SESSION 5:

CAPITAL STRUCTURE

MODERN FINANCE AND CORPORATE FINANCE

NIKOLAOS KAVADIS
[email protected]
 INTRODUCTION
Capital structure = Relative proportion of equity and debt.

When a firm wants to raise capital (funds), it has to decide which type of security to sell. This will
determine its capital structure.
But will it affect the value of the firm?
• Question of whether we reason under the assumptions of perfect capital markets:
o All securities are fairly priced, no taxes or transaction costs, the total cash flows of the firm’s projects are not affected by
how the firm finances them.

 As long as the cash flows generated by the firm’s assets are unchanged, then the value of the firm
does not depend on its capital structure.
 If capital structure affects firm value, it must come from changes to the firm’s cash flows that result
from market imperfections.

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 INTRODUCTION
• What considerations should guide funding/capital raising decisions?
• Selling shares for a cost of capital of, e.g., 15%, (assuming 5% risk-free rate and, due to firm risk, 10% risk
premium required by investors) or borrowing at, e.g., 6%?
• If we borrow, will this choice affect the NPV of the new project for which the funds are destined, and hence
change the value of the firm and its share price?

Example:
Case 1: All-equity financing
Investment opportunity for an initial investment of $800 this year.
Cash flow generation of either $1400 (strong economy) or $900 (weak economy), one year horizon  Existence
of market risk, given dependence on the economy’s state.
Risk-free rate = 5%, Risk premium = 10%. What is the NPV?

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 INTRODUCTION
Cost of capital = 15%
Expected cash flow in one year = ½*(1400) + ½*(900) = $1150
NPV = –800 + (1150/1.15) = –800 + 1000 = $200 >0

• If all-equity financing, how much would investors be willing to pay for the firm’s shares?
In the absence of arbitrage, the price of a security = the present value of its cash flows. Since no other liabilities,
equity holders will receive all of the cash flows generated:
PV(cash flows) = (1150/1.15) = $1000
 Hence, the firm can raise $1000 and keep 200 as profit.

Unlevered equity = Equity in a firm with no debt = $1000 (at t), but given cash flows vary if strong vs. weak
economy ($1400 vs $900) at t+1, shareholder returns will be 40% vs. –10% at t+1.
Assuming equally likely economy states, expected return of unlevered equity = ½*(40%) + ½*(–10%) = 15%

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 INTRODUCTION
Case 2: Both debt and equity financing
Decision to borrow $500 in addition to selling equity.
Because the project’s cash flow is enough to repay the debt, debt is risk-free. Risk-free interest rate = 5%. We’ll
owe to debt holders 500*1.05 = $525

Levered equity = Equity in a firm with debt

 Payments for debt have to be done before any payments to equity holders
 Thus, equity holders will receive either 1400–525= $875 or 900–525= $375 depending on the
economy

• At what price E should the levered equity is sold for?

• What’s the best capital structure choice for the firm?

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 INTRODUCTION

Answer provided by Modigliani & Miller (1958):

With perfect capital markets, the total value of a firm should not depend on its capital structure.
Because the firm’s total cash flows still equal the cash flows of the project, and thus have the same present value
of $1000 as calculated earlier.
Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price, the
combined values of debt and equity must be $1000.
E.g., if value of debt = 500, then the value of levered equity = 1000–500 = 500

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 EFFECT OF LEVERAGE ON RISK AND RETURN
Prior to M&M58, the belief was that leverage would affect (increase) firm value even with perfect capital
markets (because the PV of the expected cash flow discounted at 15% = (½*(875) + ½*(375))/1.15 = $543
The mistake is that leverage increases the risk of the equity of a firm. Thus, it is incorrect to discount the cash
flows of levered equity at the same discount rate of 15% that we used for unlevered equity.
 Investors in levered equity require a higher expected return to compensate for its increased risk.
 The returns to equity holders are different depending on our choice: With or without leverage.

Unlevered equity = 40% or –10%

Levered equity = 75% or –25% because of higher risk. To compensate for that risk, levered equity holders
receive a higher expected return of 25%

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 EFFECT OF LEVERAGE ON RISK AND RETURN

We can calculate the sensitivity of each return to the systematic risk of the economy (the security’s beta in this
simple two-state example) to evaluate the relation between risk and return.

*** ADD PIC WITH TABLE 14.5 PAGE 524 ***

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 EFFECT OF LEVERAGE ON RISK AND RETURN
Whereas debt’s return bears no systematic risk (hence risk premium equals zero), levered equity has twice the
systematic risk of unlevered equity, hence levered equity holders receive twice the risk premium.

Overall:
• Case with 100% equity: 15% expected return
• Case with 50-50 debt and equity: equity holders higher expected return at 25% because of increased risk
(and debt holders a lower return equal to the risk-free rate of 5%)
 Leverage increases the risk of equity even when there is no risk of default
 Thus, while debt may be cheaper, it also raises the cost of capital for equity

Considering both sources of capital together, the firm’s average cost of capital with leverage is:
Average cost of capital with leverage = ½*(5%) + ½*(25%) = 15%, which is the same as for the unlevered firm.

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 MODIGLIANI & MILLER (1958)

Key idea/Reminder: In a perfect capital market, leverage only changes the allocation of cash flows between
debt and equity without altering the total cash flows of the firm.

Assumptions
(1) Investors and firms trade the same set of securities at competitive market prices equal to the present value
of their future cash flows.
(2) There are no taxes, transaction costs or issuance costs associated with security trading.
(3) A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal
new information about them.

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 MODIGLIANI & MILLER (1958)

Under these assumptions:

Proposition 1
In a perfect capital market, the total value of a firm’s securities is equal to the market value of the total cash
flows generated by its assets and is not affected by its choice of capital structure.

Thus, as long as a firm’s financing decisions do not change the cash flows generated by its assets, they will not
change the total value of the firm or the amount of capital it can raise.

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 MODIGLIANI & MILLER (1958)

Application:

The Market Value Balance Sheet (MVBS) of the firm.

Two important differences from an (otherwise similar) accounting balance sheet:
(1) All assets and liabilities of the firm are included – even intangibles such as reputation, brand name, human
capital.
(2) All values are current market values rather than historical costs.

The total value of all securities issued by the firm must equal the total value of the firm’s assets (see slide 14)

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 MODIGLIANI & MILLER (1958)

Application (2):

MVBS captures the idea that value is created by a firm’s choice of assets and investments.
By choosing NPV>0 projects, we enhance the firm’s value.
However, by holding fixed the cash flows generated by the firm’s assets, the choice of capital structure does not
change the value of the firm. It only divides the value of the firm into different securities.

Market Value of Equity = Market Value of Assets – Market Value of Debt and Other Liabilities

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 MODIGLIANI & MILLER (1958)
Application (3):

*** ADD PIC WITH TABLE 14.8 PAGE 529 ***

Leveraged recapitalization = we repurchase a significant % of our outstanding shares by borrowing (NPV of

the transaction =0, as we “sell” an amount worth of debt and “buy” the same amount worth of equity)

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 MODIGLIANI & MILLER (1958)
Rehearsal/reminder:
If all-equity financing, 15% required expected return. Alternatively, the firm can borrow at risk-free rate of 5%.
Isn’t then debt cheaper and thus better source of capital than equity?

• Although debt does have a lower cost of capital than equity, we cannot consider this cost in isolation.
• Debt may be cheap but it increases risk and hence the cost of capital of the firm’s equity.
• How to calculate the impact of leverage on the expected return of a firm’s stock or the equity cost of capital?

 In the end, the savings from the low expected return on debt, the debt cost of capital, are exactly
offset by a higher equity cost of capital, and there are no net savings for the firm.

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 MODIGLIANI & MILLER (1958)

From M&M58’s Proposition 1 to the relation between leverage and equity cost of capital:

E+D=U=A
E and D = market value of equity and debt if the firm is levered
U = market value of equity if the firm is unlevered
A = market value of firm assets

• The total market value of the firm’s securities is equal to the market value of its assets,
whether the firm is levered or unlevered.

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 MODIGLIANI & MILLER (1958)

From M&M58’s Proposition 1 to the relation between leverage and equity cost of capital (2):

From the previous relation of equality (because the return of a portfolio is equal to the weighted average of the
returns of the securities in it), the following relationship is implied between the returns of levered equity (R E ),
debt (R D ) and unlevered equity (R U ):
𝐸 𝐷
𝑅𝐸 + 𝑅 = 𝑅𝑈
𝐸+𝐷 𝐸+𝐷 𝐷
𝐷
𝑅𝐸 = 𝑅𝑈 + (𝑅 − 𝑅𝐷 )
𝐸 𝑈

𝐷
Where 𝐸 (𝑅𝑈 − 𝑅𝐷 ) is the additional risk due to leverage.

Thus, the levered equity return equals the unlevered return plus an extra, due to leverage.

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 MODIGLIANI & MILLER (1958)

From M&M58’s Proposition 1 to the relation between leverage and equity cost of capital (3):

Consequence of this extra effect of leverage:

• When the firm performs well, it pushes the returns of levered equity even higher (R U > R D )
• When the firm does not do well, it makes the returns drop even lower (R U < R D )
The amount of additional risk depends on the amount of leverage, D/E. Because the previous equation holds for
realized returns, it holds for expected returns as well, i.e., replacing R with r.

Proposition 2:
The Cost of Capital of Levered Equity 𝑟𝐸 increases with the firm’s market value debt-equity ratio:
𝐷
𝑟𝐸 = 𝑟𝑈 + (𝑟 −𝑟 )
𝐸 𝑈 𝐷

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 MODIGLIANI & MILLER (1958)

From M&M58’s Proposition 2:

Using the data from the previous example:

Expected return of unlevered equity R U = 15%
Debt = $500
Risk-free rate 5% (expected return of the debt)

500
𝑟𝐸 = 15% + 15% − 5% = 25%
500

Which matches the expected return shown in the calculations of slide 7

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 MODIGLIANI & MILLER (1958)

Reminder: The formula for pretax WACC (= Unlevered Cost of Capital)

𝑟𝑈 = (fraction of firm value financed by equity)*(equity cost of capital) + (fraction of firm value financed by
debt)*(debt cost of capital)
𝐸 𝐷
𝑟𝑈 = 𝑟 + 𝑟
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷

In perfect capital markets (hence no taxes): 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑈 = 𝑟𝐴

That is, a firm’s WACC is independent of its capital structure and is equal to its equity cost of capital if it is
unlevered (𝑟𝑈 ), which matches the cost of capital of its assets (𝑟𝐴 )
𝐷
Firm leverage can be also measured with debt-to-value ratio = 𝐸+𝐷 (see next slide)

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 MODIGLIANI & MILLER (1958)

Effect of increasing the amount of leverage in a capital structure

on cost of capital, debt cost of capital, and WACC

o With no debt, WACC = unlevered equity cost of capital.

o WACC = the cost of capital weighted by the financing options for the assets.
o As the firm borrows at the low cost of capital for debt, its equity cost of capital rises.
o The net effect is that WACC is unchanged.
o With a further increasing amount of debt, the debt becomes more risky because of the higher chances that the firm will
default, hence debt cost of capital 𝑟𝐷 also rises.
o With 100% debt, the debt is risky as the assets themselves.

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 MODIGLIANI & MILLER (1958)
• A common mistake is to think that, since debt is cheaper than equity, a firm can reduce overall WACC by
increasing the amount of debt. But this does not consider the fact that adding debt increases the risk of equity,
which makes equity holders demand a higher risk premium, hence higher expected return. The two mutually
compensate each other.
• When a firm changes its capital structure without changing its investments, its unlevered beta will remain
unaltered. However, its equity beta will change to reflect the effect of the capital structure change on its risk.
𝐷
β𝐸 = β𝑈 + (β −β𝐷 )
𝐸 𝑈
Conclusions on M&M58
• The only way a change in leverage can affect the “attractiveness” of equity is if there is market imperfection.
 Conservation of value principle: With perfect capital markets, financial transactions neither add not
destroy value, but instead represent a repackaging of risk, and, therefore, return.
• The M&M58’s propositions imply that the true role of a firm’s financial policy is to deal with (and potentially
exploit) financial market imperfections such as taxes and transaction costs.

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 DEBT AND TAXES
Introduction

We discussed that in perfect capital markets, all financial transactions have NPV=0 (no value creation or
destruction), thus capital structure choices are unimportant.

• Why do firms devote considerable financial resources to manage their capital structure?
• Why do we see differences in capital structures across firms and industries?

If capital structure matters, then it must stem from market imperfections.

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 DEBT AND TAXES
The Interest Tax Deduction
Firms pay taxes after interest payments are deducted, thus, interest expenses reduce the amount of corporate tax
firms must pay.
At the same time, net income (available to equity holders) with leverage (debt) can be lower compared to the one
if no leverage, because of interest expenses (the gains from taxes being smaller)
But a firm can be better off with leverage even though its earnings are lower. Why?
The value of a firm is the total amount it can raise from all investors, not just equity holders. Leverage allows the
firm to pay out more in total (to both equity and debt holders, thus including interest payments to debt holders),
it will be able to raise more total capital initially.
There is gain equal to the reduction in taxes with leverage, because a firm will not owe taxes on the
earnings used to make interest payments. Those earnings are “shielded” from the corporate tax providing tax
savings.
Interest tax shield = corporate tax rate * interest payments

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 DEBT AND TAXES
The Interest Tax Deduction (2)

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 DEBT AND TAXES

The Interest Tax Deduction (3)

The “Pizza analogy”: Based on M&M58 propositions, with perfect capital markets, no matter how you slice it,
you have the same amount of pizza.
When you introduce the tax “imperfection”, every time equity holders get a slice of pizza, the authorities get a
slice as a tax payment. But when debt holders get a slice, there is no tax.
Thus, by allocating more slices to debt holders rather than to equity holders, more pizza will be available to
investors in general. While the total amount of pizza does not change, there is more pizza left over for investors
to consume because less pizza is consumed by the authorities in taxes.

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DEBT AND TAXES

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 DEBT AND TAXES
Valuing the Interest Tax Shield
To determine the benefit of leverage for the value of the firm, we compute the present value of the stream of
future interest tax shields the firm will receive.

Cash Flows to Investors with Leverage = Cash Flows to Investors without Leverage + Interest Tax Shield

By increasing the amount paid to debt holders through interest payments, the amount of the pretax cash flows
(CFs) that must be paid as taxes decreases. The gain in total CFs to investors is the interest tax shield.
By the Law of One Price, the same (to that the CFs of the levered firm are equal to the sum of CFs from the
unlevered firm plus the interest tax shield) must be true for the present values of these CFs. Thus,
V𝐿 = V𝑈 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)
Indicating that the total value of the levered firm exceeds the value of the firm without leverage due
to the present value of the tax savings from debt.

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 DEBT AND TAXES
Interest Tax Shield with Permanent Debt = Case where the firm issues debt and plans to keep the
monetary amount of debt constant forever.

Marginal tax rate = τ𝐶 , debt D is risk-free with risk-free interest rate = r𝑓

We can value the tax shield as a perpetuity:
τ𝐶 ∗ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 τ𝐶 ∗ (r𝑓 ∗ 𝐷)
𝑃𝑉 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = = = τ𝐶 ∗ 𝐷
r𝑓 r𝑓

The above assumes risk-free debt and constant risk-free interest rate.

Assuming no arbitrage, the market value of debt equals the present value of the future interest payments:
Market value of debt = D = PV(Future Interest Payments)

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 DEBT AND TAXES

WACC with Taxes

(Reminder from previous section)
WACC After Tax, where we multiply the debt component with 1 – τ𝐶 . With tax-deductible interest, r(1 – τ𝐶 ) is the
effective after-tax borrowing rate:
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟 (1 – τ𝐶 )
𝐸+𝐷 𝐸+𝐷 𝐷
𝐸 𝐷 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟𝐷 − 𝑟 τ
𝐸+𝐷 𝐸+𝐷 𝐸+𝐷 𝐷 𝐶

𝐸 𝐷 𝐷
Where 𝐸+𝐷 𝑟𝐸 + 𝐸+𝐷 𝑟𝐷 is the pre-tax WACC and 𝐸+𝐷 𝑟𝐷 τ𝐶 is the reduction due to interest tax shield.

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 DEBT AND TAXES

The Interest Tax Shield with a target Debt-to-Equity Ratio

Many firms, instead of keeping an amount of debt constant, they target a specific debt-equity ratio. They adjust
debt over time so that the debt-to-equity ratio remains constant.
We can calculate its value with leverage V𝐿 by discounting its free cash flow (FCF) using the WACC.
The value of the interest tax shield can be found by comparing V𝐿 to the unlevered value V𝑈 of the FCF
discounted at the firm’s unlevered cost of capital, the “pretax WACC”.

Example:
We expect to have FCF in the coming year $4.25 M, FCF growth rate 4% per year thereafter, equity cost of capital
10%, debt cost of capital 6%, corporate tax rate 35%.
If we want to maintain a debt-equity ratio of 0.50, what is the value of our interest tax shield?

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 DEBT AND TAXES
The Interest Tax Shield with a target Debt-to-Equity Ratio (2)
We can estimate the value of the tax shield by comparing firm value with and without leverage.
First, compute its unlevered value by discounting its FCF at its “pretax WACC”:
𝐸 𝐷 1 0.5
𝑟𝑈 = 𝑟 + 𝑟 = 10% + 6% = 8.67%
𝐸 + 𝐷 𝐸 𝐸 + 𝐷 𝐷 1 + 0.5 1 + 0.5

Because FCF is expected to grow at a constant rate, we can value the firm as a constant growth perpetuity
4.25
𝑉𝑈 = = $91 M
8.67% − 4%
Then, the levered value WACC:
𝐸 𝐷 1 0.5
𝑟𝑊𝐴𝐶𝐶 = 𝑟 + 𝑟 1 − τ𝐶 = 10% + 6% 1 − 0.35 = 7.97%
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷 1 + 0.5 1 + 0.5

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 DEBT AND TAXES

The Interest Tax Shield with a target Debt-to-Equity Ratio (3)

The firm’s value including its interest tax shield is

4.25
𝑉𝐿 = = $107 M
7.97% − 4%

Thus, the value of the interest tax shield is

PV(Interest Tax Shield) = 𝑉𝐿 – 𝑉𝑈 = 107 – 91 = $16 M.

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DEBT AND TAXES

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 DEBT FINANCING
Do firms show a preference for debt?
When firms raise new capital, they do so primarily by
issuing debt. In most recent years, aggregate equity issues
are negative, meaning that firms are reducing the amount
of equity outstanding by buying shares. This doesn’t mean
that all firms raised funds using debt. Many firms may have
sold equity to raise funds. However, at the same time, other
firms were buying or repurchasing an equal or greater
amount.
Clear preference for debt as a source of external financing
among US firms. In aggregate, firms appear to be
borrowing in excess of the funds they need for internal use
in order to repurchase equity.
CapEx greatly exceed firms’ external financing implying
that most investment and growth is supported by internally
generated funds, such as retained earnings.

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 DEBT FINANCING
Do firms show a preference for debt? (2)

Debt as fraction of firm value has varied

in a range from 30%-50% for the average
firm.

The Figure masks two important tendencies:

(1) The use of leverage varies greatly by industry. Firms in growth industries like biotech carry very little debt
and maintain large cash reserves, whereas real estate firms, tracking and automotive firms, and utilities have
high leverage ratios.
(2) Many firms retain large cash balances to reduce their effective leverage.

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 DEBT FINANCING
What is the optimal level of leverage? (from a tax saving perspective)
Example: A firm with EBIT = $1,000 and corporate tax rate = τ𝐶 = 35%. Three cases:
(1) With no leverage: The firm owes tax $350
(2) With high leverage with interest payments equal to $1,000: It can shield its earnings from taxes, thereby
saving the $350 in taxes.
(3) Excess leverage so that interest payments exceed EBIT. The firm has a net operating loss but there is no
increase in tax savings. The firm is paying no taxes already, thus no immediate tax shield from the excess leverage.
 No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT.
 Thus, the optimal level of leverage from a tax saving perspective is where interest equals EBIT.
Because we cannot predict the firm’s EBIT precisely due to uncertainty, then with a higher interest expense there
is greater risk that interest will exceed EBIT.
In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of
debt declines.

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 DEBT FINANCING
What is the optimal level of leverage? (2)

Tax savings with different amounts of leverage:

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 GROWTH AND DEBT
What’s the optimal fraction of debt in a firm’s capital structure?
In a tax-optimal capital structure, the level of interest payments depends on the level of EBIT, but also firm
specificities, e.g., the industry and life-stage in which it finds itself.
Example 1: Young biotech firms often do not have any taxable income. They “sell potential” but no income yet
from the scheduled drugs. In such as case, a tax-optimal capital structure does not include debt, but all-equity
financing. Only later the firm may become profitable and have taxable CFs, and at that time it should add debt.
Example 2: For firms with positive earnings, growth will affect the optimal leverage ratio. To avoid excess
interest, those firms should have debt with interest payments that are below its expected taxable earnings (EBIT)
From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings. But equity value
depends on earnings’ growth rate: The higher the growth rate, the higher the value of equity. Thus, the optimal
proportion of debt in the firm’s capital structure (D/E+D) will be lower the higher the firm’s growth rate.
 Compare the level of firms’ interest payments to their taxable income, not just look at the fraction of
debt in the capital structure.
Looking at the actual leverage levels of firms, these are lower than what an analysis exclusively based on the
interest tax shield would predict.
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 FINANCIAL DISTRESS
As mentioned before, industry plays an important role as to the levels of leverage.
E.g., firms in the airline industry whose future CFs are unstable and highly sensitive to shocks in the economy
run the risk of bankruptcy if they use too much leverage.

Financial distress = if a firm has trouble meeting its debt obligations.

Guiding question: How a firm’s choice of capital structure can, due to market imperfections, affect (1) its costs of
financial distress, (2) alter managers’ incentives, and (3) signal information to investors?
These three aspects can offset the tax benefits of leverage when leverage is high, and may explain the
heterogeneity in capital structures that we observe across firms and industries.

Default = if a firm fails to make the required interest or principal payments on the debt.

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 FINANCIAL DISTRESS
Leverage and the risk of default – Example:
Due to increased competition, a firm aims to launch a new product.
• Success: The firm will be worth $150 M.
• Failure: The firm will be worth $80 M.
• Two financing options: (1) All-equity; (2) Debt that matures at the end of the year with a total of $100 M due.

In case of success, if a firm receives a significant amount of debt ($100 M) and has to repay it at the end of the
year, it is not a problem if it does not have the full amount in cash (but based on anticipated future profits) in a
perfect capital market, as it can get a new loan or issue new shares.
 If a firm has access to capital markets and can issue new securities at a fair price, then it need not
default as long as the market value of its assets exceeds its liabilities.

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 FINANCIAL DISTRESS
Example (2):
In case of new product failure, and use of debt ($100 M), then the firm will default.
 In bankruptcy, debt holders receive ownership of the firm’s assets, leaving shareholders with
nothing. But debt holders too, will suffer losses equal to $20 M (the firm is worth $80 M, 20 less than
the 100 of the loan). And they cannot sue the shareholders because of limited liability.

Conclusions:
• If the product fails, both equity- and debt-holders are worse off. Without leverage, equity holders lose $70 M.
With leverage, they lose $50 M and debt holders lose $20 M (same total). Thus, investors are equally unhappy
whether the firm is levered and declares bankruptcy or whether it is unlevered and the share price declines.
• The value decline is not caused by bankruptcy, the decline (and distress) is the same whether leverage or not.
• With perfect capital markets (i.e., irrelevance of the firm’s capital structure for value), the risk of bankruptcy is
not a disadvantage of debt. Bankruptcy shifts the ownership from equity holders to debt holders; no change in
the total value available to all investors.

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 FINANCIAL DISTRESS

Bankruptcy has other (high) costs too that the assumption of perfect capital markets ignores (not just “hanging
the keys” to debt holders). E.g., involvement of different types of experts to asses the situation (e.g., legal and
accounting experts)
Given such costs, often, firms in financial distress avoid filing for bankruptcy by negotiating directly with
creditors = a workout.
Other, indirect costs: Loss of customers, suppliers, employees, receivables, etc., sales of assets quickly at a lower
price than worth to raise quickly cash and avoid bankruptcy.
• To estimate the impact of indirect costs, we must identify losses to total firm value (not solely to equity or debt
holders or transfers between them). Andrade & Kaplan (1998), in a study of highly levered firms, estimated
the potential loss due to financial distress equal to 10% to 20% of firm value.
 The above-described costs of financial distress are an important departure from M&M58’s
assumption of perfect capital markets.

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 FINANCIAL DISTRESS

Thus, coming back to the example of new product launch, debt holders will not receive $80 M but less, e.g., $60
M, due to these bankruptcy and financial distress costs (here, equal to $20 M)
Who pays for them?
Although equity holders are not supposed to care about bankruptcy costs after bankruptcy, debtholders typically
recognize in advance that, in case of bankruptcy, they will not be able to get the full value of the assets. Thus,
they will pay less for the debt initially.
How much less? The amount they are estimating to give up, i.e., the present value of the bankruptcy costs.

But if debtholders pay less for the debt, there is less money available to pay for dividends, repurchase shares, and
make investments = money out of equity holders’ pockets. Thus,
 When securities are fairly priced, the equity holders pay the present value of the costs
associated with bankruptcy and financial distress.

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The Trade-Off Theory = The total value of a levered firm equals the value of the firm without leverage plus
the present value of the tax savings from debt, less the present value of financial distress costs:
𝑉𝐿 = 𝑉𝑈 + PV(Interest Tax Shield) – PV(Financial Distress Costs)

PV(Financial Distress Costs) is determined by three factors, which can make it a quite complicated issue:
(1) the probability of financial distress
(2) the magnitude of the costs if the firm is in distress
(3) the appropriate discount rate for the distress costs

What determines each of these factors?

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(1) Probability of default increases with the amount of a firm’s liabilities relative to its assets, the volatility of a
firm’s cash flows and asset values. Thus, if steady, reliable CFs (e.g., utility industry), we can use high leverage
and have low probability of default. If in industries with more volatile CFs (semiconductor), much lower levels of
debt are preferable to avoid default.

(2) Costs’ magnitude under distress: Relative importance of the costs of bankruptcy discussed earlier, they also
vary by industry. E.g., in industries relying more on tangible capital (assets) that can be sold easily, costs may be
lower, compared to firm that rely a lot on intangibles.

(3) Discount rate of distress costs: Depends on the firm’s market risk. The higher the firm’s beta, the more likely
it will be in distress in an economic downturn, and thus the more negative the beta of the distress costs will be.
All else equal, the present value of distress costs will be higher for high beta firms.

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The estimation of the optimal leverage, thus, has to consider that the value of the levered firm varies with
the level of debt.
• With no debt, the value of the firm is 𝑉𝑈 (unlevered)
• For low levels of debt, the default risk is low and the main effect of an increase in leverage is an increase in the
interest tax shield.
• If there are no costs of financial distress, the value will continue to increase at this rate until the interest of the
debt exceeds the firm’s EBIT and the tax shield is exhausted.
• If, however, costs of financial distress are introduced, these reduce the value of the levered firm, 𝑉𝐿 . The
amount of the reduction increases with the probability of default, which increases with the level of debt.

Bottom line for the trade-off theory:

Firms should increase their leverage until it reaches the level at which 𝑉𝐿 is maximized. At this point, the tax
savings that result from increasing leverage are just offset by the increased probability of incurring the costs of
financial distress.

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Bottom line for the trade-off theory (2)
Optimal debt choices for firms with low costs of financial
distress, and for firms with high costs of financial distress.
For firms with high costs, it is optimal to choose lower
leverage.

The trade-off theory helps resolve two puzzles:

(1) The presence of financial distress costs can explain why
firms choose debt levels that are too low to fully exploit
the interest tax shield.
(2) Differences in the magnitude of financial distress costs
and the volatility of cash flows can explain the differences
in the use of leverage across industries.

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Summarized take-aways

1. M&M58: With perfect capital markets, a firm’s security choice alters the risk of the firm’s equity, not its value
or the amount it can raise from outside investors. Thus, the optimal capital structure depends on market
imperfections, such as taxes and financial distress costs (as well as agency costs and asymmetric information)

2. The probably most clear-cut market imperfection is taxes. The interest tax shield allows firms to repay
investors and avoid corporate tax. For firms with consistent taxable income, this benefit of leverage is important
to consider.

3. How much of their income should firms shield through the use of leverage? If too high leverage, increased
default risk. Financial distress may have other negative consequences for the firm that reduce its value. Thus, a
firm must balance the tax benefits of debt against the costs of financial distress.

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