,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 Capitalwithout taxes (traditional view),r,D V,rD,rE,Includes Bankruptcy Risk,WACC,Weighted Average Cost of Capitalwithout taxes (M&M view),r,D V,rD,rE,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 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,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.,