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Principles
of
Corporate
Finance
Chapter 15
How Much Should
A Firm Borrow?
Concise Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
15-2
Topics Covered
Corporate Taxes
Corporate and Personal Taxes
Cost of Financial Distress
Pecking Order of Financial Choices
15-3
Capital Structure & 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.
15-4
Capital Structure & Corporate Taxes
28
 $350
.08
Interest payment  return on debt X amount borrowed
PV (tax shield) 
 rD  D
rcorporate tax rate X interest payment
expected return on debt
T (r  D)
 C D
 TC  D
rD
PV (tax shield) 
15-5
Capital Structure & Corporate Taxes
The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.
Income
Statement of
Firm U
Earnings before interest and taxes
Interest paid to bondholders
Pretax income
Tax at 35%
Net income to stockholders
Total income to both bondholders and
stockholders
Interest tax shield (.35 x interest)
$1,000
1,000
350
650
$0+650=$650
$0
Income
Statement of
Firm L
$1,000
80
920
322
598
$80+598=$678
$28
15-6
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies
Diaper Co. The company has no debt. The
company’s annual cash flow is $900,000 before
interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your
equity position for 5% bonds with a face value of
$2,000,000.
Should you do this and why?
15-7
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company
has no debt. The company’s annual cash flow is $900,000 before interest
and taxes. The corporate tax rate is 35% You have the option to exchange
1/2 of your equity position for 5% bonds with a face value of $2,000,000.
Should you do this and why?
($ 1,000 s)
EBIT
Interest Pmt
Pretax Income
Taxes @ 35%
Net Cash Flow
All Equity
900
0
900
315
585
1/2 Debt
900
100
800
280
520
Total Cash Flow
All Equity = 585
*1/2 Debt = 620
(520 + 100)
15-8
Capital Structure & Corporate Taxes
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
= D x Tc
rD
Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
PV Tax Shield = $2,000,000 x .35 = $700,000
15-9
Capital Structure & Corporate Taxes
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield =
700,000
Firm Value with 1/2 Debt = $12,400,000
15-10
Capital Structure & Corporate Taxes
Merck Balance Sheet, December 2005
(figures in $millions)
Long-term assets
Total assets
Book values
7,746
5,126
8,500
23,796
17,916
31,542
31,542
Long-term debt
Other long-term liabilities
Equity
Total value
Net working capital
PV interest tax shield
Long-term assests
Total assets
Market values
7,746
5,126
1,974
8,500
73,315
69,409
83,035
83,035
Long-term debt
Other long-term liabilities
Equity
Total value
Net working capital
15-11
Capital Structure & Corporate Taxes
Merck Balance Sheet, December 2005 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)
Long-term assets
Total assets
Book values
7,746
5,126
8,500
23,796
17,916
31,542
31,542
Long-term debt
Other long-term liabilities
Equity
Total value
Net working capital
PV interest tax shield
Long-term assests
Total assets
Market values
7,746
6,126
1,974
8,500
73,315
68,759
83,035
83,035
Long-term debt
Other long-term liabilities
Equity
Total value
Net working capital
15-12
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-Tp
(1-TpE) (1-Tc)
RAF > 1
Advantage
Debt
RAF < 1
Equity
15-13
C.S. & Taxes (Personal & Corp)
Operating Income ($1.00)
Or paid out as
equity income
Paid out as
interest
Corporate Tax
None
Tc
Income after
Corp Taxes
$1.00
$1.00 – Tc
Personal Taxes
.
Tp
TpE (1.00-Tc)
Income after All
Taxes
$1.00 – Tp
$1.00–Tc-TpE (1.00-Tc)
=(1.00-TpE)(1.00-Tc)
To bondholders
To stockholders
15-14
C.S. & Taxes (Personal & Corp)
Example
Income before tax
Less corporate tax at Tc =.35
Income after corpotare tax
Personal tax at Tp = .35 and TpE = .125
Income after all taxes
Interest
Equity Income
$1
0
1
0.35
$0.650
$1
0.35
0.65
0.081
$0.569
Advantage to debt= $ .081
15-15
C.S. & Taxes (Personal & Corp)
Another Example
Income before tax
Less corporate tax at Tc =.35
Income after corpotare tax
Personal tax at Tp = .35 and Tpe = .105
Income after all taxes
Interest
$1
0
1
0.35
$0.675
Equity Income
$1
0.35
0.65
0.068
$0.582
Advantage to debt= $ .068
15-16
C.S. & Taxes (Personal & Corp)
Today’s RAF & Debt vs Equity preference.
1-.33
RAF =
(1-.16) (1-.35)
= 1.23
Why are companies not all debt?
15-17
Capital Structure
Structure of Bond Yield Rates
r
Bond
Yield
D
E
15-18
WACC w/o taxes (traditional view)
r
Includes Bankruptcy Risk
rE
WACC
rD
D
V
15-19
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
15-20
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
15-21
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of financial
distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
15-22
Default Payoff Scenarios
15-23
Ace Limited Example
Total payoff to Ace Limited security holders. There is a $200
bankruptcy cost in the event of default (shaded area).
15-24
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Book Values)
Net W.C.
20
50
Bonds outstanding
Fixed assets
80
50
Common stock
Total assets
100
100
Total liabilities
15-25
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Market Values)
Net W.C.
20
25
Bonds outstanding
Fixed assets
10
5
Common stock
Total assets
30
30
Total liabilities
 Why does the equity have any value ?
 Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.
15-26
Conflicts of Interest
Circular File Company has may invest $10 as
follows.
Now
Possible Payoffs Next Year
$120 (10% probabilit y)
Invest $10
$0 (90% probabilit y)
 Assume the NPV of the project is (-$2).
What is the effect on the market values?
15-27
Conflicts of Interest
Circular File Company value (post project)
Circular File Company (Market Values)
Net W.C.
10
20
Bonds outstanding
Fixed assets
18
8
Common stock
Total assets
28
28
Total liabilities
 Firm value falls by $2, but equity holder gains $3
15-28
Conflicts of Interest
Circular File Company value (assumes a safe
project with NPV = $5)
Circular File Company (Market Values)
Net W.C.
20
33
Bonds outstanding
Fixed assets
25
12
Common stock
Total assets
45
45
Total liabilities
 While firm value rises, the lack of a high potential payoff
for shareholders causes a decrease in equity value.
15-29
Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch
15-30
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.
15-31
Trade Off Theory & Prices
1. Stock-for-debt
Stock price
exchange offers
falls
Debt-for-stock
Stock price
exchange offers
rises
2. Issuing common stock drives down stock prices;
repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
15-32
Issues and Stock Prices
 Why do security issues affect stock price?
The demand for a firm’s securities ought to
be flat.
 Any firm is a drop in the bucket.
 Plenty of close substitutes.
 Large debt issues don’t significantly depress
the stock price.
15-33
Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.
Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.
If external finance is required, firms issue debt first andequity as a
last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.
15-34
Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).