Chapter 16

Capital Structure
Capital Structure Choices
When raising funds from outside investors, a
firm must choose what type of security to
issue and what capital structure to have.
Capital Structure Choices
Capital structure
The collection of securities a firm issues to raise
capital from investors.
Firms consider whether the securities issued:
Will receive a fair price in the market
Have tax consequences
Entail transactions costs
Change future investment opportunities
Capital Structure Choices
A firms debt-to-value ratio is the fraction of
the firms total value that corresponds to debt

D / (E+D)

Capital Structures of Amazon.com and
Barnes & Noble
Capital Structure in Perfect Capital Markets
A perfect capital market is a market in which:
Securities are fairly priced
No tax consequences or transactions costs
Investment cash flows are independent of
financing choices

Capital Structure in Perfect Capital Markets
Unlevered equity
equity in a firm with no debt
Levered equity
equity in a firm that has debt outstanding
Leverage will increase the risk of the firms
equity and raise its equity cost of capital
Capital Structure in Perfect Capital Markets
Modigliani and Miller (MM) with perfect capital
markets
In an unlevered firm, cash flows to equity equal the
free cash flows from the firms assets.
In a levered firm, the same cash flows are divided
between debt and equity holders.
The total to all investors equals the free cash flows
generated by the firms assets.

Unlevered Versus Levered Cash Flows with
Perfect Capital Markets
Capital Structure in Perfect Capital Markets
MM Proposition I:
In a perfect capital market, the total value of a firm
is equal to the market value of the free cash flows
generated by its assets and is not affected by its
choice of capital structure.
V
L
= E + D =V
U

Capital Structure in Perfect Capital Markets
Homemade leverage
Investors use leverage in their own portfolios to
adjust firms leverage
A perfect substitute for firm leverage in perfect
capital markets.
Capital Structure in Perfect Capital Markets
Leverage and the Cost of Capital
Weighted average cost of capital (pretax)
U D E
D E
r r r
D E D E
= +
+ +
Capital Structure in Perfect Capital Markets
MM Proposition II: The cost of capital of
levered equity:
The Cost of Levered Equity



Cost of levered equity equals the cost of unlevered
equity plus a premium proportional to the debt-
equity ratio.

r
E
= r
U
+
D
E
(r
U
r
D
)
WACC and Leverage with Perfect Capital
Markets
Debt and Taxes
Market imperfections can create a role for the
capital structure.
Corporate taxes:
Corporations can deduct interest expenses.
Reduces taxes paid
Increases amount available to pay investors.
Increases value of the corporation.
Debt and Taxes
Consider the impact of interest expenses on taxes paid by
Safeway, Inc.
In 2008, Safeway had earnings before interest and taxes of $1.85 billion
Interest expenses of $400 million
Corporate tax rate is 35%
Compare Safeways actual net income with what it would have been
without debt.
Safeways Income with and without Leverage,
2008 ($ millions)
Total amount available to all investors is:


Debt and Taxes
Interest Tax Shield
The gain to investors from the tax deductibility of
interest payments
Interest Tax Shield = Corporate Tax Rate Interest Payments

Debt and Taxes
When a firm uses debt, the interest tax shield provides a
corporate tax benefit each year.
To determine the benefit, compute the present value of the
stream of future interest tax shields.

Cash Flows to Investors
with Leverage
|
\

|
.
|
=
Cash Flows to Investors
without Leverage
|
\

|
.
|
+ (Interest Tax Shield)
The Cash Flows of the Unlevered and Levered
Firm
Debt and Taxes
By increasing the cash flows paid to debt
holders through interest payments, a firm
reduces the amount paid in taxes.
The increase in total cash flows paid to
investors is the interest tax shield.
Debt and Taxes
Value of the Interest Tax Shield
Cash flows of the levered firm are equal to the sum of the cash flows
from the unlevered firm plus the interest tax shield.
By the Valuation Principle the same must be true for the present values
of these cash flows.
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)


Debt and Taxes
Interest Tax Shield with Permanent Debt
The level of future interest payments varies due to:
changes in the amount of debt outstanding,
changes in the interest rate on that debt,
changes in the firms marginal tax rate, and
the risk that the firm may default and fail to make an
interest payment.
Debt and Taxes
Weighted Average Cost of Capital with Taxes
Another way to incorporate the benefit of the
firms future interest tax shield
Weighted Average Cost of Capital with Taxes
Debt and Taxes
The reduction in the WACC increases with the
amount of debt financing.
The higher the firms leverage, the more the
firm exploits the tax advantage of debt, and
the lower its WACC.
The WACC with and without Corporate Taxes
The Costs of Bankruptcy and Financial
Distress
If increasing debt increases the value of the
firm, why not shift to 100% debt?
With more debt, there is a greater chance that
the firm will default on its debt obligations.
A firm that has trouble meeting its debt
obligations is in financial distress.
The Costs of Bankruptcy and Financial
Distress
Direct Costs of Bankruptcy
Each country has a bankruptcy code designed to provide an orderly
process for settling a firms debts.
However, the process is still complex, time-consuming, and costly.
Outside professionals are generally hired.
The creditors may also incur costs during the process. They often
wait several years to receive payment.
Average direct costs are 3% to 4% of the pre-bankruptcy market
value of total assets.
Likely to be higher for firms with more complicated business
operations and for firms with larger numbers of creditors.


The Costs of Bankruptcy and Financial
Distress
Indirect Costs of Financial Distress
Difficult to measure accurately, and often much
larger than the direct costs of bankruptcy.
Often occur because the firm may renege on both
implicit and explicit commitments and contracts.
Estimated potential loss of 10% to 20% of value
Many indirect costs may be incurred even if the
firm is not yet in financial distress, but simply faces
a significant possibility that it may occur in the
future.
The Costs of Bankruptcy and Financial
Distress
Examples:
Loss of customers:
Customers may be unwilling to purchase products whose value
depends on future support or service from the firm.
Loss of suppliers:
Suppliers may be unwilling to provide a firm with inventory if they
fear they will not be paid
Cost to employees:
Most firms offer their employees explicit long-term employment
contracts.
During bankruptcy these contracts and commitments are often
ignored and employees can be laid off
Fire Sale of Assets:
Companies in distress may be forced to sell assets quickly.


Optimal Capital Structure: The Tradeoff
Theory
Tradeoff Theory:
Total value of a levered firm equals the value of
the firm without leverage plus the present value of
the tax savings from debt, less the present value of
financial distress costs:
(Interest Tax Shield)
(Financial Distress Costs)
L U
V V
PV
PV
=
+

Optimal Capital Structure: The Tradeoff

Theory
Key qualitative factors determine the present value of financial distress
costs:
The probability of financial distress
Depends on the likelihood that a firm will default.
Increases with the amount of a firms liabilities (relative to its
assets).
It increases with the volatility of a firms cash flows and asset
values.
The magnitude of the direct and indirect costs related to financial
distress that the firm will incur.
Depends on the relative importance of the sources of these costs
and likely to vary by industry.


Optimal Capital Structure:
The Tradeoff Theory
As debt increases, tax benefits of debt increase until interest
expense exceeds EBIT.
Probability of default, and hence present value of financial
distress costs, also increases.
The optimal level of debt, D*, occurs when the value of the
levered firm is maximized.
D* will be lower for firms with higher costs of financial
distress.

Optimal Leverage with Taxes and Financial
Distress Costs
Optimal Capital Structure: The Tradeoff
Theory
Tradeoff Theory:
firms should increase their leverage until it reaches
the maximizing level.
The tax savings that result from increasing leverage
are just offset by the increased probability of
incurring the costs of financial distress.
With higher costs of financial distress, it is optimal
for the firm to choose lower leverage.
Optimal Capital Structure: The Tradeoff
Theory
The Tradeoff Theory helps to resolve two
important facts about leverage:
The presence of financial distress costs can explain
why firms choose debt levels that are too low to
fully exploit the interest tax shield.
Differences in the magnitude of financial distress
costs and the volatility of cash flows can explain
the differences in the use of leverage across
industries.
Additional Consequences of Leverage: Agency Costs and
Information
Agency costs:
costs that arise when there are conflicts of interest
between stakeholders.
Managerial Entrenchment:
managers often own shares of the firm, but usually
own only a very small fraction of the outstanding
shares.
Shareholders have the power to fire managers.
In practice, they rarely do so.
Additional Consequences of Leverage: Agency Costs and
Information
Separation of ownership and control creates
the possibility of management entrenchment
Managers may make decisions that:
Benefit themselves at investors expense,
Reduce their effort,
Spend excessively on perks
Engage in empire building.
Additional Consequences of Leverage: Agency Costs and
Information
If these decisions have negative NPV for the
firm, they are a form of agency cost.
Debt provides incentives for managers to run the
firm efficiently:
Ownership may remain more concentrated, improving
monitoring of management.
Since interest and principle payments are required, debt
reduces the funds available at managements discretion
to use wastefully.
Additional Consequences of Leverage: Agency Costs and
Information
Equity-Debt Holder Conflicts
A conflict of interest exists if investment decisions
have different consequences for the value of
equity and the value of debt.
most likely to occur when the risk of financial distress is
high.
managers may take actions that benefit shareholders
but harm creditors and lower the total value of the firm.
Additional Consequences of Leverage: Agency Costs and
Information
Agency costs for a company in distress that will
likely default:
Excessive risk-taking
A risky project could save the firm even if the expected
outcome is so poor that it would normally be rejected.
Under-investment problem
Shareholders could decline new projects.
Management could distribute as much as possible to
the shareholders before the bondholders take over.
Optimal Leverage with Taxes, Financial Distress, and
Agency Costs
Additional Consequences of Leverage: Agency Costs and
Information
As debt increases, firm value increases
Interest tax shield (T
C
D)
Improvements in managerial incentives.
If leverage is too high, firm value is reduced by
present value of financial distress costs
agency costs
The optimal level of debt, D*, balances these
benefits and costs of leverage.

Additional Consequences of Leverage: Agency Costs and
Information
Asymmetric information
Managers information about the firm and its future cash flows is likely
to be superior to that of outside investors.
This may motivate managers to alter a firms capital structure.
Leverage as a Credible Signal
Managers use leverage to convince investors that the firm will grow,
even if they cannot provide verifiable details.
The use of leverage as a way to signal good information is known as the
signaling theory of debt.
Market Timing
Managers sell new shares when they believe the stock is overvalued,
and rely on debt and retained earnings if they believe the stock is
undervalued.

Additional Consequences of Leverage: Agency Costs and
Information
Adverse Selection and the Pecking Order Hypothesis
Suppose managers issue equity when it is overpriced.
Knowing this, investors will discount the price they are willing to pay
for the stock.
Managers do not want to sell equity at a discount so they may seek
other forms of financing.
The pecking order hypothesis states:
Managers have a preference to fund investment using retained
earnings, followed by debt, and will only choose to issue equity as a
last resort.


Capital Structure: Putting It
All Together
Use the interest tax shield if your firm has consistent taxable income
Balance tax benefits of debt against costs of financial distress
Consider short-term debt for external financing when agency costs are
significant.
Increase leverage to signal confidence in the firms ability to meet its debt
obligations.
Be mindful that investors are aware that you have an incentive to issue
securities that you know are overpriced
Rely first on retained earnings, then debt, and finally equity
Do not change the firms capital structure unless it departs significantly
from the optimal level.