Chapter 16
Capital Structure
Chapter Outline
16.1 Capital Structure Choices
16.2 Capital Structure in Perfect Capital Markets
16.3 Debt and Taxes
16.4 Costs of Bankruptcy and Financial Distress
16.5 Optimal Capital Structure: The Tradeoff
Theory
16.6 Additional Consequences of Leverage:
Agency Costs and Information
Learning Objectives
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

Learning Objectives (cont’d)
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

16.1 Capital Structure Choices

When raising funds from outside investors, a
firm must choose what type of security to
issue and what capital structure to have.
16.1 Capital Structure Choices

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
16.1 Capital Structure Choices

A firm’s debt-to-value ratio is the fraction of
the firm’s total value that corresponds to debt
D / (E+D)
Figure 16.1
Debt-toValue Ratio
[D/(E + D)]
for Select
Industries
Figure 16.2 Capital Structures of
Amazon.com and Barnes & Noble
16.2 Capital Structure in Perfect Capital
Markets

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
16.2 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
16.2 Capital Structure in Perfect Capital
Markets

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.
Figure 16.3 Unlevered Versus Levered
Cash Flows with Perfect Capital Markets
16.2 Capital Structure in Perfect Capital
Markets

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)
Table 16.1 Returns to Equity in Different Scenarios with
and Without Leverage
Figure 16.4 Unlevered Versus Levered
Returns with Perfect Capital Market
Example 16.1 The Risk and Return of
Levered Equity
Problem:


Suppose you borrow only $6,000 when financing your coffee shop.
According to Modigliani and Miller, what should the value of the equity be?
What is the expected return?
Example 16.1 The Risk and Return of
Levered Equity
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 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).
Example 16.1 The Risk and Return of
Levered Equity
Execute:


The firm will owe debt holders
$6,000  1.05 = $6,300 in one year.
Thus, the expected payoff to equity holders is
$34,500 – $6,300 = $28,200,
for a return of
$28,200 / $24,000 – 1 = 17.5%.
Example 16.1 The Risk and Return of
Levered Equity
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 – $6,300 = $20,700, for a return of $20,700/$24,000 – 1 = –
13.75%.
Example 16.1 The Risk and Return of
Levered Equity
Evaluate (cont’d):

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% with more leverage).
Example 16.1a The Risk and Return of
Levered Equity
Problem:


Suppose you borrow $50,000 when financing a coffee shop
which is valued at $75,000.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.
According to Modigliani and Miller, what should the value of
the equity be? What is the expected return?
Example 16.1a The Risk and Return of
Levered Equity
Solution:
Plan:

The value of the firm’s total cash flows does not change: it is
still $75,000 (expected cash flow of $84,000 discounted at
12%). Thus, if you borrow $50,000, your firm’s equity will be
worth $25,000. 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).
Example 16.1a The Risk and Return of
Levered Equity
Execute:


The firm will owe debt holders
$50,000  1.04 = $52,000 in one year.
Thus, the expected payoff to equity holders is
$84,000 – $52,000 = $32,000,
for a return of
$32,000 / $25,000 – 1 = 28%.
Example 16.1a The Risk and Return of
Levered Equity
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.
To illustrate, if demand is weak, the equity holders will receive $75,000 –
$52,000 = $23,000, for a return of $23,000/$25,000 – 1 = – 8%.
If demand is strong, the equity holders will receive $93,000 – $52,000 =
$41,000, for a return of $41,000/$25,000 – 1 = 64%.
Without debt, equity holders expect to receive $84,000/75,000 – 1 = 12%.
Example 16.1b The Risk and Return of
Levered Equity
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.
According to Modigliani and Miller, what should the value of the equity be?
What is the expected return?
Example 16.1b The Risk and Return of
Levered Equity
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).
Example 16.1b The Risk and Return of
Levered Equity
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 / $50,000 – 1 = 16%.
Example 16.1b The Risk and Return of
Levered Equity
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/$50,000 – 1 = – 2%.
If demand is strong, the equity holders will receive $93,000 –
$26,000 = $67,000, for a return of $67,000/$50,000 – 1 = 34%.
16.2 Capital Structure in Perfect Capital
Markets

Homemade leverage
◦ Investors use leverage in their own portfolios to
adjust firm’s leverage
◦ A perfect substitute for firm leverage in perfect
capital markets.
16.2 Capital Structure in Perfect Capital
Markets

Leverage and the Cost of Capital
◦ Weighted average cost of capital (pretax)
D
E
rU 
rD 
rE
DE
DE
(Eq. 16.2)
16.2 Capital Structure in Perfect Capital
Markets

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 debtequity ratio.
Figure 16.5 WACC and Leverage with
Perfect Capital Markets
Example 16.2 Computing the Equity Cost
of Capital
Problem:

Suppose you borrow only $6,000 when financing your coffee shop.
According to MM Proposition II, what will your firm’s equity cost of capital
be?
Example 16.2 Computing the Equity Cost
of Capital
Solution:
Plan:

Because your firm’s assets have a market value of $30,000, by MM
Proposition I the equity will have a market value of $24,000 = $30,000 –
$6,000. We can use Eq. 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%.
Example 16.2 Computing the Equity Cost
of Capital
Execute:
6000
rE  15% 
(15%  5%)  17.5%
24,000
Example 16.2 Computing the Equity Cost
of Capital
Evaluate:

This result matches the expected return calculated in Example 16.1 where
we also assumed debt of $6,000. The equity cost of capital should be the
expected return of the equity holders.
Example 16.2a Computing the Equity
Cost of Capital
Problem:

Referring back to Example 16.1a, suppose you borrow $50,000 when
financing your coffee shop. According to MM Proposition II, what will your
firm’s equity cost of capital be?
Example 16.2a Computing the Equity
Cost of Capital
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 $25,000 = $75,000 –
$50,000. We can use Eq. 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%.
Example 16.2a Computing the Equity
Cost of Capital
Execute:
$50,000
rE  12% 
(12%  4%)  28%
$25,000
Example 16.2a Computing the Equity
Cost of Capital
Evaluate:

This result matches the expected return calculated in Example 16.1a
where we also assumed debt of $50,000. The equity cost of capital should
be the expected return of the equity holders.
Example 16.2b Computing the Equity
Cost of Capital
Problem:

Referring back to Example 16.1b, 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?
Example 16.2b Computing the Equity
Cost of Capital
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 Eq. 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%.
Example 16.2b Computing the Equity
Cost of Capital
Execute:
$25,000
rE  12% 
(12%  4%)  16%
$50,000
Example 16.2b Computing the Equity
Cost of Capital
Evaluate:

This result matches the expected return calculated in Example 16.1b
where we also assumed debt of $25,000. The equity cost of capital should
be the expected return of the equity holders.
16.3 Debt and Taxes

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.
16.3 Debt and Taxes

Consider the impact of interest expenses on taxes paid by
Safeway, Inc.
◦
◦
◦
◦
In 2008, Safeway had earnings before interest and taxes of $1.85 billion
Interest expenses of $400 million
Corporate tax rate is 35%
Compare Safeway’s actual net income with what it would have been
without debt.
Table 16.2 Safeway’s Income with and
without Leverage, 2008 ($ millions)
Total amount available to all investors is:
16.3 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
Example 16.3 Computing the Interest Tax
Shield
Problem:

Shown on the next slide 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 DFB in years 2007 through 2010?
Example 16.3 Computing the Interest Tax
Shield
Example 16.3 Computing the Interest Tax
Shield
Solution:
Plan:
 From Eq. 16.4, the interest tax shield is the tax
rate of 35% multiplied by the interest
payments in each year.
Example 16.3 Computing the Interest Tax
Shield
Execute:
Example 16.3 Computing the Interest Tax
Shield
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 $115.5 million higher over the four-year period.
Example 16.3a Computing the Interest
Tax Shield
Problem:

Shown on the next slide is the income statement for Comanche Industries.
Given its marginal corporate tax rate of 39%, what is the amount of the
interest tax shield for Comanche in years 2007 through 2010?
Example 16.3a Computing the
Interest Tax Shield
Comanche Income Statement ($ million)
Total sales
Cost of sales
Selling, general, and administrative expense
Depreciation
Operating income
Other income
EBIT
Interest expense
Income before tax
Taxes (39%)
Net Income
$
$
$
$
$
$
$
$
$
$
$
2007
1,058
(670)
(207)
(64)
117
2
119
(27)
92
(36)
56
2008
$
960
$ (572)
$ (187)
$
(65)
$
136
$
7
$
143
$
(29)
$
114
$
(44)
$
70
$
$
$
$
$
$
$
$
$
$
$
2009
1,036
(621)
(195)
(65)
155
1
156
(32)
124
(48)
76
$
$
$
$
$
$
$
$
$
$
$
2010
1,117
(634)
(193)
(59)
231
9
240
(35)
205
(80)
125
Example 16.3a Computing the
Interest Tax Shield
Solution:
Plan:

From Eq. 16.4, the interest tax shield is the tax rate of 39% multiplied by
the interest payments in each year.
Example 16.3a Computing the
Interest Tax Shield
Execute:
($million)
Interest expense
Interest tax shield (39% × interest expense)
2007
$
$
2008
2009
2010
27 $
29 $
32 $
35
10.5 $ 11.3 $
12.5 $
13.7
Example 16.3a Computing the
Interest Tax Shield
Evaluate:

By using debt, Comanche is able to reduce its taxable income and
therefore decreased its total tax payments by $48.0 million over the fouryear period. Thus the total amount of cash flows available to all investors
(debtholders and equity holders) is $48.0 million higher over the four-year
period.
16.3 Debt and Taxes


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 
Figure 16.6 The Cash Flows of the
Unlevered and Levered Firm
16.3 Debt and Taxes

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.
16.3 Debt and Taxes

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.
16.3 Debt and Taxes

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:
VL = VU + PV(Interest Tax Shield) (Eq. 16.5)
Example 16.4 Valuing the Interest Tax
Shield
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?
Example 16.4 Valuing the Interest Tax
Shield
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%.
Example 16.4 Valuing the Interest Tax
Shield
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:
1 
1 
PV (Interest Tax Shield)  $42 million 
1 

0.06  1.0610 
 $309 million

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.
Example 16.4 Valuing the Interest Tax
Shield
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: $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.
Example 16.4a Valuing the Interest Tax
Shield
Problem:

Suppose Comanche from Example 16.3a borrows $1 billion by issuing 5year bonds. Comanche’s cost of debt is 8%, so it will need to pay $80
million in interest each year for the next 5 years, and then repay the
principal of $1 billion in year 5. Comanche’s marginal tax rate will remain
39% throughout this period. By how much does the interest tax shield
increase the value of Comanche?
Example 16.4a Valuing the Interest Tax
Shield
Solution:
Plan:

In this case, the interest tax shield lasts for 5 years, so we can value it as a
5-year annuity. Because the tax savings are as risky as the debt that creates
them, we can discount them at Comanche’s cost of debt: 8%.
Example 16.4a Valuing the Interest Tax
Shield
Execute:

The interest tax shield each year is 39%  $80 million = $31.2
million.Valued as a 5-year annuity at 8%, we have:
PV (InterestT axShield)  $31.2million
 $124.6million

1 
1 
1 
5 
.08  1.08 
The final repayment of principal in year 5 is not deductible, so
it does not contribute to the tax shield.
Example 16.4a Valuing the Interest Tax
Shield
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: $1 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 $124.6 million.
16.3 Debt and Taxes

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.
16.3 Debt and Taxes

Weighted Average Cost of Capital with Taxes
◦ Another way to incorporate the benefit of the
firm’s future interest tax shield
◦ Weighted Average Cost of Capital with Taxes
16.3 Debt and 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.

Figure 16.7 The WACC with and
without Corporate Taxes
16.4 The Costs of Bankruptcy and
Financial Distress
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.

16.4 The Costs of Bankruptcy and
Financial Distress

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.
16.4 The Costs of Bankruptcy and
Financial Distress

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.
16.4 The Costs of Bankruptcy and
Financial Distress

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.
16.4 The Costs of Bankruptcy and
Financial Distress

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
16.4 The Costs of Bankruptcy and
Financial Distress

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.
16.5 Optimal Capital Structure: The
Tradeoff Theory

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  VU
 PV (Interest Tax Shield)
 PV (Financial Distress Costs)
(Eq. 16.10)
16.5 Optimal Capital Structure: The
Tradeoff Theory

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.
16.5 Optimal Capital Structure: The
Tradeoff Theory

Key qualitative factors determine the present
value of financial distress costs:
◦ 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.
16.5 Optimal Capital Structure: The
Tradeoff Theory




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.
Figure 16.8 Optimal Leverage with
Taxes and Financial Distress Costs
16.5 Optimal Capital Structure: The
Tradeoff Theory

Costs of financial distress reduce the value of
the levered firm.
◦ Amount of the reduction increases with probability
of default, which increases with debt level.
16.5 Optimal Capital Structure: The
Tradeoff Theory

Tradeoff Theory:
◦ firms should increase their leverage until it reaches
the maximizing level.
◦ The tax savings that result from increasing leverage
are just offset by the increased probability of
incurring the costs of financial distress.
◦ With higher costs of financial distress, it is optimal
for the firm to choose lower leverage.
16.5 Optimal Capital Structure: The
Tradeoff Theory

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.
16.6 Additional Consequences of Leverage: Agency Costs
and Information

Agency costs:
◦ costs that arise when there are conflicts of interest
between stakeholders.

Managerial Entrenchment:
◦ managers often own shares of the firm, but usually
own only a very small fraction of the outstanding
shares.
◦ Shareholders have the power to fire managers.
 In practice, they rarely do so.
16.6 Additional Consequences of Leverage: Agency Costs
and Information

Separation of ownership and control creates
the possibility of management entrenchment
◦ Managers may make decisions that:




Benefit themselves at investors’ expense,
Reduce their effort,
Spend excessively on perks
Engage in “empire building.”
16.6 Additional Consequences of Leverage: Agency Costs
and Information

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.
16.6 Additional Consequences of Leverage: Agency Costs
and Information

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.
16.6 Additional Consequences of Leverage: Agency Costs
and Information

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.
Figure 16.9 Optimal Leverage with Taxes, Financial
Distress, and Agency Costs
16.6 Additional Consequences of Leverage: Agency Costs
and Information

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.
16.6 Additional Consequences of Leverage: Agency Costs
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.
16.6 Additional Consequences of Leverage: Agency Costs
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.
16.6 Additional Consequences of Leverage: Agency Costs
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.
16.6 Additional Consequences of Leverage: Agency Costs
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.
16.6 Additional Consequences of Leverage: Agency Costs
and Information

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.
Example 16.5 The Pecking Order of
Financing Alternatives
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, they 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?
Example 16.5 The Pecking Order of
Financing Alternatives
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.
Example 16.5 The Pecking Order of
Financing Alternatives
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.
Example 16.5 The Pecking Order of
Financing Alternatives
Execute (cont’d):
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.

Example 16.5 The Pecking Order of
Financing Alternatives
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.
Example 16.5a The Pecking Order of
Financing Alternatives
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?
Example 16.5a The Pecking Order of
Financing Alternatives
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.
Example 16.5a The Pecking Order of
Financing Alternatives
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.
Example 16.5a The Pecking Order of
Financing Alternatives
Execute (cont’d):
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.

Example 16.5a The Pecking Order of
Financing Alternatives
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.
16.7 Capital Structure: Putting It
All Together
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.

16.7 Capital Structure: Putting It
All Together
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.
