1- 1

Corporate Finance

Week 10-11
How Much Should A
Firm Borrow?

10- 1
 1- 2

Topics Covered
Corporate Taxes
Tax Shield Effects
Cost of Financial Distress
Trade-Off Theory
Pecking Order of Financial Choices

10- 2
 1- 3

Capital Structure & Corporate Taxes

Review of important terms

- Financial Risk - Risk to ( )
resulting from the use of debt.
- Financial Leverage - Increase in the
( ) that comes from the use of debt.
- Interest Tax Shield- Tax savings resulting
from ( ) of interest payments.

10- 3
 1- 4

Capital Structure & Corporate Taxes

 The tax deductibility of interest increases the total
distributed income to both bondholders and shareholders.

Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

10- 4
 1- 5

Capital Structure & Corporate Taxes

 Suppose that the debt of L is fixed and permanent (The expected rate of
return demanded by investors who are holding the firm’s debt: 8%)

28
PV (tax shield)   $350
.08
Interest payment  return on debt  amount borrowed
 rD  D

corporate tax rate  interest payment

PV (tax shield) 
expected return on debt
TC (rD  D)
  TC  D
rD
10- 5
 1- 6

Capital Structure & Corporate Taxes

Example - You own all the equity of Space Babies
Diaper Co. The company has no debt. The
company’s annual cash flow is $900,000 before
interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your
equity position for 5% bonds with a face value of
$2,000,000.

Should you do this and why?

10- 6
 1- 7

Capital Structure & Corporate Taxes

Example - You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is
$900,000 before interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your equity position for
5% bonds with a face value of $2,000,000.
Should you do this and why?
($ 1,000 s) All Equity 1/2 Debt Total Cash Flow
EBIT 900 900 All Equity = 585
Interest Pmt 0 100
Pretax Income 900 800 *1/2 Debt = 620
Taxes @ 35% 315 280
(520 + 100)
Net Cash Flow 585 520

10- 7
 1- 8

Capital Structure & Corporate Taxes

corporate tax rate  interest payment
PV (tax shield) 
expected return on debt
TC (rD  D)
  TC  D (assume perpetuity)
rD

Example: (continued)
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
 PV Tax Shield = $2,000,000 x .35 = $700,000

10- 8
 1- 9

Capital Structure & Corporate Taxes

Firm Value =
Value of All Equity + PV(Tax Shield)

Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield = 700,000

Firm Value with 1/2 Debt = $12,400,000

10- 9
 1- 10

Capital Structure & Corporate Taxes

Value of the Levered Firm
– Calculate the annual after-tax CF of an unlevered
firm: 𝐸𝐵𝐼𝑇 × (1 − 𝑇𝑐 )
– Calculate the value of an unlevered firm:
𝐸𝐵𝐼𝑇×(1−𝑇𝑐 )
PV(𝐸𝐵𝐼𝑇 × (1 − 𝑇𝑐 ))=
𝑟𝐸
– Calculate PV(tax shield): 𝑇𝑐 𝐷
𝐸𝐵𝐼𝑇×(1−𝑇𝑐 )
– 𝑉𝐿 = + 𝑇𝑐 𝐷
𝑟𝐸
𝑉𝑈
Leverage increases the value of the firm by the
tax shield effect.
10- 10
 1- 11

Capital Structure & Corporate Taxes

Merck Balance Sheet, December 2008
(figures in $millions)

Book values
Net working capital 4,986.2 3,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 18,758.3 Equity
Total assets 32,877.0 32,877.0 Total value

Market values
Net working capital 4,986.2 3,943.3 Long-term debt
PV interest tax shield 1,380.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,928.3 Equity
Total assets 79,047.0 79,047.0 Total value

10- 11
 1- 12

Capital Structure & Corporate Taxes

Merck Balance Sheet, December 2008 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)
Book values
Net working capital 4,986.2 4,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 17,758.3 Equity
Total assets 32,877.0 32,877.0 Total value

Market values
Net working capital 4,986.2 4,943.3 Long-term debt
PV interest tax shield 1,730.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,278.3 Equity
Total assets 79,397.0 79,397.0 Total value
10- 12
 1- 13

MM Propositions I & II (With Taxes)

Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC D
Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is
offset by the interest tax shield
rE = r0 + (D/E)×(1-TC)×(r0 - rD)
rD is the interest rate (cost of debt)
rE is the return on equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
D is the value of debt
E is the value of levered equity
10- 13
 MM Proposition I (With Taxes) : 1- 14

supplementary
The total cash flow to all stakeholders is
( EBIT  rD D)  (1  TC )  rD D

The present value of this stream of cash flows is VL

Clearly (EBIT  rD D)  ( 1  TC )  rD D 

 EBIT  ( 1  TC )  rD D  ( 1  TC )  rD D
 EBIT  ( 1  TC )  rD D  rD DTC  rD D
The present value of the first term is VU
The present value of the second term is TCD
 VL  VU  TC D 10- 14
 1- 15

Exercise I-1
 Example:
 A firm is considering two financing plans. The
first (plan A) is an all-equity plan in which $1
million will be raised by selling stock at $50 per
share. Plan B involves financial leverage. The
firm will raise $500,000 by issuing bonds with a
10 percent effective interest rate. The remaining
$500,000 will be raised by issuing common
stock at $50 per share. The tax rate is 40 percent.
Find the EBIT level which will result in the
same EPS for the two plans.

10- 15
 1- 17

Exercise I-2
Refer to the above problem. Using the bottom
portion of an income statement, show that the
EBIT calculated results in the same EPS for
plans A and B.

10- 17
 MM Proposition II (With Taxes): 1- 19

- supplementary
Start with M&M Proposition I with taxes: VL  VU  TC B
Since VL  E  D  E  D  VU  TC D

VU  S  B(1  TC )
The cash flows from each side of the balance sheet must equal:
ErE  DrD  VU r0  TC DrD
ErE  DrD  [ E  D(1  TC )]r0  TC rD D
Divide both sides by E
D D D
rE  rD  [1  (1  TC )]r0  TC rD
E E E
D
Which quickly reduces to rE  r0   (1  TC )  (r0  rD )
E
10- 19
 1- 20

The Effect of Financial Leverage

Cost of capital: r(%) D

rE  r0   (r0  rD )
E
D
rE  r0   (1  TC )  (r0  rD )
E

r0
D EL
rWACC   rD  (1  TC )   rE
DEL D  EL
rD

Debt-to-equity
10- 20
ratio (D/E)
 1- 21

Financial Distress Costs

Direct Costs
– Legal and administrative costs
Indirect Costs
– Impaired ability to conduct business (e.g., lost sales)
Agency Costs: conflicts of interest
– Selfish Strategy 1: Incentive to take large risks
– Selfish Strategy 2: Incentive toward underinvestment

10- 21
 1- 22

Bankruptcy Costs
Bankruptcy is a legal mechanism allowing
creditors to take over when a firm defaults
– Bankruptcy costs are the costs of using this
mechanism
Corporate bankruptcies occur when stock
holders exercise their right to default
Limited liability(LL) allows stockholders
simply to walk away from it
– Leave all its troubles to its debtholders
– The former creditors become the new stockholders
10- 22
 1- 23

Bankruptcy Costs
Example: suppose LL is not allowed to all
firms, two firms w/ identical assets and
operations
– Each firm has debt outstanding, and each has
promised to repay $1,000 next year
– But only Ace Limited enjoys LL
– Suppose that the next year the assets of each
company are worth only $500
– Suppose that court and legal fees are $200 if
Ace Limited defaults.
10- 23
 1- 24

Default Payoff Scenarios

 1- 25

Ace Limited Example

Total payoff to Ace Limited security holders. There
is a $200 bankruptcy cost in the event of default
(shaded area).
 1- 26

Financial Distress w/o Bankruptcy

Not every firm that gets into trouble goes
bankruptcy
But the mere threat of financial distress can be
costly to the threatened firm
– Customers and suppliers are extra cautious about
doing business
– Employment problems, too

10- 26
 1- 27

Financial Distress
Costs of Financial Distress - Costs arising
from ( ) or (
) before bankrupcy
 Costs of financial distress depend on the
probability of distress and the magnitude of costs
encountered if distress occurs

Market Value = Value if all Equity Financed

+ PV Tax Shield
- PV Costs of Financial Distress
10- 27
 Financial Distress (tradeoff b/w tax 1- 28

Market Value of The Firm benefits and costs of FD)

Maximum value of firm
Costs of
financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal Debt
debt ratio ratio
( ) of capital structure!
 1- 29

Conflicts of Interest: Risk Shifting

 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 liabilities

– Assume one share and one bond outstanding

– Stockholder = manager
– Bondholder = somebody else

10- 29
 1- 30

Conflicts of Interest: Risk Shifting

 Circular File Company has $50 of 1-year debt.

BV MV BV MV
Net W.C. 20 20 50 25 Bonds outstanding
Fixed assets 80 10 50 5 Common stock
Total assets 100 30 100 30 Total liabilities

 How do you know this is a case of financial distress?

– Since ( ) ( ) the firm’s total value
 Why does the equity have any value ?
– ( )
– Shareholder has an option: she can obtain the rights to the
assets by paying off the $50 debt. She controls investment &
operating strategy. 10- 30
 1- 31

Conflicts of Interest: Risk Shifting

 Circular File Company has may invest $10 as
follows.

Now Possible Payoffs Next Year

$120 (10% probability)
Invest $10
$0 (90% probability)

 Assume the NPV of the project is (-$2).

What is the effect on the market values?
10- 31
 1- 32

Conflicts of Interest: Risk Shifting

 Circular File Company value (post project):
assumed

Circular File Company (Market Values)

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 holder gains $3

– A game has been played at the expense of Circular’s bondholder.
– Errors of ( )
10- 32
 Conflicts of Interest: Refusing to 1- 33

Contribute Equity Capital

 Circular File Company value (assumes a safe
project with NPV = $5 by costing $10)

Circular File Company (Market Values)

Net W.C. 20 33 Bonds outstanding
Fixed assets 25 12 Common stock
Total assets 45 45 Total liabilities

– Assume two new shares are issued to the original owner for $10
cash
 While firm value rises by $15, bondholder receives a
capital gain of $8, but the stockholder loses what the
bondholder gain.
– Errors of ( ) 10- 33
 Financial Distress Games: 1- 34

- supplementary
 Cash In and Run
– Stockholders are happy to take out the money out
(cash dividend)
 Playing for Time
– When the firm is in financial distress, creditors would like
to salvage what they can by forcing the firm to settle up
– Stockholders want to delay this as long as they can
(accounting changes, encouraging false hope of
spontaneous recovery, cutting corners on maintenance and
R&D, etc.)
 Bait and Switch
– Start with a conservative policy, issuing a limited amount
of relatively safe debt
10- 34
– Then suddenly switch and issue a lot more
 1- 35

Financial Choices
 Trade-off Theory - capital structure is based on a
trade-off between ( ) and (
)

 Pecking Order Theory - firms prefer to issue

debt rather than equity if internal finance is
insufficient ( )
– Asymmetric information affects the choice b/w internal
and external financing and b/w new issues of debt and
equity securities pecking order, financed first w/
internal funds, reinvested earnings primarily; then by
new issues of debt; and finally w/ new issues of equity
10- 35
 1- 36

Trade-Off Theory
 There is a trade-off b/w interest tax shields and the
costs of financial distress
– Target ratios may vary from firm to firm (safe vs.
risky)
– MM’s seemed to say that firms should take on as
much debt as possible
– But, it avoids extreme predictions and rationalize
optimal debt ratios
 Can the trade-off theory of capital structure explain
how companies actually behave?

10- 36
 1- 37

Trade-Off Theory & Prices

1. Stock-for-debt Stock price

exchange offers falls

Debt-for-stock Stock price

exchange offers rises

2. Issuing common stock drives down stock prices;

repurchase increases stock prices.

10- 37
 1- 38

Pecking Order Theory

 Consider the following story:
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.

Therefore firms prefer internal finance since funds can be

raised without sending adverse signals.

If external finance is required, firms issue debt first andequity as a

last resort.

The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.

10- 38
 1- 39

Pecking Order Theory

Some Implications:
– Firms prefer ( ) finance
– They adapt their target dividend payout ratios
to their investment opportunities, while trying
to avoid sudden changes in dividends: sticky
dividend policy

10- 39
 1- 40

Pecking Order Theory

Some Implications: (continued)
 Sticky dividend policies, plus unpredictable
fluctuations in profitability and investment
opportunities, mean that internally generated cash
flow is sometimes more than capital expenditures
and other times less.
– If it is less, the firm first draws down its cash
balance or sells its marketable securities.
 If external capital is required, firms issue the
safest first (debt  hybrid securities  equity)
10- 40
 Trade-off Theory vs. 1- 41

Pecking Order Theory

 Rajan and Zingales (1995)
– Studied debt vs. equity choices by large firms
in Canada, France, Germany, Italy, Japan, UK,
and US.
– Found that the debt ratios of individual
companies seemed to depend on 4 main factors
– Size, Tangible assets, Profitability, Market to
book

10- 41
 Trade-off Theory vs. 1- 42

Pecking Order Theory

 Rajan and Zingales (1995)
– 1. Size: large firms tend to have higher debt
ratios
– 2. Tangible assets: firms w/ high ratios of fixed
assets to total assets have higher debt ratios
– 3. Profitability: More profitable firms have
lower debt ratios
– 4. Market to book: firms w/ higher ratios of MB
value have lower debt ratios
 These results are good for both of the theories
10- 42
 Trade-off Theory vs. 1- 43

Pecking Order Theory

 Rajan and Zingales (1995) are good for both!
 Trade-off:
– large companies w/ tangible assets are less
exposed to costs of financial distress  borrow
( )
– MB ratios: growth opportunities  argue that
growth companies face high costs of financial
distress borrow ( )
 Pecking-order: profitability
– profitable firms can rely on internal financing
 borrow ( )
– MB ratios: also implies profitability 10- 43
 Trade-off Theory vs. 1- 44

Pecking Order Theory

Conclusion
 Pecking-order works best for ( ) that
have access to public bond markets
– They rarely issue ( ) and prefer ( )
financing, but turn to debt markets if needed to
finance investment
 Trade-off works best for ( )
– They issue ( ) when external financing is
required

10- 44
 1- 45

Other theory
Debt ratios incorporate the cumulative effects
of ( )
– Financial manager can take advantage by issuing
shares when the stock price is ( )and
switching to debt when price is ( )
– It explains why companies tend to issue shares after
run-ups in stock prices and also why aggregate stock
issues are concentrated in bull markets and fall
sharply in bear market.
– Lucky companies will issue less debt & more shares
( ); Unfortunate companies will avoid
share issues  ( ) 10- 45