Capital Structure Limits to the Use of Debt

Capital Structure: Limits to the Use of Debt Chapter 16 1

• MM Proposition I with taxes: VL = V U + TC B It implies that firm should maximize its value by borrowing an infinite amount. In Reality • However, as the debt/equity ratio rises, the probability that the firm could not be able to pay the interest and principal to bondholders increases. • In principal, a firm is in bankruptcy when the value of its assets equals the value of the debt. • When this occurs, the value of equity is zero and the shareholders turn over control of the firm to the bondholders. • In a perfect world, there are no costs associated with this transfer of ownership. In the real world, it is expensive to go bankruptcy. 2

Costs of Bankruptcy • Direct Bankruptcy Costs • Legal and administrative costs (e. g. lawyers, accounting, expert witnesses) • Indirect Bankruptcy Costs • The difficulties of running a business that is experiencing financial distress. • Since shareholders and bondholders are different groups. In the financial distress, shareholders may engage in • Selfish strategy 1: Incentive to take large risks • Selfish strategy 2: Incentive toward under-investment • Selfish Strategy 3: Milking the property • The above three Selfish strategies are called as ‘agency cost of equity’. 3

Integration of Tax Effects and Financial Distress Costs v Tax effects: A firm borrows because the valuable interest tax shield v Financial Distress Costs: A firm can not borrow an infinite amount because of bankruptcy risk • At a relative low debt level, the benefit from debt outweighs the cost • At a relative high debt level, the cost from debt outweighs the benefit • It suggests that an optimal capital structure exists somewhere between these extremes. The Value of a levered firm: VL = VU + TC B – PV [expected costs of financial distress] • Conclusion: The firm should borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. 4

The Optimal Capital Structure and the Value of the Firm Value of the firm (VL ) VL = VU + TC Present value of tax shield on debt Maximum firm value VL* B Financial distress costs Actual firm value VU VU = Value of firm with no debt (B/S) * Optimal Leverage Ratio Total Debt (B) 5

The Optimal Capital Structure and the Cost of Capital WACC = (S/V) r. S + (B/V) r. B (1 -TC) +Premium for Costs of Financial Distress Cost of capital (%) r. S r. U WACC r. B (1 – TC) r. U Minimum cost of capital WACC* Debt/equity ratio (B/S) * Optimal Leverage Ratio 6

Personal Taxes: The Miller Model • The Miller Model shows that the value of a levered firm can be expressed in terms of an unlevered firm as: Where: TS = personal tax rate on dividends. TB = personal tax rate on interests. TC = corporate tax rate Note: Both personal taxes and corporate taxes are included. Assuming the cash flows in perpetuity. Bankruptcy costs and agency costs are ignored. 7

Value of firm (V) Effect of Financial Leverage on Firm Value with Both Corporate and Personal Taxes VU 1 2 3 4 Debt (B) 8

Example: Nortel anticipates a perpetual pretax earning stream of $100, 000 and faces a 45% corporate tax rate. Investors discount the earning after corporate taxes at 15 percent. The personal tax rate on dividend is 30% and the personal tax rate on interest is 47%. Nortel currently has an all equity capital structure but is considering borrowing $120, 000 at 10%. Calculate the value of the levered Nortel firm. Answer: The value of the all equity firm is: Vu =____ The value of the levered firm is: VL = ______ 9