing Alternatives (3 of 5)
Execute:
• If the firm spends $32 million out of retained earnings,
rather than paying that money out to shareholders as a
dividend, the cost of financing the project is $32 million.
• Using one−year debt costs the firm $32 × (1.05) = $33.6
million in one year, which has a present value based on
management’s view of the firm’s risk of $33.6  (1.04) =
$32.31 million.
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Example 16.5a The Pecking Order of
Financing Alternatives (4 of 5)
Execute:
• If equity is underpriced by 7%, then to raise $32 million the
firm will need to issue shares that are actually worth $34.4
million.
• (For example, if the firm’s shares are each worth $86.02,
but it sells them for 0.93 × $86.02 = $80 per share, it will
need to sell $32 million  $80/share = 400,000 shares.
These shares have a true value of 400,000 shares ×
$86.02/share = $34.4 million.)
• Thus, the cost of financing the project with equity will be
$34.4 million.
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Example 16.5a The Pecking Order of
Financing Alternatives (5 of 5)
Evaluate:
• Comparing the three options, retained earnings are the
cheapest source of funds, followed by debt, and finally by
equity. The ranking reflects the effect of differences in
information between managers and investors that result in
a lemons problem when they issue new securities,
particularly when issuing new equity.
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16.7 Capital Structure: Putting It All
Together (1 of 2)
• Use the interest tax shield if your firm has consistent
taxable income
• Balance tax benefits of debt against costs of financial
distress
• Consider short−term debt for external financing when
agency costs are significant.
• Increase leverage to signal confidence in the firm’s
ability to meet its debt obligations
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16.7 Capital Structure: Putting It All
Together (2 of 2)
• Be mindful that investors are aware that you have an
incentive to issue securities that you know are
overpriced
• Rely first on retained earnings, then debt, and finally
equity
• Do not change the firm’s capital structure unless it
departs significantly from the optimal level.
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Chapter Quiz
1. What are some factors a manager must consider
when making a financing decision?
2. In a perfect capital market, can you alter the firm’s
value or WACC by relying more on debt capital?
3. How does the interest tax deduction affect firm
value?
4. What are the direct costs of bankruptcy?
5. According to the tradeoff theory, how should a
financial manager determine the right capital
structure for a firm?
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Appendix: The Bankruptcy Code (1 of 2)
• Chapter 7
– Liquidation
 Trustee is appointed to oversee the liquidation of the
firm’s assets
 The proceeds are used to pay the firm’s creditors, and
the firm ceases to exist
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Appendix: The Bankruptcy Code (2 of 2)
• Chapter 11
– Reorganization
 Firm’s existing management is given the opportunity to
propose a reorganization plan
 The reorganization plan specifies the treatment of each
creditor of the firm
 If an acceptable plan is not put forth, the court may
ultimately force a Chapter 7 liquidation of the firm
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