TheCapitalStructureDecision

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1、The McGraw-Hill Companies,Inc.,200115-1Irwin/McGraw-HillIrwin/McGraw-HillChapter 15Fundamentals of Corporate FinanceThird EditionThe Capital Structure DecisionBrealey Myers Marcusslides by Matthew WillIrwin/McGraw-HillThe McGraw-Hill Companies,Inc.,2001The McGraw-Hill Companies,Inc.,200115-2Irwin/Mc

2、Graw-HillTopics CoveredDebt and Value in a Tax Free EconomyCapital Structure and Corporate TaxesCost of Financial DistressExplaining Financial ChoicesThe McGraw-Hill Companies,Inc.,200115-3Irwin/McGraw-HillM&M(Debt Policy Doesnt Matter)Modigliani&MillerWhen there are no taxes and capital markets fun

3、ction 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.The McGraw-Hill Companies,Inc.,200115-4Irwin/McGraw-HillM&M(Debt Policy Doesnt Matter)AssumptionsBy issuing 1 security rather

4、than 2,company diminishes investor choice.This does not reduce value if:Investors do not need choice,OR There are sufficient alternative securitiesCapital structure does not affect cash flows e.g.No taxesNo bankruptcy costsNo effect on management incentivesThe McGraw-Hill Companies,Inc.,200115-5Irwi

5、n/McGraw-HillExample-River Cruises-All Equity Financed17.5%12.5%7.5%shares on Return1.751.25$.75shareper Earnings175,000125,000$75,000Income OperatingBoomExpectedSlump Economy theof State Outcomemillion 1$Shares of ValueMarket$10shareper Price100,000shares ofNumber DataM&M(Debt Policy Doesnt Matter)

6、The McGraw-Hill Companies,Inc.,200115-6Irwin/McGraw-HillExample cont.50%debt25%15%5%shares on Return2.501.50$.50shareper Earnings125,00075,000$25,000earningsEquity 50,00050,000$50,000Interest175,000125,000$75,000Income OperatingBoomExpectedSlump Economy theof State Outcome500,000$debt of ueMarket va

7、l500,000$Shares of ValueMarket$10shareper Price50,000shares ofNumber DataM&M(Debt Policy Doesnt Matter)The McGraw-Hill Companies,Inc.,200115-7Irwin/McGraw-HillExample-River Cruises-All Equity Financed-Debt replicated by investors25%15%5%investment$10 on Return2.501.50$.50investment on earningsNet 1.

8、001.00$1.0010%Interest :LESS3.502.50$1.50shares twoon EarningsBoomExpectedSlump Economy theof State OutcomeM&M(Debt Policy Doesnt Matter)The McGraw-Hill Companies,Inc.,200115-8Irwin/McGraw-HillWeighted Average Cost of Capitalwithout taxes(traditional view)rDVrDrEIncludes Bankruptcy RiskWACCThe McGra

9、w-Hill Companies,Inc.,200115-9Irwin/McGraw-HillWeighted Average Cost of Capitalwithout taxes(M&M view)rDVrDrEIncludes Bankruptcy RiskWACCThe McGraw-Hill Companies,Inc.,200115-10Irwin/McGraw-HillFinancial Risk-Risk to shareholders resulting from the use of debt.Financial Leverage-Increase in the vari

10、ability of shareholder returns that comes from the use of debt.Interest Tax Shield-Tax savings resulting from deductibility of interest payments.C.S.&Corporate TaxesThe McGraw-Hill Companies,Inc.,200115-11Irwin/McGraw-HillExample-You own all the equity of Space Babies Diaper Co.The company has no de

11、bt.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 TaxesThe McGraw-Hill Companies,Inc.,200115-12Irwin/McGraw-Hi

12、llC.S.&Corporate Taxes All Equity1/2 DebtEBIT1,0001,000Interest Pmt 0 100 Pretax Income1,000 900Taxes 40%400 360Net Cash Flow$600$540Total Cash Flow All Equity=600 (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

13、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?The McGraw-Hill Companies,Inc.,200115-13Irwin/McGraw-HillCapital StructurePV of Tax Shield=(assume perpetuity)D x rD x Tc rD

14、=D x TcExample:Tax benefit=1000 x(.10)x(.40)=$40 PV of 40 perpetuity=40/.10 =$400PV Tax Shield=D x Tc=1000 x.4 =$400The McGraw-Hill Companies,Inc.,200115-14Irwin/McGraw-HillCapital StructureFirm Value=Value of All Equity Firm+PV Tax ShieldExampleAll Equity Value=600/.10=6,000 PV Tax Shield =400Firm

15、Value with 1/2 Debt=$6,400The McGraw-Hill Companies,Inc.,200115-15Irwin/McGraw-HillFinancial DistressCosts 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 DistressThe

16、 McGraw-Hill Companies,Inc.,200115-16Irwin/McGraw-HillFinancial DistressDebtMarket Value of The FirmValue ofunleveredfirmPV of interesttax shieldsCosts offinancial distressValue of levered firmOptimal amount of debtMaximum value of firmThe McGraw-Hill Companies,Inc.,200115-17Irwin/McGraw-HillFinancial ChoicesTrade-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.