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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,The McGraw-Hill Companies, Inc.,2001,15-,17,Irwin/McGraw-Hill,Irwin/McGraw-Hill,Chapter 15,Fundamentals of Corporate Finance,Third Edition,The Capital Structure Decision,Brealey Myers Marcus,slides by Matthew Will,Irwin/McGraw-Hill,The McGraw-Hill Companies, Inc.,2001,Topics Covered,Debt and Value in a Tax Free Economy,Capital Structure and Corporate Taxes,Cost of Financial Distress,Explaining Financial Choices,M&M,(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.,M&M,(Debt Policy Doesnt Matter),Assumptions,By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if:,Investors do not need choice, OR,There are sufficient alternative securities,Capital structure does not affect cash flows e.g.,No taxes,No bankruptcy costs,No effect on management incentives,Example,- River Cruises - All Equity Financed,M&M,(Debt Policy Doesnt Matter),Example,cont.,50% debt,M&M,(Debt Policy Doesnt Matter),Example,- River Cruises - All Equity Financed,- Debt replicated by investors,M&M,(Debt Policy Doesnt Matter),Weighted Average Cost of Capital,without taxes (traditional view),r,D,V,r,D,r,E,Includes Bankruptcy Risk,WACC,Weighted Average Cost of Capital,without taxes (M&M view),r,D,V,r,D,r,E,Includes Bankruptcy Risk,WACC,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.,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?,C.S. & Corporate Taxes,C.S. & Corporate Taxes,All Equity1/2 Debt,EBIT1,0001,000,Interest Pmt,0 100,Pretax Income1,000 900,Taxes 40%,400 360,Net Cash Flow,$600$540,Total Cash Flow,All Equity = 600,*1/2 Debt = 640,(540 + 100),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?,Capital Structure,PV of Tax Shield =,(assume perpetuity),D x r,D,x Tc,r,D,=,D x Tc,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,Capital Structure,Firm Value =,Value of All Equity Firm + PV Tax Shield,Example,All Equity Value = 600 / .10 = 6,000,PV Tax Shield = 400,Firm Value with 1/2 Debt = $6,400,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,Financial Distress,Debt,Market Value of The Firm,Value of,unlevered,firm,PV of interest,tax shields,Costs of,financial distress,Value of levered firm,Optimal amount,of debt,Maximum value of firm,Financial Choices,Trade-off Theory,- Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.,Pecking Order Theory,- Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.,
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