Corporate Finance
Lecture 3: Capital Structure - Optimal Debt Policy
Tak-Yuen Wong
Department of Quantitative Finance
National Tsing Hua University
Towards an Optimal Capital Structure
▶ If capital structure were irrelevant, we should observe random variations in
actual leverage. But obviously not.
▶ Leverage varies systematically across industries and over a firm’s life
cycle
▶ CFOs pay attention to many factors when deciding debt policy
▶ MM suggest we should look beyond perfect capital markets
▶ This lecture: a theory combining MM’s insights and the effects of ...
1. Taxes
2. Costs of financial distress and bankruptcy
3. Asymmetric information
Corporate Taxes
▶ In practice, companies pay corporate taxes. Tax system in the U.S. and
many other countries provides an advantage to debt financing:
Interest is a tax-deductible expense
▶ That is, interest expenses are not included in taxable income
▶ So, return to debt holders escape taxation at the corporate level
▶ Debt financing creates an interest tax shield (tax savings)
▶ In the United States, the statutory marginal corporate tax rate is
Tc = 21% since 2018
▶ Average rates can be different because of accelerated depreciation
and other tax adjustments
▶ Basic economics: always use the marginal rate for decision-making
Interest Tax Shield
▶ Income statements for an unlevered (all-equity) firm and a levered firm
▶ MM’s idea: both firms have the same operating assets, i.e., earnings
before interest and taxes (EBIT)
▶ Levered firm has borrowed $1,000 at 8% interest rate
Income statement All-Equity Levered Firm
EBIT $1,000 $1,000
Interest paid to debt holders 0 80
Taxable income $1,000 $920
Tax payment at 21% 210 193
Net income to shareholders $790 $727
Total income to equity and debt 0+790=$790 80+727=$807
Interest tax shield (0.21×interest) $0 $17
▶ Interest tax shield: levered firm pays $17 less than unlevered firm
Valuation of Tax Shield (1)
Tax shield can be valued as an asset. How do we value them?
▶ Application of the fundamental principle of valuation requires us to know
the “cash flows” and “discount rate” of the tax shield
▶ “Cash flows” are the amount of tax savings every period. First,
Interest payment =interest rate on debt × amount borrowed
=rD × D
▶ Second, given corporate tax rate TC , the per-period tax shield is
Interest tax shield =tax rate × interest payment
=Tc × rD D
In principle, D can change over time. A common approach is to assume:
▶ Permanent debt: a company commits to rollover debt obligations
indefinitely ⇒ D is constant over time
▶ That is, the stream of per-period tax shield is a perpetuity
Valuation of Tax Shield (2)
What about the discount rate? We assume
▶ Risk of tax shields is the same as the risk of interest payments ⇒
discount rate for tax shields is rD
▶ The present value of the tax shield can then be computed as:
corporate tax rate × interest payment
PV (tax shield) =
expected return on debt
Tc rD D
= = Tc D
rD
▶ Under the imposed assumption, the present value of the tax shield is
independent of the expected return on debt
▶ In the example, PV (tax shield) = 17
0.08 = $210
The Pie View
▶ Corporate taxation adds a third slice of the pie (the firm’s assets)
▶ Firm value = debt +equity
▶ Interest tax shield reduces the slice of taxes (to the government) and
increases the cash flows to investors as a whole
▶ In fact, it adds value back to the firm as part of the assets
How Should We Think About Firm Valuation?
▶ Suppose you are a manager and decide to borrow an additional $10 billion
on a permanent basis and use the proceeds to repurchase shares
Market values balance sheet ($ billion)
Net working capital $12.5 Long-term debt $30.6 40.6
PV(tax shield) 6.4 8.5 Other liabilities 35.9
Long-term assets 426.1 Equity 378.5 370.6
Total assets $445 447.1 Total value $445 447.1
▶ Equity goes down by $10 billion first, but we know the new borrowing
generates interest tax shields.
▶ Assets increase by PV (tax shield) = Tc D = 0.21 × $10 = $2.1billion
▶ Net effect on equity: −10 + 2.1 = −$7.9 billion
▶ Key observation: asset side contains the financial value of tax shields and
the real value if firm is all-equity financed
MM with Corporate Taxes (1963)
▶ MM Proposition 1 with corporate taxes
value of a value if
= + PV (tax shield)
levered firm all-equity financed | {z }
=Tc D if debt is permanent
▶ Debt policy is generally non-permanent. Yet, the formula Tc D still
provides a quick approximation for interest tax shield
▶ Generally, PV (tax shield) is about 10% of a firm value
▶ Sound good, but what should the optimal debt policy be?
▶ All firms should be 100% debt-financed
▶ Two ways out
1. Does tax system in practice bring disadvantage to borrowing? Look
into personal taxation
2. Does debt financing incur other costs? Look into financial distress
Personal Taxation
▶ Two types of personal taxes are relevant
▶ Debt holders pay Tp on interest income
▶ Shareholders pay TpE in equity income (dividends on capital gains)
▶ As of 2018, in the United States...
▶ the top marginal rate on dividends and capital gains is TpE = 20%
▶ the top rate on interest income is Tp = 37%
How Personal Taxes Affect Leverage?
▶ Shareholders are double-taxed : both corporate level and personal level
▶ Interest income taxes on debt holders create a disadvantage for borrowing
▶ Borrowing is better only if 1 − Tp is greater than (1 − TpE ) × (1 − Tc )
Relative Advantage of Debt
▶ Formally, we can define
1 − Tp
Relative tax advantage of debt =
(1 − TpE )(1 − Tc )
▶ Debt financing is better if the ratio is greater than 1
▶ How to optimize the debt policy? Suppose the marginal investor is in the
top tax bracket, Tp = 37% and TpE = 20%
1 − 0.37
=0.9968
(1 − 0.20)(1 − 0.21)
▶ Slight disadvantage: debt investors receive 0.32% less
▶ In practice, difficult to identify the tax bracket marginal investors is in
▶ Shareholders of large corporations may include tax-exempt investors
like pension funds, university endowments
Costs of Financial Distress
▶ Financial distress: a situation in which a company has difficulty or is
unable to meet their financial obligations
▶ Skating on thin ice or even bankruptcy
▶ Firm valuation should be understood as
value of a value if costs of
= + PV (tax shield) − PV
levererd firm all-equity financial distress
▶ The costs of financial distress depend on
1. the probability of distress
2. the magnitude of costs incurred if distress happens
The Trade-off Theory of Capital Structure
▶ Optimal debt policy trades off the tax benefits and costs of distress
▶ At low debt levels, the probability of financial distress is small and the benefit of
tax shields dominates
▶ Heavy borrowing increases distress chance, substantially reduces the firm value
Limited Liability Revisited
▶ Limited liability grants shareholders the right to default and allows them to walk
away from trouble
Bankruptcy Costs
▶ Shareholders payoff reduces to zero in default, but it is not a cost of
bankruptcy
▶ In the previous figure, bankruptcy simply transfers assets from
shareholders to debt holders. The total firm value is always $500
▶ Bankruptcy is a legal mechanism allowing creditors to take over
▶ Bankruptcy costs are the costs of using this mechanism
▶ Actual transfers of assets involve accountants, lawyers, the court,
and other professionals. Fees must be paid to them
Indirect Costs of Financial Distress
▶ Bankruptcy costs involve direct transfers to the third party*
▶ But, firms do not immediately go bankrupt when get into trouble
(distress)
▶ Indirect costs are incurred in financial distress
▶ Scare off customers and suppliers
▶ Key employees may seek other jobs
▶ Loss of market share and reputation
▶ In times of financial distress, conflicts of interest between shareholders
and debt holders escalate
▶ Anticipating the firm dissolution, stakeholders prioritize narrow
self-interest over maximizing the firm’s market value
*Law Firm’s Lehman Tab May Reach $430 Million
Debt and Incentives (1): Risk-Shifting
▶ The company has $10 cash in liquid assets, and the face value of debt is
$50 and it matures next year
▶ Bonds still worth $27 now but the company is in trouble: total assets
cannot pay off the debt
Market values balance sheet
Liquid assets $20 Bonds $27
Fixed assets 10 Common stock 3
Total assets $30 Total value $30
▶ A risky project that adds to its fixed assets has NPV -$2
▶ Question: should the company invest in this risky project?
Debt and Incentives (1): Risk-Shifting
Market values balance sheet
Liquid assets $20 $10 Bonds $27 $22
Fixed assets 10 18 Common stock 3 6
Total assets $30 $28 Total value $30 $28
▶ Overall assets decrease, bond holders have fewer assets to claim in default
▶ Shareholders gain: may hit the $120 jackpot
▶ Question: should the shareholders invest in this risky project? do they
lose anything?
▶ Risk-shifting: Shareholders of levered firms favor risky projects over safe
projects. In distress, gambling for resurrection
▶ Gain gain when business risk increases but do not care about the
downside
Debt and Incentives (2): Debt Overhang
▶ Suppose instead the company has no cash. But it has a safe project that
costs $10 and deliver a return with present value $15. Project NPV is $5
▶ To finance the project, the company can raise new equity capital, issung
$10 new shares to original owner
Market values balance sheet
Liquid assets $20 $20 Bonds $27 $35
Fixed assets 10 25 Common stock 3 10
Total assets $30 $45 Total value $30 $45
▶ With more assets, the probability of default is smaller and payoff to bond
holders in default is larger: bonds value increase by $8
▶ Question: should the shareholders invest in this project?
Debt and Incentives (2): Debt Overhang
▶ With the possibility of default, the total gain from investment is shared
among shareholders and debt holders
▶ Yet, shareholders bear all the investment cost (new equity capital)
▶ Equity value increases by $7 but the cost is $10
▶ Debt holders are free riders: they pay nothing and capture part of
the gain
▶ Debt overhang: firms in distress are likely to bypass valuable investment
opportunities
▶ Shareholders may just cash in and run: liquidate assets and pay the
proceeds as cash dividends
▶ Agency cost of borrowing: loss in efficiency in investment and
operations attributable to leverage
Implications of the Trade-off Theory (1)
Optimal capital structure is affected by these factors:
1. Profitability increases cash-flow generation, reduces probability of
distress, and increases leverage
2. Business risk: firms with risky cash flows are more difficult to meet
periodic debt obligations, and can only support lower levels of debt
3. Asset tangibility: tangible assets can pass through bankruptcy,
liquidation, and reorganization much less costly than intangible assets
4. Growth opportunities: firms with lots of positive NPV projects use less
debt to avoid debt-overhang effect
5. Corporate tax rate: larger tax shield favor borrowing
6. Macroeconomic cycles: over recessions and uncertain times, market is
more risky and firms will deleverage
Implications of the Trade-off Theory (2)
Predictions:
▶ High-tech and growth firms, typically have risky cash flows and intangible
assets, use relatively little debt
▶ Heavy industries, manufacturing, airlines, real estates have stable cash
flows and tangible assets, use more debt
Practical implications:
▶ Firms maintain a target leverage ratio and should manage liabilities to
stay at the target level:
▶ Issue debt after positive shocks (increase in profitability)
▶ Reduce debt (buyback, early repayment) after negative shocks
(decrease in profitability)
Myers-Majluf (1984)
▶ Capital markets have asymmetric information: there are good and bad
firms, but hard to know
▶ Say one share of a good firm worth $100; and $0 for a bad firm
▶ Suppose a firm raises $100 by selling share, how would investors
value the stock?
▶ With symmetric information, suffice to sell one
▶ Good firms’ shares are undervalued: need to sell two shares to raise
capital, but this dilutes existing shareholders
▶ Adverse selection: only bad firms issue equity to finance new investment
▶ The market interprets equity issuance as a signal of bad firms
▶ Myers-Majluf: application of Akerlof (1970) lemon (second-hand cars
market) idea in finance
Pecking-Order Theory of Financing Choices
The analysis with asymmetric information delivers practical implications on
financing pecking order:
Internal Fund/Safe Debt ≻ Risky Debt ≻ Equity
▶ Use cash whenever possible; Otherwise, use debt financing; Issue equity at
last (say when there are too much debt outstanding)
General idea: asymmetric information makes the market underprices the
corporate securities issued by good firms
▶ Debt is less sensitive to information, can be priced more fairly
▶ Equity is very sensitive to information, unlikely to be priced according to
fundamental under information problems
Testable Implications (Asymmetric Information)
1. Stock price declines on the announcement of an equity issue (only bad
firms issue equity, announcement signals to the market that firm’s stock is
over-priced)
2. Stock price tends to rise prior to the announcement of an equity issue
(good firms delay issuance to wait for good news)
3. Firms tend to issue equity when information asymmetries are minimized,
such as immediately after earnings announcement (information asymmetry
reduces)
An Empirical Observation
▶ Negative announcement effect: on average, announcement of equity issuance
reduces equity return by 3%
▶ Market interprets equity issuance as a signal of bad quality, revise future prices
downward
Cash Holdings and Corporate Taxes
▶ Managers pay great attention to the tax implications of financial decisions
▶ For example, Apple Inc., with over $100 billion cash borrowed $17 billion by
issuing corporate bonds in 2013
▶ But, moving cash back to the States triggers > 20% tax liability
The CFOs Survey
The trade-off and pecking order theory of capital structure inform the importance of
these considerations
