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Capital Structure: The Trade-Off Theory

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What Is the Trade-Off?

Debt has costs and benefits relative to equity.

The optimal target capital structure is determined by balancing:


Tax Shield of Debt
Expected Costs of Financial Distress

In practice, the trade-off theory does not specify a precise target but
rather a range, an order of magnitude.

The range may change over time, in response to changes in the firms
operating performance.

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What Is the Tax Shield of Debt?

Dividends and retained earnings are taxable.

Debt increases firm value by reducing the corporate tax bill because
interest payments are tax deductible.

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How Does the Pie Grow?

Unlevered Firm Levered Firm

Debt 0 Interest Expense


Equity (1 ) EBIT (1 ) (EBITInterest Expense)

Total (1 ) EBIT (1 ) EBIT + Interest Expense

Levered Firm Value = Unlevered Firm Value + Tax Shield

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Measuring the Tax Shield
For illustrative purposes, assume that:
the tax rate is constant through time

the debt D is perpetual

the debt is riskless

Then,
the interest expense per year is rf D
rf D
the present value of the tax shield over all years is rf = D

Remember that
1 1 1
the infinite sum 1+r + (1+r )2
+ (1+r )3
+ = 1r .
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A Debt-Financed Stock Repurchase Grows Size of the Pie

In 2000, Microsoft had sales of $23 billion, earnings before taxes of $14.3
billion and net income of $9.4 billion. Microsoft paid $4.9 billion in taxes,
had a market value of $423 billion, and had no long-term debt outstanding.

Bill Gates was thinking about a recapitalization, issuing $50 billion in


long-term debt (at interest of 7%) and repurchasing $50 billion in stock.
How would this transaction affect Microsofts after-tax cash flows to all
claim holders?

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Countervailing Effects

Taking into account personal taxes tends to reduce but not offset the
tax shield.

Tax credits (e.g. tax loss carry-forward) reduce the tax shield.

Beware of non-tax paying firms.

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Just To Make Sure Things Are Clear...

Debt creates value relative to raising the same amount in equity.

Firm value can be increased by the tax shield with:


a recapitalization
an investment financed with debt rather than equity

However, you cant create value by borrowing and putting the cash in
a bank account.

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There is a Tax Cost of Excess Cash

Excess Cash:
It is the part of cash that is not useful in running operations.
It is hopefully invested in financial assets.
It is like negative debt for the company: Net Debt = Debt Cash

It comes with a negative tax shield!

In practice, it is sometimes hard to pin down exactly how much cash


is excess cash.

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Excess Cash Shrinks the Size of the Pie

An unlevered firm holds $100 million in excess cash in a bank account


earning 10% interest. The firm distributes the interest income to
shareholders after paying taxes at a 35% rate.

Calculate the annual interest income received by shareholders (before


personal taxes) under two scenarios:
1 Status quo.

2 The firm distribute the excess cash to shareholders, and the


shareholders themselves invest the cash the bank.

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Expected Cost of Financial Distress

There are two important terms:


(Probability of Distress) (Costs if actually in distress)

Probability of Distress has to do with risk


Technology risk
Firm risk (e.g., large fixed costs)
Industry risk (e.g., competitors)
Macroeconomic risk
Etc.

The Costs of Distress include any deadweight loss of firm value...

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Direct Bankruptcy Cost

What are they?


Legal expenses, court costs, advisory fees, etc.

Opportunity costs, e.g., time spent by dealing with creditors

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Indirect Financial Distress Costs

What are they?


Agency Cost on Investment:
Debt Overhang: Pass up positive NPV projects because shareholders
dont benefit
Asset Substitution (Risk Shifting): Undertake negative NPV projects
because shareholders benefit

Competitors: More aggressive

Customers, suppliers, employees: Scared off

Management: Incompetent handling of distress

Asset: Fire Sales

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How Big Are the Costs of Financial Distress?

Direct Costs represent about 3-5% of firm value at distress time


(Weiss, 1990).

Indirect Costs represent about 10-23% of firm value at distress time


(Andrade and Kaplan, 1998).
When weighted by the probability of bankruptcy, the expected indirect
costs can be significant. E.g., 4.5% of pre-distress firm value with
BBB-rated debt (Almeida and Philippon, 2007).

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An Investment Decision Example

Investment of $15m today

Safe return of $22m next year

Discount next years return with a discount rate of 10%


22
NPV= 15 + 1.1 = 5m
The firm should undertake the project.

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What if Assets-in-Place Are Risky?

State Probability Assets-in-Place (next years value)


Good 0.5 100
Bad 0.5 10

The firm has an existing debt face value of $35m to repay next year.

Will shareholders want to pay (from cash) the $15m today to fund the
project?

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Debt Overhang

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Another Investment Decision Example

The new investment is $21m today

The investment return is risky: $54m or -10$m with equal probability


next year

The assets in place are the same as before: $100m or $10m with
equal probability next year, so either $100m and $54m will realize or
$10m and -$10m.

NPV= 21 + 0.554+0.5(10)
1.1 = 1m
The firm should not undertake the project.

The firm still has the existing debt face value of $35m to repay next
year.

Will shareholders want to pay the $21m to fund the project?


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Asset Substitution

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Trade-Off Theory Take-Aways

Companies with low expected distress costs (e.g., gas and


electricity) should load up on debt to take advantage of the tax shield.

Companies with high expected distress costs (e.g., computer


software) should be more conservative.

Companies which expect to have valuable investment opportunities in


the future should avoid too much debt.

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