Chapter 15
Capital
Structure
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter Outline
15.1 Capital Structure Choices
15.2 Capital Structure in Perfect Capital Markets
15.3 Debt and Taxes
15.4 Costs of Bankruptcy and Financial Distress
15.5 Optimal Capital Structure: The Tradeoff Theory
15.6 Additional Consequences of Leverage: Agency Costs
and Information
15.7 Capital Structure: Putting It All Together
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Learning Objectives
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•
•
•
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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 the firm
Describe how leverage increases the risk of the firm’s equity
Demonstrate how debt can affect firm value through taxes and bankruptcy costs
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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15.1 Capital Structure Choices
• The collection of securities a firm issues to raise
capital from investors is called the firm’s
capital structure.
• When raising funds from outside investors, a
firm must choose what type of security to issue
and what capital structure to have.
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15.1 Capital Structure Choices
• Firms consider whether the securities issued:
w Will receive a fair price in the market
w Have tax consequences
w Entail transactions costs
w Change its future investment opportunities
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15.1 Capital Structure Choices
• A firm’s debt-to-value ratio
D / (E+D)
is the fraction of the firm’s total value that
corresponds to debt
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Figure 15.1
Debt-to-Value Ratio
[D/(E + D)] for
Select Industries
Figure 15.2 Capital Structures of
Blockbuster and Netflix
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15.2 Capital Structure
in Perfect Capital Markets
• A perfect capital market is a market in which:
w Securities are fairly priced
w No tax consequences or transactions costs
w Investment cash flows are independent of financing
choices
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15.2 Capital Structure
in Perfect Capital Markets
• Unlevered equity: equity in a firm with no debt
• Levered equity: equity in a firm that has debt
outstanding
• Leverage will increase the risk of the firm’s
equity and raise its equity cost of capital
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15.2 Capital Structure
in Perfect Capital Markets
• Modigliani and Miller (MM) concluded that with perfect capital
markets the total value of a firm should not depend on its capital
structure.
w When the firm has no debt, the cash flows paid to equity holders
correspond to the free cash flows generated by the firm’s assets.
w When the firm has debt, these cash flows are divided between debt and
equity holders.
w With perfect capital markets, the total paid to all investors still
corresponds to the free cash flows generated by the firm’s assets.
w Therefore, the value of the unlevered firm, V U, must equal the total value
of the levered firm, V L, which is the combined value D + E of its debt D
and levered equity E .
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Figure 15.3 Unlevered Versus Levered Cash
Flows with Perfect Capital Markets
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MM Proposition I
• 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.
w We can write this result in an equation:
V L= E + D =V U
(Eq. 15.1)
VL= value of the firm with leverage
VU= value of the unlevered firm
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unlevered
levered
$30,000 down
$15,000 down
$15,000 borrowed
$30,000 equity
$15,000 equity
$15,000 debt
if interest rate is at 5% then if
we pay back the loan in one
year, we would payback
$15,750
unlevered
levered
$30,000 equity
$15,000 equity
$15,000 debt
demand
cash flow
low
$27,000
medium
$34,500
high
$42,000
if interest rate is at 5% then if
we pay back the loan in one
year, we would payback
$15,750
unlevered
levered
$30,000 equity
$15,000 equity
$15,000 debt
equation
%
returns
equation
%
returns
27,000/30,000
90%
-10%
(27,000-15,750)/15,000
75%
-25%
34,500/30,000
115%
15%
(34,500-15,750)/15,000
125%
25%
42,000/30,000
140%
40%
(42,000-15,750)/15,000
175%
75%
so do u see the advantages of borrowing funds?
demand
cash flow
low
$27,000
medium
$34,500
high
$42,000
if interest rate is at 5% then if
we pay back the loan in one
year, we would payback
$15,750
Table 15.1 Returns to Equity in Different
Scenarios with and without Leverage
=
=
=
Free cash flows
are given for the
three scenarios
If levered:
If unlevered:
$30,000 equity $15,000 equity
$15,000 debt
no debt
+
+
+
Equity risk premium:
10% if unlevered
20% if levered
Assumptions for leverage:
$15,000 borrowed to be paid
back in one year at 5% interest,
15,000×1.05 = 15,750
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15.2 Capital Structure
in Perfect Capital Markets
• Homemade leverage: when investors use
leverage in their own portfolios to adjust the
leverage choice made by the firm.
• Homemade leverage is a perfect substitute for
the use of leverage by the firm in perfect capital
markets.
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MM Proposition II: The Cost of Capital
of Levered Equity
• MM Proposition II:
The Cost of Capital of Levered Equity
(Eq. 15.3)
rE = expected return (cost of capita) of levered equity
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computing the equity cost of capital
Because your firm’s assets have a market value of
$30,000, by MM Proposition I the equity will have a
market value of $15,000 = $30,000 – $15,000. We can
use Eq. 15.3 to compute the cost of equity. We know
the unlevered cost of equity is ru = 15%. We also
know that rD is 5%.
rE
15000
= .15 +
( .15 − .05 ) = ?
15000
= .25
unlevered
levered
$30,000 equity
$15,000 equity
$15,000 debt
equation
%
returns
equation
%
returns
27,000/30,000
90%
-10%
(27,000-15,750)/15,000
75%
-25%
34,500/30,000
115%
15%
(34,500-15,750)/15,000
125%
25%
42,000/30,000
140%
40%
(42,000-15,750)/15,000
175%
75%
so do u see the advantages of borrowing funds?
demand
cash flow
low
$27,000
medium
$34,500
high
$42,000
if interest rate is at 5% then if
we pay back the loan in one
year, we would payback
$15,750
15.3 Debt and Taxes
• In the real world, markets are imperfect, and these
imperfections can create a role for the firm’s capital
structure. A firm’s capital structure can affect the
corporate taxes it must pay.
w Corporations can deduct interest expenses from their taxable
income.
w The deduction reduces the taxes paid which increases the
amount available to pay investors.
w In doing so, the interest tax deduction increases the value of
the corporation.
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15.3 Debt and Taxes
• Consider the impact of interest expenses on taxes paid
by Safeway, Inc., a grocery store chain.
• In 2006, Safeway had earnings before interest and taxes
of $1.65 billion, and interest expenses of $400 million.
Given a corporate tax rate of 35%, we can compare
Safeway’s actual net income with what it would have
been without debt.
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Table 15.2 Safeway’s Income with and
without Leverage, 2006 ($ million)
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15.3 Debt and Taxes
• Interest Tax Shield: The gain to investors from
the tax deductibility of interest payments
Interest Tax Shield =
Corporate Tax Rate × Interest Payments
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Example 15.3 Computing the Interest
Tax Shield
Problem:
• Shown on the next slide is the income statement
for D.F. Builders (DFB). Given its marginal
corporate tax rate of 35%, what is the amount of
the interest tax shield for DFB in years 2005
through 2008?
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Example 15.3 Computing the Interest
Tax Shield
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Example 15.3 Computing the Interest
Tax Shield
Solution:
Plan:
• From Eq. 15.4, the interest tax shield is the tax
rate of 35% multiplied by the interest payments
in each year.
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Example 15.3 Computing the Interest
Tax Shield
Execute:
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Example 15.3 Computing the Interest
Tax Shield
Evaluate:
• By using debt, DFB is able to reduce its taxable
income and therefore decreased its total tax
payments by $115.5 million over the four-year
period. Thus the total amount of cash flows
available to all investors (debtholders and equity
holders) is $115.5 million higher over the fouryear period.
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Example 15.3a Computing the Interest
Tax Shield
Problem:
• Shown on the next slide is the income statement
for Invite Only, an invitation/card company.
Given its marginal corporate tax rate of 40%,
what is the amount of the interest tax shield for
Invite Only in years 2006 through 2008?
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Example 15.3a Computing the Interest
Tax Shield
Invite Only Income Statement
($ million)
2006
2007
2008
Total sales
Cost of sales
$4,750
–2,543
$5,350
–2,428
$6,177
–3,114
Selling, general, and administrative
expense
–446
–399
–470
Depreciation
–32
–29
–35
Operating Income
1,729
2,494
2,558
Other income
14
12
16
EBIT
Interest expense
1,743
–100
2,506
–110
2,574
–115
Income before tax
1,643
2,396
2,459
Taxes (40%)
–657
–958
–984
Net income
$986
$1,438
$1,475
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Example 15.3a Computing the Interest
Tax Shield
Solution:
Plan:
• From Eq. 15.4, the interest tax shield is the tax
rate of 40% multiplied by the interest payments
in each year.
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Example 15.3a Computing the Interest
Tax Shield
Execute:
($ million)
2006
2007
2008
Interest expense
Interest tax shield
(40% × interest
expense)
–100
–110
–115
40
44
46
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Example 15.3a Computing the Interest
Tax Shield
Evaluate:
• By using debt, Invite Only is able to reduce its
taxable income and decrease its total tax
payments. Therefore, the total amount of cash
flows available to all investors (debtholders and
equity holders) is $130 million higher over the
three-year period.
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15.3 Debt and Taxes
• When a firm uses debt, the interest tax shield provides a
corporate tax benefit each year. To determine the
benefit of leverage for the value of the firm, we must
compute the present value of the stream of future
interest tax shields the firm will receive.
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Figure 15.6 The Cash Flows of the
Unlevered and Levered Firm
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15.3 Debt and Taxes
• The graph shows that by increasing the cash
flows paid to debtholders 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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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.
• Here’s the change to MM Proposition I with the
presence of 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:
VL = VU + PV(Interest Tax Shield) (Eq. 15.5)
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