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Book summery corporate financeChapter 14
Capital structures in a perfect market
14.1 equity Versus Debt Financing
The collection of securities a firm issues to raise capital from investors is called the firm’s capital
structure. Equity and debt are the securities most commonly used by firms. When equity is used
without debt, the firm is said to be unlevered. Otherwise, the amount of debt determines the firm’s
leverage.
The owner of a firm should choose the capital structure that maximizes the total value of the
securities issued.
14.2 Modigliani-Miller I: leverage, arbitrage, and Firm Value
Capital markets are said to be perfect if they satisfy three conditions:
1. Investors and firms can trade the same set of securities at competitive market prices equal to
the present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance costs associated with security trading.
3. A firm’s financing decisions do not change the cash flows generated by its investments, nor
do they reveal new information about them.
According to MM Proposition I, with perfect capital markets the value of a firm is independent of its
capital structure.
o With perfect capital markets, homemade leverage is a perfect substitute for firm leverage.
o If otherwise identical firms with different capital structures have different values, the Law of
One Price would be violated and an arbitrage opportunity would exist.
The market value balance sheet shows that the total market value of a firm’s assets equals the total
market value of the firm’s liabilities, including all securities issued to investors. Changing the capital
structure therefore alters how the value of the assets is divided across securities, but not the firm’s
total value.
A firm can change its capital structure at any time by issuing new securities and using the funds to pay
its existing investors. An example is a leveraged recapitalization in which the firm borrows money
(issues debt) and repurchases shares (or pays a dividend). MM Proposition I implies that such
transactions will not change the share price.
14.3 Modigliani-Miller II: leverage, risk, and the Cost of Capital
According to MM Proposition II, the cost of capital for levered equity is
D
r E=r U + (r −r ¿
E U D
Debt is less risky than equity, so it has a lower cost of capital. Leverage increases the risk of equity,
however, raising the equity cost of capital. The benefit of debt’s lower cost of capital is offset by the
higher equity cost of capital, leaving a firm’s weighted average cost of capital (WACC) unchanged with
perfect capital markets:
E D
r wacc =r A =r U = r + r
E+ D E E+ D D
The market risk of a firm’s assets can be estimated by its unlevered beta:
E D
βU= β E+ β
E+ D E+ D D
Leverage increases the beta of a firm’s equity:
, D
β E =β U + ( β −β D ¿
E U
A firm’s net debt is equal to its debt less its holdings of cash and other risk-free securities. We can
compute the cost of capital and the beta of the firm’s business assets, excluding cash, by using its net
debt when calculating its WACC or unlevered beta.
14.4 Capital Structure Fallacies
Leverage can raise a firm’s expected earnings per share and its return on equity, but it also increases
the volatility of earnings per share and the riskiness of its equity. As a result, in a perfect market
shareholders are not better off and the value of equity is unchanged.
As long as shares are sold to investors at a fair price, there is no cost of dilution associated with issuing
equity. While the number of shares increases when equity is issued, the firm’s assets also increase
because of the cash raised, and the per-share value of equity remains unchanged.
14.5 MM: beyond the Propositions
With perfect capital markets, financial transactions are a zero-NPV activity that neither add nor
destroy value on their own, but rather repackage the firm’s risk and return. Capital structure— and
financial transactions more generally—affect a firm’s value only because of its impact on some type of
market imperfection.
Chapter 15
Dept and taxes
15.1 The Interest Tax Deduction
Because interest expense is tax deductible, leverage increases the total amount of income avail- able
to all investors.
The gain to investors from the tax deductibility of interest payments is called the interest tax shield.
Interest Tax Shield = Corporate Tax Rate * Interest Payments
15.2 Valuing the Interest Tax Shield
When we consider corporate taxes, the total value of a levered firm equals the value of an unlevered
firm plus the present value of the interest tax shield.
V L = V U + PV(Interest Tax Shield)
When a firm’s marginal tax rate is constant, and there are no personal taxes, the present value of the
interest tax shield from permanent debt equals the tax rate times the value of the debt, τ cD.
τ c x interest τ c x (r f x D)
PV (interest Tax Shield) = =
rf rf
= τ cx D
The firm’s pretax WACC measures the required return to the firm’s investors. Its effective after- tax
WACC, or simply the WACC, measures the cost to the firm after including the benefit of the interest
tax shield. The two notions are related as follows:
E D
r wacc = r + r (1−τ c )
E + D E E+ D D
E D D
= r E+ rD - r τ
E+ D E+ D E+ D D c
, Pre-tax WACC Reduction due to interest tax
Absent other market imperfections, the WACC declines with a firm’s leverage.
When the firm maintains a target leverage ratio, we compute its levered value VL as the present value
of its free cash flows using the WACC, whereas its unlevered value VU is the present value of its free
cash flows using its unlevered cost of capital or pretax WACC.
15.3 recapitalizing to Capture the Tax Shield
When securities are fairly priced, the original shareholders of a firm capture the full benefit of the
interest tax shield from an increase in leverage.
15.4 personal Taxes
Personal taxes offset some of the
corporate tax benefits of leverage.
Every $1 received after taxes by debt
holders from interest payments costs
equity holders
$(1 - τ *) on an after-tax basis, where
effective tax advantage of dept
(1−τ c )(1−τ e )
τ* = 1 -
(1−τ i )
15.5 optimal Capital Structure with Taxes
The optimal level of leverage from a tax-saving perspective is the level such that interest equals EBIT.
In this case, the firm takes full advantage of the corporate tax deduction of interest but avoids the tax
disadvantage of excess leverage at the personal level.
We can quantify the tax disadvantage for excess interest payments by setting τ c= 0 (assuming there is
no reduction in the corporate tax for excess interest payments)
¿ ( 1−τ e ) τ e −τ i
τ ex =1− = <0
( 1−τ i ) ( 1−τ i )
The optimal fraction of debt, as a proportion of a firm’s capital structure, declines with the growth
rate of the firm.
The interest expense of the average firm is well below its taxable income, implying that firms do not
fully exploit the tax advantages of debt.
Chapter 16
Financial distress, managerial incentives and information
16.1 Default and Bankruptcy in a perfect Market
In the Modigliani-Miller setting, leverage may result in bankruptcy, but bankruptcy alone does not
reduce the value of the firm. With perfect capital markets, bankruptcy shifts owner- ship from the
equity holders to debt holders without changing the total value available to all investors.
16.2 the Costs of Bankruptcy and Financial Distress
U.S. firms can file for bankruptcy protection under the provisions of the 1978 Bankruptcy Reform Act.
o In a Chapter 7 liquidation, a trustee oversees the liquidation of the firm’s assets.
o In a Chapter 11 reorganization, management attempts to develop a reorganization plan that
will improve operations and maximize value to investors. If the firm cannot successfully
reorganize, it may be liquidated under Chapter 7 bankruptcy.
, Bankruptcy is a costly process that imposes both direct and indirect costs on a firm and its investors.
o Direct costs include the costs of experts and advisors such as lawyers, accountants,
appraisers, and investment bankers hired by the firm or its creditors during the bankruptcy
process.
o Indirect costs include the loss of customers, suppliers, employees, or receivables during
bankruptcy. Firms also incur indirect costs when they need to sell assets at distressed prices.
16.3 Financial Distress Costs and Firm Value
When securities are fairly priced, the original shareholders of a firm pay the present value of the costs
associated with bankruptcy and financial distress. (since the dept holders will pay less for the dept
initially. How much less? Precisely the amount they will ultimately give up the present value of the
bankruptcy costs. But if the debt holders pay less for the debt, there is less money available for the
firm to pay dividends, repurchase shares, and make investments. That is, this difference is money out
of the equity holders’ pockets.)
16.4 optimal Capital Structure: the trade-off theory
According to the trade-off theory, the total value of a levered firm equals the value of the firm without
leverage plus the present value of the tax savings from debt minus the present value of financial
distress costs:
V L = V U + PV(Interest Tax Shield) – PV(financial distress Costs)
Optimal leverage is the level of debt that maximizes V L
16.5 exploiting Debt holders: the agency Costs of Leverage
Agency costs arise when there are conflicts of interest between stakeholders. A highly levered firm
with risky debt faces the following agency costs:
o Asset substitution: Shareholders can gain by making negative-NPV investments or decisions
that sufficiently increase the firm’s risk.
o Debt overhang or under-investment problem: Shareholders may be unwilling to finance new,
positive-NPV projects.
o Cashing out: Shareholders have an incentive to liquidate assets at prices below their market
values and distribute the proceeds as a dividend.
With debt overhang, equity holders will benefit from new investment only if
NPV β D D
>
I βE E
I: investment from equity holders in the project with similar risk as the rest of the firm
When a firm has existing debt, debt overhang leads to a leverage ratchet effect:
o Shareholders may have an incentive to increase leverage even if it decreases the value of the
firm.
o Shareholders will not have an incentive to decrease leverage by buying back debt, even if it
will increase the value of the firm.
16.6 Motivating Managers: the agency Benefits of Leverage
Leverage has agency benefits and can improve incentives for managers to run a firm more efficiently
and effectively due to
o Increased ownership concentration: Managers with higher ownership concentration are more
likely to work hard and less likely to consume corporate perks.
o Reduced free cash flow: Firms with less free cash flow are less likely to pursue wasteful
investments.
o Reduced managerial entrenchment and increased commitment: The threat of financial
distress and being fired may commit managers more fully to pursue strategies that improve
operations.
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