Session 9

1. Session 9 • Topics to be covered: • Debt Policy • Capital Structure • Modigliani-Miller Propositions

2. Debt Policy • A firm’s basic resource is the stream of cash flows produced by its assets. • When a firm is financed entirely by common stock, all of those cash flows belong to the stockholders. • When it issues both debt and equity securities, it undertakes to split up the cash flows into two streams. • A relatively safe stream of cash flows goes to debtholders. • A relatively risky stream of cash flows goes to stockholders

3. Exercise Company1998 Debt Ratio (LTD/LTD+E) Eli Lilly 72% Colgate Palmolive 52% Waste Management 33% PepsiCo 39%

4. Capital Structure • A firm’s mix of different securities is known as its capital structure. • A firm can issue many different types of distinct securities to attempt to maximize its overall value. • Are these efforts worthwhile? • To analyze this question, we will proceed in four steps: • Assume no taxes or transactions costs • Consider corporate taxes • Consider investor taxes • Consider bankruptcy and other transactions costs

5. Modigliani and Miller • Modigliani-Miller Proposition I: Assuming perfect capital markets (no taxes or transaction costs), the market value of any firm is independent of its capital structure. • The value of an asset is preserved regardless of the nature of the claims against it. • We have assumed that companies and individuals can borrow and lend at the same risk-free rate (or at least on the same terms). We have also ignored taxes, transaction costs, etc.

6. How Leverage Affects Returns • Recall that we computed the expected return on a portfolio consisting of all the firm’s securities (ignoring taxes): • Also, we can write the ß of a firm’s assets as follows: • MM Proposition I means that • market value of assets • risk of assets (ßA) • expected return to assets (E(rA)) are all unaffected by the capital structure.

7. Example • Assume that there are no taxes or transaction costs. • Company ABC is 100% common stock. • ße= 1.0 • E(re) = .10 • The company decides to repurchase half of the common stock and substitute and equal value of risk-free debt, E(rd) = .05. • How do the ß and expected returns of the various parts of the capital structure change?

8. Taxes and Transaction Costs • How much should a firm borrow? • When markets are perfect and competitive, a firm’s borrowing policy does not matter. • In reality, markets are not perfect and competitive. • Some major sources of market imperfections are: • taxes • costs of financial distress (bankruptcy, reputation) • potential conflicts of interest • interaction of investment and financing decisions.

9. Corporate Taxes • When we ignore taxes, we ignore some important differences between debt and equity. • Interest on debt is deductible by the issuer, but dividends are not. • Firm value is maximized when we minimize the total payments we make to “outsiders,” including the IRS. • As we increase debt, we reduce corporate taxes paid. • Corporate taxes alone create a strong incentive for firms to borrow.

10. Personal Taxes • Investor taxes vary for debt and equity. • Individuals (investors) pay taxes on interest as ordinary income. • Dividends are also taxed at ordinary tax rates. • Under many tax regimes, taxes on capital gains are taxed at a lower rate. • There are additional benefits, lowering effective capital gains tax rates (timing, deferral). • A corporate objective could be to minimize the present value of all taxes paid on corporate income.

11. Personal Taxes • Although corporate taxes favor debt, personal taxes favor equity. • Personal taxes help explain why we don’t see 100% debt firms. • Investors have many different tax rates. • Firms don’t often know these rates. • Therefore, it is difficult for an individual firm to base its capital structure decision on the tax rates of its investors.

12. Bankruptcy Costs • Bankruptcy costs are an important factor for capital structure decisions. • As the amount of debt in a firm’s capital structure increases, so does the probability it will default. • The expected costs of financial distress can be huge. • Costs include • Lawyer and banker fees. • Managers time and effort. • Disruption of supplies and customer research. • Delay of research or capital improvement projects. • These costs can be difficult to estimate.

13. Bankruptcy Costs • Investors know that levered firms may fall into financial distress, and they demand to be compensated through higher returns. • Eventually, the expected costs of bankruptcy offset the tax benefits of debt. • There is such a thing as too much debt.

14. Optimal Capital Structure:Trade-Off Theory • Based on corporate taxes, debt is preferable to equity. • Personal taxes help explain why we see some equity in the economy, but do not explain the capital structure of any particular firm. • Bankruptcy costs become large at high debt levels, so there is such a thing as too much debt. • The optimal capital structure is that which maximizes value available to debt and equity by minimizing value going to the IRS and bankruptcy costs.

15. Example • You are CFO of New Industries, Inc. • New Industries needs to raise capital, and has 3 choices. (Table summarizes old+new capital) Plan Debt E(rd) Equity E(re) All Equity 60 0.072 240 0.130 Debt/Equity 80 0.075 225 0.135 All Debt 100 0.080 200 0.150

16. Example • Given a corporate tax rate of 36%, which capital structure should you choose? • Compute total value of assets (debt+equity): Assets (1) = 60+240 = $300 Assets (2) = 80+225 = 305 Assets (3) = 100+200 = 300 • Plan 2 (debt and equity) maximizes firm value.

17. Example • Compute the WACC • Plan 2 also minimizes the WACC.

18. Example • You should choose the second plan (debt+equity), because this plan maximizes firm value and minimizes the WACC. • The first plan does not take optimal advantage of the interest tax shield • The third plan has so much debt that the probability of bankruptcy appears nontrivial.