Lecture 11: Corporate Equity,
Debt and Taxes
Leverage
• Corporate Leverage is measured by Debt D
divided by equity E.
• Highly levered firms court bankruptcy
• Unlevered firms cannot go bankrupt
(Microsoft owned $5.9 billion of other
firms’ long-term debt and $23.8 billion in
cash and short-term investments in 2000.
Xerox Corporation Consolidated
Balance Sheet 1999 (in millions)
• Assets:
–
–
–
–
–
–
Cash $126
Receivables $15940
Inventories $2961
Buildings & equipment $2456
Other $7331
Total $28814
Xerox Corporation Consolidated
Balance Sheet 1999 Cont.
• Liabilities
–
–
–
–
–
–
–
Short-term debt $3957
Long-term debt $10994
Deferred taxes $2263
Preferred stock $669
Other $6020
Shareholders equity $4911
Total $28814
Microsoft Balance Sheet 2000
(in $ millions)
• Assets:
–
–
–
–
–
–
Cash & equivalents $4846
Short-term investments $18952
Property & equipment $1611
Equity and debt investments $17726
Other $9015
Total assets $52150
Microsoft Balance Sheet 2000
in $Millions Continued.
• Liabilities
–
–
–
–
–
–
Income taxes $585
Accounts payable $1016
Unearned revenue $4816
Other $4065
Stockholders equity $41368
Total $52150
» No debt: no corporate bonds or bank loans!
Comparing Market Caps
• Xerox Market Capitalization = 667 million
shares  $6.95/share = $4.6 billion 2/11/01
(compare with shareholders equity = $4.9b.)
• Microsoft Market Capitalization = 5.3
billion shares  $59.13/share = $315.3b.
(compare with stockholders equity=$41.4b)
Expected Return on Assets
• Expected return on assets = rA= weighted
cost of capital = expected return on a
portfolio consisting of all of a companies
liabilities.
rA 
D
E
rD 
rE
DE
DE
D
rE  rA  (rA  rD )
E
Value of Firm in Terms of rA
• Suppose Dividends are constant =Div and
debt is perpetual, paying Coupon C.
• D=C/rD and E=Div/rE
• Value of firm = V=D+E=C/rD+Div/rE
• Value of firm = V = (C+Div)/rA
• rA=weighted average cost of capital =
(D/(D+E))rD+(E/(D+E))rE
Firm’s Objective: Maximize
Overall Market Value V
• Present Value Model: V=(C+Div)/rA
• Strategies: Increase C+Div, or lower rate of
discount rA.
Traditional Position (Before
Modigliani-Miller)
• Both rD and rE are not much affected by the
ratio, probability of bankruptcy is so low
that it is approximately zero.
• Since rD<rE, so firms should borrow money
and buy back shares to lower rA, thereby
raising the value V of the firm.
Modigliani-Miller
• In absence of taxes, value of firm is
independent of D/E.
• D/E only affects division of income stream
between C and Div, so one who buys all D
and all E doesn’t care what D/E is. Hence, V
is unaffected by D/E.
Adding Taxes to M&M
• Interest paid is deductible for corporate
profits taxes, dividends paid are not.
• Therefore, raising D/E raises numerator of
V: firms can pay out more since their taxes
are lower.
• Conclusion: firms should make D=V?
• Problem with that: if D/E=, the firm is
bankrupt, and debt becomes equity.
Bankruptcy Costs Limit D/E
• If D/E gets too high, the probability of a
bankruptcy gets too high.
• Bankruptcies disrupt the operations of the
firm.
• Legal costs.
• Conclusion: Each firm must judge how high
it can push D/E against its risks and costs of
bankruptcy.
Recent Trends in Corporate Debt
• Just as firms are paying less dividends to reduce
taxes, they are also borrowing more.
• Typical large firm in late 1990s purchased 2% of
shares per year, issued 1%, so 1% net repurchase.
• In first 11 months of 2000, firms issued $146
billion in equity, and $935 billion in corporate
bond market
• Debt is becoming riskier, more equity-like
Other Motives for Issuing
Corporate Debt
• Management Incentive Options –
Management shares in up side, but does not
lose in down side
• Management has an increasing incentive to
pursue a high-risk strategy in recent years.