Ê

Ê 


 
 

 á


1.There are no corporate or personal

income taxes and no bankruptcy costs
2. The ratio of debt to equity for a firm is
changed.
3. The firm has a policy of paying 100% of
its earnings in dividends
`. The expected value of the subjective
probability distributions of expected
future operating earnings for each
company are the same for all investors
in the market
5. The operating earnings of the firm are
not expected to grow
 
 



h1)ki= F/B
F-annual interest charge
B- market value of debt
outstanding
£ ki - yield on the company¶s debt
h2) ke= E/S
E- earnings available to common
stakeholders
S- Market value of stock outstanding

£ ke - required return on equity

h
ko ÷

÷- Net operating earnings
V- Total Market value of the firm

£ ko ë
ë 


 
Ê 
Ê  

 

 

á
To illustrate assume that a firm has $1,
000 in debt @10% interest, that the
expected value of annual operating
earnings is $1, 000 , and that the overall
capitalization rate is 15%. Given this
information we may calculate the value
of the firm as follows:
Net ÷perating Income $ 1,
000
÷verall Capitalization Rate .15
Total Value of the Firm $ 6, 667
Market Value of Debt
1,000
Market Value of Stock $
5,667
The earnings available to common
shareholders, is simply NET
÷ ERATING INC÷ME MINUS
INTEREST AYMENTS, or $ 1,000 - $
100= $900. the implied required return
on equity is:

ke = $900÷$5,667 = 15.88%
Net ÷perating Income Œ1,
000
÷verall Capitalization Rate .15
Total Value of the Firm Œ6, 667
Market Value of Debt
3,000
Market Value of Stock Œ
,667
The implied required return on equity is:


4 Œ

Π 


 

ë ë ë

  





Ê
Ê 

* The traditional approach to valuation
and leverage assumes that there is an
optimal capital structure.
* The firm can increase the total value of
the firm through the judicious use of
leverage.
* The approach suggests that the firm
can initially lower its cost of capital and
raise its total value through leverage.
* Although investors raise the required
rate of return on equity, this does not
offset entirely the benefit of using
cheaper debt funds.
* As more leverage occurs, investor¶s
increasingly penalize the firm¶s required
equity return until eventually this effect
more than offsets the use of cheaper
debt funds.
* The traditional position also implies
that the cost of capital is not
independent of the capital structure
of the firm and that there is an
optimal capital structure.
 
 Ê 
 

þ
þ
þþ 
á
* is similar to the N÷I
* provides a behavioral justification for
constant cost of capital and value of the
firm
 á
  þþ
á
* Capital markets are perfect
* The average expected future operating
earnings of a firm are represented by
subjective random variables
* Firms can be categorized into
³equivalent return´ classes.
* The absence of corporate income taxes
is assumed.
 Ô







á


* omemade leverage
± The support idea that investors
harbitragers) are able to substitute
personal or homemade leverage for
corporate leverage, thereby
replicating any capital structure might
undertake
* Arbitrage rocess
±Is the operational justification for
the MM approach and is
essentially a balancing operation
 á


Consider two firms identical in every

respect except that company A is not
levered, while company B has $30,000
of 12% bonds outstanding. According to
the traditional position, company B may
have a higher total value and lower
average cost of capital than company A.
the valuation of the two firms is
assumed to be the following:
 Company A Company B
÷ Net operating income $10,000 $10,000
Interest on Debt 3600

Earnings available to

common stockholders $10,000 $6,`00

 Required equity return 0.15 0.16
 Market value of debt $66,667 $`0,000

 Market value of stock $30,000

 Total value of firm $66,667 $70,000

 Implied overall capitalization rate 15% 1`%

 Debt-to-equity ratio 0 75.00%
 á
 


If you are a rational investors who owns 1

percent of the stock of company b, the
levered firm, worth $`00 hmarket
value) you should:
1. Sell the stock in company B for $`00.
1. Borrow $300 at 12% interest. This
personal debt is equal to 1% of the
debt of company B, your previous
proportional ownership of the
company.
2. Buy 1% of the shares of company A,
the unlevered firm, for $666.67.



 áþ


 þ

* Both corporate and personal taxes,

capital structure decisions by the firm
were irrelevant.
* Changes in capital structure have no
effect on the firm¶s total valuation.
 þ

* Miller¶s model suggest that in market

equilibrium personal and corporate tax
effects cancel out. is model implies
that at the margin, personal tax rate
debt income, ?pd, must equal the
corporate tax rate, ?
 
 
áþá
þ

* Different investors²different personal

tax rate.
* ension funds²tax exempt;
* igh income individuals²high tax
brackets
=))Miller¶s position is based on the idea
that when the market is in
disequilibrium, corporations alter their
capital structures to take advantage of
clienteles of investors in different tax
brackets.
 þÔþá

* In the case of capital structure, the product is

a financial instrument and the niche is an
unsatisfied investor clientele.

* Clientele is unsatisfied simply because there

are not enough securities available at the
type necessary to satisfy its tax motivated
investment desires.
* Market equilibrium occurs when the
total debt issued causes the two
marginal tax rates to be the same
* For all companies there is the total
optimal capital structure that depends
on the tax brackets of different
clienteles of investors and the amount
of the funds that this clienteles need to
invest.
* Implication: if the corporate tax rate
were to increase relative to the personal
tax rate, the equilibrium would call for
higher total debt-to-equity ratios for
companies overall.
 áþ

* If the tax rate on the stock income is

zero , we would expect that there to be
an equilibration of returns between
common stocks and tax-exempt bonds,
because the tax rate on municipal debt
income is zero.
* ÷n the supply side of the equation,
different corporations have diff. effective
tax rates at the margin. This makes the
market equilibrium process two-sided
and more likely that there will be a net
tax effect associated with corporate
leverage.

  
Ê




* The irrelevance of capital structure rests
on an absence of market imperfections.
* No matter how one slices the corporate
pie between debt and equity, there is a
conservation of value, so that the sum
of the parts is always the same.
 


* The advantage of debt in a world of

corporate taxes is that interest
payments are deductible as an
expense.
* They elude taxation at the corporate
level, whereas dividends or retained
earnings associated with stock are not
deductible by the corporation for tax
purposes
 Example

* Suppose the earnings before interes

and taxes are $2000 for companies X
and Y., they are alike in every rwspect
except in leverage. Company Y has
$5000 in debt at 12% interest, whereas
company X has no debt. If the tax rate
is `0% for each company we have«
Company X Y
EBIT $2,000 $2,000
Interest, income to debt holders 0 0
rofit before taxes $2,000 $2,000
Taxes 800 560
Income Available to stockholders $1,200 $ 8`0
Income to debt holders plus income
to stockholders $1, 200 $1,``0
 


* resent value of tax shield =

?
 = ? 

? is the corporate tax rate

the interest rate on the debt
 the market value of the debt
* Tax shield ± is a thing of value and that
the overall value of the company will
increase debt is employed than if the
company has no debt
* This is increased valuation occurs
because the stream of income to all
investors is greater.
* Value of firm =
Value if unlevered + Value of tax
shield
* The greater the amount of debt, the
greater the tax shield and the greater
the value of the firm, all other things are
the same.
* The original MM proposition as
subsequently adjusted for corporate
taxes suggest that an optimal is to take
on a maximum amount of leverage.
 
 
 


* Tax savings associated with the use of

debt are not certain.
* If reported income is consistently low or
negative, the tax shield on debt is
reduced or even eliminated
* If the firm should go bankrupt and
liquidate, the potential future tax savings
associated with debt would stop
altogether.
* The greater the responsibility of going
out of business, the greater the
probability the tax shield will not be
effectively utilized.
* If earnings in a given year are
sufficiently low, these other tax shields
may entirely use up the earnings at
hand.
* As a result, the tax liability would be
zero, and the company would be unable
to utilize interest payments as a tax
deduction.
* As a company takes on more debt, it
increases the probability that earnings
in some years will not be sufficient to
offset all the tax deductions.
* The uncertain nature of the interest tax
shield, together with the possibility of at
least some tax shelter, redundancy,
may cause firm value to rise less with
leverage than the corporate tax
advantage alone would suggest.
*
everage increases, the uncertainty
associated with the interest tax shields
come into play.
* More leverage occurs, tax shield
uncertainty causes value to increase at
an ever ± decreasing rate and may
eventually to turn down.
* Value of firm = Value if unlevered + ure
value of corporate tax shield ± Value lost
through tax shield uncertainty

> The last 2 factors combined give the present

value of the corporate tax shield. The greater
the uncertainty associated with the tax shield,
the less important it becomes
 


 


* The presence of taxes on personal

income may reduce or possibly
eliminate the corporate tax advantage
associated with debt
 



 

* resent value of tax shield =

h1 ± tc)h1-tps)
1- 1 ± tpd 

? and  as before are the corporate tax

and market value of the firm¶s debt
 


 


h1 ± tc)h1-tps)
1- 1 ± tpd 

tps is the personal income tax applicable to

common stock income
tpd is the personal tax rate applicable to
debt income
 


 


* resent value of tax shield = tc 

* After ± tax income for debt holders =
$1h1 ± tpd )
* After ± tax income for stockholders =
$1h1 ± tc )
* Stock income is composed of:
- dividends
- capital gains
* Dividend income ± large tax at the same
personal tax rate as interest income
* Capital Gains often are taxed at a lower
rate.
* A company will need to decide whether
to finance with debt or with stock.
* If a dollar of operating earnings is paid
out as interest to debt holders, the
company pays no corporate tax on it
because interest is deductible as an
expense.
* If the dollar of operating earnings is
directed instead to stockholders, the
company pays a tax on those earnings
at the corporate tax rate.
* If the company is concerned with only
after tax income to the investor, it would
finance either with debt or stock
* If the personal tax rate on debt income
> the corporate tax rate, the company
would finance stock
* If tpd < tc, it would finance debt

* If tpd = tc, it would be a matter of

indifference whether debt or
stock
  

 




 BANKRU TCY
± the reorganization or liquidation of a
firm that cannot pay its debts.
* Bankruptcy costs are more legal and
administrative expenses of bankruptcy
* They involves inefficiencies in operating
a company when it is about to go
bankrupt as well as liquidation of assets
at distress prices below their economic
values
* The levered firm may be less attractive
to investors that the unlevered one
* If the firm goes bankrupt, assets can be
sold at their economic values with no
liquidating or legal costs involved
 áÔ

á
* The possibility of bankruptcy usually is not the
linear function of the debt-to-equity ratio, but
it increases at an increasing rate beyond
some threshold.
* The expected cost of bankruptcy increases in
this manner and would be expected to have a
corresponding negative effect on the value of
the firm and on its cost of capital.
 ááá 

* Both taxes and bankruptcy costs, there
will be an optimal capital structure.
* The net tax effect will have a positive
influence on value, at least for moderate
amounts of leverage; bankruptcy costs
and tax shield uncertainty exert a
negative influence.
 Value of the firm =
Value as unlevered firm
+
resent value of net tax shield on debt
±
resent value of bankruptcy costs
 
 
Ê  
Ê 
 ÷ther capital market imperfection impede the
equilibration of security prices according to
their expected return and risks.
-it may result in leverage having an effect on
the value of the firm apart from taxes and
bankruptcy costs.
-it must not be only material but also one-
directional.
 áá
Ôþþá

á
 
* The perceived risks of personal
leverage and corporate leverage may
differ. Despite the implication in the MM
analysis that personal and corporate
leverage are perfect substitutes, there
are various reasons for suspecting that
this may not be the case.
* ersonal
everage involves a certain
amount of inconvenience for investors,
which they do not experience in
corporate leverage.
* In addition, stockholders have
limited liability with a stock investment,
whereas their liability with personal
loans is unlimited. Moreover, the cost
of borrowing may be higher for an
individual than for the corporation.
 á
 
* Restriction on investment
behavior may retard the arbitrage
process. Many institutional investors,
such as pension funds and life
insurance companies, are not allowed
to engage in the ³homemade´ leverage.
* Regulatory bodies, often restrict
stock and bond investments to a list of
companies meeting certain quality
standards, such as only a ³safe¶ amount
of leverage.
Ê 
Ê Ê 
 
 


 
 

  

Ô


* The equity of a firm can be viewed as a
call option on the firm¶s total value, the
value being associated or an asset of
the option.
* The writers of the option are the debt
holders.
* Assume that debt is represented by
discount bonds paid at maturity.
* The stockholders as having sold the
firm with the option to but it back at a
specified price.
* The option has an exercise price equal
to the face value of the debt, and its
expiration date is the maturity date.
Ñ
ë

ëë 


ë 


Vo= max hVf ± D,0)
Where:
Vf = the value of the firm at the
expiration date
D = the face value of the debt
max = the maximum value of
Vf - D, or zero whichever is greater
 Ñ
ë





ë 



Vf= min hVf,D)

Where: min = Vf or D, whichever is

less.

  




 
 
á

š

 
  

 

 



 
 
 





š  



 

 


 

 
š 



  


    
   
 

 
  

v
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 ë  ë


m
    


 Œ

 

 
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m !
"
! #
$%&'%()*+,-*!'"$!")"./
!"0/
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#"("
£


  
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$%&'%()*+,-!'"$!")"./
!"0/
#//!-1"
"-1("1
#",-
Vo is the value of the stock
$`milh.9898) - $3mil h.9803)
2.71828h.06x5)
= $1, 780,526
Value of debt = $`,000,000 - $1,780,526
= $2,219,`7`
 

 

÷ 
2 
3   


 

 




 
 

  


 


š 
  

 
 


  




 

  

š 34 5#%! 

š 4 m #%("---1!

š 4 
5#
%&,,,,,,%("---1!#%6(((!7
2 89 :
 
%( 


 
%",1&&(!
%!7!//-7
 The ercentage Increase for Debt are:

-
  
 
Face Value of $1,000,000 $3,000,000 200%
Debt
Value of Debt 733,319 1,915,569 161
š



  

 




 
 




  
 
š 

 
 ; 





 



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9 






 
 

 


š 5
 

 

9  
 







š
 


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š = 



 

  e underinvestment
Problem

A positive N V project should be

accepted but this may not always
happen
The underinvestment proposition can be
put in an option pricing model
framework
 á
   þ





* Monitoring requires the expenditure of

resources, and the costs involved are
one form of agency cost.
* Agency costs are ultimately borne by
the stockholders.
* Every decision of the firm would need to
be monitored.
* It is not that monitoring costs per se are
bad for the owners of the company: it is
that monitoring needs to be efficient.
* Dividend and financing decisions can be
monitored with only moderate cost.
* roduction and investment decisions of
the firm are much more costly to
monitor.
* When there is little or no debt, lenders
may engage in only limited monitoring,
whereas with a great deal of debt
outstanding they may insist on
extensive monitoring.
* Monitoring costs would act as a further
factor decreasing firm value for extreme
leverage.
 


þ

  
 
* ensen¶s free ± cash ± flow theory
alleges that if managements are left
to their own devices they will invest in
capital projects and acquisitions that
do not provide sufficient expected
returns.
* There is a need to incent
management to disgorge free cash
flow to stockholders, the rightful
owners of excess liquidity. This way
can the agency problem be
resolved.
Ê  Ê
Ê Ê
* It occurs when a capital structure
changes convey information to security
holders
* It assumes an asymmetry in information
between the management and
stockholders.
á 
  

* An information wherein one party in a

transaction has more or superior
information compared to another.
* ÷ften happens in transactions where
the seller knows more than the buyer,
although the reverse can happen as
well.
³The greater the asymmetry in
information between the insider
hmanagement) and the outsiders
hsecurity holders), the greater the likely
stock price reaction to a financing
announcement.´


 



There is a great deal of controversy

whether capital structure as determined
by its financing decision affects its
overall value.
 
á

* Argue that the firm can lower its cost of

capital and increase market value per
share by the judicious use of leverage.
þ

þ

á

* Argue that in the absence of taxes and

other market imperfections, the total
value of the firm and its cost of capital
are independent of capital structure.
* Based on the notion that there is a
conservation of investment value.
 

 




* There is a substantial advantage to the

use of debt which is lessened with tax
shield uncertainty particularly if leverage
is high.
* Tax advantage was reduced if
personal income taxes was allowed
and higher personal tax rate on
debt income than on stock income
 
   

* It work to the disadvantage of leverage,

particularly high leverage.

* A combination of net tax affect with

bankruptcy cost will result in an optimal
capital structure.
* ÷ther market imperfections impede the
equilibration of security prices according
to the expected return and risk. As a
result, leverage affect the value of the
firm.
 





á
   
* An option pricing model framework
gives stockholders an option to buy
back the firm at the maturity of the debt.

* An increase in the variance of the

associated asset hvalue of the firm) will
increase the value of the option.
* It is the stockholders¶ advantage to
increase variance by increasing the
riskiness of the assets of the firm or by
increasing the proportion of debt.
* Debt holders can protect themselves
against this occurrence by imposing
protective covenants which involves
monitoring costs, which is a form of
agency cost
* Stockholders, who ultimately bear the
cost of monitoring, have an incentive to
see that it is efficient.

* Monitoring cost likely to increase at an

increasing rate with leverage. It may
limit the amount of debt in an optimal
capital structure.
* In the context of agency costs,
other incentive issues affecting
capital structure decisions were
analyzed.
  

* It occurs when a capital structure

changes convey information to security
holders.

* It assumes an asymmetry in information

between the management and
stockholders.

 ëv




 

ë