Finance 70391

Topic 10: Capital Structure

Topic 11: Valuation and Capital Budgeting with Leverage

Prof. Tetiana Davydiuk

CMU – Tepper School of Business

Fall 2021
Big Picture

Finance

Capital Financing
Budgeting Decisions
Risk &
Return

Present Value Investment Cash Flows Capital WACC

Rules Structure
How much are W hat rules do How is revenue How much W hat is the cost
f uture f irms use making converted into debt should of capital
cash f lows invetsment cash f lows? company have? of the company?
worth today? decisions?

Portfolio Theory CAPM

How do investors How can asset

trade of f returns
risk and return? be modeled?

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Big Picture

Capital budgeting
Decisions about the operations of the company
What investments should funded?

Financing decisions
Decisions about the capital structure of the company
How should a project be funded?

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Capital Structure

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Capital Structure

How do firms pay for their investments?

Equity financing
Private firms: founders and others contribute money
Publicly-traded firms: shareholders contribute money in the initial public
offering (IPO); subsequently, more funds can be raised in a seasoned equity
offering
Retained earnings: shareholders money gets “plowed back in”

Debt financing
Bank loans
Corporate bonds

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Capital Structure

Capital structure: a firm’s mix of securities

Assets (A) Debt (D)

Equity (E)

BIG question - does capital structure matter for firm’s market

value?

M V of the f irm = M V of debt + M V of equity

In the “real world” the answer appears to be yes

Theoretically, not so clear

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A Yogiism
Yogi ordered a pizza. The waitress asked “How
many pieces do you want your pie cut?”

Yogi responded, “Four. I don’t think I could eat

eight.”

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Modigliani Miller (MM) Proposition # 1
Frictionless (=Perfect) Capital Markets

Financial leverage (↑):

Does NOT change firm value (∼)

,→ The MV of the unlevered firm (i.e., debt =0) is the same as the MV of the
levered firm (i.e., debt>0)
VU = VL

Does change equity value (↓) and debt value (↑)

∼ Assets (A) ↑ Debt (D)

↓ Equity (E)

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Modigliani Miller (MM) Proposition # 2
Frictionless (=Perfect) Capital Markets

Financial leverage (↑):

Does NOT make the firm riskier (∼)

,→ Does not change firm cost of assets E [r̃A ] (∼)
E D
E [r̃A ] = E [r̃E ] + E [r̃D ]
E+D E+D

Does change the distribution of risk and expected return between debt
and equity holders
,→ Can make the debt risky (or riskier) E [r̃E ] (∼, ↑)
,→ Does make the equity riskier E [r̃E ] (↑)
D
E [r̃E ] = E [r̃A ] + (E [r̃A ] − E [r̃D ])
E

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Modigliani Miller (MM) Proposition # 2
Frictionless (=Perfect) Capital Markets

17%
16%
15%
14%
13%
12%
11%
10%
9%
8%
0 0.5 1 1.5 2

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Importance of MM Propositions

But were Modigliani & Miller seriously arguing that capital

structure does not matter?

No! Many of the assumptions are questionable approximations to the real

world

Firms and shareholders pay taxes

Firms and shareholders face bankruptcy costs (or, more generally, costs of
financial distress)
....

Trade-off theory relaxes the assumptions of “no taxes” and “no costs of
financial distress”

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Capital Structure and Taxes

Under the U.S. corporate tax code there is an important difference in the
way in which interest and dividends are treated

Historically, interest is regarded as a cost of doing business and as a result

is tax deductible

By contrast, dividends are treated as a return to the firm’s owners and are
therefore not tax deductible

Bias towards debt finance!

Holding before-tax cash flows fixed, debt finance reduces a firm’s taxable
income, resulting in higher after-tax cash flows

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Another Way To Think About This
P V of

VU VU VL T ax Shields
without taxes af ter taxes af ter taxes
paid paid

The first pizza is the value of an unlevered firm (i.e., debt=0) that pays
no corporate taxes
The second pizza is the value of an unlevered firm (i.e., debt=0) that pays
corporate taxes
The third pizza is the value of a levered firm (i.e., debt>0) that pays
corporate taxes
Issuing debt allows a firm to reduce its taxable income and, thereby, its tax
payments
The firm’s value increases by PV of the tax shields (=savings)
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Modified Modigliani Miller (MM) Proposition # 1
Imperfect Capital Markets

The market value of a levered firm (i.e., debt>0) equals the market value
of an unlevered (i.e., debt=0) firm plus the value of interest tax savings

VL = VU + P V of T ax Shields

,→ Financial leverage can increase firm value!

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Costs of Financial Distress
Bankruptcy is typically not the main problem
Bankruptcy is a division of the cash flows
Nevertheless .... dividing-up results in “deadweight costs”: costs that a
non-levered firm would not face if in the same business situation

Direct bankruptcy costs (e.g., legal fees)

Indirect bankruptcy costs
Firms may have to sell assets in fire sales
Firms may lose flexibility if they must continually obtain permission from
the bankruptcy court for any important decision
Debtholders may try to steer the firm towards investing in relatively safe
but possibly less profitable projects
Firms may lose customers who think the firm might go out of business
Suppliers may be reluctant to continue supplies and less willing to grant
trade credit
...

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Modified Modigliani Miller (MM) Proposition # 1
Imperfect Capital Markets

The market value of a levered firm (i.e., debt> 0) equals the market value
of an unlevered (i.e., debt=0) firm plus the value of interest tax savings
minus the costs of financial distress

VL = VU + P V of T ax Shields − Costs of F inancial Distress

,→ Financial leverage can decrease firm value!

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Capital Structure and Trade-off Theory

Optimal capital structure trades-off tax benefits of debt against costs of

financial distress

Starting out from a situation where the firm is unlevered, a small increase
in leverage has benefits (tax shields) but virtually no costs as the
probability of financial distress remains negligible

As leverage increases beyond the point where financial distress is

negligible, the probability of financial distress, and thus the expected costs
associated with it, becomes more and more important

At some point, the expected costs of financial distress become so large that
the firm value decreases if leverage is increased any further. At this point,
the firm has reached its optimal capital structure.

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Valuation and Capital Budgeting with Leverage

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Motivation

Debt finance can affect the value of a firm!

i. Debt finance reduces the firm’s tax bill

ii. Debt finance increases the likelihood of bankruptcy and therefore the
expected costs of financial distress
Difficult to measure and commonly left out in valuation exercises

To incorporate debt tax benefits into valuation

Apply Weighted Average Cost of Capital (WACC) method

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Market Value of Unlevered Firm

The market value of an unlevered firm (i.e., debt=0)

T
X F CFt
VU = t
t=0 (1 + E [r̃E ])

The unlevered firm’s cash flows

F CF = EBIT × (1 − τ ) + Depreciation − CAP EX − ∆N W C

| {z }
N OP AT
= EBIT − EBIT × τ + Depreciation − CAP EX − ∆N W C
| {z }
T axes

NOPAT ignores interest expense

⇒ Taxes in FCF are too large if a firm is levered (i.e., debt> 0)

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Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) method incorporates tax

benefits of debt by discounting the unlevered cash flows at a lower rate

E [r̃W ACC ]

The market value of a levered firm (i.e., debt> 0)

T
X F CFt
VL = t,
t=0 (1 + E [r̃W ACC ])

where the weighted average cost of capital

E D
E [r̃W ACC ] = E [r̃E ] + E [r̃D ] (1 − τ )
E+D E+D

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Weighted Average Cost of Capital (WACC)

E D
E [r̃W ACC ] = E [r̃E ] + E [r̃D ] (1 − τ )
E+D E+D

The tax benefit of debt is included in E [r̃W ACC ], which is based on the
firm’s after-tax cost of debt E [r̃D ] (1 − τ )
E [r̃D ] (1 − τ ) is the firm’s “effective” cost of debt
For every dollar in interest the firm pays it receives a tax deduction of τ
dollars

By contrast, E [r̃A ] is based on the firm’s before-tax cost of debt E [r̃D ]

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