1. When does Capital Structure Matter?
MF 807: Corporate Finance
Professor Thomas Chemmanur 1

2. When does capital structure matter?
We learned earlier that absent market imperfections, the financing mix (capital structure) of a firm is irrelevant.
But as a general rule, the capital structure of the firm will affect firm value whenever markets are imperfect.
In this lecture, we will review the impact of several kinds of market imperfections on firm value, and we will discuss how corporate financial managers should go about making capital structure decisions to maximize firm value.
We will therefore introduce market imperfections one by one into a perfect capital market and study the effect these will have on firm value. 2 2

3. Using Capital Structure to Satisfy Clienteles
Under Modigliani-Miller Proposition-I, a firm doesn’t change its value by splitting up its total cash flow stream into two different cash flow streams: cash flow to debt and cash flow to equity.
However, this will not be the case if the firm can issue a new kind of security (ie., a financial innovation) which offers a financial service which was thus far unavailable to investors because of market imperfections.
If there exists a clientele of investors who want this service, these investors with an unsatisfied demand will be willing to pay a premium for that security (in other words, the firm will have to pay only a lower expected return to raise capital from selling this security than the rate of return corresponding to the risk of this security). 3 3

4. Using Capital Structure to Satisfy Clienteles
This is why corporate financial managers are always seeking financial innovations: they may offer a cheaper source of capital. Examples:
money market accounts (which were enormously popular when they were first introduced),
floating rate notes (these are medium-term bonds whose interest payments vary corresponding to short-term rates)
However, as more and more firms start offering the same innovation, the unsatisfied clientele vanishes, along with the premium. Any advantage to issuing the security is now gone.
Studies have found that, most of the time, only the innovator gets a bargain from raising capital using that security.
Thus, raising firm value by financing projects with exotic new securities is a tall order for most corporate managers 4 4

5. Using Capital Structure to Reduce Taxes
We will first look at the effect of corporate taxes alone.
Consider two firms, which are identical except for their capital structures.
Let us assume that the mean operating income (Earnings Before Interest and Taxes, EBIT) of either firm, Y = 1000,000.
The first firm is financed by 100% equity (unlevered firm)
The second firm is financed partly by equity and partly by debt: assume that the firm has debt of face value $5000,000 at 10% interest per year, for ever (ie., the debt is a perpetuity).
To simplify matters, assume ßA = 0. Then, ßEU = 0 and ßEL =0, so that if the risk-free rate is 10%, we can use this to discount all cash flows.
Also assume corporate taxes are 34% 5 5

6. Using Capital Structure to Reduce Taxes
Unlevered firm
Levered firm
Operating Income, Y
1000,000
Interest
---
500,000
Taxable Income
Tax (at Tc = 34%)
340,000
170,000
Net Income
660,000
330,000
Value of the unlevered firm, VU = EU = 660,000/0.1 = 6,600,000
Value of the levered firm = VL = Market Value of debt (DL) + Market Value of equity (EL)
DL = Interest payments/rD = 500,000/0.1 = 5,000,000
EL = Cash flow to equity/rE = 330,000/0.1 = 3,300,000
VL = 5,000, ,300,000 = 8,300,000 6 6

7. Using Capital Structure to Reduce Taxes
Thus, the value of the levered firm is $1,700,000 higher than that of the unlevered firm. Why is this?
The levered firm is able to save money on taxes compared to the unlevered firm: because the interest payments on debt is deductible from corporate taxable income. Let us compute the present value of this tax savings per year
Tax savings from debt per year = 170,000
Present Value of tax savings = 170,000/0.1 = 1,700,000
In general, use the expected return on debt as the discounting rate to compute this present value of the debt tax shield.
The amount of corporate tax savings possible from having a certain amount of debt is usually referred to as the debt tax shield 7 7

8. Using Capital Structure to Reduce Taxes
Value of the Levered Firm VL = Value of the Unlevered firm VU + Present Value of Debt Tax shield for the Levered Firm
The above result is a general result, applicable to all kinds of debt (ie., not only to the specific kind of debt we have assumed in the above example). Further, for the special case where the debt is a perpetuity, we can show that:
Present Value of debt tax shield = Tc (rD• D)/rD = Tc • D
Here D is the market value of debt, which is the same as the face value of debt in this case
rD is the expected return on debt which is the same as the coupon rate in this case. 8 8

9. Using Capital Structure to Reduce Taxes
Thus, if the only relevant market imperfection is corporate tax, we can write (for the special case of permanent debt):
(1) VL = VU + TCD
The above result brings up a puzzle: clearly, higher the debt, higher the present value of debt tax shield (you would think). So why don't all firms have very high proportions of debt in their capital structure (close to 100% debt)?
But the fact is, many companies (eg: advertising firms, drug manufacturers) have almost no debt! The answer here is in two parts:
(1) On closer examination, the value of the debt tax shield may not be as high as we think it is
(2) There may be costs to having debt. Let us examine the first point next. 9 9

10. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
As individuals also pay taxes, we have to take into account the impact of personal taxes also on the advantage from leverage.
The tax rates on individual income from stocks and bonds are sometimes different from each other.
Let us consider the following example of a company with $1 expected operating income.
Assume that this income can be paid to investors either as interest income (by financing the firm with debt) or as equity income (financing the firm with equity).
Assume personal tax is at 0.40 for interest income and .09 for equity income. 10 10

11. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
Surprise! There is actually a small advantage to paying out the $1 as equity income from the investors point of view!
Interest income
Equity Income
Operating Income 1
Less Corporate tax at 34%
0.34
Net income after corp tax
0.66
Less personal tax
0.40
0.0594
After-tax income to investor
0.60
0.6006 11 11

12. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
Of course, the above example was cooked up to make this point by assuming a large differential in the personal tax rates on interest income and equity income.
The truth is less spectacular: although personal taxes lessens the gain in firm value obtained from having debt in a firm's capital structure, it still exists in most cases.
We can derive the following general formula for the increase in value of the firm with debt (we will not bother with the details of the derivation of this formula here): 12 12

13. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
Here TE and TD are the effective personal tax rates on debt and equity income respectively.
The above expression applies strictly only if the debt on the firm is perpetual debt.
However, it gives us a feel for the size of the tax shield from debt under different assumptions about TE and TD.
We can think of the second term on the right as the gain from leverage in a world with corporate and personal taxes since it represents how much higher the value of the levered firm is compared to the unlevered firm. There are three cases:
Case 1: If TE = TD, the above equation reduces to, VL = VU + Tc • D. I.e., the gain from leverage is the same as in the case where there was only corporate taxes in the economy. 13 13

14. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
Case 2: If TE < TD, the expression on right is smaller than before, ie., VL < VU + TC • D. Thus, the gain from leverage may still be there, but it is much smaller than if we merely considered corporate taxes. (This reflects the current tax law, when capital gains were taxed at a much lower rate than interest payments on bonds, which are taxed as ordinary income).
The numerical example above is an extreme (and unrealistic) case of this where TD = 0.4 and TE = 0.09.
In this case, VL < VU ! 14 14

15. Factors reducing the PV of the tax shield
The impact of taking the effect of personal taxes into account
Case 3: if TE > TD, then VL > VU + TC • D.
The benefit of debt is even higher than in the case where we considered corporate taxes alone.
This, however, has never been the case under U.S. tax law.
Thus, under current personal tax rates, there is still an advantage to the corporation in issuing debt, even after we consider personal taxes. 15 15

16. Factors reducing the PV of the tax shield
Possible wastage of debt tax shields
There is a second reason why the benefit to issuing debt may not be as high as we thought at first: the company may not be able to fully use the tax shield it gets from issuing debt.
There may be many years in which the company may not make a high enough profit, so it may not have enough income to shelter from taxes (you can carry the tax shield forward, but you lose some value since you get benefits only later).
Further, the firm may have other tax-shields like depreciation tax shields also, which accentuate the problem since the operating income may not be high enough to utilize the entire extent of tax shields the firm has. 16 16

17. Factors reducing the PV of the tax shield
Possible wastage of debt tax shields
Remember, tax shields add value to the firm only if you can convert them into actual savings in tax-dollars!
Thus, it does not make sense to increase the debt in the capital structure beyond a certain extent, since, higher the level of debt, higher the chance that the firm may not be able to fully utilize the debt tax shield involved.
Taking into account the two effects we discussed above: (a) the effect of personal taxes and (b) the possibility of wastage of debt tax shields, we can conclude that while there may be a net tax advantage to having debt, it is not as large as TC• D. 17 17

18. Factors reducing the PV of the tax shield
Thus we can write,
Where T* is some fraction less than TC (i.e, 0 < T* < Tc).
The problem, however, is in estimating T*!
Remember also that the formula (3) applies only to the special case of permanent debt. A more general formula is:
VL = VU + PV of {interest payment on debt • T*}. 18 18

19. Capital structure and financial distress costs
When a company issues debt, it essentially enters into a contract with debt holders promising them to pay certain specific amounts (interest payments and face value) at specific points in time.
If the amount of debt issued is very small compared with the various possible levels of operating income of the firm, then there is zero probability that the firm will not be able to meet its payment obligations, and the debt is riskless.
However, if the size of the debt obligations of the company are significant compared to the possible levels of operating income, and there is a chance that in certain states of the world the company may not be able to pay up its obligations to its debt holders, the debt is risky. 19 19

20. Capital structure and financial distress costs
In case the firm is unable to meet its debt obligations, the company can declare bankruptcy, in which case debt holders will take over control of the company.
For a given level of operating income, the higher the level of debt, the higher the chance that the firm cannot honor its obligations to debt holders (i.e., higher the chance that the firm goes bankrupt).
Notice that the fact higher debt increases the chance of bankruptcy does not by itself imply that firm value should be affected.
In fact, the company will go on running even after bankruptcy, the only change will be that all cash flows will now go to the former debt holders in the firm (who take over control)! 20 20

21. Capital structure and financial distress costs
In fact, if bankruptcy is costless, the value of the levered firm is exactly the same as that of the unlevered firm, even if the level of debt is so high that the chances of bankruptcy are significant.
To illustrate this, consider the following example of two firms which are otherwise identical (for instance, they have the same probability distribution of operating income) except for the fact that one is unlevered (100% equity) and the other is financed partly by debt (perpetual debt with a promised interest of 500,000 per year) and partly equity.
Again assume for simplicity that the firm has no systematic risk: ßA = ßEU = ßEL= 0. Then, if the risk-free rate is 10%, we can discount all cashflows at this rate.
Now assume two possible states of the world: 21 21

22. Capital structure and financial distress costs
Expected cashflow to equity holders in unlevered firm = 0.1(1000,000) (300,000) = 370,000.
Value of unlevered firm, VU = Value of equity in the unlevered firm, EU = 370,000/0.1 = 3,700,000
Expected cashflow to equity holders in levered firm = 500,000(0.1) + 0(0.9) = 50,000
Value of equity in levered firm, EL = 50,000/0.1 = 500,000
Operating Income, Y
Prob.
Cash flow to debt holders (levered firm)
Cash flow to equity holders (levered firm)
1000,000
0.1
500,000
300,000
0.9 22 22

23. Capital structure and financial distress costs
Expected cashflow to debt holders in levered firm = 500,000(0.1) + 300,000(0.9) = 320,000
Value of debt in the levered firm, DL = 320,000/0.1 = 3,200,000
Value of levered firm, VL = EL + DL = 500, ,000 = 3,700,000
Thus value of unlevered firm = value of levered firm, so that firm value is unaffected so long as bankruptcy is costless.
The problem, however, is that in most cases, debt holders do not get to take over the entire cashflow of the healthy firm if the firm goes bankrupt. The threat of bankruptcy, and the bankruptcy process itself, robs the firm of a certain proportion of the operating income, which can be thought of as the costs of financial distress. 23 23

24. Capital structure and financial distress costs
These costs may consist of direct costs of bankruptcy, for example:
legal and administrative costs of the bankruptcy process
loss of income to the firm because of loss of confidence by consumers who switch to competing products, etc.
Or they may consist of indirect costs, which are incurred even if the firm doesn't go bankrupt. Examples include:
unwillingness of customers, suppliers, employees etc. to enter into long-term relationships with the firm ("it will probably go bankrupt soon, and then who knows what will happen?"),
loss in the incentives of corporate management to take advantage of positive NPV growth options, ("if the debt holders are likely to take over the firm, why bother to put in more money ?"), 24 24

25. Capital structure and financial distress costs
possible incentives to pay a liquidating dividend (instead of investing money in new projects, pay it out as dividends!),
or increased incentives for risk shifting (taking on highly risky projects in the hope that they pay off and can save the firm from bankruptcy, even though they are negative NPV projects: if they pay off, well and good; if they don't, the firm would probably go bankrupt any way, so on average, shareholders gain).
The last three cases I cited here are examples of costs associated with incentive problems which may exist within a firm even when there is a low chance of bankruptcy: however these problems, and the costs associated with them, get much worse as the probability of bankruptcy goes up and we will therefore include them also as costs of financial distress. 25 25

26. Capital structure and financial distress costs
The size of bankruptcy costs differ with the nature of the type of business that the firm is engaged in.
For example, the bankruptcy costs associated with a chain of grocery stores are somewhat low: if the firm cannot meet interest payments on its debt, management may declare bankruptcy, and the lenders takeover and sell it to a new operator (or, less likely, manage it themselves).In this case, the costs of bankruptcy could be very small: perhaps only the legal and court fees, and some administrative expenses.
However, if it is a drug manufacturer that goes bankrupt, the loss in value can be very high:
as the chances of bankruptcy go up, the company may cut down on R&D expenses for developing new drugs, thus losing the NPV from these opportunities. 26 26

27. Capital structure and financial distress costs
A number of the most talented (and hence sought after) employees may leave the firm for competing concerns.
Consumers may lose confidence in the firm and switch to competing brands.
Thus, by the time the firm actually goes bankrupt, the operating cash flow (and hence value) of the firm that the debt holders get to take over may be far less than before bankruptcy.
It is this possible leakage in operating income (and hence in firm value) that can occur as a by-product of bankruptcy that makes corporate managers wary of jacking up debt in those industries where bankruptcy costs are high.
Thus, while debt may have a net tax advantage, managers have to trade-off this tax advantage against the present value of expected costs of financial distress. 27 27

28. Capital structure and financial distress costs
Taking this trade-off into account, we can now modify the formula for the value of the levered firm to be,
Value of levered firm = Value of unlevered firm + Present Value of debt tax shield - Present Value of costs of financial distress
VL = VU + PVTax Shield – PVDistress Costs
Firm Value
Firm Value Ignoring Distress Costs
Total Firm Value
Optimum Debt
Debt 28 28

29. Example: Wallace Corporation
The Wallace Corporation is currently an all equity firm worth $12 million.
Wallace's corporate tax rate is 40%. Management is considering issuing debt (Debt would be used to buy back an equal value of equity).
The firm's analysts have estimated that bankruptcy (if it occurs at all) will occur 10 years from now and will cost the company $8 million at that time; further, the probability of bankruptcy would increase with leverage according to the following schedule (only columns (1), (2) and (3) are part of the question; All figures in millions of dollars)
Assume that the debt on the company will be a perpetuity. 29 29

30. Example: Wallace Corporation
a) Taking into account bankruptcy costs as well as the effect of debt tax shields, what is the level of debt that the company should choose (among the possible levels given above) to maximize firm value? (Use a discounting rate of 10% to discount bankruptcy costs)
Value of Debt
PV of Tax Shield
Prob. of bankruptcy
Expected bankruptcy costs
PV of bankruptcy costs 2
0.8
0.01
0.08
0.0308
2.5 1
0.25
2.0
0.7710 4
1.6
0.60
4.8
1.8504 6
2.4
0.80
6.4
2.4672 30 30

31. Example: Wallace Corporation
b) What is the right level of debt (among the different levels given above) if you ignore bankruptcy costs? (Assume that both debt and equity income are taxed alike at the personal level). Taking into account bankruptcy costs as well as the effect of debt tax shields, what is the level of debt that the company should choose (among the possible levels given above) to maximize firm value? (Use a discounting rate of 10% to discount bankruptcy costs)
Solution to (a):
a) Part of the solution is given in Coloumns (2),(3), (5) of the table above. For each debt level, compute the expected bankruptcy costs, and the present value of bankruptcy costs. 31 31

32. Example: Wallace Corporation
E.g: Debt (D) = 2 million
Present value of tax shields = 0.8
Expected bankruptcy cost = 8(0.01) + 0 ( ) = 0.08
Present Value of bankruptcy costs = 0.08 [PVIF 10%,10yrs] = 0.08 (.3855) =
Value of the levered firm at this debt level = VU + PV of debt tax shield - PV of bankruptcy costs = =
Working similarly, Value of levered firm at Debt of 2.5 million = =
(It can be checked that firm value is even lower with more debt).
Thus, the firm should issue $2 million debt since firm value is maximized at this level of debt ($12.77 million). Thus, the firm has increased value by 0.83 million by replacing $2 million of equity with debt. 32 32

33. Example: Wallace Corporation
Solution to (b)
If bankruptcy costs are zero, the firm should issue the highest possible level of debt: I.e, the optimal debt is $6 million.
The example illustrates that both the size of the bankruptcy costs and the probability of bankruptcy matter (which depends on the riskiness of the operating income) since the expected bankruptcy cost is the product of the two.
Thus, in general, firms with high business risk generally issue less debt. (Bankruptcy costs are a rationale for firm managers trying to diversify a company's business: ie., why a firm in the tobacco industry may go into the food products business).
In the absence of market imperfections, firm managers should not worry about diversifying at the firm level: stockholders can diversify by holding stock in different companies 33 33

34. Capital structure and Information Asymmetry
Capital structure can matter when there are costs imposed by asymmetric information and/or "issue costs" (like investment banker fees).
When we studied efficient markets, we learned that in practice, the financial markets are not strong form efficient: I.e., all information available to insiders are not reflected in market prices.
This fact can sometimes be costly for a firm trying to raise equity capital to invest in projects.
For example, assume that the management of a software company has news that one of their programmers has just developed an exciting new software program which they feel will have an NPV of $500,000. 34 34

35. Capital structure and Information Asymmetry
Assume further the without the new product, the value of this firm is $1000,000.
The firm is currently all equity financed, and has 50,000 shares outstanding.
Current price per share (without the new product) = $ 1000,000/50,000 = $20/share.
Now, assume that the investment required for this project is $600,000, to pay for testing this software, marketing etc. The problem before management is this: how should we raise the $600,000?
Let us see what will happen to firm value if they issue new equity. 35 35

36. Capital structure and Information Asymmetry
If the firm cannot convince outside investors about their having this new product, investors will pay only the current price ($20/share) for the newly issued shares of the company. In that case, how many shares will they have to sell? 600,000/20 = 30,000.
In this setting, managers feel that they are giving these shares away at a bargain. This is because, once the information about the new product comes out, total firm value = Value of firm without new product + NPV of new product + amount raised by selling equity = 1000, , ,000 = 2,100,000.
Price per share = 2,100,000 / New number of shares = 2,100,000/80,000 = $26.25 per share 36 36

37. Capital structure and Information Asymmetry
The firm could instead finance this project from "internal financing". Internal financing refers to funds internally generated within the firm and is defined as accumulated retained earnings (net income minus dividends) plus depreciation. Let us compute the value of the firm and price per share if the firm finances this projects from internally generated funds:
Value of the firm = Value of the firm without new product + NPV of new product = 1,500,000
Price per share = 1,500,000/50,000 = $30/share
Thus, while the firm used up some available cash by using internal financing, the price per share after the information about the new product gets revealed will be $30 instead of $26.25, so that current stock holders are much better off (by $3.75 for each share they own) if the firm uses internal financing instead of issuing new equity! 37 37

38. Capital structure and Information Asymmetry
This loss in value which can come from issuing equity is sometimes referred to as "asymmetric information costs of financing with equity".
This cost arises when management is forced to issue new equity in a situation in which the firm's shares are undervalued. (This is perhaps the reason why firm managers worry about the 'timing of equity issues': issuing equity at the 'wrong time' can be very costly for the firm).
Such asymmetric information costs also exist for risky debt, but they are much smaller than for equity (they are zero for riskless debt: in general, riskier the security, larger the asymmetric information costs of financing). 38 38

39. Capital structure and Information Asymmetry
In the absence of asymmetric information, the firm could have sold new equity to outsiders at $30 per share because, in this case, outside investors would also know about the new product developed by the firm. (You can check that the price after financing will be $30 per share by repeating the above computation.) Stockholders are indifferent between financing the project using internal funds or new equity financing.
It is therefore asymmetric information which makes equity financing costly.
Another important cost of issuing equity and to a lesser extent, debt, are issue costs: investment banker fees and other transactions costs involved in issuing and selling these securities. Clearly, these "issue costs" are zero for internal financing. 39 39

40. Capital Structure Considerations: Summary
We have talked about the different costs involved in financing projects with three different sources: debt, equity and internal financing.
Debt has an important benefit: it confers an important source of tax savings to the firm.
It has also an important cost: the probability of bankruptcy goes up with debt, and, if there are costs to financial distress, this can reduce the value of the firm.
Selling equity is not always the answer: the costs of issuing equity can be high, particularly when the firm's shares are undervalued in the stock market.
Financing projects with internally generated funds has obviously none of these costs. 40 40

41. Capital Structure Considerations: Summary
Thus, in practice, firms prefer to finance projects with internal financing if possible or, if not, with debt.
At the same time, managers usually do not exhaust all internal funds, or even borrow up to the hilt, because they prefer to maintain some 'financial slack' (which can be thought of as project financing capacity which can be put into effect quickly without issuing equity: this consists of cash, marketable securities,, or unused debt capacity).
This financial slack helps them finance good projects without being forced to sell equity at the "wrong time". So, firms may choose to finance a given project with equity even when they have internal financing available, if firm managers feel that the moment is ripe to raise equity financing, thus reserving their available internal funds for financing future projects. 41 41

42. Capital Structure Considerations: Summary
Firms will use a combination of debt and equity to finance their projects depending on:
(1) size of tax savings they can hope to obtain from issuing debt
(2) risk of the business they are operating in
(3) Type of business (asset type), which affects the size of potential costs of financial distress
(4) Extent of asymmetric information in the capital markets about the true value of the firm
(5) Issue costs
(6) Extent of financial slack the firm wants to maintain. 42 42