LIMITS TO THE USE OF DEBT
Personal Taxes
• The cash flows to investors are typically taxed twice. Once
at the corporate level and then investors are taxed again
when they receive their interest or dividend payment.
• For individuals:
 Interest payments received from debt have been taxed as ordinary
income.
 Equity investors also must pay taxes on dividends and capital
gains.
• The price individuals will pay for a security depends upon
the cash flows after all taxes have been paid.
After-Tax Investor Cash Flows Resulting
from $1 Received by Debt Holders
Considering Personal Taxes
in the Interest Tax Shield
• In general, every $1 received after taxes by debt
holders from interest payments costs equity
holders $(1 − *) on an after-tax basis, where:
 Effective Tax Advantage of Debt:


(1   i )  (1   c ) (1   e )
(1   c ) (1   e )

 1 
(1   i )
(1   i )
• When there are no personal taxes on debt income (i = 0) or
when the personal tax rates on debt and equity income are
the same (i = e ), the formula reduces to * = c.
• When equity income is taxed less heavily (e is less than i ),
then * (.15) is less than c (.34).
Valuing the Interest Tax Shield
with Personal Taxes
• With personal taxes and permanent debt, the
value of the firm with leverage becomes
V
L
 V
U
  D

 If * is less than c, the benefit of leverage is reduced in
the presence of personal taxes.
Limits to the Tax Benefit of Debt
• The optimal level of leverage from a tax saving
perspective is where interest equals EBIT.
 At the optimal level of leverage, the firm shields all of
its taxable income and it does not have any taxdisadvantaged excess interest.
• However, it is unlikely that a firm can predict its
future EBIT precisely.
 If there is uncertainty regarding EBIT, there is a risk
that interest will exceed EBIT. As a result, the
expected tax savings for high levels of interest falls,
reducing the optimal level of the interest payment.
The Low Leverage Puzzle
• It would appear that firms, on average, are underleveraged. However, it is hard to accept that most
firms are acting suboptimally.
 In reality, there is more to the capital structure story
than discussed so far.
• A key item missing from the analysis thus far is
that increasing the level of debt increases the
probability of bankruptcy.
• If bankruptcy is costly, the expected costs offset
the tax advantages of debt financing.
The Costs of Bankruptcy
and Financial Distress
• With perfect capital markets, the risk of
bankruptcy is not a disadvantage of debt, rather
bankruptcy simply shifts the ownership of the
firm from equity holders to debt holders without
changing the total value available to all
investors.
 In reality, bankruptcy is rarely simple and
straightforward. It is often a long and complicated
process that imposes both direct and indirect costs
on the firm and its investors.
Direct Costs of Bankruptcy
• The direct costs of bankruptcy reduce the
value of the assets that the firm’s investors
will ultimately receive.
 Costly outside experts are often hired by the firm to
assist with the bankruptcy process.
 Creditors also incur costs during bankruptcy.
 The direct costs of bankruptcy average about 3% to 4%
of the pre-bankruptcy market value of total assets.
• Workouts and pre-packaged bankruptcies may help reduce
these small costs as well.
Indirect Costs of Financial Distress
• While the indirect costs of bankruptcy are difficult to measure
accurately, they are often much larger than the direct costs.
 Loss of Customers
 Loss of Suppliers
 Loss of Employees
 Loss of Management’s Time
 Fire Sale of Assets
 Delayed Liquidation
 Costs to Creditors
 It is estimated that the potential loss due to financial distress (or the
threat of distress) is 10% to 20% of firm value
The Tradeoff Theory
• The firm picks its capital structure by trading off
the benefits of the tax shield from debt against the
costs of financial distress and agency costs.
• According to the tradeoff theory, the total value of
a levered firm equals the value of the firm without
leverage plus the present value of the expected
tax savings from debt, less the present value of
the expected financial distress costs.
V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)
Optimal Leverage
• For low levels of debt, the risk of default remains
low and the main effect of an increase in leverage
is an increase in the interest tax shield.
• As the level of debt increases, the probability
of default increases.
 As the level of debt increases, the costs of financial
distress increase, ultimately reducing the value of the
levered firm.
 The rate at which the costs and benefits change are
different across firms.
Optimal Leverage with Taxes and
Financial Distress Costs
Optimal Leverage
• The tradeoff theory states that firms should set
their leverage to the level at which firm value is
maximized.
 At this point, the tax savings that result from increasing
leverage are perfectly offset by the increased
probability of incurring the costs of financial distress.
 The tradeoff theory helps explain why firms choose
debt levels that are too low to fully exploit the interest
tax shield (due to financial distress costs)
 And helps explain differences in the use of leverage
across industries (due to differences in the magnitude
of distress costs and the volatility of cash flows)
Exploiting Debt Holders:
The Agency Costs of Leverage
• Agency Costs
 Costs that arise when there are conflicts of interest
between the firm’s stakeholders
• Management will generally make decisions
that increase the value of the firm’s equity.
However, when a firm has leverage, managers
may make decisions that benefit shareholders
but harm the firm’s creditors and lower the total
value of the firm.
Over-Investment
• Big Trouble Corp. (BTC) owes its creditors $5
million, due in six months.
• BTC has liquidated its assets because it could not
operate profitably. Its remaining asset is $1
million cash.
• Big Bill, the lone shareholder and general
manager is considering two possible investments.
 (1) Buy six month T-bills to earn 3% interest.
 (2) Go to Vegas and wager the entire $1 million on a
single spin of the roulette wheel.
• Why might Bill consider the second “investment”?
• Would he have considered it in the absence of
high leverage?
Under-Investment
• Slight Trouble Corp. (STC) has a small but significant
chance of bankruptcy in the next few years. Its debt is
trading below par.
• Managers are evaluating an investment project that will
cost $1 million to undertake. The alternative is to pay $1
million out as dividends.
• While the NPV of the project is positive it may be that the
shareholders are better off with the dividend than if the
project is taken.
• The reason is that while shareholders pay all the costs of
the project, they will have to share its value with
bondholders, the added value will raise bond prices as
well as stock prices.
Disciplinary Power of Debt
• “On the other hand” as economists are fond of saying,
debt can be a disciplinary device.
 It is well recognized that an owner works harder and
makes better decisions than an employee.
 This was an often cited justification for the LBO wave of
the mid 80’s and early 90’s.
• Similarly, one of the most contentious issues between
managers and shareholders is the payout of excess
cash. Consider Hollinger International and Conrad
Black’s behavior.
 Debt allows manager to commit to the payout in a way
that cannot be accomplished with a dividend policy.
Agency Costs and the Tradeoff Theory
• The value of the levered firm can be thought of as
being given by:
V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)
 PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)
Debt-toValue Ratio
[D / (E + D)]
for Select
Industries
Asymmetric Information
and Capital Structure
• Asymmetric Information
 A situation in which parties have different information
• For example, when managers have superior information to
investors regarding the firm’s future cash flows
 Allows for a signaling role for leverage
Issuing Equity and Adverse Selection
• Adverse Selection
 The idea that when the buyers and sellers have
different information, the average quality of assets in
the market will differ from the average quality overall
• Lemons Principle
 When a seller has private information about the value
of a good, buyers will discount the price they are willing
to pay due to adverse selection.
Implications for Equity Issuance
• The lemons principle directly implies that:
 The stock price declines on the announcement of an
equity issue.
 The stock price tends to rise prior to the announcement
of an equity issue.
 Firms tend to issue equity when information symmetries
are minimized, such as immediately after earnings
announcements.
• Leads to a “Pecking Order” for incremental
financing choices.
PAYOUT POLICY
Historical View
• Illustrated by the arguments of Gordon (1959) more dividends means more value.
• Follows from the discounted dividend approach to
valuing a firm:

Dt
V0  
t
t 1 (1  rt )
Historical View
• Gordon argued that retained earnings rather than
paying current dividends makes the cash flow stream
for the shareholder riskier.
• This would increase the cost of capital.
• The future dividend stream would presumably be
higher due to the investment of retained earnings
(+NPV).
• However, he argued the first effect would be the
dominant one.
• Now called the “bird in the hand fallacy.”
Along Came M&M
• Basic Point: Firm value is determined by its
investment policy, net dividends are simply the
residual of earnings after investment.
 Cash flow identity:
Earnings + Net new financing = Investment + Dividends
• Dividend Irrelevance
• In perfect capital markets, holding fixed the investment
policy of a firm, the firm’s choice of dividend policy is
irrelevant and does not affect the current share price.
Dividend Irrelevance Example
• Consider the case of Ralph Inc.
 Currently (time 0) Ralph Inc. is expected to survive another
year in business (till time 1). At which time the firm will
liquidate and all value will be distributed to claimants.
 The firm is presently all equity financed with 50,000 shares
outstanding. The cash flow of the firm is risk free and it is
common knowledge that Ralph Inc. will receive $1 million
immediately and another $1 million at time 1.
 The current dividend policy is for Ralph Inc. to payout its
entire cash flow as dividends as it is received. So $20 per
share, now and at time 1.
 The risk free rate in the economy is 5%. And the firm has no
positive NPV projects available.
Dividend Irrelevance Example
• Ralph, the CEO of Ralph Inc. is convinced that an
alternative dividend policy would increase the current
stock price.
• The current value of the firm and the price per share
is: V0 = Div0 + Div1/(1.05) = $1m + $1m/(1.05)
= $1,952,380.95 or P0 = $39.05 per share.
• The share price will drop to $19.05 after the time 0
dividend is paid (P1) but our focus in on today’s price
(P0).
• Ralph wants you to evaluate the impact on the current
stock price of an increase or a decrease of the current
dividend of $2 per share.
Dividend Irrelevance Example
• $2 per share dividend increase:
 A $2 per share dividend requires $1,100,000 in total so the
firm must raise $100,000 to accomplish this policy change.
 The firm can issue risk free bonds to raise $100,000 today
they must promise to repay $105,000 (5% risk free rate) in
one year.
 This will leave only $895,000 in total dividends, or $17.90
per share, for the existing shareholders at time 0.
 The time zero stock price will then be:
P0 = $22 + $17.90/(1.05) = $39.05 (??). The price will drop
to $39.05 - $22 = $17.05 when the time 0 dividend is paid.
Dividend Irrelevance Example
• $2 per share dividend decrease:
 With an $18 per share dividend today this leaves an
extra $100,000 in cash within the firm.
 Because the firm has no positive NPV projects it does
the next best thing and makes a zero NPV investment,
buying t-bills.
 With a risk free rate of 5%, the t-bills will return
$105,000 at time 1. This implies a total dividend of
$1,105,000 or $22.10 per share at time 1.
 The current stock price is:
P0 = $18 + $22.10/(1.05) = $39.05
 Again, the stock price will drop (by $18 per share) after
the dividend is paid.
Dividend Irrelevance Example
• What made this example work?
 Two things were critical:
1. We fixed the cash the firm will receive and assumed they
had no positive NPV projects. This is simply an extreme
version of the assumption that the dividend policy will not
alter the investment policy of the firm.
2. We assumed no taxes or transactions costs.
 Several were not:
• The one year time frame.
• The risk free cash flows.
• The fact that the firm was all equity financed to begin with.
Dividend Irrelevance Example
• The insight this example is supposed to bring to you
is that under the irrelevance assumptions a change in
dividend policy results in the company simply moving
money across time.
• Using the capital markets (so the NPV is zero)
ensures that no value is created or destroyed by such
action. Thus the current stock price is not changed.
• Viewed another way, moving money across time is
exactly what the capital markets allow individual
investors to do on their own. Therefore, a change in
dividend policy doesn’t do anything for the investors
they can’t do themselves. Again no price change is
the result.
Empirical Observation 1
• Five empirical observations have shaped the
academic study of dividend policy.
• Corporations typically payout a significant percentage
of their after-tax profits as dividends.
 Examination of dividend payouts over time shows that on
average firms paid out between 40% and 50% of their
profits.
• This confirms that the dividend decision is indeed an important
financing decision!
 Recently, a smaller percentage of all firms are paying
dividends. Seems in part due to there being a lot of new
firms (who traditionally don’t pay dividends) and in part to the
fact that fewer firms of all types are paying dividends. Some
evidence suggests that firms are beginning to substitute
repurchases for dividends.
Empirical Observation 2
• Historically, dividends have been the predominant
form of payout. Share repurchases were relatively
unimportant until the mid 1980’s.
• This is despite the fact that in many years dividends
have been taxed at the individual level at a rate that
is twice as high as capital gains were taxed.
 Before 1984 repurchases amounted to between 2% and
11% of corporate earnings. Since 1984 they have
accounted for between 30% and 40% and have been on
the rise.
• It is interesting to note that in the mid 80’s the other major
form of payout from the corporate sector, M&A activity, also
dramatically increased.
The Changing Composition of Payouts
Empirical Observation 3
• Individuals in high tax brackets receive large
amounts of dividends and pay large taxes on
these dividends.
 That they choose to do so was labeled the “Dividend
Puzzle” by Fisher Black.
 Study by Peterson, Peterson, & Ang (1985) showed
that individuals received $33 B in dividends in 1979
(2/3rds of total paid) and the marginal tax rate paid on
the dividends was 40% (versus 20% on capital gains).
 More recently, 1996, individual investors held 54% of all
stocks by market value yet received only 35% of all
dividends paid indicating that individuals tend to hold
low dividend paying stocks but still receive significant
amounts of dividends.
Empirical Observation 4
• Corporations smooth dividends.
 Lintner in a survey of companies noted that:
• Firms are primarily concerned with the stability of their
dividends.
• Changes in earnings are the most important determinant of
changes in dividends.

Dividend changes lag earnings changes.
• Dividend policy is set first then the investment and financing
decisions are made, taking dividends as given.

Firms with many valuable investment projects are likely to set a
low target payout ratio and those with few a higher target.
GM: 1985–2008
Empirical Observation 5
• There are positive stock price reactions to unexpected
dividend increases and big negative reactions to
unexpected dividend decreases.
 Pettit(1972), Charest(1978), Aharony & Swary(1980).
 Consistent with asymmetric information models (dividends
relay information) and with incomplete contracting models
(dividends solve agency problems).
 Inconsistent with the existence of a large tax differential (or
at least the tax effects are swamped by other effects).