6- 1 Outline 6: Capital Structure 6.1 Debt and Value in a Tax Free Economy 6.2 Capital Structure and Corporate Taxes 6.3 Cost of Financial Distress 6.4 Explaining Financial Choices

6- 2 Value and Capital Structure AssetsLiabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm

6- 3 Average Book Debt Ratios

6- 4 M&M (Debt Policy Doesn’t Matter)  Modigliani & Miller  When there are no taxes and capital markets function 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.

6- 5 M&M (Debt Policy Doesn’t Matter) Assumptions Capital structure does not affect cash flows e.g...  No taxes  No bankruptcy costs  No effect on management incentives

6- 6 Example - River Cruises - All Equity Financed M&M (Debt Policy Doesn’t Matter)

6- 7 Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

6- 8 Example - River Cruises - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

6- 9 Cost of Capital

6- 10 r DVDV rDrD rErE Weighted Average Cost of Capital rArA

6- 11 Weighted Average Cost of Capital without taxes (M&M view) Includes Bankruptcy Risk r DVDV rDrD rErE WACC

6- 12 r DVDV rDrD rErE WACC Weighted Average Cost of Capital

6- 13 Financial Risk - Risk to shareholders resulting from the 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. Cap. Struct. And Corp. Taxes

6- 14 Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual EBIT is $1,000. 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? Cap. Struct. And Corp. Taxes

6- 15 All Equity1/2 Debt EBIT1,000 Interest Pmt 0 Pretax Income1,000 40% 400 Net Cash Flow$600 All Equity1/2 Debt EBIT1,0001,000 Interest Pmt Pretax Income1, % Net Cash Flow$600$540 Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s 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 Taxes

6- 16 Cap. Struct. and Corp. Taxes All Equity1/2 Debt EBIT1,0001,000 Interest Pmt Pretax Income1, % Net Cash Flow$600$540 Total Cash Flow All Equity = 600 *1/2 Debt = 640 ( ) Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s 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?

6- 17 Capital Structure PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 /.10 = $400 PV Tax Shield = D x Tc = 1000 x.4 = $400

6- 18 Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 /.10 = 6,000 PV Tax Shield = 400 Firm Value with 1/2 Debt = $6,400

6- 19 Financial Distress Costs 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 Distress

6- 20 Financial Distress Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm

6- 21 Financial Choices Trade-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.