1. How Much Should a Firm Borrow?
Student Presentations
Why M & M Does Not Hold
Corporate Taxes
Personal Taxes
Financial Distress
Pecking Order of Financing Choices

2. Corporate Taxes Debt provides a tax shield Interest is tax deductible
Government’s share of income declines
Value of bondholders’ and stockholders’ share increases

3. Present Value of Tax Shield
If debt is assumed to be a perpetuity

4. Table 18.1: Comparison of Unlevered Firm and Levered Firm with $1000 of Debt at 8%

5. 1 year $1,000,000 loan at 8% A) $25,926 B) $28,000 C) $35,000
Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:
1 year $1,000,000 loan at 8%
A) $25,926
B) $28,000
C) $35,000
D) $350,000
E) None of the above

6. $1,000,000 perpetuity loan at 8% A) $28,000 B) $80,000 C) $324,074
Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:
$1,000,000 perpetuity loan at 8%
A) $28,000
B) $80,000
C) $324,074
D) $350,000
E) None of the above

7. Claims on Firm Bondholders: Debt Government: Taxes
Equityholders: Remainder of firm value

8. M&M and Taxes
Value of firm = Value of all-equity-financed firm + PV(tax shield)

9. Pfizer Balance Sheet 2004 and Adjusted for $1 billion Debt for Equity Trade
ACTUAL
ADJUSTED

10. What’s Wrong with Pfizer’s CFO?
Should also consider personal taxes
Cost of financial distress

11. Corporate and Personal Taxes
Relative tax advantage of debt vs. equity
If the relative advantage is > 1, debt is preferred
If the relative advantage is < 1, equity is preferred

12. Example – Advantage to Debt
Assume dividends are 40% of earnings
Each dollar of earnings generates $0.40 in dividends and $0.60 in capital gains
Marginal investor is in the 35% tax bracket on interest and 15% on dividends and capital gains
Deferral of capital gains reduces capital gains rate in half (to 7.5%)

13. Example - continued

14. A) 0.76 B) 1.16 C) 1.35 D) 1.76 E) None of the above
Calculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ; Tp = Personal tax rate on interest income = 20% :
A) 0.76
B) 1.16
C) 1.35
D) 1.76
E) None of the above

15. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20%
A) $0.66
B) $0.25
C) -$0.66
D) -$0.34
E) None of the above

16. Costs of Financial Distress
Value of firm = Value of all-equity-financed firm
+ PV(tax shield)
– PV(costs of financial distress)

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

18. Types of Financial Distress
Bankruptcy costs
Direct: legal and court costs
Indirect: Inefficient operations, creditors, employees, suppliers, customers
Financial distress without bankruptcy
Incentives for a firm in difficulty
Risk shifting
Refusing to contribute equity capital
Taking cash from firm
Delaying tactics
Bait and switch on use of funds from debt

19. Costs of Financial Distress by Asset Type
Tangible assets unaffected by ownership
Real estate
Airplanes
Intangible assets
Brand image
Technology
Human capital

20. Trade-off Theory of Capital Structure
Capital structure depends on trade-off between interest tax shield and financial distress
High debt firms
Safe, tangible assets
High taxable income
Low debt firms
Risky, intangible assets
Unprofitable companies
Does theory work?
Yes and no

21. Pecking Order of Financing Choices
Firms prefer internal finance
Firms adapt payout targets to investment opportunities trying to avoid sudden changes
Sticky dividend policies and fluctuations in profitability and investment opportunities lead to cash flow shifts
If external finance is required, firms issue debt first, then equity

22. Tests of Pecking Order Large firms tend to have higher debt ratios
Firms with high ratios of fixed assets to total assets have higher debt ratios
More profitable firms have lower debt ratios
Firms with higher ratios of book-to-market values have lower debt ratios

23. Next Class Thursday, April 12 Financing and Valuation – Chapter 19
Problem Set 3