Additional debt can affect the behavior of managers.
Reductions in agency costs: debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.
Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects.
Depends on business factors such as competition, operating leverage, etc.
Additional business risk concentrated on common stockholders when financial leverage is used.
Depends on the amount of debt and preferred stock financing.
Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Consider Two Hypothetical Firms Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt .
Impact of Leverage on Returns EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800 $1,080 ROE 9.0% 10.8% Firm U Firm L
Firm L: Leveraged Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U. Economy Bad Avg. Good
Firm U Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% TIE n.a. n.a. n.a. Firm L Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 4.8% 10.8% 16.8% TIE 1.7x 2.5x 3.3x
Corporate tax laws favor debt financing over equity financing.
With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.
MM show that: V L = V U + TD .
If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
Value of Firm, V 0 Debt V L V U MM relationship between value and debt when corporate taxes are considered. Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD
Cost of Capital (%) 0 20 40 60 80 100 Debt/Value Ratio (%) MM relationship between capital costs and leverage when corporate taxes are considered. r s WACC r d (1 - T)
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
Miller’s Model with Corporate and Personal Taxes V L = V U + [ 1 - ] D. T c = corporate tax rate. T d = personal tax rate on debt income. T s = personal tax rate on stock income. (1 - T c )(1 - T s ) (1 - T d )
T c = 40%, T d = 30%, and T s = 12%. V L = V U + [ 1 - ] D = V U + (1 - 0.75)D = V U + 0.25D. Value rises with debt; each $1 increase in debt raises L’s value by $0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30)
A second agency problem is the potential for “underinvestment”.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have positive NPVs.
Choosing the Optimal Capital Structure: Example Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; r s = 12%; P 0 = $25; T = 40%; b = 1.0; r RF = 6%; RP M = 6%.
Estimates of Cost of Debt Percent financed with debt, w d r d 0% - 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.
The Cost of Equity at Different Levels of Debt: Hamada’s Equation
MM theory implies that beta changes with leverage.
b U is the beta of a firm when it has no debt (the unlevered beta)