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Chapter Sixteen
Capital Structure:
Corporate Finance
Ross Westerfield Jaffe
Limits to the Use of Debt


16
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
16.1 Costs of Financial Distress
16.2 Description of Costs
16.3 Can Costs of Debt Be Reduced?
16.4 Integration of Tax Effects and Financial Distress Costs
16.5 Shirking, Perquisites, and Bad Investments: A Note on
Agency Cost of Equity
16.6 The Pecking-Order Theory
16.7 Growth and the Debt-Equity Ratio
16.8 Personal Taxes
16.9 How Firms Establish Capital Structure
16.10 Summary and Conclusions
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16.1 Costs of Financial Distress
• Bankruptcy risk versus bankruptcy cost.
• The possibility of bankruptcy has a negative effect
on the value of the firm.
• However, it is not the risk of bankruptcy itself that
lowers value.
• Rather it is the costs associated with bankruptcy.
• It is the stockholders who bear these costs.
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16.2 Description of Costs
• Direct Costs
– Legal and administrative costs (tend to be a small
percentage of firm value).
• Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)
– Agency Costs
• Selfish Strategy 1: Incentive to take large risks
• Selfish Strategy 2: Incentive toward underinvestment
• Selfish Strategy 3: Milking the property
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Balance Sheet for a Company in Distress
Assets
Cash
Fixed Asset
Total
BV
$200
$400
$600
MV
$200
$0
$200
Liabilities
LT bonds
Equity
Total
BV
$300
$300
$600
MV
$200
$0
$200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.
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Selfish Strategy 1: Take Large Risks
The Gamble
Win Big
Lose Big
Probability
10%
90%
Payoff
$1,000
$0
Cost of investment is $200 (all the firm’s cash)
Required return is 50%
Expected CF from the Gamble = $1000 × 0.10 + $0 = $100
$100
NPV  $200 
1.50
NPV  $133
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Selfish Stockholders Accept Negative NPV
Project with Large Risks
• Expected CF from the Gamble
– To Bondholders = $300 × 0.10 + $0 = $30
– To Stockholders = ($1000 - $300) × 0.10 + $0 = $70
• PV of Bonds Without the Gamble = $200
• PV of Stocks Without the Gamble = $0
• PV of Bonds With the Gamble = $30 / 1.5 = $20
• PV of Stocks With the Gamble = $70 / 1.5 = $47
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Selfish Strategy 2: Underinvestment
• Consider a government-sponsored project that guarantees
$350 in one period
• Cost of investment is $300 (the firm only has $200 now) so
the stockholders will have to supply an additional $100 to
finance the project
• Required return is 10%
•
$350
NPV  $300 
1.10
NPV  $18.18
• Should we accept the project?
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Selfish Stockholders Forego Positive NPV
Project
• Expected CF from the government sponsored project:
– To Bondholder = $300
– To Stockholder = ($350 - $300) = $50
• PV of Bonds Without the Project = $200
• PV of Stocks Without the Project = $0
• PV of Bonds With the Project = $300 / 1.1 = $272.73
• PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55
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Selfish Strategy 3: Milking the Property
• Liquidating dividends
– Suppose our firm paid out a $200 dividend to the shareholders.
This leaves the firm insolvent, with nothing for the
bondholders, but plenty for the former shareholders.
– Such tactics often violate bond indentures.
• Increase perquisites to shareholders and/or management
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16.3 Can Costs of Debt Be Reduced?
• Protective Covenants
• Debt Consolidation:
– If we minimize the number of parties, contracting costs
fall.
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Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– Pay dividends beyond specified amount.
– Sell more senior debt & amount of new debt is limited.
– Refund existing bond issue with new bonds paying lower interest
rate.
– Buy another company’s bonds.
• Positive covenant: Thou shall:
– Use proceeds from sale of assets for other assets.
– Allow redemption in event of merger or spinoff.
– Maintain good condition of assets.
– Provide audited financial information.
– Segregate and maintain specific assets as security for debt.
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16.4 Integration of Tax Effects and
Financial Distress Costs
• There is a trade-off between the tax advantage of
debt and the costs of financial distress.
• It is difficult to express this with a precise and
rigorous formula.
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Integration of Tax Effects and Financial
Distress Costs
Value of firm under
MM with corporate
taxes and debt
Value of firm (V)
Present value of tax
shield on debt
VL = VU + TCB
Maximum
firm value
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Debt (B)
0
B*
Optimal amount of debt
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The Pie Model Revisited
• Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
• Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
• VT = S + B + G + L
S
B
L
G
• The essence of the M&M intuition is that VT depends on the
cash flow of the firm; capital structure just slices the pie.
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16.5 Shirking, Perquisites, and Bad
Investments: The Agency Cost of Equity
• An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
• Who bears the burden of these agency costs?
• While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
• The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
• The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.
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16.6 The Pecking-Order Theory
• Theory stating that firms prefer to issue debt rather
than equity if internal finance is insufficient.
– Rule 1
• Use internal financing first.
– Rule 2
• Issue debt next, equity last.
• The pecking-order theory is at odds with the tradeoff theory:
– There is no target D/E ratio.
– Profitable firms use less debt.
– Companies like financial slack
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16.7 Growth and the Debt-Equity Ratio
• Growth implies significant equity financing, even in
a world with low bankruptcy costs.
• Thus, high-growth firms will have lower debt ratios
than low-growth firms.
• Growth is an essential feature of the real world; as a
result, 100% debt financing is sub-optimal.
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16.8 Personal Taxes: The Miller Model
• The Miller Model shows that the value of a levered firm
can be expressed in terms of an unlevered firm as:
 (1  TC )  (1  TS ) 
VL  VU  1 
 B
1  TB


Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
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Personal Taxes: The Miller Model
The derivation is straightforward:
Shareholde rs in a levered firm receive
( EBIT  rB B)  (1  TC )  (1  TS )
Bondholder s receive
rB B  (1  TB )
Thus, the total cash flow to all stakeholde rs is
( EBIT  rB B)  (1  TC )  (1  TS )  rB B  (1  TB )
This can be rewritten as
 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB B  (1  TB )  1 

1  TB


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Personal Taxes: The Miller Model (cont.)
The total cash flow to all stakeholders in the levered firm is:
 (1  TC )  (1  TS ) 
EBIT  (1  TC )  (1  TS )  rB B  (1  TB )  1 

1

T
B


The first term is the cash
flow of an unlevered firm
after all taxes.
A bond is worth B. It promises to
pay rBB×(1- TB) after taxes. Thus
the value of the second term is:
 (1  TC )  (1  TS ) 
B  1 

1

T
B


The value of the sum of these
Its value = VU.
two terms must be VL
 (1  TC )  (1  TS ) 
VL  VU  1 
B
1  TB


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Personal Taxes: The Miller Model (cont.)
• Thus the Miller Model shows that the value of a levered
firm can be expressed in terms of an unlevered firm as:
 (1  TC )  (1  TS ) 
VL  VU  1 
 B
1  TB


 In the case where TB = TS, we return to M&M with
only corporate tax:
VL  VU  TC B
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Effect of Financial Leverage on Firm Value
with Both Corporate and Personal Taxes
 (1  TC )  (1  TS ) 
VL  VU  1 
 B
1  TB


VL = VU+TCB when TS =TB
VU
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VL =VU
when (1-TB) = (1-TC)×(1-TS)
VL < VU when (1-TB) < (1-TC)×(1-TS)
Debt (B)
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Integration of Personal and Corporate Tax Effects
and Financial Distress Costs and Agency Costs
Present value of
financial distress costs
Value of firm (V)
Present value of tax
shield on debt
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum
firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
Agency Cost of Debt
Debt (B)
0
B*
Optimal amount of debt
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16.9 How Firms Establish Capital Structure
• Most Corporations Have Low Debt-Asset Ratios.
• Changes in Financial Leverage Affect Firm Value.
– Stock price increases with increases in leverage and
vice-versa; this is consistent with M&M with taxes.
– Another interpretation is that firms signal good news
when they lever up.
• There are Differences in Capital Structure Across
Industries.
• There is Evidence that Firms Behave as If They
had a Target Debt-to-Equity ratio.
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Factors in Target D/E Ratio
• Taxes
– If corporate tax rates are higher than bondholder tax rates,
there is an advantage to debt.
• Types of Assets
– The costs of financial distress depend on the types of
assets the firm has.
• Uncertainty of Operating Income
– Even without debt, firms with uncertain operating income
have high probability of experiencing financial distress.
• Pecking Order and Financial Slack
– Theory stating that firms prefer to issue debt rather than
equity if internal finance is insufficient.
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16.10 Summary and Conclusions
• Costs of financial distress cause firms to restrain
their issuance of debt.
– Direct costs
• Lawyers’ and accountants’ fees
– Indirect Costs
• Impaired ability to conduct business
• Incentives to take on risky projects
• Incentives to underinvest
• Incentive to milk the property
• Three techniques to reduce these costs are:
– Protective covenants
– Repurchase of debt prior to bankruptcy
– Consolidation of debt
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16.10 Summary and Conclusions
• Because costs of financial distress can be reduced
but not eliminated, firms will not finance entirely
with debt.
Value of firm (V)
Present value of tax
shield on debt
Maximum
firm value
0
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Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
B*
Optimal amount of debt
Debt (B)
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16.10 Summary and Conclusions
• If distributions to equity holders are taxed at a lower effective
personal tax rate than interest, the tax advantage to debt at the
corporate level is partially offset. In fact, the corporate
advantage to debt is eliminated if (1-TC) × (1-TS) = (1-TB)
Value of firm (V)
Present value of
financial distress costs
Present value of tax
shield on debt
Value of firm under
MM with corporate
taxes and debt
VL = VU + TCB
VL < VU + TCB when TS < TB
but (1-TB) > (1-TC)×(1-TS)
Maximum
firm value
VU = Value of firm with no debt
V = Actual value of firm
Agency Cost of Equity
0
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Agency Cost of Debt
B*
Optimal amount of debt
Debt (B)
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16.10 Summary and Conclusions
• Debt-to-equity ratios vary across industries.
• Factors in target D/E ratio
– Taxes
• If corporate tax rates are higher than bondholder tax
rates, there is an advantage to debt.
– Types of Assets
• The costs of financial distress depend on the types of
assets the firm has.
– Uncertainty of Operating Income
• Even without debt, firms with uncertain operating
income have high probability of experiencing
financial distress.
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Appendix 16B The Miller Model and the
Graduated Income Tax
• In our previous discussion, we assumed that all
investors share a single personal income tax on
interest income.
• Consistent with the real world, Miller’s model
allows for the real world case where tax rates differ
across individuals.
• In Canada, federal tax rates for individuals are 0,
17, 26, and 29-percent, depending on their income.
• Other entities, such as pension
universities, are tax exempt.
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and
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The Miller Model and the Graduated
Income Tax: Example
• Consider an economy with: TC = 40%, TS = 0, rS = 15%,
individual tax rates range between 0 and 50-percent, and all
individuals are risk neutral.
• ABC corp. is considering a $1 million issue of debt.
• The after-corporate-tax cost of debt for ABC is: (1 - TC)rB,
and its cost of equity is rS .
• The maximum interest rate that ABC can pay on its debt and
still prefer issuing debt to issuing equity, is given by setting:
(1 - TC)rB = rS . Or the break-even rate is given by:
rB 
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rS
1TC

0.15
10.4
 25%
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The Miller Model and the Graduated
Income Tax: Example (continued)
• Tax-exempt investors will be indifferent between purchasing
ABC’s stocks or ABC’s bonds yielding also 15-percent.
• If ABC is the only firm issuing debt, it can pay an interest
rate greater or equal to 15-percent, and well below its breakeven rate of 25-percent.
• Noticing this advantage, other firms are likely to issue debt.
• However, since the number of tax-exempt individuals is
limited, such new debt issues must pay interest high enough
to attract individuals in higher brackets.
• For these individuals, the tax rate that applies to debt is
greater than that applies to equity (0-percent).
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The Miller Model and the Graduated
Income Tax: Example (continued)
• Thus, tax-exempt individuals will only buy debt if its yield is
greater than that of equity (15%).
• An individual in the 20% tax bracket, will be indifferent between
debt and equity if rB = 18.75%, because 0.1875×(1-0.2) = 15%.
• Since 18.75% is less than the break-even rate of 25%, firms still
gain from issuing debt to individuals in the 20% tax bracket.
• For individuals in the 40% tax bracket, the after-tax return from a
bond paying 25% is 0.25×(1-0.4) = 15%.
• Thus, individuals in a tax bracket that equals the corporate tax
rate (40%), will be indifferent between debt and equity.
• In equilibrium, firms will issue enough debt so these individuals
will hold debt.
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