Capital Structure Terminology

1
Capital Structure Terminology

• Optimal capital structure
• Minimizes a firms weighted cost of capital
• Maximizes the value of the firm
• Target capital structure
• Capital structure at which the firm plans to
  operate
• Debt capacity
• Amount of debt in the firms optimal capital
  structure

2
No-tax MM
Market value of firm Market value of equity
Market value of debt
D Dividend I Interest
3
No-tax MM

• Firm U (The unlevered firm)
• EBIT 1000
• Then
• D 1000, Ke10

• Firm L (The levered firm)
• 2,000 in debt financing
• EBIT 1000
• I 100 D900
• Kd5 (Kdcoupon rate)
• Ke11.25

4
No-tax MM
Cost of Capital

Ke
Ka
Kd
Financial Leverage
0
The overall cost of capital is independent of the
capital structure. The firms value is
independent of the capital structure.
5
Modigliani and Miller (MM) with Corporate Income
Tax (With-tax MM)

• Now, relax the no-tax assumption assume the
  existence of corporate income taxes.
• Interest on debt is tax deductible tax benefit
  to use of debt.
• Tax savings are called Tax Shield
• Tax Shield i x B x T
• PV of Tax Shield (i x B x T) / i
• B x T

6
With-tax MM T 40

• Firm U
• EBIT 1000
• Then
• D 600

• Firm L
• EBIT 1000
• I 100
• D50040540
• Tax shield amount IBT 0.052,0000.40 40

7
With-tax MM

• Market value of the levered firm is greater than
  the market value of the unlevered firm.
• Market Value Market Value
  Present Value
• of of of
• Levered Firm Unlevered Firm
  Tax Shield
• 6000 2000 x 0.4
• 6000 800 6800

8
With-tax MM
Cost of Capital

Ke
Ka
Ki kd(1-T)
0
Financial leverage
The cost of capital decreases with the amount of
debt. The firm maximizes its value by choosing a
capital structure that is all debt.
9
What Happens With Taxes, Bankruptcy, and Agency
Costs ?

• Market value of leveraged firm
• Market value of unleveraged firm
• PV of tax shield
• PV of bankruptcy costs (Financial Distress
  Costs)
• PV of agency costs