Chapter

18
HOW MUCH SHOULD A
CORPORATION BORROW?

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER OVERVIEW
In the previous chapter we discuss MMs
theory on capital structure that basically
says in a world of no taxes and perfect
capital market, capital structure does not
influence firms value.
In this chapter we bring in market realities
industry differences, taxes, financial
distress and cost of bankruptcy, conflicts
between security holders.
Well find that, in the final analysis, capital
structure does matter, after all. 18-2
TABLE 18.1 RATIOS OF DEBT TO DEBT-PLUS-
EQUITY FOR VARIOUS SECTORS (US CASE)

Note: Debt to total capital ratio = D/(D + E), where D and E are book values
of long-term debt and equity.
18-3
TABLE 18.2 TAX-DEDUCTIBLE INTEREST

The tax deductibility of interest increases the total income

that can be paid out to bondholders and stockholders

Note: Look at the difference in corporate tax paid. Interest tax shield =$28.

18-4
18-1 CORPORATE TAXES
If the interest tax shield is perpetual, its PV is:

Another way to arrive at PV of tax shield is as follows:

PV tax shield = TcD = .35 x 1,000 = $350 18-5

18-1 CORPORATE TAXES
Examples
You own all equity of Space Babies Diaper Co.
Company has no debt
Company has annual cash flow of $900,000
before interest and taxes
Corporate tax rate is 35%
You have the option to exchange 1/2 of your
equity position for 5% bonds with face value of
$2,000,000
Should you do this and why?
18-6
18-1 CORPORATE TAXES

Example Continued
($ 1,000 s) All Equity 1/2 Debt Total Cash Flow
EBIT 900 900 All equity = 585
Interest pmt 0 100
*1/2 debt = 620
Pretax income 900 800
Taxes @ 35% 315 280 (520 + 100)
Net cash flow 585 520

Note: Total returns to investors are $585 and $620

respectively. Notice the difference in cash flow to the
government: 315 280 = 35

18-7
18-1 CORPORATE TAXES

Example:
Tax benefits = Interest x Tc = $100,000 x 0.35 =
$35,000
PV of tax benefits $35,000 in perpetuity at 5% =
$35,000/.05 = $700,000
Alternative calculation:
PV of tax shield = Debt xTc = $2,000,000 x .35
= $700,000.

18-8
18-1 CORPORATE TAXES

Example
All-equity value = 585/.05 = 11,700,000
PV tax shield = 700,000
Firm value of debt = 11,700,00 + 700,000 =
$12,400,000

18-9
TABLE 18.3 MARKET VALUE BALANCE
SHEETS

18-10
TABLE 18.4A J&J BALANCE SHEETS, ORIGINAL
POSITION

18-11
TABLE 18.4B J&J BALANCE SHEETS, BORROW $10
BILLION AND REPURCHASE SHARES

Book value remains unchanged. Market value increases by

$3,500 due to tax savings.
18-12
THUS FAR WE HAVE SEEN
Capital structure is irrelevant in a perfect
capital market (MMs proposition I)
With the presence of corporate tax, firm
value increases as leverage increases, due
to tax shield.
What happens if we bring in also personal
tax, i.e. tax on equity income (dividend as
well as capital gains)?
Miller (1977) explains as follows:

18-13
FIGURE 18.1 CAPITAL STRUCTURE WITH
CORPORATE AND PERSONAL TAXES

18-14
18-2 CORPORATE AND PERSONAL TAXES
Capital structure decision boils down to which
route is more beneficial to security holders, debt or
equity?
We calculate the Relative Advantage Formula
(RAF) of Debt vs. Equity
1- Tp

(1- T ) (1- T )
pE c
RAF > 1 = issue debt
RAF < 1 = issue equity
RAF = 1: indifferent, irrelevant
18-15
18-2 CORPORATE AND PERSONAL TAXES
Example

RAF = 1.13>1, issue debt

18-16
18-2 CORPORATE AND PERSONAL TAXES
In Malaysia, lets assume: Tc=25%,
Tp=15%, Tpe=10%
RAF of Debt vs. Equity:

RAF =
1 .15
1.26
1 .101 .25
So issue debt. But why are companies not
going for high leverage? Because high
leverage results in financial distress.
18-17
COSTS OF FINANCIAL DISTRESS

Financial distress without bankruptcy costs

Customers, suppliers are extra cautious
Good staff leaving
Conflict of interest between shareholders and
bondholders
Financial distress with bankruptcy costs
Direct costs: mostly legal fees (p.458)
Indirect costs: operating business with
difficulties (p. 458/9)
18-18
FIGURE 18.2 TRADE-OFF THEORY
Firm value is true if all-equity-financed plus PV
tax shield minus PV costs of financial distress

18-19
18-3 THE TRADE-OFF THEORY OF CAPITAL
STRUCTURE

18-20
18-3 COSTS OF FINANCIAL DISTRESS

Maximum value of firm

Costs of
financial distress
Market Value of the Firm

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount Debt

of debt
18-21
FIGURE 18.3 COMPARISON OF LIMITED AND
UNLIMITED LIABILITY

18-22
FIGURE 18.4 PAYOUT TO ACE LIMITED
SECURITY HOLDERS

18-23
18-3 COSTS OF FINANCIAL DISTRESS

Circular File company has $50 of one-year

debt

18-24
18-3 COSTS OF FINANCIAL DISTRESS
Circular File Company has $50 of one-year debt. Debt
is greater than firm market value.

Sign of financial distress: MV<BV

Why does equity have any value? The 1-yr period allows
shareholders to take a high risk project that has a small
probability of large pay-off.

18-25
18-3 COSTS OF FINANCIAL DISTRESS
Example 1: Risk shifting game. There is a project
costing $10 and having pay-off as follows:

Assume NPV of project is -$2 (i.e. r = 50%)

What is effect on market values?
18-26
18-3 COSTS OF FINANCIAL DISTRESS

Example 1: The investment uses $10 cash

form NWC

Firm value falls by $2, shareholders gain

(+$3), bondholders lose (-$5).
This strategy is called risk-shifting

18-27
18-3 COSTS OF FINANCIAL DISTRESS
Example 2: Second game: rejecting positive NPV project.
There is a safe project costing $10 to be financed by new
equity. It generates NPV = $5

Firm value rises by $15. This is shared by shareholders

(+$7) and bondholders (+8).
This being the expected scenario, shareholders will not
contribute the new money even if NPV>0.
18-28
18-3 COSTS OF FINANCIAL DISTRESS

Financial Distress Games (see p. 462)

Cash In and Run
Playing for Time
Bait and Switch

18-29
18-4 PECKING ORDER THEORY OF CAPITAL
STRUCTURE
This is a theory of financing preference, proposed by
Myers and Majluf (1984)
Assume information asymmetry. Cost of financing
increases with information asymmetry
Firms have three sources of financing which are picked
based on the following order:
Internal funding will be used first
If external funding is required, debt is preferred to
equity
Equity financing is last

18-30
18-4 EMPIRICAL EVIDENCE ON CAPITAL
STRUCTURE
Stock-for-debt exchange (reducing
leverage) offers results in stock price falling
Debt-for-stock exchange (increasing
leverage) offers results in stock price rising
Issuing common stock drives down stock
prices as it signals overpricing of shares
Repurchases increase stock prices as it
signals underpricing of shares

18-31