14- 1
B40.2302 Class #8
 BM6 chapters 16.5-16.8,18.1-18.3,18.5,19
16.5-16.8: Dividend relevance under taxes etc.
 18.1-18.3, 18.5: Capital structure relevance under
taxes and financial distress
 19: Valuation under financing effects

 Based on slides created by Matthew Will
 Modified 10/31/2001 by Jeffrey Wurgler
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
The Dividend Controversy
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter
16.5-16.8
©The McGraw-Hill Companies, Inc., 2000
14- 3
Topics Covered
 Views on dividend relevance
The “Rightists” (dividends increase value)
 The “Radical Left” (dividends decrease value)
 The “Middle-of-the-Roaders” (little or no effect)

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 4
Dividends Increase Value
A “rightist” (high-payout) view
… the considered and continuous verdict of the stock
market is overwhelmingly in favor of liberal dividends as
against niggardly ones…
Benjamin Graham and David Dodd
Security Analysis (1951) (1st ed. 1934)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 5
Dividends Increase Value
Rightist argument: M&M ignore risk



Dividends are cash in hand, but capital gains are not
“Bird in hand versus bird in bush”
So isn’t the dividend to be preferred?
Questionable argument



Declaring high dividend makes (residual) capital gain component
more risky, overall risk to shareholders does not change
Can get dividend-like “bird in hand” whenever you like, just by
selling some of your stock
M&M assume efficient capital market: $1 in dividend would
otherwise be capitalized at $1 in share price. So long as this is true,
the “bird in hand” argument is invalid. If this is not true (as Graham
and Dodd imply), argument is valid.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 6
Dividends Increase Value
Rightist argument: There are “clienteles” that prefer dividends





Some financial institutions cannot hold stocks that do not have established
dividend records
Trusts and endowments may be discouraged from spending capital gains
(which may be viewed as “principal”) but allowed to spend dividends
(may be viewed as “income”)
Retirees(?)/Small investors(?) may prefer to spend from their AT&T
dividend checks rather than sell a few shares every month. (Reduces
transaction costs, inconvenience)
Corporations pay corporate income tax on only 30% of dividends they
receive, but 100% of capital gains.
The demand of these “dividend clienteles” may increase the price of a
dividend-paying stock
But…

Unclear whether any particular firm can benefit by increasing dividends.
There may already be enough high-dividend stocks to choose from.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 7
Dividends Increase Value
Rightist argument: Dividends can’t be wasted


Investors may not trust managers to invest retained
earnings wisely
Firms that refuse to pay out cash may sell at a discount
Comments


In this case dividend decision is tied to investment decision
May have particular merit in countries with poor corporate
governance systems
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 8
Dividends Decrease Value
Leftist (low-payout) argument: Taxes
If dividends are taxed more heavily than capital
gains, investors dislike dividends.
 Firms should pay low dividend, retain cash or
repurchase shares
 Investors should require higher pre-tax return on
dividend-paying stocks (i.e, dividend-paying
stocks sell at a discount price)

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 9
Dividends decrease value
Effect of investor taxes (50% dividend, 20% capital gain)
on share prices and returns
Firm A
Firm B
Next year' s price
Dividend
(no dividend)
112.50
0
(high dividend)
102.50
10
Total pretax payoff
Today' s stock price
Capital gain
112.50
100
12.50
112.50
96.67
5.83
Pretax rate of return (%)
Tax on div @ 50%
12.5
 100
100
 12.5
0
Tax on Cap Gain @ 20%
.20  12.50  2.50
Total After Tax income
(0  12.50)  2.50  10
(div  cap gain - taxes)
10
After tax rate of return (%)
 100  10.0
100
Irwin/McGraw Hill
15.83
 100
96.67
 16.4
.50  10  5.00
.20  5.83  1.17
(10  5.83)  (5  1.17)  9.66
9.66
 100
96.67
 10.0
©The McGraw-Hill Companies, Inc., 2000
14- 10
Dividends decrease value
1998 Marginal Income Tax Brackets
Income Bracket
Marginal Tax Rate
15%
28
31
36
39.6
Single
$0 - $25,350
25,351 - 61,400
61,401 - 128,100
128,101 - 278,450
over 278,450
Married (joint return)
$0 - $42,350
42,351 - 102,300
102,301 - 155,950
155,951 - 278,450
over 278,450
• Dividends are taxed at the personal income rate
• Capital gains are, for most investors, taxed at 28%
• High-tax-bracket investors therefore still prefer capital gains
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 11
Dividends decrease value
Empirical evidence on dividends, prices, returns:
•
Mixed.
•
Generally a positive relationship between dividend yield
and pre-tax returns, as predicted by “leftists”
•
But statistically unreliable
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 12
Middle of the road
Maybe M&M conclusion of irrelevance is right even when some
of the assumptions are relaxed:
• High- or low-payout clienteles may exist, but they are
already satisfied, so no firm can increase its value by
changing dividends
• This “middle of the road” view argues that dividends have
little or no effect on value
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
How Much Should a Firm Borrow?
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 18.118.3, 18.5
©The McGraw-Hill Companies, Inc., 2000
14- 14
Topics Covered
 Corporate Taxes
 Corporate and Personal Taxes
 Costs of Financial Distress

Financial distress games
 The “trade-off theory” of capital structure
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 15
Corporate Taxes
 Main advantage of debt in U.S.:
Corporations can deduct interest
 Whereas retained earnings and dividends are
taxed at the corporate level
 Thus, more cash left for investors if firm
uses debt finance

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 16
Corporate Taxes
Example – Firm U is unlevered, firm L is levered. Firms have same
investment policy (so same operating cash flows).
U
L
1,000
1,000
0
80
1,000
920
350
322
Net Income to shhs $650
$598
EBIT
Interest Pmt
Pretax Income
Tax @ Tc= 35%
Net to bhhs
Total to investors
80
650
Interest tax shield (.35*interest)
Irwin/McGraw Hill
678
28
©The McGraw-Hill Companies, Inc., 2000
14- 17
Corporate Taxes
What is present value of tax shield?
• If the same savings occur every year, value as a perpetuity
• If the savings are as risky as the debt, discount at cost of debt
• Under these assumptions:
PV of Tax Shield =
D x rD x Tc
= D x Tc
rD
Example (D = 1000, rD =.10, Tc=.35):
Yearly savings = 1000 x (.10) x (.35) = $35
PV Perpetual Tax Shield @ 10% = 35 / .10 = 1000*.35 = $350
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 18
Corporate Taxes
Taxes don’t change the total size of the pretax “pizza.”
But now the government gets a slice.
 Government’s slice is smaller (and investors’ slices are bigger)
when debt is used.


M&M proposition I with corporate taxes:
Firm Value = Value of All Equity Firm
+ PV(Tax Shield)

… and in special case where debt is permanent …
Firm Value = Value of All Equity Firm + Tc*D
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 19
Corporate Taxes
 So why not 100% debt, then, or close to it?


Maybe looking at corporate and personal taxation
will uncover a personal tax disadvantage to
borrowing (to offset the corporate tax advantage)
Or, maybe firms that borrow incur other costs –
such as costs of financial distress – that offset
interest tax shield
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 20
Corporate and Personal Taxes
TC
TP
TPE
Corporate tax rate
Personal tax rate on interest income
Personal tax rate on Equity income (= TP if all equity
income comes in form of cash dividends, but < TP if
comes as capital gains, << if they are deferred)
--------------------------------------------------------------------------$1 in operating income paid as interest:
= $(1 – TP) to bondholder (escapes corporate tax)
$1 in operating income paid as equity income:
= $(1 – TPE)*(1 – TC) (hit by corporate tax, then
personal tax)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 21
Corporate and Personal Taxes
Relative Tax Advantage of Debt over Equity
=
1-TP
(1-TPE)*(1-TC)
Tax advantage
RA > 1
Debt
RA < 1
Equity
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 22
Corporate and Personal Taxes
Example 1
Interest
Equity income
Income before tax
1.00
1.00
Corp taxes Tc=.35
0.00
0.35
To investor
1.00
0.65
Pers. taxes TP =.40, TPE=.10 0.40
0.065
Income after all taxes
0.585
RA = 1.025
Irwin/McGraw Hill
0.60
 Advantage: Debt (barely)
©The McGraw-Hill Companies, Inc., 2000
14- 23
Corporate and Personal Taxes
Example 2
Interest
Equity income
Income before tax
1.00
1.00
Corp taxes Tc=.35
0.00
0.35
To investor
1.00
0.65
Pers. taxes TP =.40, TPE= 0 0.40
0.00
Income after all taxes
0.65
0.60
RA = 0.923  Advantage: Equity
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 24
Corporate and Personal Taxes
So then … equity or debt? Merton Miller’s argument:
Suppose TPE = 0 and TP varies across investors. Then
•
Economy-wide tax-minimizing mix of debt and equity
depends on distribution of personal tax rates
•
But there still may be are no tax gains left for
individual firms to get by varying their own leverage
- “Low-tax” investors already hold all the bonds they want
- If “marginal investor” has high tax rate, may be no tax
gain left from issuing debt to him!
- Current tax law still seems to favor borrowing, though
(TPE not as low as Miller assumed)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 25
Costs of Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions on the
brink of bankruptcy.
Firm value =
Irwin/McGraw Hill
Value of All Equity Firm
+ PV(Tax Shield)
- PV(Costs of Financial Distress)
©The McGraw-Hill Companies, Inc., 2000
14- 26
Trade-off Theory
Market Value
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value if
All Equity
Optimal amount
of debt
Irwin/McGraw Hill
Debt ratio
©The McGraw-Hill Companies, Inc., 2000
14- 27
Costs of Financial Distress
 Bankruptcy is not costly in itself; bankruptcy costs
are the cost of using this legal mechanism
 Bankruptcy costs and costs of financial distress
are borne by shareholders
Creditors foresee the costs and foresee that they will pay
them if default occurs
 For this, they demand higher interest rates in advance
 This reduces the present market value of shares

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 28
Costs of Financial Distress
 Direct costs (legal, administrative fees)



Manville (1982, asbestos): $200m on fees
Eastern Airlines (1989): $114m on fees
On average, direct costs = 3% of book assets, or 20% of
market equity in year prior to bankruptcy
 Indirect costs


Customers may stray if firm may not be around, suppliers
may be unwilling to give much effort to firm’s account, good
employees hard to attract …
Hard to measure, but probably large
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 29
Costs of Financial Distress
 US bankruptcy procedures
Chapter 11
Aims to rehabilitate firm; protect value of assets while
reorganization plan is worked out; used more by large, public
companies
Chapter 7
Aims to dismember firm; assets are auctioned and creditors
paid off (usually) according to seniority; used more by small
companies
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 30
Costs of Financial Distress
 Financial distress may be costly even without formal bankruptcy
 When a firm is in trouble, both shareholders and bondholders
want it to recover, but otherwise their interests may conflict
 Shareholders may pursue self-interest rather than the usual
objective of maximizing overall market value
Shareholders may play “games” at creditors’ expense
 These games can reduce overall value

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 31
Financial distress games
Circular File Company has $50 of 1-year debt.
Circular File Company (Book Values)
Net W.C.
20
50
Bonds outstanding
Fixed assets
80
50
Common stock
Total assets
100
100
Total value
Circular File Company (Market Values)
Net W.C.
20
25
Bonds outstanding
Fixed assets
10
5
Common stock
Total assets
30
30
Total value
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 32
Financial distress games
Game #1: Risk shifting
Circular File Company may invest $10 as follows:
Now
Possible Payoffs Next Year
$120 (10% probabilit y)
Invest $10
$0 (90% probabilit y)
 Suppose NPV of the project is (-$2).
What is the effect on the market values?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 33
Financial distress games
Circular File Company (Market Values - post project)
Net W.C.
10
20
Bonds outstanding
Fixed assets
18
8
Common stock
Total assets
28
28
Total liabilities
 Firm value falls by $2
 But equity gains $3 (say)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 34
Financial distress games
Game #2: Refusing to contribute equity capital
Suppose NPV = $5 project (costs 10 new equity, returns 15)
Circular File Company (Market Values - post project)
Net W.C.
20
33
Bonds outstanding
Fixed assets
25
12
Common stock
Total assets
45
45
Total liabilities
 While firm value rises, the lack of a high potential payoff for
shareholders actually causes a decrease in equity value.
 Shareholders will therefore resist the project
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 35
Financial distress games
Other games
Cash In and Run
Playing for Time
Bait and Switch
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 36
Trade-off theory redux
 Trade-off theory argues that optimal debt ratios
vary from firm to firm

PV (tax shields) vary
• Depends on level and risk of taxable income

PV (costs of financial distress) vary
• Tangible assets lose least value in distress
• So can take on more debt
 So trade-off theory may explain why different
firms have different capital structures
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Financing and Valuation
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 19
©The McGraw-Hill Companies, Inc., 2000
14- 38
Topics Covered
 After-Tax WACC
 Using WACC: Tricks of the Trade
 Adjusting WACC when risks change
 Adjusted Present Value (APV)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 39
After Tax WACC
 The tax shield of interest reduces the after-tax
weighted-average cost of capital.
 The amount of the reduction depends on Tc
D
E
WACC  rD (1  Tc)  rE
V
V
 Note WACC < r (our previous “opportunity cost of
capital”)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 40
After Tax WACC
 So WACC incorporates the tax advantages of debt
financing in lower discount rate
 Note that all variables in WACC refer to whole firm
So after-tax WACC gives right discount rate only for new
projects that are just like the firm’s “average”
 Would need to be adjusted for projects whose acceptance
would cause a change in the firm’s overall debt ratio
(we’ll show how later)
 Would need to be adjusted for safer or riskier projects (we
won’t show how)

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 41
After Tax WACC
Example - Sangria Corporation
The firm has a marginal tax rate Tc of 35%. The
cost of equity is 14.6% and the pretax cost of debt is
8%. Given the following market value balance
sheets, what is the after tax WACC?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 42
After Tax WACC
Example - Sangria Corporation - continued
Given:
Tc=35%, rE=.146, rD=.08, and the market value balance sheet:
Balance Sheet (Market Value, millions)
Assets
125
50
Debt (D)
75
Equity (E)
Total assets
125
125
Firm value (V)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 43
After Tax WACC
Example - Sangria Corporation - continued
Debt ratio = (D/V) = 50/125 = .4
Equity ratio = (E/V) = 75/125 = .6
Plug and chug to solve for WACC …
D
E
WACC  rD (1  Tc)  rE
V
V
Irwin/McGraw Hill
= .1084
©The McGraw-Hill Companies, Inc., 2000
14- 44
After Tax WACC
Example - Sangria Corporation - continued
How to use the WACC of 10.84%?
Suppose company has following investment
opportunity: can invest in an ice-crushing machine with
perpetual, pretax cash flows of $2.085 million per year.
Given an initial investment of $12.5 million, and
assuming that firm will finance it without changing its
current debt ratio, what is the value of the opportunity?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 45
After Tax WACC
Example - Sangria Corporation - continued
The company would like to invest in a perpetual ice-crushing machine with
cash flows of $2.085 million per year pre-tax. Given an initial investment
of $12.5 million, what is the value of the machine?
Cash Flows
Pretax cash flow
Tax @ 35%
After-tax cash flow
Irwin/McGraw Hill
2.085
0.730
$1.355 million
©The McGraw-Hill Companies, Inc., 2000
14- 46
After Tax WACC
Example - Sangria Corporation – contd.
 Discount after-tax cash flow (not accounting for
debt tax shield) at after-tax WACC. I.e., calculate
taxes as if company were all-equity financed.
 Value of debt tax shield is already being counted in
the after-tax WACC!
1.355
NPV  12.5 
.1084
0
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 47
After Tax WACC
 Interim review:
After-tax WACC methodology is one way to
calculate value when interest is tax-deductible
 Required assumptions:
1. Project’s business risks are same as firm average
2. Project supports the same fraction of D/V as
overall firm
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 48
WACC Tricks of the Trade
What about other forms of financing?
 Preferred stock (P) and other forms of
financing are easily included
D
P
E
WACC  rD (1  Tc)  rP  rE
V
V
V
 In this case, V = D + P + E
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 49
WACC Tricks of the Trade
How do you get the inputs?
 Can use stock market data to estimate rE
 rD , debt and equity ratios usually easy …
… Unless the debt is junk. If default risk is high,
promised yield overstates true cost, true expected
return
 No easy solution. (Try sensitivity analysis, see if
your choice makes a difference.)

Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 50
WACC Tricks of the Trade
Some common mistakes
D
E
WACC  rD (1  Tc)  rE
V
V
 “My firm could borrow 90% of project cost if I want. So D/V=.9, E/V=.1.
My firm’s cost of debt is 8%, and cost of equity is 15%. When I discount at
WACC = .08*(1-.35)*.9+.15*.1=6.2%, project looks great!”
 Mistakes:


Formula doesn’t apply if project isn’t same as firm. E.g. if firm isn’t already
90% debt financed, can’t use formula without making adjustment.
Even if firm was going to lever up to 90% debt, its cost of capital would not
decline to 6.2%. The increased leverage would increase the cost of debt and
the cost of equity, too.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 51
WACC for U.S. oil industry
Percent (nominal)
30
Cost of Equity
WACC
Treasury Rate
25
20
15
10
5
Irwin/McGraw Hill
98
19
95
19
92
19
89
19
86
19
83
19
80
19
77
19
74
19
71
19
68
19
19
65
0
©The McGraw-Hill Companies, Inc., 2000
14- 52
WACC(y?) adjustments
What if project is not financed at same D/E proportions as firm?
•
Can’t just plow ahead with regular WACC. Need to adjust.
•
Three-step process:
1. Calculate opportunity cost of capital using firm debt ratio
r = rD(D/V) + rE (E/V)
2. Estimate project cost of debt rD at project debt-equity ratio,
and then use this and r to calculate project cost of equity rE
rE = r + (r - rD)(D/E)
3. Recalculate WACC at project rD , rE , debt ratio
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 53
WACC(y?) adjustments
Sangria contd.
What if project supports 20% D/V, not 40% D/V like overall firm?
1. Calculate opportunity cost of capital using firm debt ratio
r = rD(D/V) + rE (E/V) = .08(.4) + .146(.6) = .12
2. Estimate project cost of debt rD at project debt-equity ratio,
and then use this and r to calculate project cost of equity rE
rE = r + (r - rD)(D/E) = .12 + (.12-.08)(.25) = .13
•
Notes: assumed rD stays at 8%; D/V =.20  D/E = .25
3. Recalculate WACC at project rD , rE , debt ratio
WACC = .08(1-.35)(.2) + .13(.8) = .1140 (vs. .1084 orig.)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 54
Adjusted Present Value
 APV is second way to incorporate tax advantages of debt
 WACC messes around with discount rate, while APV explicitly
adjusts the cash flows and present values.
APV = base-case NPV
+ PV(Financing effects)
 “Base case” = All-equity NPV.
 “Financing effects” = costs/benefits due to financing
(interest tax shields, security issue costs)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 55
Adjusted Present Value
Example (financing effect = issue cost):
Project A has a base-case NPV of $150,000. But
in order to finance the project we must issue stock,
which costs $200,000 in fees.
Project NPV =
150,000
Stock issue cost = -200,000
APV
- 50,000
APV < 0  don’t do it
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 56
Adjusted Present Value
Example (financing effect = tax shield):
Project B has a base-case NPV of -$100,000. If
financed with debt, however, it adds a tax shield
with a PV of $140,000.
Project NPV =
PV(tax shield) =
APV
-100,000
140,000
40,000
APV > 0  do it (but wouldn’t do it if all-equity)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
14- 57
After-Tax WACC vs. APV
 With consistent assumptions, get same answer.
 WACC assumes constant debt ratio , but then
don’t have to value tax shield explicitly 
 APV lets tax shields vary over time , but have
to calculate them yourself .

APV more flexible: can handle other financing
effects besides interest tax shields 
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000