Transcript Firm Value

15-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
15-2
Chapter 15
The Capital Structure Decision
Chapter Outline
How Borrowing Affects Value in a TaxFree Economy
 Capital Structure and Corporate Taxes
 Costs of Financial Distress
 Explaining Financing Choices

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15-3
Borrowing and Value
• How
Borrowing Affects Value in a TaxFree Economy



Your objective as a financial manager is to
undertake actions which will maximize the
value of your firm.
A firm’s capital structure is the mix of debt and
equity its financial managers choose.
The key question this chapter will pose is:
Can you change the value of your firm
by changing its capital structure?
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15-4
Borrowing and Value
• Firm
Value in a Tax-Free Economy
The value of a firm is determined by
discounting the stream of cash flows
produced by its assets and operations.
 The age, quantity, quality and the efficiency
with which those assets are utilized will
determine the size of those cash flows.
 However, you cannot increase the size of
these cash flows simply by altering the way
you finance the firm’s operations.

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15-5
Borrowing and Value
• Modigliani


and Miller
This concept was first put forward in 1958 by
Franco Modigliani and Merton Miller (MM).
They demonstrated that:
 When
there are no taxes and well functioning
capital markets exist, the market value of a
company does not depend on its capital
structure.
 In other words, managers cannot increase firm
value by changing the mix of securities used to
finance the company.
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15-6
Borrowing and Value
• Modigliani

and Miller
MM’s proposition rests on a number of critical
simplifying assumptions:
 Capital
markets have to be “well functioning”.
 Investors can trade securities without
restrictions.
 Investors can borrow or lend on the same terms
as the firm.
 Capital markets are efficient, so securities are
fairly priced given the information available to
investors.
 There are no taxes or costs of financial distress.
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15-7
Borrowing and Value
• Modigliani

and Miller
If these simplifying assumptions are true, then
the firm’s capital structure cannot make a
difference to the value of the firm.
 Thus
the most important decisions are about the
company’s assets and capital structure decisions
are unimportant.

If these simplifying assumptions are not true,
then the firm’s capital structure can make a
difference to the value of the firm.
 Capital
structure decisions would become important.
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15-8
Borrowing and Value
• Modigliani




and Miller
If you look at Table 15.1 on page 447 of your
text, you will see the financial data for River
Cruises (RC).
RC is entirely equity financed.
It produces a level stream of earnings and
dividends in perpetuity.
The value of the firm is $1 million.
 This
value arises entirely from the expected cash
flows generated by RC’s assets and operations.
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15-9
Borrowing and Value
• Modigliani

and Miller
Since the cash flows are a perpetuity, you can
calculate the value of RC by discounting the
cash flows at the cost of capital:
State of the Economy
Slump
Normal
Boom
Operating Income
$75,000
$125,000
$175,000
Return on Shares
(Cost of Capital)
7.5%
12.5%
17.5%
$1,000,000
$1,000,000
$1,000,000
Present Value of
Cash flows
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15-10
Borrowing and Value
• Modigliani
and Miller
Notice that regardless of the state of the
economy, the firm is worth $1million to its
shareholders.
 If there are 100,000 shares outstanding,
then each share must be worth $10.

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15-11
Borrowing and Value
• Modigliani

and Miller
But, what if you were to change the firm’s
capital structure?
 Suppose
you were to issue $500,000 of debt
with a 10% coupon and use the funds to
repurchase 50,000 shares at $10 apiece.
Would this change in capital
structure increase the value of
the firm’s remaining shares?
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15-12
Borrowing and Value
• Modigliani
and Miller
If RC were to borrow money, then part of its
income would be paid out as interest.
 The remaining cash flow would belong to
the shareholders.
 But, what would these cash flows be worth?

 As
before, you can calculate their value by
working out the present value of the firm’s
equity earnings.
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15-13
Borrowing and Value
• Modigliani

and Miller
You can calculate the new value of RC’s equity
by discounting the cash flows at the cost of
capital:
State of the Economy
Slump
Normal
Boom
Operating Income
$25,000
$75,000
$125,000
Return on Shares
(Cost of Capital)
5.0%
15.0%
25.0%
$500,000
$500,000
$500,000
Present Value of
Cash flows
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15-14
Borrowing and Value
• Modigliani

and Miller
Thus, regardless of the state of the
economy, the equity is now worth
$500,000 to the shareholders.
If
there are 50,000 shares outstanding,
then each share must be worth $10.

Notice RC has not changed the
value of the firm’s equity by altering
its capital structure.
copyright © 2003 McGraw Hill Ryerson Limited
15-15
Borrowing and Value
• Modigliani

and Miller
Furthermore, RC has not changed the
total value of the firm:
 Before
the restructuring the firm was all
equity and had a total value of $1 million.
 After the restructuring, the firm consists of
$500,000 of debt and $500,000 of equity.
Thus, the firm still has a
total value of $1 million!
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15-16
Borrowing and Value
• MM’s
Proposition I
(Debt Irrelevance Proposition)

MM proposed that:
 The
value of a firm is unaffected by its capital
structure.

This conclusion is known as MM’s
Proposition I.
shows that under ideal conditions, a firm’s
debt policy shouldn’t matter to its
shareholders.
 It
copyright © 2003 McGraw Hill Ryerson Limited
15-17
Borrowing and Value
• How

Borrowing Affects Risk and Return
This proposition can be shown graphically.
 Notice
that the firm is worth $1 million regardless
of the amount of equity value:
All Equity Financing
Firm Value:
After Restructuring
Debt:
$500 k
Equity:
$500 k
$1 million
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15-18
Borrowing and Value
• How

Borrowing Affects Risk and Return
The firm is worth $1 million because,
regardless of its capital structure, its assets
generate $125,000 per year of expected cash
flow:
All Equity Financing
Equity Income
Expected
Income:
$125,000
After Restructuring
Total Income
Interest:
$50,000
Dividend:
$75,000
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15-19
Borrowing and Value
• How
Borrowing Affects Risk and Return
Equity Income
Expected
Income:
$125,000
Total Income
Interest:
$50,000
Dividend:
$75,000
Proof:
Value of Equity Income = $125,000/0.125 = $1 million
Value of Total Income
= $75,000/0.15 + $50,000/0.10
= $500,000 + $500,000 = $1 million
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15-20
Borrowing and Value
• How

Borrowing Affects Risk and Return
Before the restructuring, the firm is worth $1
million and is owned 100% by the shareholders.
 After
the restructuring, the firm is still worth $1 million
and is owned 50% by the shareholders and 50% by
the creditors.

Notice that the two circles on the previous slide
are the same size:
 Both

represent $125,000 of expected cash flow.
However, the second circle shows that the
shareholders expect to receive 60% of the
income ($75,000/$125,000), even though they
own only 50% of the firm.
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15-21
Borrowing and Value
• How
Borrowing Affects Risk and Return
Does the fact that the shareholders will
receive more than 50% of the cash flow mean
they are better off?
 Note that if they were better off, then their
shares should increase in value.

 Thus
the shares would be worth more than ½ the
value of the firm ($500,000).
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15-22
Borrowing and Value
• How
Borrowing Affects Risk and Return
MM say no – the shareholders are not better
off, even though they receive more than ½ of
the cash flow.
 Why?

 The
answer is that, with more debt, the
shareholders bear more risk and thus demand a
higher rate of return.
 As you can see on Slide #19, the discount rate for
the equity cash flows increased from 12.5% to
15%.
 This increase in the discount rate exactly cancels
out the increased dollar return.
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15-23
Borrowing and Value
• How

Borrowing Affects Risk and Return
To recapitulate:
 Restructuring
does not affect operating
income.

The operating risk, or business risk, of the
firm is unchanged.
 However,
with more debt in the capital
structure, the eps become more uncertain (in
other words, more risky).

That is, debt financing increases the financial
risk of the firm.
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15-24
Borrowing and Value
• How

Borrowing Affects Risk and Return
If the firm is financed entirely by equity, a
decline of $50,000 in operating income
reduces the return on the shares by 5%.
 That
is, if you look at Table 15.1, the return
falls from 12.5% to 7.5%.

However, if the firm is financed 50% with
debt, then a decline of $50,000 in
operating income reduces the return on
the shares by 10%.
 That
is, if you look at Table 15.2, the return
falls from 15.0% to 5.0%.
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15-25
Borrowing and Value
• How

Borrowing Affects Risk and Return
This increase in earnings uncertainty (risk),
is why the use of debt financing is referred
to as financial leverage.
 Financial
leverage means that debt financing
amplifies the effects of changes in operating
income on the returns to stockholders.

With increased uncertainty and risk, the
shareholders must demand a higher rate of
return.
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15-26
Borrowing and Value
• How

Borrowing Affects Risk and Return
The result:
 Adding
debt to the capital structure of the
firm will increase the shareholders’ expected
returns.
 However, it will also increase the risk of
those returns.
 These two effects cancel each other out,
leaving the shareholder value unchanged.
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15-27
Borrowing and Value
• Debt
and the Cost of Equity
 What is RC’s cost of capital?
 When
it is all equity financed, the answer is
easy:
Shareholders are paying $10 per share and
expect eps of $1.25.
 If the earnings are a perpetuity, the expected
return is $1.25/$10.00 = 12.5%.
 Thus requity is 12.5%

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15-28
Borrowing and Value
• Debt


and the Cost of Equity
If requity is 12.5% and the firm has no debt, the
rassets is also 12.5%.
Suppose RC now issues debt and you can
afford to buy all of its securities, both debt and
equity:
 What
rate of return would you expect on this
package of securities?
 In other words, what should you pay to own a
cash flow of $125,000 per year in perpetuity?

Hint: restructuring so that RC has 50% debt will not
change its cash flows.
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15-29
Borrowing and Value
• Debt

and the Cost of Equity
The answer is 12.5% since, if you own all of
the securities, you will effectively own all of
RC’s assets and receive all of its operating
income.
 Proof:
From Chapter 11, you know that in a
tax free world:
RC’s
rassets
rassets
= (D/V x rdebt) + (E/V x requity)
= (0.50 x 10%) + (0.50 x 15%)
= 12.5%
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15-30
Borrowing and Value
• Debt
and the Cost of Equity
Thus, the return on the package of
securities is unchanged.
 What does change is the return the
investors require on each of the
components in the package.
 Leverage increases the risk of the equity
and the return that the shareholders will
demand.

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15-31
Borrowing and Value
• MM’s

Proposition II
To see how the expected return on equity
varies with leverage, we rearrange the formula
for the company cost of capital as follows:
requity = rassets + (D/E) x (rassets - rdebt)

This formula is known as MM’s Proposition II.
 It states that the required return on a firm’s
equity increases as the firm’s debt-equity
ratio increases.
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15-32
Borrowing and Value
• MM’s
Proposition II
If you look at Figure 15.3 on page 454 of
your text, you can see a graph of these
relationships.
 Notice that:

 The rassets
is constant, no matter how much
the firm borrows.
 The expected return on the individual
securities does, however, change:
 The expected return on the equity rises
smoothly as the firm adds more debt.
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15-33
Borrowing and Value
• MM’s
Proposition II
In Figure 15.3, notice that the interest
rate on the debt is shown as constant, no
matter how much the firm borrows.
 This is not realistic.

 As
companies borrow more, their debt
becomes more risky as higher interest
payments increase the chance of default.
 The consequence is that, at some point, the
firm will have to pay a higher interest rate if it
wishes to borrow more.
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15-34
Borrowing and Value
• MM’s Proposition II
 Proposition II continues to predict that the
expected return on the package of debt and
equity does not change.
 This is demonstrated in Figure 15.4:
 The rassets line is still constant.
 However, the rdebt line now increases.
 Notice, though, that the requity line tapers off
as the D/E increases.

This happens because, as the firm borrows more,
some of the risk is transferred from the
shareholders to the bondholders.
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15-35
Capital Structure and Corporate Taxes
• Does



Debt Matter?
MM’s propositions suggest that debt policy
should not matter.
However, in reality, debt matters a lot, and
financial managers spend a great deal of their
time worrying about the optimal debt to equity
ratio for their firm.
Which leads to a critical question:
What is wrong with MM’s theory?
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15-36
Capital Structure and Corporate Taxes
• Does

Debt Matter?
Debt financing has an important advantage.
 If
the company pays tax, interest is a tax
deductible expense.

To see the advantage conferred by debt,
let’s assume that RC is in a 35% tax
bracket.
 On
the next slide, the left-hand column shows
what happens if RC is entirely financed with
equity.
 The right-hand column shows what happens if it
is 50% financed with debt.
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15-37
Capital Structure and Corporate Taxes
• Does
Debt Matter?
Operating Income
Less: Interest (10%)
Before-Tax Income
Zero Debt
50% Debt
$125,000
$125,000
0
50,000
125,000
75,000
+
+
Less: Tax (35%)
43,750
26,250
After-Tax Income
81,250
48,750
Combined Payments
to Security Holders
(Interest + After-Tax Income)
81,250
$98,750
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15-38
Capital Structure and Corporate Taxes
• Does
Debt Matter?
Notice on the previous slide that aftertax income available to just the
shareholders falls from $81,250 to
$48,750 if the firm borrows.
 But, the combined cash flow available
to all the security holders rises from
$81,250 to $98,750.

What explains this?
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15-39
Capital Structure and Corporate Taxes
• Debt

and Taxes
The combined income to the debt and
equityholders is higher by $17,500
when RC is levered.
 This
occurs because interest payments
are tax deductible.
 Therefore every $1 of interest RC pays
reduces its taxes by $0.35:
Tax Savings = tax rate x interest payments
= 0.35 x $50,000
= $17,500 per year
copyright © 2003 McGraw Hill Ryerson Limited
15-40
Capital Structure and Corporate Taxes
• Debt

and Taxes
When it has no debt, the value of RC to
the shareholders is simply the PV of the
$81,250 after-tax income in perpetuity.
 If
the firm is all equity financed, we know
its required return on equity is 12.5%:
Value of RC With no Debt = $81,250 / 0.125
= $650,000*
Without taxes RC was worth $1 million. With taxes,
35% of the firm’s value is lost to the government.
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15-41
Capital Structure and Corporate Taxes
• Debt
and Taxes
But, if RC issues $500,000 of debt, the
value of all of the firm’s securities must
increase by the value of the tax shield.
 This means, in a world with taxes, the
value of a firm increases with debt:

Value of RC with Debt = Value of RC Without Debt
+ Tax Shield
= $650,000 + $175,000
= $825,000
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15-42
Capital Structure and Corporate Taxes
• Debt

and Taxes
To generalize:
Annual Tax Shield = Corporate Tax Rate x Interest
= Tc x (rdebt x Amount of Debt)
= Tc x (rdebt x D)

If the tax shield is perpetual, we can use the
perpetuity formula to calculate the value of the
tax shield:
PV of Tax Shield = Annual Tax Shield / rdebt
= [Tc x (rdebt x D)] / rdebt
= Tc x D
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15-43
Capital Structure and Corporate Taxes
• MM’s


Modified Proposition I
In a no tax world, MM’s Proposition I states
that the value of the firm is unaffected by
capital structure.
MM’s modified Proposition I recognizes the
impact of taxes on firm value:
Value of Levered Firm = Value of All-Equity Financed
Firm + PV of Tax Shield

In the special case of permanent debt:
Value of Levered Firm = Value of All-Equity Financed
Firm + TcD
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15-44
Capital Structure and Corporate Taxes
• WACC

and Debt Policy
To summarize for RC if it issues $500,000 of
debt:
 Value
of the firm = $825,000
 Value of the Debt = $500,000
  Value of the Equity = $325,000

MM’s Proposition II with corporate taxes tells
us RC’s cost of equity should be:
requity = rassets + (D/E) x (1 - Tc) x (rassets - rdebt)
= 12.5% + (500/325) x (1-0.35) x (12.5%-10%)
= 15%
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15-45
Capital Structure and Corporate Taxes
• WACC

and Debt Policy
We now have all the information we need
to calculate RC’s WACC if it issues debt
in a world with taxes:
rassets = [D/V x (1-Tc)rdebt] + (E/V x requity)
= [500/825 x (1 - 0.35) x 10%] +
(325/825 x 15%)
= 9.85%

Thus, adding debt in a world with taxes reduces
RC’s WACC from 12.5% to 9.85%.
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15-46
Capital Structure and Corporate Taxes
• WACC

and Debt Policy
If you look at Figure 15.3 on page 459 of your
text, you can see that as RC borrows more, its
expected return on equity increases.
 But
the rise is less rapid than it would be in a tax
free world.


In addition, the cost of debt has fallen from
10% to 6.85%.
The result:
WACC declines as RC’s debt-equity ratio
increases.
 The
copyright © 2003 McGraw Hill Ryerson Limited
15-47
Capital Structure and Corporate Taxes
• Does

Debt Matter?
If borrowing provides a debt shield, then we
discover that the optimal debt policy is for all
firms to borrow to the extreme.
 This
minimizes the WACC and thus maximizes the
value of the firm.

In reality, financial managers do not believe
that if they borrow to the hilt this will maximize
the value of the their firm.
So, now what is wrong with MM’s theory?
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15-48
Costs of Financial Distress
• Other




Factors to Consider
Clearly, there are factors other than taxes which
a financial manager must consider when
determining how much their firm should borrow.
Costs of Distress arise from bankruptcy or
distorted business decisions before bankruptcy
occurs.
These distress costs reduce the value of the firm.
And, as the firm adds debt to its capital structure,
these costs start to increase significantly.
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15-49
Costs of Financial Distress
• Other
Factors to Consider
As debt increases, the costs of distress
offset the benefits the firm receives from
the interest tax shield.
 The result:

Value of All-Equity Firm
+ PV of the Tax Shield
– PV of the Costs of Financial Distress
= Value of the Levered Firm
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15-50
Costs of Financial Distress
• Other
Factors to Consider
This formula is known as the Trade-Off
Theory.
 The Trade-Off Theory says that financial
managers choose the level of debt which
will balance the firm’s interest tax shields
against its costs of financial distress.
 Look at Figure 15.7 on page 460 to see
how the Trade-Off Theory works.

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15-51
Costs of Financial Distress
• The

Trade-Off Theory
In Figure 15.7, you can see that, at first, adding
debt to the firm’s capital structure increases the
value of the firm.
 This
reflects the benefits the firm receives from the
interest tax shields.


But, at some point, as the firm borrows more,
the costs of distress become more important.
They offset the benefits of the tax shield and
the value of the firm starts to decline.
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15-52
Explaining Financing Choices
•A



Competing Theory
The Trade-Off Theory states that the firm’s
choice of its debt-equity ratio is a trade-off
between its interest tax shields and the costs of
financial distress.
The Trade-Off Theory can explain much of how
firms in various industries behave when they
take-on debt.
However, there are things this theory cannot
explain.
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15-53
Explaining Financing Choices
•A




Competing Theory
The Pecking Order Theory states that firms
prefer to issue debt rather than equity if internal
finance is insufficient.
They do this, because, as we saw in the
previous chapter, investors believe that a share
issue is an indicator the management believes
the firm’s shares are overvalued.
A share issue is thus interpreted by the
markets as a bad omen.
Debt is less likely to be interpreted this way.
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15-54
Explaining Financing Choices
•A



Competing Theory
As we saw in Chapter 13, Canadian
corporations do rely on internal funds to
finance the majority of their new investment.
In addition, most external financing comes from
debt.
Thus, aggregate financing patterns are
consistent with the Pecking Order theory.
 But,
the theory works best for mature firms.
 As with the Trade-Off Theory, there are things it
cannot explain.
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15-55
Summary of Chapter 15



The goal of the financial manager is to maximize
the value of the firm.
The key question is: Can a financial manager
increase the value of the firm by changing the
firm’s debt-equity ratio?
MM’s Proposition I states that the value of a firm
arises from the cash flows produced by its
assets.
 You
cannot change these cash flows by changing
the way the assets are financed.
 All you can change is how those cash flows are
distributed to investors.
copyright © 2003 McGraw Hill Ryerson Limited
15-56
Summary of Chapter 15




If you cannot change the size of the cash flows
by changing the financing of the firm, then its
debt-equity structure is irrelevant.
MM’s Proposition I holds only in well-functioning
capital markets in which there are no taxes and
no costs of financial distress.
With the existence of taxes, the firm’s interest
payments become tax deductible, creating a tax
shield which increases the value of the firm.
Under these circumstances, managers should
borrow as much as possible, because it
maximizes the value of the firm.
copyright © 2003 McGraw Hill Ryerson Limited
15-57
Summary of Chapter 15


But, as you add debt to the firm’s capital
structure, the costs of financial distress
increase, offsetting the value of the tax shields.
The Trade-Off Theory states that there is an
optimal capital structure for a firm.
 It
occurs when the value of the tax shields balances
the costs of distress.


A competing theory, the Pecking Order Theory,
says that firms prefer internal financing.
However, if internal funds are insufficient, the
firm will prefer debt financing to issuing equity.
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