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Chapter 15Fundamentals of Corporate FinanceThird Edition
The Capital
Structure
Decision
Brealey Myers Marcus
slides by Matthew Will
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Topics Covered
?Debt and Value in a Tax Free Economy
?Capital Structure and Corporate Taxes
?Cost of Financial Distress
?Explaining Financial Choices
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M&M (Debt Policy Doesn’t 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.
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M&M (Debt Policy Doesn’t 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
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Example - River Cruises - All Equity Financed
1 7, 5 %1 2, 5 %7, 5 % s h ar es on R et u r n
1, 7 51, 2 5$, 7 5s h ar ep er E ar n i n g s
1 7 5,0 0 01 2 5,0 0 0$ 7 5,0 0 0I n c o m e O p er at i n g
B o o mE x p ec t edS l u m p
E c o n o m y t h eof S t at e O u t c o m e
m i l l i o n 1 $S h ar es of V al u eM ar k et
$ 1 0s h ar ep er P r i c e
1 0 0,0 0 0s h ar es ofN u m b er
D at a
M&M (Debt Policy Doesn’t Matter)
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Example
cont.
50% debt
2 5 %1 5 %5% s h a r es on R et u r n
2, 5 01, 5 0$, 5 0s h ar ep er E ar n i n g s
1 2 5,0 0 07 5,0 0 0$ 2 5,0 0 0ear n i n g sE q u i t y
5 0,0 0 05 0,0 0 0$ 5 0,0 0 0I n t er es t
1 7 5,0 0 01 2 5,0 0 0$ 7 5,0 0 0I n c o m e O p er at i n g
B o o mE x p ec t edS l u m p
E c o n o m y t h eof S t at e O u t c o m e
5 0 0,0 0 0 $d eb t of ueM ar k et v al
5 0 0,0 0 0 $S h ar es of V al u eM ar k et
$ 1 0s h ar ep er P r i c e
5 0,0 0 0s h ar es ofN u m b er
D at a
M&M (Debt Policy Doesn’t Matter)
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Example - River Cruises - All Equity Financed
- Debt replicated by investors
2 5 %1 5 %5% i n ves t m en t$ 1 0 on R et u r n
2, 5 01, 5 0$, 5 0i n v es t m en t on ear n i n g sN et
1, 0 01, 0 0$ 1, 0 01 0 % @I n t er es t,L E S S
3, 5 02, 5 0$ 1, 5 0s h ar es t w oon E ar n i n g s
B o o mE x p ec t edS l u m p
E c o n o m y t h eof S t at e O u t c o m e
M&M (Debt Policy Doesn’t Matter)
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Weighted Average Cost of Capital
without taxes (traditional view)
r
D
V
rD
rE
Includes Bankruptcy Risk
WACC
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Weighted Average Cost of Capital
without taxes (M&M view)
r
D
V
rD
rE
Includes Bankruptcy Risk
WACC
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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
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Example - You own all the equity of Space Babies
Diaper Co.,The company has no debt,The
company’s 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
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C.S,& Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
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 company’s 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?
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Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= 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
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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
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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
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Financial Distress
Debt
Ma
rke
t V
alu
e of
Th
e F
irm
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
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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.