The Capital Structure

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Chapter 15
The Capital Structure Decision

Mila Getmansky Sherman
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Topics Covered

• Debt and Value in a Tax Free Economy
• Capital Structure and Corporate Taxes
• Cost of Financial Distress
• Explaining Financial Choices

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Value and Capital Structure
Assets
Liabilities and Stockholders Equity
Value of cash flows from firms real assets and
operations
Market value of debt Market value of equity
Value of Firm
Value of Firm
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Average Book Debt Ratios
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MM (Debt Policy Doesnt Matter)

• Modigliani Miller
• When there are no taxes and capital markets
  function well, it makes no difference whether the
  firm borrows or individual shareholders borrow.
  Therefore, the market value of a company does not
  depend on its capital structure.

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MM Assumptions

• By issuing 1 security rather than 2, company
  diminishes investor choice. This does not reduce
  value if
• Investors do not need choice
• There are sufficient alternative securities
• Investors can borrow and lend on the same terms
  as the firm
• Capital structure does not affect cash flows
  e.g...
• No taxes
• No bankruptcy costs
• No effect on management incentives

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MM (Debt Policy Doesnt Matter)
Example - River Cruises - All Equity Financed
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MM (Debt Policy Doesnt Matter)
Example cont. 50 debt (i10)
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MM (Debt Policy Doesnt Matter)
Example - River Cruises - All Equity
Financed - Debt replicated by investors
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MM (Debt Policy Doesnt Matter)
Example - River Cruises Re-Structured -
Debt is undone by investors
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Risk and Return

• Operating Risk (business risk) Risk in firms
  operating income
• Financial Risk Risk to shareholders resulting
  from the use of debt
• Debt finance does not affect the operating risk,
  but it does add financial risk.

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Cost of Capital
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Weighted Average Cost of Capital
r
rE
rA
rD
D V
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Weighted Average Cost of Capitalwithout taxes
(MM view)
Includes Bankruptcy Risk
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Capital Structure
D x rD x Tc rD
D x Tc

• PV of Tax Shield
• (assume perpetuity)

Example Tax benefit 1000 x (.10) x (.40)
40 PV of 40 perpetuity 40 / .10
400 PV Tax Shield D x Tc 1000 x .4 400
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Capital Structure

• Firm Value
• Value of All Equity Firm PV Tax Shield

Example All Equity Value 6,000
PV Tax Shield 400 Firm Value with 1/2 Debt
6,400
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Weighted Average Cost of Capital
r
rE
Rises more slowly Than in the no-tax case
WACC
rD
D V
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C.S. Corporate Taxes

• Financial Risk - Risk to shareholders resulting
  from the use of debt.
• Financial Leverage - Increase in the variability
  of shareholder returns that comes from the use of
  debt.
• Interest Tax Shield- Tax savings resulting from
  deductibility of interest payments.

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C.S. Corporate Taxes

• Example - You own all the equity of Space Babies
  Diaper Co.. The company has no debt. The
  companys annual cash flow is 1,000, before
  interest and taxes. The corporate tax rate is
  40. You have the option to exchange 1/2 of
  your equity position for 10 bonds with a face
  value of 1,000.
• Should you do this and why?

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C.S. Corporate Taxes
All Equity 1/2 Debt EBIT 1,000 Inter
est Pmt 0 Pretax Income 1,000
Taxes _at_ 40 400 Net Cash Flow 600
All Equity 1/2 Debt EBIT 1,000 1,000
Interest Pmt 0 100 Pretax
Income 1,000 900 Taxes _at_ 40 400 360 Net
Cash Flow 600 540
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C.S. Corporate Taxes

• Calculate Total Cash Flow In Both Cases
• 100 equity 600
• 50 equity 50 debt 540100640

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Financial Distress

• Costs of Financial Distress - Costs arising from
  bankruptcy or distorted business decisions before
  bankruptcy.

• Market Value Value if all Equity Financed
• PV Tax Shield
• - PV Costs of Financial Distress

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Financial Distress
Maximum value of firm
Costs of financial distress
PV of interest tax shields
Market Value of The Firm
Value of levered firm
Value of unlevered firm
Optimal amount of debt
Debt