How Much Should a Firm Borrow?
• Student Presentations
• Why M & M Does Not Hold
– Corporate Taxes
– Personal Taxes
– Financial Distress
• Pecking Order of Financing Choices
Corporate Taxes
• Debt provides a tax shield
– Interest is tax deductible
– Government’s share of income declines
– Value of bondholders’ and stockholders’ share
increases
Present Value of Tax Shield
• Present value of tax shield
n
Tc (rD D)
PV (Tax Shield )  
t
t 1 (1  rD )
• If debt is assumed to be a perpetuity
Tc (rD D)
PV (Tax Shield ) 
 Tc D
rD
Table 18.1: Comparison of Unlevered Firm
and Levered Firm with $1000 of Debt at 8%
Compute the present value of the tax shield for a firm in the
35% tax bracket on the following debt issue:
1 year $1,000,000 loan at 8%
A) $25,926
B) $28,000
C) $35,000
D) $350,000
E) None of the above
Compute the present value of the tax shield for a firm in the
35% tax bracket on the following debt issue:
$1,000,000 perpetuity loan at 8%
A) $28,000
B) $80,000
C) $324,074
D) $350,000
E) None of the above
Claims on Firm
• Bondholders: Debt
• Government: Taxes
• Equityholders: Remainder of firm value
M&M and Taxes
Value of firm = Value of all-equity-financed firm
+ PV(tax shield)
Pfizer Balance Sheet 2004 and Adjusted for
$1 billion Debt for Equity Trade
A
C
T
U
A
L
A
D
J
U
S
T
E
D
Net working capital
Long-term assets
Total assets
Net working capital
PV interest tax shield
Long-term assests
Total assets
Book values
10,752
7,144
21,460
86,900
69,048
97,652
97,652
Long-term debt
Other long-term liabilities
Equity
Total value
Market values
10,752
7,144
2,500
21,460
283,373
268,021
296,625
296,625
Long-term debt
Other long-term liabilities
Equity
Total value
What’s Wrong with Pfizer’s CFO?
• Should also consider personal taxes
• Cost of financial distress
Corporate and Personal Taxes
Let Tp  Personal tax on int erest
TpE  Personal tax on equity income
Relative tax advantage of debt vs. equity

1  Tp
(1  T pE )(1  Tc )
If the relative advantage is > 1, debt is preferred
If the relative advantage is < 1, equity is preferred
Example – Advantage to Debt
Assume dividends are 40% of earnings
Each dollar of earnings generates $0.40 in
dividends and $0.60 in capital gains
Marginal investor is in the 35% tax bracket on
interest and 15% on dividends and capital
gains
Deferral of capital gains reduces capital gains
rate in half (to 7.5%)
TpE  (.4 x15)  (.6 x7.5)  10.5%
Example - continued
Income before tax
Less corporate tax at Tc =.35
Income after corporate tax
Personal tax at Tp = .35 and Tpe = .105
Income after all taxes
Interest
Equity Income
$1
0
1
0.35
$0.675
$1
0.35
0.65
0.068
$0.582
Advantage to debt= $ .068
Calculate the relative tax advantage of debt with personal and
corporate taxes where:
TC = (Corporate tax rate) = 35%;
TpE = Personal tax rate on equity income = 30% ;
Tp = Personal tax rate on interest income = 20% :
A)
B)
C)
D)
E)
0.76
1.16
1.35
1.76
None of the above
Given the following information, leverage will
add how much value to the unlevered firm per
dollar of debt?
Tc = 34% Tp = 30% TpE=20%
A)
B)
C)
D)
E)
$0.66
$0.25
-$0.66
-$0.34
None of the above
Costs of Financial Distress
Value of firm = Value of all-equity-financed firm
+ PV(tax shield)
– PV(costs of financial distress)
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
Types of Financial Distress
• Bankruptcy costs
– Direct: legal and court costs
– Indirect: Inefficient operations, creditors,
employees, suppliers, customers
• Financial distress without bankruptcy
• Incentives for a firm in difficulty
–
–
–
–
–
Risk shifting
Refusing to contribute equity capital
Taking cash from firm
Delaying tactics
Bait and switch on use of funds from debt
Costs of Financial Distress by
Asset Type
• Tangible assets unaffected by ownership
– Real estate
– Airplanes
• Intangible assets
– Brand image
– Technology
– Human capital
Trade-off Theory of Capital Structure
• Capital structure depends on trade-off between
interest tax shield and financial distress
• High debt firms
– Safe, tangible assets
– High taxable income
• Low debt firms
– Risky, intangible assets
– Unprofitable companies
• Does theory work?
– Yes and no
Pecking Order of Financing Choices
1. Firms prefer internal finance
2. Firms adapt payout targets to investment
opportunities trying to avoid sudden changes
3. Sticky dividend policies and fluctuations in
profitability and investment opportunities
lead to cash flow shifts
4. If external finance is required, firms issue
debt first, then equity
Tests of Pecking Order
1. Large firms tend to have higher debt ratios
2. Firms with high ratios of fixed assets to total
assets have higher debt ratios
3. More profitable firms have lower debt ratios
4. Firms with higher ratios of book-to-market
values have lower debt ratios
Next Class
• Thursday, April 12
– Financing and Valuation – Chapter 19
– Problem Set 3