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Learning Objectives
Describe six different views of capital
Why Capital structure.
Describe how these views depend on the
Structure 16 three capital market imperfections.
Explain how capital market imperfections lead
Matters to a preference ordering of financing
alternatives.
Evaluate the effect of capital structure on the
Corporate Financial Management 3e firm’
firm’s weighted average cost of capital.
Emery Finnerty Stowe
16-1 16-2
Capital Structure and the
Chapter Outline
Principles of Finance
Incremental Benefits
16.1 Does Capital Structure Matter? Minimize the value lost to capital market
imperfections (such as asymmetric taxes,
16.2 The Role of Income Taxes asymmetric information, and transaction costs)
16.3 The Role of Agency Costs and Capital Market Efficiency
Financial Distress Costs The potential to increase firm value through
16.4 External Financing Transaction Costs capital structure is smaller than the introduction of
valuable new ideas and the use of real
16.5 Financial Leverage Clienteles comparative advantages.
16.6 The Capital Market Imperfections Signaling
View of Capital Structure Financing transactions and capital structure
changes convey information to outsiders (that
16-3 16-4 may be misunderstood)
Capital Structure and the
16.1 Capital Structure
Principles of Finance
Capital structure refers to how a firm is
Time- Value- of-
Time-Value-of-Money financed.
time- value- of-
Include time-value-of-money tax benefits from
capital structure choices In simple terms, capital structure refers to the
Valuable Ideas proportion of debt financing used by the firm.
Securities in short supply and tax law changes can Leverage ratio
provide opportunities to create value
Is firm value dependent on its choice of capital
Behavioral
structure?
Look to information in capital structure decisions
and financing transactions of other firms If so, how?
Risk- Trade-
Risk-Return Trade-Off
fair-
Capital structure changes made at fair-market
equity-
value can change equity-debt risk bearing, but
such transactions do not affect firm value
16-5 16-6
1
Perfect Market View of Capital Perfect Market View of Capital
Structure Structure
In perfect capital markets, capital Medi-
Medi-Forms, Inc., (MFI) is an all equity
structure does not affect firm value. financed (i.e. unleveraged) firm. Expected
Capital structure choice is a pure risk-return
risk- annual cash flow is $300 per year, with a
tradeoff. minimum of $100. shareholders of MFI
Leverage does not affect the firm’s cost of
firm’ require a 15% rate of return.
capital. What is the total value of MFI, the value of
its equity, and its WACC?
16-7 16-8
Perfect Market View of Capital Capital Structure Change in
Structure Perfect Markets
Since the expected annual cash flow to Suppose MFI sells $1,000 of debt at 10%
the shareholders is $300, and they and pays the proceeds to its shareholders.
MFI’
require a 15% return, the value of MFI’s
What is the total value of the firm, the
equity is
MFI’ shareholder’
value of MFI’s equity, its shareholder’s
$300/0.15 = $2,000.
wealth, its leverage ratio, and its WACC?
Since MFI has no debt outstanding, the
total value of the firm (VU) is also
$2,000.
With no debt financing, the WACC =
shareholder’
shareholder’s required rate of return =
15%
16-9 16-10
Total Firm Value in Perfect
Equity Value in Perfect Markets
Markets
MFI’
The value of MFI’s debt is $1,000. Total firm value = value of debt + value of
equity.
In perfect markets, the value of the firm
MFI’
Value of MFI’s equity = $2,000 – $1,000 or
is independent of its capital structure.
$1,000.
Since the unleveraged firm has a value MFI’
Prior to the capital structure change, MFI’s
MFI’
of $2,000, MFI’s total value after the equity was worth $2,000.
capital structure change will remain at After the change, the equity is worth $1,000
$2,000. but the shareholders have $1,000 in cash.
Shareholder wealth remains unchanged.
16-11 16-12
2
Perfect Market View of Capital Shareholder’s Required Return
Structure in Perfect Markets
MFI’
At 10%, MFI’s annual interest expense is
$100.
The annual expected cash flow to its
$1,000 $1,000
shareholders is $300 – $100 or $200.
$2,000
Equity Equity Debt Since the equity is worth $1,000, the rate of
return required by the shareholders is 20%:
$1,000 = $200/0.20
Unleveraged Firm Leveraged Firm With leverage, equity is riskier and the
VU = $2,000 VL = $2,000 shareholder’
shareholder’s required rate of return
16-13 16-14increases.
WACC and Capital Structure in
Leverage Ratio
Perfect Markets
The leverage ratio, (L) is: The weighted average cost of capital is 15%:
Market value of debt
L=
total firm value WACC = (1 – L)re + L rd
$1, 000 WACC = (1 – 0.5)×(0.20) + 0.5×0.10
0.5)× 0.5×
= = 0.50 or 50%
$2, 000
WACC = 15%
16-15 16-16
Arbitrage Argument for Capital
WACC in Perfect Markets
Structure Irrelevance
If firm value varies with leverage,
Required
Return arbitrage profits can be made.
re In perfect markets, arbitrage
opportunities cannot exist.
WACC
The arbitrage profits are eliminated
when firm value is independent of
capital structure.
(1 - T)rf (1 - T)rd
0.0
L
1.0
16-17 16-18
3
Arbitrage Argument for Capital
Arbitrage in Perfect Markets
Structure Irrelevance
Consider firm U that is identical to MFI
before its capital structure change. L’
Suppose you own 10% of firm L’s
equity.
Firm L is identical to MFI after its capital
Your shares are worth $150.
L’
structure change. However, L’s equity is
L’
You are entitled to 10% of L’s cash flow to
valued at $1,500. its shareholders [i.e. 10%×$200 = $20].
10%×
MFI’
MFI’s equity is valued at $1,000 after the Sell your shares of firm L.
capital structure change.
Borrow another $150 at 10%.
Total value of Firm L is thus $2,500. You have $300 in cash.
Your personal leverage ratio is 50%, same
as that of firm L.
16-19 16-20
Arbitrage in Perfect Markets Arbitrage in Perfect Markets
U’
Buy $300 of firm U’s stock. After paying $15 of interest, your annual
Since U’s equity is worth $2,000, you
U’ cash flow increases from $20 to $30
own 15% of U’s equity.
U’ without any additional investment on
You are entitled to 15% of U’s cash flow your part.
U’
to its shareholders. This arbitrage opportunity cannot exist
You get 15%×$300 = $45 from firm U.
15%× in perfect markets.
It will be eliminated when the total value
of firm L equals the total value of firm U.
L’
Value of L’s equity must be $1,000.
16-21 16-22
16.2 Capital Market
Capital Structure with
Imperfections: Corporate Income
Taxes
Corporate Income Taxes
Interest payments made by a Medi-
Consider Medi-Forms again, before its
corporation are tax deductible, while MFI’
leverage change. Assume that MFI’s
dividend payments are not. corporate income tax rate is 40%.
This tax asymmetry makes debt Compute the value of the equity and the
financing cheaper than equity financing. total firm value.
The corporate tax view of capital
structure implies that firm value is
all-
maximized when the firm is all-debt
financed.
16-23 16-24
4
Capital Structure with Capital Structure with
Corporate Income Taxes Corporate Income Taxes
after-
The after-corporate income tax cash flow to Now suppose MFI sells $1,000 of new debt
MFI’
MFI’s shareholders is $300(1 - 0.40) or $180. at 10%, and pays the proceeds to the
MFI’
Since MFI’s shareholders require a 15% rate of shareholders.
firm’
return from this unleveraged firm’s equity, the
value of the equity is $180/0.15 or $1,200.
What is the total value of the firm, the
MFI’ shareholder’
value of MFI’s equity, its shareholder’s
Since MFI has no debt outstanding, this is also
the total value of the firm. wealth, its leverage ratio, and its WACC?
16-25 16-26
Capital Structure with Capital Structure with
Corporate Income Taxes Corporate Income Taxes
Annual interest expense = $100.
After-corporate-tax cash flow to MFI’s
After- corporate- MFI’ The wealth of the shareholders
increases from $1,200 before the
shareholders is
leverage change to ($600 in stock +
($300 – $100)×(1 – 0.40) = $120.
$100)× $1,000 in cash) or $1,600 after.
Since the shareholders require a 20% The total value of the firm increases to
return, the value of the equity is $1,600:
$120/0.20 = $600. Value of debt ($1,000) + Value of
Equity($600)
All of the increase in firm value accrues
MFI’
to MFI’s shareholders.
16-27 16-28
Capital Structure with
Gain from Leverage
Corporate Taxes
The gain from leverage comes from the
savings in corporate income taxes.
$400
As an unleveraged firm, MFI pays
Taxes
$1,200 $300×(0.40) = $120 per year in taxes.
$300×
$1,000
Equity $800 $600 Debt As a leveraged firm, MFI pays
Taxes Equity ($300 – $100)×(0.40) = $80 in taxes.
$100)×
Unlevered Firm Leveraged Firm
VU = $1,200 VL = $1,600
16-29 16-30
5
Gain from Leverage Gain from Leverage
This savings of $40 in annual income The value of the leveraged firm can also
taxes has an opportunity cost of 10% be computed as:
(= the return required by the debt VL = VU + TD
holders).
The value of this savings is thus
$40/0.10 = $400. = $1,200 + .40×$1,000
All of this gain is realized by the
shareholders. = $1,600
16-31 16-32
Leverage Ratio WACC with Corporate Taxes
The leverage ratio, L is:
The weighted average cost of capital is:
WACC = (1 – L)re + L(1 – T) rd
market value of debt
L=
total firm value = (1 – 0.625)×(0.20) + 0.625(1 – 0.40)×0.10
0.625)× 0.40)×
$1, 000 = 11.25%
= = 0. 625 or 62. 50%
$1, 600
16-33 16-34
Alternative Valuation of the
WACC with Corporate Taxes
Leveraged Firm
Required The value of the leveraged firm can also
Return be computed in terms of:
re basic” after-
the “basic” after-tax cash flow of the firm,
and
WACC WACC adjusted for leverage and corporate
income taxes.
(1 - T)rf
(1 - T)rd
I (1 − T ) $300(1 − .40)
1.0
L VL = = = $1,600
0.0 WACC .1125
16-35 16-36
6
Firm Value with Corporate
WACC with Corporate Taxes
Taxes
I (1 − T ) Trd D I (1 − T ) I (1 − T ) I (1 − T )
VL = + = + TD VL = VL =
r rd r WACC WACC
I (1 − T )
A value for WACC can be found by setting the two equations VU =
above equal to each other and solving for WACC. The result is: r
WACC = r (1 − TL )
For MFI: VL = VU + TD
WACC = .15(1 − 0.40 × .625) = 11.25%
16-37 16-38
Personal Income Taxes Personal Income Taxes
The capital gains timing option lowers
Interest and dividend income received by the effective tax rate on shareholder
investors in the firm is taxed immediately income.
upon receipt.
The differential between tax rates on
Capital gains are taxed only when the shares
are sold. personal income from debt and equity
Capital gains taxes can be postponed by not cancels out the effect of corporate tax
selling the shares. asymmetry.
Capital losses can be deducted immediately by
The personal tax view is that capital
realizing the gain.
Tax timing option is valuable.
structure is again irrelevant.
16-39 16-40
Capital Structure and Personal Unleveraged Firm Value with
Income Taxes Corporate and Personal Taxes
Consider MFI again. Assume it is an after- corporate-
The after-corporate-tax cash flow to the
shareholders of MFI is:
unlevered firm. The annual cash flows are
$300(1 – 0.40) = $180 per year.
$300 per year, the corporate income tax
The shareholders pay taxes on this income at
rate is 40%, and shareholders pay 10% ( after- personal-
10%. Their after-personal-tax cash flow is:
= Te) income taxes on their equity income. $180(1 – 0.10) = $162 per year.
Since they require a 15% return, the value of
Compute the value of MFI’s equity and its MFI’
MFI’s equity (and the total firm value) is:
MFI’
$162/0.15 = $1,080.
total firm value.
16-41 16-42
7
Capital Structure and Personal
Interest on New Debt
Income Taxes
Now suppose MFI issues $540 of debt. Since the debtholders want a 10%
Debtholders require a 10% rate of return after return after personal taxes, they require
personal taxes. Debtholders face an income tax after-tax interest income of $54 on $540
after-
rate of 46% ( = Τd). The debt proceeds are paid
to the shareholders.
of debt:
$540×(10%) = $54.
$540×
Compute the value of MFI’s equity, the total firm
MFI’ before-
On a before-tax basis, they require
value, and shareholder’s wealth after the capital
shareholder’ $100:
structure change. $54 / (1 – 0.46) = $100
16-43 16-44
Equity Value and Shareholder
Cash Flows to Shareholders
Wealth
after- corporate-
The after-corporate-tax cash flow to Since they require a 20% rate of return,
MFI’
MFI’s shareholders is: MFI’
the value of MFI’s equity is:
($300 – $100)×(1 – 0.40) = $120
$100)× $108 / 0.20 = $540
Since shareholders pay income taxes on The shareholders have stock worth $540
after- personal-
this at 10%, their after-personal-tax and $540 in cash (proceeds from the
cash flow is: debt issue).
$120 (1 – 0.10) = $108 Their wealth is therefore unchanged.
The total value of the firm is also
$1,080.
16-45 16-46
Capital Structure with Tax Rates for Capital Structure
Corporate and Personal Taxes Irrelevance
With corporate and personal taxes, the The difference in personal tax rates on debt
and equity income will exactly cancel the
firm value and shareholder wealth is corporate tax asymmetry when:
firm’
independent of the firm’s capital
structure.
The personal tax asymmetry cancels the (1 − Td ) = (1 − Te )(1 − T )
effect of the corporate tax asymmetry.
For MFI:
This occurs only for a particular set of tax
rates. (1 − 0.46) = (1 − 0.10)(1 − 0.40)
16-47 16-48
8
Capital Structure with 16.3 Agency Costs View of
Corporate Taxes Capital Structure
Capital market imperfections resulting
from agency cost considerations create a
complex environment in which capital
$120
Personal $306.67
$540 Debt
structure affects firm value.
Taxes
Personal
$1,080 Debt Taxes
Equity $800
$80
Equity Personal
Taxes
Types of agency costs:
Corp. $540
Taxes
$533.33
Corporate
Debt
Equity Taxes
Equity
Employee
Unlevered Firm Leveraged Firm
Consumer
VU = $1,080 VL = $1,080
16-49 16-50
Agency Costs of Debt Agency Costs of Debt
Examples of conflicts between As leverage increases, the potential for these
debtholders and equityholders: conflicts increases.
The costs of resolving these conflicts increases.
Asset substitution
However, increased leverage also helps to
Claim dilution
firm’
reduce the firm’s agency costs:
Underinvestment problem Monitoring costs via “free” audits when new debt is
free”
Asset uniqueness issued.
Sinking fund provisions.
Secured debt.
16-51 16-52
Agency Cost View of Capital Bankruptcy Cost View of
Structure Capital Structure
There are agency costs associated with Capital market imperfections associated
obtaining any financing. with financial distress and bankruptcy
Agency costs are also associated with other offset the other benefits from leverage
firm claimants: created by taxes and agency costs.
Employees
Customers
At the optimal capital structure, the
Society marginal expected costs of financial
The optimal capital structure minimizes total distress and bankruptcy equal the
agency costs.
costs. marginal benefits of leverage.
Firm value is at a maximum.
16-53 16-54
9
Direct Costs of Bankruptcy Indirect Costs of Bankruptcy
Notification costs, court costs, legal fees. Management time devoted to dealing
Paid only if bankruptcy occurs. with distress and the bankruptcy
Generally small when compared to the process.
indirect costs. Lost tax credits.
Lost sales and goodwill.
These are more significant in their
magnitude, and are also more difficult to
measure.
16-55 16-56
16.3 Pecking Order View of
Expected Costs of Bankruptcy
Capital Structure
The expected costs of bankruptcy depend on: The firm incurs transaction costs when
The degree of specialization of a firm’s assets.
firm’ external financing is obtained.
Type of assets - tangible versus intangible.
There are both direct and indirect costs.
As leverage increases, the expected
bankruptcy costs increase. In the pecking order view, the firm
This increase offsets other benefits of should use the method of financing with
leverage: the least amount of transaction costs
Personal and corporate taxes. first.
Agency costs. Financing methods with higher
transaction costs are used next.
16-57 16-58
Pecking Order View of Capital Signaling and Capital Structure
Structure Decisions
Retained earnings (internal equity) have firm’ project’
A firm’s decision about a project’s
the least cost. financing reflects its choice of capital
Next is newly issued debt. structure.
Debt-Equity combinations are third in
Debt- It also conveys information about the
the pecking order. project.
Convertible debt
New external equity comes last in the
pecking order.
16-59 16-60
10
Signaling and Capital Structure Signaling and Capital Structure
Decisions Decisions
If a project has a large positive NPV, financing Alternatively, if the firm is currently
it internally will allow the current owners of overvalued, existing owners may want to seek
the firm to get all of the benefits. outside partners so as to share the decline in
If a project has a small (or zero) NPV, the value.
current owners would be indifferent to If the firm is currently undervalued, the firm
allowing outside investors to share in the might use debt financing to keep the gains to
gains. themselves.
Thus, how a project is financed (internal Thus, new equity issues signal overvaluation,
versus external funds) conveys information while new debt issues signal undervaluation.
project’
about the project’s value.
16-61 16-62
16.5 Financial Leverage Clienteles Financial Leverage Clienteles
Investors will take into account their Investors in high tax brackets may find
own tax situations into account in debt securities less attractive.
deciding which firm to invest in. Debt income is taxed at a higher rate than
The clientele effect refers to the equity income.
investor’s choice of a particular security
investor’ They prefer equity income.
or a firm with a particular capital Investors in low tax brackets may prefer
structure. corporate leverage to personal leverage
Market segmentation because of the higher corporate tax rate.
16-63 16-64
16.6 Capital Market Imperfections
Financial Leverage Clienteles
View of Capital Structure
When a firm selects its capital structure, it Debt is generally valuable.
personal-
attracts investors with a certain personal-tax
At low levels of leverage,
driven incentive for investment.
the expected costs of financial distress are
High leverage firm will attract investors in
low.
lower tax brackets and vice versa.
value-
value-enhancing aspects of leverage
If the demand for each type of leverage is
resulting from taxes and agency costs
satisfied, there is no gain from changing the
exceed the expected costs of financial
current capital structure.
distress.
Capital structure is irrelevant.
As leverage increases,
these costs increase and at some level will
16-65 16-66 exceed the benefits of leverage.
11
Capital Market Imperfections Capital Market Imperfections View
View of Capital Structure of Capital Structure
VT
Let VL = Total firm value, Value
Value of unlevered firm
VT = Net tax benefit from additional plus next tax benefits
leverage
VA = Total agency costs from additional
leverage, and Hypothetical
L
VB = Expected costs of financial distress optimal L = L*
VL
and bankruptcy. Total agency costs considerations
VA
L* = optimal capital structure (optimal Total expected financial distress and
VB
16-67 leverage) 16-68 bankruptcy costs
Cost of Capital and Market Capital Market Imperfections
Imperfections View of Capital Structure
re
Required Let T* denote the net-benefit-to-leverage
net- benefit- to-
Return
factor.
VL = VU + T D
*
r I (1 − T )
WACC VU =
Hypothetical r
minimum (1 – T)rd
I (1 − T ) T *rd D
WACC
(1 – T)rf
VL = +
r rd
Hypothetical 1.0 L WACC = r (1 − T * L)
16-69 optimal L = L* 16-70
Capital Structure with Market Summary—
Summary—Does capital structure
Imperfections affect the value of the firm?
In a perfect market, No.
$2,000 = Pie = $2,000 = Pie = $2,000 With certain imperfections, Yes.
Corporate taxation favors debt
Personal taxation offsets some of this bias
Debt Bankruptcy costs favor equity
Taxes Taxes Agency costs and tax timing options favor a mixed
Equity
Equity
capital structure
Clientele effect can favor certain securities
Transactions
Asymmetric
information Asymmetric Managers must balance tax advantage
Transactions information against agency costs, costs of financial
Financing Irrelevant All-Equity Leveraged distress, and cost of reduced flexibility from
additional debt.
Perfect Market View Capital Markets Imperfections View best”
The “best” capital structure cannot be
16-71 16-72 precisely determined.
12
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