The Capital Structure Decision

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1、The McGraw-Hill Companies, Inc.,2001 15- 1 Irwin/McGraw-Hill Chapter 15Fundamentals of Corporate FinanceThird Edition The Capital Structure Decision Brealey Myers Marcusslides by Matthew Will The McGraw-Hill Companies, Inc.,2001 15- 2 Irwin/McGraw-Hill Topics CoveredDebt and Value in a Tax Free Econ

2、omyCapital Structure and Corporate TaxesCost of Financial DistressExplaining Financial Choices The McGraw-Hill Companies, Inc.,2001 15- 3 Irwin/McGraw-Hill M&M (Debt Policy Doesnt Matter)Modigliani & MillerWhen there are no taxes and capital markets function well, it makes no difference whether the

3、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.,2001 15- 4 Irwin/McGraw-Hill M&M (Debt Policy Doesnt Matter)AssumptionsBy issuing 1 security rather than 2, company diminishes investor c

4、hoice. 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 costs No effect on management incentives The McGraw-Hill Companies, Inc.,2001 15- 5 Irwin/McGraw-Hill Example - Riv

5、er Cruises - All Equity Financed 17.5%12.5%7.5% shares on Return 1.751.25$.75shareper Earnings 175,000125,000$75,000Income Operating BoomExpectedSlump Economy theof State Outcome million 1 $Shares of ValueMarket $10shareper Price 100,000shares ofNumber Data M&M (Debt Policy Doesnt Matter) The McGraw

6、-Hill Companies, Inc.,2001 15- 6 Irwin/McGraw-Hill Example cont.50% debt 25%15%5% shares on Return 2.501.50$.50shareper Earnings 125,00075,000$25,000earningsEquity 50,00050,000$50,000Interest 175,000125,000$75,000Income Operating BoomExpectedSlump Economy theof State Outcome 500,000 $debt of ueMarke

7、t val 500,000 $Shares of ValueMarket $10shareper Price 50,000shares ofNumber DataM&M (Debt Policy Doesnt Matter) The McGraw-Hill Companies, Inc.,2001 15- 7 Irwin/McGraw-Hill Example - River Cruises - All Equity Financed- Debt replicated by investors25%15%5% investment$10 on Return 2.501.50$.50invest

8、ment on earningsNet 1.001.00$1.0010% Interest :LESS 3.502.50$1.50shares twoon Earnings BoomExpectedSlump Economy theof State OutcomeM&M (Debt Policy Doesnt Matter) The McGraw-Hill Companies, Inc.,2001 15- 8 Irwin/McGraw-Hill Weighted Average Cost of Capitalwithout taxes (traditional view)r DVrD rEIn

9、cludes Bankruptcy RiskWACC The McGraw-Hill Companies, Inc.,2001 15- 9 Irwin/McGraw-Hill Weighted Average Cost of Capitalwithout taxes (M&M view)r DVrD rEIncludes Bankruptcy RiskWACC The McGraw-Hill Companies, Inc.,2001 15- 10 Irwin/McGraw-Hill Financial Risk - Risk to shareholders resulting from the

10、 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 The McGraw-Hill Companies, Inc.,2001 15- 11 Irwin/McGraw-Hill Example - You o

11、wn 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

12、.S. & Corporate Taxes The McGraw-Hill Companies, Inc.,2001 15- 12 Irwin/McGraw-Hill C.S. & Corporate Taxes All Equity 1/2 DebtEBIT 1,000 1,000Interest Pmt 0 100 Pretax Income 1,000 900Taxes 40% 400 360 Net Cash Flow $600 $540 Total Cash Flow All Equity = 600 (540 + 100)Example - You own all the equi

13、ty 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? The McGraw-Hill

14、 Companies, Inc.,2001 15- 13 Irwin/McGraw-Hill Capital StructurePV of Tax Shield = (assume perpetuity) D x rD x Tc rD = 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 = $400 The McGraw-Hill Companies, Inc.,2001 15- 14 Ir

15、win/McGraw-Hill Capital StructureFirm Value = Value of All Equity Firm + PV Tax ShieldExampleAll Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400Firm Value with 1/2 Debt = $6,400 The McGraw-Hill Companies, Inc.,2001 15- 15 Irwin/McGraw-Hill Financial DistressCosts of Financial Distress - Costs a

16、rising from bankruptcy or distorted business decisions before bankruptcy.Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress The McGraw-Hill Companies, Inc.,2001 15- 16 Irwin/McGraw-Hill Financial DistressDebtMarket Value of The Firm Value ofunleveredfirm PV

17、of interesttax shields Costs offinancial distressValue of levered firm Optimal amount of debtMaximum value of firm The McGraw-Hill Companies, Inc.,2001 15- 17 Irwin/McGraw-Hill Financial 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.