Topic 6 Debt Policyv2

CORPORATE FINANCE: THEORY & PRACTICE
DEBT POLICY
& CAPITAL STRUCTURE
Prof. Marta Degl’Innocenti
LEARNING OBJECTIVES
• Identify the types of debts.
• Explain the composition of firms’ capital structure.
• Briefly explain MM’s irrelevance propositions and
apply the proposition in explaining firms’ value
before/after restructuring.
• Explain how firms’ value can be affected in
financial distress.
• List the costs of bankruptcy.
• Discuss the main argument of trade-off and
pecking order theory.
DEBTS COME IN MANY FORMS
• Interest rate
• Coupon bond / zero coupon bond.
• Fix / Floating-rate loan.
• Income bond: Interest payments on such bonds
may be skipped or deferred if the firm’s income is
insufficient to make the payment.
• Seniority
• Senior debt / subordinated debt.
1
DOES BORROWING AFFECT
FIRM VALUE?
• The company’s choice of capital structure does NOT
increase the underlying value of the firm.
• Modigliani and Miller (1958): MM proposition.
• Modigliani and Miller argued that with perfect

capital markets, the total value of a firm should
not depend on its capital structure.
2
MM’S IRRELEVANCE PROPOSITION
Example:
Assuming a company has no debt and all its operating income
is distributed to the shareholders as dividends. The current
stock price is $10, the operating income is $125,000.
Before After
Restructuring Restructuring
Number of Shares 100,000 shares
Price per share $10
Market value of
$1 million
shares
Market value of
0
debt
3
Example:
Before After
Restructuring Restructuring
Number of Shares 100,000 shares 50,000 shares
Price per share $10 $10
Market value of
$1 million $0.5 million
shares
Market value of
0 $0.5 million
debt
4
Example:
$75,000
The changes of
expected operating $125,000 $125,000
income:
$175,000
5
• Before restructuring:
6
Investors in levered equity will require a
higher expected return to compensate for
• After restructuring: the increased risk.
7
• Borrowing increases earning per share.
8
Financing a Firm with Debt and Equity)
• Because the cash flows of levered equity are smaller than

those of unlevered equity, levered equity will sell for a
lower price ($500.000 versus $1,000,000).
– However, you are not worse off.
– You will still raise a total of $1,000,000 by issuing
both debt and levered equity.
– Consequently, you would be indifferent between these
two choices for the firm’s capital structure.
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The Effect of Leverage on Risk and
Return
• Leverage increases the risk of the equity of a firm.
– Therefore, it is inappropriate to discount the cash flows
of levered equity at the same discount rate of 12.5%
that you used for unlevered equity.
– Investors in levered equity will require a higher
expected return to compensate for the increased risk
(15%).
– The relationship between risk and return can be
evaluated more formally by computing the sensitivity of
each security’s return to the systematic risk of the
economy.

Restructuring & Cost of Capital
• Restructuring does NOT change the cost of capital.
Before Restructuring After Restructuring
Expected
12.5% 15%
equity return
Debt interests 10% 10%
Market value of
$1 million $0.5 million
shares
Market value of
0 $0.5 million
debt
WACC
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The Effect of Leverage on Risk and
Return
• In summary,
– In the case of perfect capital markets, if the firm is
100% equity financed, the equity holders will require a
12.5% expected return.
– If the firm is financed 50% with debt and 50% with
equity, the debt holders will receive a return of 10%,
while the levered equity holders will require an
expected return of 15% (because of their increased
risk).
– Considering both the sources of capital together, the
average cost of capital for the firm will be equal to
12.5% as in the case of unlevered firm (10%+15%)/2.
Homemade Leverage
• Homemade Leverage
– When investors use leverage in their own portfolios to
adjust the leverage choice made by the firm
• MM demonstrated that if investors would prefer an
alternative capital structure to the one the firm has chosen,
investors can borrow or lend on their own and achieve the
same result.
• Firm’s value is not affected by the choice of capital
structure.

CAN RESTRUCTURING
INCREASE FIRM VALUE?
• Assuming the firm does NOT want to conduct restructuring,
but the investor wants to do that, how individual investors
can replicate firm’s borrowing by borrowing by their own?
• The investor can put up $10 of her own money and borrow
$10 from the bank to purchase 2 shares. (Investing $10 in
total)
9
CAN RESTRUCTURING
INCREASE FIRM VALUE?
• Assuming the firm conducted restructuring, but the investor
does NOT like that, how individual investors can undo firm’s
leverage by lending their money to the firm?
• The investor can buy 1 share for $10 from the restructured firm
and invest $10 in firm’s debt. (Investing $20 in total)
10
IMPLICATION OF MM’S PROPOSITION I
• Leverage increase the equity risk and equity required
return.
12
MM’S PROPOSITION I
• MM’s proposition I (MM debt-irrelevance proposition)
• The value of the firm must be unaffected by its
capital structure.
• Key assumptions:
• Same borrowing rate.
• No transaction cost.
• No Tax
• Restructuring and risk & return
• Firm’s borrowing does NOT changes its operating
income.
• However, debt finance adds financial risk. With
only half the equity to absorb the same amount of
operating risk, risk per share must double.
11
Modigliani−Miller I: Leverage, Arbitrage,
and Firm Value
• Leverage will not affect the total value of the firm.
– Instead, it merely changes the allocation of cash flows
between debt and equity, without altering the total cash
flows of the firm.

14.2 Modigliani−Miller I: Leverage,
Arbitrage, and Firm Value
• Modigliani and Miller (MM) showed that this result holds
more generally under a set of conditions referred to as
perfect capital markets:
– Investors and firms can trade the same set of securities
at competitive market prices equal to the present value
of their future cash flows.
– There are no taxes, transaction costs, or issuance
costs associated with security trading.
– A firm’s financing decisions do not change the cash
flows generated by its investments, nor do they reveal
new information about them.

Modigliani−Miller I: Leverage, Arbitrage,
and Firm Value
• MM Proposition I
– In a perfect capital market, the total value of a firm is
equal to the market value of the total cash flows
generated by its assets and is not affected by its choice
of capital structure.
• MM established their result with the following argument:
– In the absence of taxes or other transaction costs, the
total cash flow paid out to all of a firm’s security holders
is equal to the total cash flow generated by the firm’s
assets.

Modigliani−Miller II: Leverage, Risk, and
the Cost of Capital
• Leverage and the Equity Cost of Capital
– MM Proposition I states that
E + D = U = A.
– The total market value of the firm’s securities is equal
to the market value of its assets, whether the firm is
unlevered or levered.

the Cost of Capital
– The return on unlevered equity (RU) is related to the
returns of levered equity (RE) and debt (RD):
E D
RE + RD = RU
E+D E+D

the Cost of Capital (6 of 9)
– Solving for RE:
D
RE = RU + ( RU − RD )
Risk without
E
leverage Additional risk
due to leverage
▪ The levered equity return equals the unlevered

return, plus a premium due to leverage.
– The amount of the premium depends on the
amount of leverage, measured by the firm’s
market value debt−equity ratio, D .
E
the Cost of Capital (7 of 9)
– MM Proposition II:
▪ The cost of capital of levered equity is equal to the
cost of capital of unlevered equity plus a premium
that is proportional to the market value debt−equity
ratio
▪ Cost of Capital of Levered Equity
D
rE = rU + (rU − rD )
E

MM’S PROPOSITION II
• Restructuring does NOT change the cost of capital.
• Thus, the cost of capital should be same after
restructuring.
• MM’s proposition II
D E
rcapital =  rdebt +  requity
V V
D
 requity = rcapital +  ( rcapital − rdebt )
E
• The expected rate of return on the common stock of a
levered firm increases in proportion to the debt-equity
ratio (D/E). Because the risk to equity holders increases
with leverage
14
14.1 WACC and Leverage with Perfect
Capital Markets No taxes: RWACC=RU
(a) Equity, debt, and weighted

average costs of capital for
different amounts of leverage.
The rate of increase of rD and
rE, and thus the shape of the
curves, depends on the
characteristics of the firm’s
cash flows.tt
(b) Calculating the WACC for
alternative capital structures.
As debt increases= more
change that the firm will
default: so rD increases as well
Capital Budgeting and the Weighted
Average Cost of Capital
• With no debt, the WACC is equal to the unlevered equity
cost of capital.
• As the firm borrows at the low cost of capital for debt, its
equity cost of capital rises. The net effect is that the firm’s
WACC is unchanged.

Textbook Example 14.5 (1 of 3)
Reducing Leverage and the Cost of Capital
Problem
– NRG Energy, Inc. (NRG) is an energy company with a
market debt-equity ratio of 2. Suppose its current debt cost
of capital is 6%, and its equity cost of capital is 12%.
Suppose also that if NRG issues equity and uses the
proceeds to repay its junior debt and reduce its debt-equity
ratio to 1, it will lower its debt cost of capital to 5.5%. With
perfect capital markets, what effect will this transaction have
on NRG’s equity cost of capital and WACC? What would
happen if NRG issues even more equity and pays off its
debt completely? How would these alternative capital
structures affect NRG’s enterprise value?

Solution
• We can calculate NRG’s initial WACC and unlevered cost
of capital using Eqs. 14.6 and 14.7:
E D 1 2
rWACC = rU = rE + rD = (12%) + (6%) = 8%
E+D E+D 1+ 2 1+ 2
• Given NRG’s unlevered cost of capital of 8%, we can use

Eq. 14.5 to calculate NRG’s equity cost of capital after the
reduction in leverage:
D 1
rE = rU + (rU − rD ) = 8% + (8% − 5.5%) = 10.5%
E 1

• The reduction in leverage will cause N G R’s equity cost of
capital to fall to 10.5%. Note though, that with perfect capital
markets, N G R’s WACC remain unchanged at
D 1 1
rE = rU + (rU − rD ) = 8% = (10.5% ) + (5.5%),
E 2 2
and there is no net gain from this transaction.
– If NRG pays off its debt completely, it will be unlevered.
Thus, its equity cost of capital will equal its WACC and
unlevered cost of capital of 8%.
– In either scenario, NRG’s WACC and free cash flows remain
unchanged. Thus, with perfect capital markets, its enterprise
value will not be affected by these different capital structure
choices.
Alternative Example 14.5 (1 of 4)
Problem
– Honeywell International Inc. (HON) has a market
debt−equity ratio of 0.5.
– Assume its current debt cost of capital is 6.5%, and its
equity cost of capital is 14%.
– If HON issues equity and uses the proceeds to repay
its debt and reduce its debt−equity ratio to 0.4, it will
lower its debt cost of capital to 5.75%.

Problem
– With perfect capital markets, what effect will this
transaction have on HON’s equity cost of capital and
WACC?

Solution
– Current WACC
E D 2 1
rwacc = rE + rD = 14% + 6.5% = 11.5%
E+D E+D 2 +1 2 +1
– New Cost of Equity

D
rE = rU + (rU − rD ) = 11.5% + 0.4(11.5% − 5.75%) = 13.8%
E

Solution
– New WACC
1 0.4
rNEWwacc = 13.8% + 5.75% = 11.5%
1 + 0.4 1 + 0.4
– The cost of equity capital falls from 14% to 13.8%,

while the WACC is unchanged.

Levered and Unlevered Betas
• The effect of leverage on the risk of a firm’s securities can
also be expressed in terms of beta:
E D
βU = βE + βD
E+D E+D
• Unlevered beta meaures the market risk of the firm’s

underlying assets.
D
βE = βU + ( βU − βD )
E
• Leverage amplifies the market risk of a firm’s assets, βU,

raising the market risk of its equity

MM WITH TAXES
• Debt financing advantage: the interest that a firm
pays on debt is tax deductible.
• Interest tax shield: Tax savings resulting from
deductibility of interest payments.
Interest tax shield =Tc  ( rdebt  D )
• Assuming interest tax shield is perpetual, its PV will be:
Tc  (rdebt  D)
=Tc D
rdebt
15
The Interest Tax Shield and Firm Value
• The cash flows a levered firm pays to investors will be

higher than they would be without leverage by the amount
of the interest tax shield
 Cash Flows to Investors   Cash Flows to Investors 

 =  + (Interest Tax Shield)
 with Leverage   without Leverage 

Figure 15.1 The Cash Flows of the
Unlevered and Levered Firm

The Interest Tax Shield and Firm Value
(2 of 2)
• MM Proposition I with Taxes

– The total value of the levered firm exceeds the
value of the firm without leverage due to the
present value of the tax savings from debt:
V L = V U + PV (Interest Tax Shield)

Valuing the Interest Tax Shield Without Risk
Problem
Suppose DFB restructures its existing debt, and will instead
pay $80 million in interest each year for the next 10 years,
and then repay the principal of $1.6 billion in year 10. These
payments are risk free, and DFB’s marginal tax rate will
remain 25% throughout this period. If the risk-free interest
rate is 5%, by how much does the interest tax shield
increase the value of DFB?

Solution
In this case, the interest tax shield is 25% × $80 million =
$20 million each year for the next 10 years. Therefore, we
can value it as a 10-year annuity. Because the tax savings
are known and not risky, we can discount them at the 5%
risk-free rate:
1  1 
PV (Interest Tax Shield) = $20 million  1 − 
0.05  1.0510 
= $154 million
The final repayment of principle in year 10 is not deductible,

so it does not contribute to the tax shield.
The Interest Tax Shield with Permanent
Debt
• If the debt is fairly priced, no arbitrage implies that its
market value must equal the present value of the future
interest payments:
Market Value of Debt = D = PV (Future Interest Payments)

The Interest Tax Shield with Permanent
Debt
• If the firm’s marginal tax rate is constant, then
PV (Interest Tax Shield) = PV (τ c  Future Interest Payments)

= τ c  PV (Future Interest Payments)
= τc  D

The Weighted Average Cost of Capital
with Taxes
• With tax-deductible interest, the effective after-tax
borrowing rate is r(1 − c) and the weighted average cost of
capital becomes
E D
rWacc = rE + rD (1 − c )
E+D E+D
E D D
rWacc = rE + rD − rD c
E+D E+D E+D
Pretax WACC Reduction Due
to Interest Tax Shield

Figure 15.2 The WACC with and Without
Corporate Taxes

MM WITH TAXES
• For an unlevered firm, its income after tax is:
EBIT(1 − Tc )
• Its PV is,
EBIT(1 − Tc )
VU =
rcapital
• Therefore, firm value under MM I with tax should be,
EBIT(1 − Tc )
VL = +Tc D = VU + Tc D
rcapital
• MM II is therefore,
D
requity = rcapital +  (1 − Tc )  ( rcapital − rdebt )
E 16
The Interest Tax Shield with a Target
Debt-Equity Ratio (1 of 2)
• When a firm adjusts its leverage to maintain a target debt-
equity ratio, we can compute its value with leverage, VL, by
discounting its free cash flow using the weighted average
cost of capital.

The Interest Tax Shield with a Target
Debt-Equity Ratio (2 of 2)
• The value of the interest tax shield can be found by
comparing the value of the levered firm, VL, to the
unlevered value, VU, of the free cash flow discounted at
the firm’s unlevered cost of capital, the pretax WACC.

Valuing the Interest Tax Shield with a Target Debt-Equity
Ratio
Problem
Western Lumber Company expects to have free cash flow in
the coming year of $4.25 million, and its free cash flow is
expected to grow at a rate of 4% per year thereafter.
Western Lumber has an equity cost of capital of 10% and a
debt cost of capital of 6%, and it pays a corporate tax rate of
21%. If Western Lumber maintains a debt-equity ratio of
0.50, what is the value of its interest tax shield?

Solution
We can estimate the value of western Lumber’s interest tax shield by
comparing its value with and without leverage. We compute its unlevered
value by discounting its free cash flow at its pretax WACC:
E D 1 0.5
Pre-tax WACC = rE + rD = 10% + 6% = 8.67%
E+D E+D 1 + 0.5 1 + 0.5
Because western Lumber’s free cash flow is expected to grow at a

constant rate, we can value it as a constant growth perpetuity:
4.25
Vu = = $91 million
8.67% − 4%
To compute western Lumber’s levered value, we calculate its WACC:

E D
WACC = rE + rD (1 − c )
E+D E+D
1 0.5
= 10% + 6%(1 − 0.21) = 8.25%
1.05 1 + 0.5
Thus, Western Lumber’s value including the interest tax

shield is
4.25
V =
L
= $100 million
8.25% − 4%
The value of the interest tax shield is therefore

PV (Interest Tax Shield) = V L + V U = 100 − 91 = $9 million

Optimal Capital Structure with Taxes (1
of 3)
• Do Firms Prefer Debt?

– When firms raise new capital from investors, they do so
primarily by issuing debt.
– In most years, aggregate equity issues are negative,
meaning that on average, firms are reducing the
amount of equity outstanding by buying shares.

Figure 15.5 Net External Financing and Capital
Expenditures by U.S. Corporations, 1975–2017
Source: Federal Reserve, Flow of Funds Accounts of the United

States, 2017.
of 3)

– While firms seem to prefer debt when raising external
funds, not all investment is externally funded.
– Most investment and growth is supported by internally
generated funds.
▪ Even though firms have not issued new equity, the
market value of equity has risen over time as firms
have grown.
▪ For the average firm, the result is that debt as a
fraction of firm value has varied in a range from 30%
to 45%.
Figure 15.6 Debt-to-Value Ratio
[D/(E + D)] of U.S. Firms, 1975–2017
Source: Compustat and Federal Reserve, Flow of Funds Accounts of

the United States, 2017.
of 3)

– The use of debt varies greatly by industry.
– Firms in growth industries like biotechnology or high
technology carry very little debt, while airlines,
automakers, utilities, and financial firms have high
leverage ratios.

Figure 15.7 Debt-to-Enterprise Value
Ratio for Select Industries (1 of 2)
Source: Capital IQ, 2018.

Figure 15.7 Debt-to-Enterprise Value
Ratio for Select Industries (2 of 2)
Source: Capital IQ, 2018.

Limits to the Tax Benefit of Debt
• To receive the full tax benefits of leverage, a firm need not
use 100% debt financing, but the firm does need to have
taxable earnings.

FINANCIAL DISTRESS AND
BANKRUPTCY
• Financial distress
• Costs of financial distress: costs arising from bankruptcy
or distorted business decisions before bankruptcy.
• Bankruptcy costs
• Direct costs, i.e. legal and administrative costs.
• Indirect costs.
• Firm value:
Firm value = Value all-equity financed + PV tax shield
−PV costs of financial distress
17
FINANCING CHOICES
• Trade-off Theory: Debt levels are chosen to balance
interest tax shields against the costs of financial
distress.
18
FINANCING CHOICES
• Pecking Order Theory
• Information asymmetry–managers know more than
outside investors about the profitability and prospects
of the firm.
• New issued stocks might be overpriced; Manager
would not issue new stocks if they are underpriced. So
whenever the firm issues new stocks, market should
respond negatively on their prices.
• Certain pecking order in terms of financing:
• Firms prefer internal finance (Retained earnings).
• Firms prefer to issue debt rather than equity if
internal finance is insufficient.
19
READING
• Corporate Finance (11th ed.), Chapter 16-18.
• Principles of Corporate Finance (12th ed.),
Chapter 17-18.
• Myers, S. C. and N. S., Majluf (1984) Corporate
financing and investment decisions when firms
have information that investors do not have,
Journal of Financial Economics, 13:187-221.

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CORPORATE FINANCE: THEORY & PRACTICE

• Modigliani and Miller (1958): MM proposition.

• Modigliani and Miller argued that with perfect

• Because the cash flows of levered equity are smaller than

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved. 13

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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▪ The levered equity return equals the unlevered

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(a) Equity, debt, and weighted

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Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

• Given NRG’s unlevered cost of capital of 8%, we can use

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– New Cost of Equity

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– The cost of equity capital falls from 14% to 13.8%,

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• Unlevered beta meaures the market risk of the firm’s

• Leverage amplifies the market risk of a firm’s assets, βU,

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• The cash flows a levered firm pays to investors will be

 Cash Flows to Investors   Cash Flows to Investors 

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• MM Proposition I with Taxes

V L = V U + PV (Interest Tax Shield)

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The final repayment of principle in year 10 is not deductible,

Market Value of Debt = D = PV (Future Interest Payments)

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PV (Interest Tax Shield) = PV (τ c  Future Interest Payments)

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Because western Lumber’s free cash flow is expected to grow at a

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Thus, Western Lumber’s value including the interest tax

The value of the interest tax shield is therefore

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• Do Firms Prefer Debt?

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Source: Federal Reserve, Flow of Funds Accounts of the United

• Do Firms Prefer Debt?

Source: Compustat and Federal Reserve, Flow of Funds Accounts of

• Do Firms Prefer Debt?

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Source: Capital IQ, 2018.

Source: Capital IQ, 2018.

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