cash Flows and Financial Forecast As someone who already runs a business, it is hard to consider a new platform using an online store since my company is a service-oriented business. In fact, we do not offer any retail product However, as skilled craftsman, we do have the skill sets needed to create custom built wooden furniture for customers. This is a venture I have considered many times, but do not feel it is in our best interest to do so despite the potential earning capacity. I feel that the cannibalism to our niche will have too far an impact to change our operations in this way. For the purpose of this discussion, I will present a hypothetical 5-year financial forecast for the creation and sale of mission style living room furniture through an online marketplace. To test the viability of the custom furniture market, we will only offer two products that can be purchased together as a set or separately. Coffee tables will sell for a price of $450 each and end tables will sell for a price of $325 each. We anticipate that we can manufacture no more than 2 of each of the products every month, totaling 24 per year. In order to start this project, we will need to invest in a new table saw for $3500. The saw has a salvage value of $500 and a life of 10 years. Using straight-line depreciation, the asset will depreciate at $300 per year during the initial 5-year period. We will assume a 28% tax rate for this venture leaving the after-tax cost of the saw $2520. To construct the tables, there will be an annual cost of $2,500 for lumber and $450 in finishing supplies and materials. Construction of tables will take an increased labor cost of $11,000 annually. Projected Revenues and Expenses Revenues Year  1 2 3 4 5 End Tables @$325 $7,800.00 $7,800.00 $7,800.00 $7,800.00 $7,800.00 Coff. Tables @ $450 $10,800.00 $10,800.00 $10,800.00 $10,800.00 $10,800.00 Total Revenues $18,600.00 $18,600.00 $18,600.00 $18,600.00 $18,600.00 Expenses Year 1 2 3 4 5 Wages $11,000.00 $11,000.00 $11,000.00 $11,000.00 $11,000.00 Equipment $3,500.00 $250.00 $250.00 $250.00 $250.00 Lumber $2,500.00 $2,500.00 $2,500.00 $2,500.00 $2,500.00 Finishing Supplies  $450.00 $450.00 $450.00 $450.00 $450.00 Depreciation $300.00 $300.00 $300.00 $300.00 $300.00 Total Expenses $17,750.00 $14,500.00 $14,500.00 $14,500.00 $14,500.00 Taxes, Profits, and Cash Flow Year  1 2 3 4 5 Profit $850.00 $4,100.00 $4,100.00 $4,100.00 $4,100.00 Taxes $238.00 $1,148.00 $1,148.00 $1,148.00 $1,148.00 Net Profit $612.00 $2,952.00 $2,952.00 $2,952.00 $2,952.00 Cash Flow $912.00 $3,252.00 $3,252.00 $3,252.00 $3,252.00 The table above shows positive cash flows totaling $13,920 over the 5-year period. However, this number does not take into account the future value of present projections. We will assume an infla.

1. cash Flows and Financial Forecast
As someone who already runs a business, it is hard to consider a
new platform using an online store since my company is a
service-oriented business. In fact, we do not offer any retail
product However, as skilled craftsman, we do have the skill sets
needed to create custom built wooden furniture for customers.
This is a venture I have considered many times, but do not feel
it is in our best interest to do so despite the potential earning
capacity. I feel that the cannibalism to our niche will have too
far an impact to change our operations in this way. For the
purpose of this discussion, I will present a hypothetical 5-year
financial forecast for the creation and sale of mission style
living room furniture through an online marketplace.
To test the viability of the custom furniture market, we will
only offer two products that can be purchased together as a set
or separately. Coffee tables will sell for a price of $450 each
and end tables will sell for a price of $325 each. We anticipate
that we can manufacture no more than 2 of each of the products
every month, totaling 24 per year. In order to start this project,
we will need to invest in a new table saw for $3500. The saw
has a salvage value of $500 and a life of 10 years. Using
straight-line depreciation, the asset will depreciate at $300 per
year during the initial 5-year period. We will assume a 28% tax
rate for this venture leaving the after-tax cost of the saw $2520.
To construct the tables, there will be an annual cost of $2,500
for lumber and $450 in finishing supplies and materials.
Construction of tables will take an increased labor cost of
$11,000 annually.
Projected Revenues and Expenses

2. Revenues
Year
1
2
3
4
5
End Tables @$325

3. $7,800.00
$7,800.00
$7,800.00
$7,800.00
$7,800.00
Coff. Tables @ $450
$10,800.00
$10,800.00
$10,800.00
$10,800.00
$10,800.00
Total Revenues
$18,600.00
$18,600.00

4. $18,600.00
$18,600.00
$18,600.00
Expenses
Year
1
2
3

5. 4
5
Wages
$11,000.00
$11,000.00
$11,000.00
$11,000.00
$11,000.00
Equipment
$3,500.00
$250.00
$250.00
$250.00
$250.00

6. Lumber
$2,500.00
$2,500.00
$2,500.00
$2,500.00
$2,500.00
Finishing Supplies
$450.00
$450.00
$450.00
$450.00
$450.00
Depreciation
$300.00
$300.00
$300.00
$300.00
$300.00

7. Total Expenses
$17,750.00
$14,500.00
$14,500.00
$14,500.00
$14,500.00
Taxes, Profits, and Cash Flow

8. Year
1
2
3
4
5

9. Profit
$850.00
$4,100.00
$4,100.00
$4,100.00
$4,100.00
Taxes
$238.00
$1,148.00
$1,148.00
$1,148.00
$1,148.00
Net Profit
$612.00
$2,952.00
$2,952.00
$2,952.00
$2,952.00
Cash Flow
$912.00

10. $3,252.00
$3,252.00
$3,252.00
$3,252.00
The table above shows positive cash flows totaling $13,920 over
the 5-year period. However, this number does not take into
account the future value of present projections. We will assume
an inflation rate of 2% to adjust future earnings into today’s
value. To do this, I went and found the factor for each value to
be .9803 at year 1, .9609 at year 2, .9420 at year 3, .9234 at
year 4, and .9053 at year 5. I used these factors to bring all
dollar values into today’s terms resulting in the table below.
Adjusted Revenues and Expenses to Present Value
Revenues
Year
1

11. 2
3
4
5
End Tables @$325
$7,646.34
$7,495.02
$7,347.60
$7,202.52
$7,061.34
Coff. Tables @ $450
$10,587.24
$10,377.72
$10,173.60

12. $9,972.72
$9,777.24
Total Revenues
$18,233.58
$17,872.74
$17,521.20
$17,175.24
$16,838.58

13. Expenses
Year
1
2
3
4
5
Wages

14. $10,783.30
$10,569.90
$10,362.00
$10,157.40
$9,958.30
Equipment
$3,431.05
$240.23
$235.50
$230.85
$226.33
Lumber
$2,450.75
$2,402.25
$2,355.00
$2,308.50
$2,263.25
Finishing Supplies
$441.14
$432.41

15. $423.90
$415.53
$407.39
Depreciation
$294.09
$288.27
$282.60
$277.02
$271.59
Total Expenses
$17,400.33
$13,933.05
$13,659.00

16. $13,389.30
$13,126.85
Taxes, Profits, and Cash Flow
Year

17. 1
2
3
4
5
Profit
$833.26
$3,939.69
$3,862.20
$3,785.94
$3,711.73
Taxes
$233.31
$1,103.11

18. $1,081.42
$1,060.06
$1,039.28
Net Profit
$599.94
$2,836.58
$2,780.78
$2,725.88
$2,672.45
Cash Flow
$894.03
$3,124.85
$3,063.38
$3,002.90
$2,944.04
As you can see, the adjusted cash inflow in present dollars is
$13,029.20. This is important in financial projecting because
the present value of future earnings will always be less than the
future value. We see this in the PV formula with the factor
of (1(1+r))nwhere n is the point in time we are evaluating, and r
is the rate of change. Financially speaking, this would appear to
be a great investment opportunity, but the qualatative factors
that are in play would still steer me away from pursuing this

19. project for my shop.
Capital budgeting is the system used by businesses to allocate
funds to projects and investments that create additional value
for the company (Hickman, Byrd, & McPherson, 2013). Value is
determined by weighing the costs of an investment against the
potential revenue. An investment that creates more value than
the cost is said to be a sound investment decision (Hickman,
Byrd, & McPherson, 2013). You have spoken about four
quantitative methods used in determining if a project is worthy
of investment: the payback method, the rate of return method,
net present value, and the internal rate of return (gordonhensley,
2012). However, there are other factors that managers should
consider before giving an investment project the green light.
Factors used in capital budgeting can be numeric (quantitative)
or non-numeric (qualitative). The four methods to determine if
an investment makes sense represent quantitative factors in
deciding capital budgets. Another numeric consideration should
be the tax shield a capital expense provides a company. A
capital purchase reduces net income which in turn reduces the
tax liability of a company (Wainwright, 2012). Additionally, the
depreciation of the asset further reduces tax liability over the
life of the capital asset. Let’s take a look at an example to
demonstrate the tax shield effect on capital budgeting.
Initial Investment
$26,000
Salvage

20. $5,000
Annual Revenue
$4,000.00
Life Span
15 years
Taxes w/out depreciation
$1,200.00
Annual Depreciation
Taxes w/depreciation
$780.00
$1,400
Tax Rate
Cash flow savings
$420.00
30%
Looking at the numbers, the company would pay $1,200 in taxes
if their revenue increases by $4,000 without any means to
reduce tax liabilities. However, the depreciation of a capital
asset reduces the revenue providing protection on the taxation
of $1,400. This provides the company with an increase in cash
flow of $420 since the company will not pay 30% taxes on

21. $1,400 of the $4,000 in revenue. Other considerations in capital
budgeting involve qualitative factors.
One such qualitative factor is human capital. According to
Youssef (2015), human capital refers to knowledge skills,
abilities, and other qualitative benefits an organization receives
from its workforce. With this factor, the financial bottom line
should not matter. If a company does not have the personnel to
transform an investment intvalue-creatingting venture, the
venture will likely end in failure and any capital spent pursuing
that venture will end up being a sunk cost, that is, a cost that
cannot be recovered through business operations (Hickman,
Byrd, & McPherson, 2013). Sunk costs do not provide
operational benefits as they do not generate revenue. A failed
venture no longer generates revenue meaning all costs
associated with the venture will become sunk costs.
Thank you again for having me speak on your program today.
May your capital live long and prosper.
References
gordonhensley. (2012). Capital budgeting lecture. [Video file].
Retrieved from
https://www.youtube.com/watch?v=TrKVj_wLgUc
Hickman, K. A., Byrd, J. W., & McPherson, M.
(2013). Essentials of finance [Electronic version]. Retrieved
from https://content.ashford.edu/
Wainwright, S. K. (Ed.) (2012). Principles of accounting:
Volume II [Electronic version]. Retrieved from
https://content.ashford.edu/
Youssef, C. (2015). Human resource management (2nd ed.).
Retrieved from https://ashford.content.edu
Learning Objectives
Upon completion of Chapter 8, you will be able to:

22. • Describe the various theories of capital structure.
• Understand the tax advantage of debt.
• Know how potential bankruptcy costs limit the amount of debt
firms take on.
• Understand some agent–principal conflicts associated with
capital structure.
• Understand why debt capacity is a valuable resource and
identify the factors that determine it.
• Discuss some practical factors that affect a company’s capital
structure decision.
Leverage, Financial Risk, and
Firm Value
8
D-BASE/Getty Images
byr80656_08_c08_185-216.indd 185 3/28/13 3:34 PM
CHAPTER 8Section 8.1 Perfect Capital Markets
Managers choose products and services that create value for
shareholders. Chap-ters 5, 6, and 7 discussed how these
investments affect shareholders’ wealth. Investing in positive
NPV projects adds to the wealth of shareholders, whereas
investing in negative NPV projects detracts from it. In this
chapter we examine how man-

23. agers choose the mix of financing required to support these
investment decisions. We call
this the capital structure decision. As we turn our attention to
the right-hand side of the bal-
ance sheet, we assume that capital budgeting decisions have
been made. Our concerns are
choosing the mix of debt and equity used to fund the firm’s
assets and whether this capital
structure choice can affect shareholders’ wealth.
You might think that there is a standard proportion of debt that
most firms use—a finan-
cial rule-of-thumb—but the debt–equity mix varies enormously
across industries and
companies. Some, such as young high-tech or biotech firms, use
little or no debt, while
public utilities use high levels. Private equity firms such as
Bain, KKR, the Blackstone
Group, and Warburg Pincus often finance their purchases of
companies with 60% or even
80% debt.
Why do debt ratios vary so much? The general answer is that in
each case managers
believe they are choosing a capital structure that maximizes
their firm’s worth while stay-
ing within its risk tolerance. How each of these decisions can be
optimal yet so different is
explained in this chapter as we explore the link between capital
structure and firm value.
The use of debt to fund the firm (called leveraging) carries with
it benefits as well as
risks. As the term leverage implies, the presence of debt in a
company’s financial structure
can magnify profits when times are good, just as a mechanical

24. lever can magnify your
strength when you’re trying to move a heavy object. Another
benefit of debt is that inter-
est payments to lenders are a tax-deductible expense, unlike
dividend payments made to
equity holders. Paying bills with pretax dollars is much cheaper
than making an equiva-
lent payment with dollars after taxes have been paid.
8.1 Perfect Capital Markets
Our discussion of the debt–equity mix begins with the
assumption that capital mar-kets are perfect. Perfect capital
markets are an ideal and do not reflect the real world, but they
are very useful for developing an understanding of capital struc-
ture’s impact on share value. Under the very strict (and
unrealistic) assumptions of perfect
markets, we will see that capital structure has no impact on
value. That is, the decision
of how much debt versus equity to use in financing the firm is
irrelevant to shareholders
under perfect market condition: Any mix of debt and equity
results in the same overall
value of the firm. It may seem like a poor use of time to study
something that is irrelevant
to firm value, but this model gives us insights about why capital
structure may matter in
the real world. As we relax the assumptions of perfect capital
markets, we will begin to
identify the factors that help determine a company’s optimal
capital structure.
byr80656_08_c08_185-216.indd 186 3/28/13 3:34 PM

25. CHAPTER 8Section 8.1 Perfect Capital Markets
Perfect capital markets may be characterized as
1. being strong-form efficient,
2. having no leakages, such as taxes or transaction costs, and
3. having the same cost of borrowing for investors and
companies.
Strong-form efficiency defines a market in which security
prices reflect all pertinent infor-
mation. Prices in such markets are unbiased estimates of value,
fully reflecting the cash
flows and risk expected to accrue to security holders. In strong-
form efficient markets,
securities offering the same cash flows with equal risk will be
equally priced.
The second characteristic is that no leakages occur as cash
flows move between the firm
and capital suppliers. Examples of leakages include taxes
(where a portion of the cash
which otherwise would flow to security holders is paid to the
government) and transac-
tion costs (cash paid to investment bankers as part of the firm’s
capital acquisition). Figure
8.1 illustrates some leakages.
Figure 8.1: The financial balance sheet, illustrating some
leakages
Because in perfect capital markets such leakages do not exist,
these markets are some-
times characterized as being frictionless. In physics, friction
refers to resistance as objects
are moved. The more friction there is, the more energy it takes

26. to move an object. Thus,
it is easier to push a heavy box across a smooth tile floor than
across a carpeted floor.
The analogy to economic friction is straightforward: As cash or
securities move from
the investors to the firm, between investors, or from the firm to
investors, there is no
loss of value in a frictionless market. Anyone who has sold a
house for $150,000 yet nets
only $135,000 after commissions, fees, and taxes can attest to
the frictions that exist in
most markets.
$
Corporate income taxes
Product and
service markets
Goods
Services
Investments
made by
the firm
Claims on
cash flow
Capital markets
Fees to investment bank
$ $

27. $
$
$
byr80656_08_c08_185-216.indd 187 3/28/13 3:34 PM
CHAPTER 8Section 8.1 Perfect Capital Markets
Capital Market Irrelevance When Markets Are Perfect
We illustrate the irrelevance of capital structure to shareholders
by developing a simple
example in which capital markets are assumed to be perfect, and
the firm’s investments
are identified. Suppose the firm in our example is a small,
closely held corporation that
does business as a doughnut shop. Further, suppose that you are
the sole owner of the
shop, providing 100% of the corporation’s capital. All of the
shop’s capital is provided via
stock, so its capital structure is all equity, and you own all the
shares.
In the perfect markets we have described, the value of the
doughnut shop is unaffected by
the fact that you have chosen to finance it using only equity.
Had you decided to loan the
company half of its capital and provided the other half in the
form of equity, then the total
value of your investment would be unchanged. Why doesn’t
capital structure matter?

28. Capital structure is irrelevant because it does not affect the cash
flows that the shop gener-
ates or their riskiness, and it is these characteristics of the shop
that determine its value. To
see this, ask yourself whether you think customers care about a
doughnut shop’s capital
structure when they choose to make a purchase. No, they care
about price, flavor, cleanli-
ness, selection, service, and convenience when choosing the
shop they wish to patronize.
These shop characteristics are independent of the proportion of
debt and equity the busi-
ness chooses to use as sources of capital. It’s the shop’s menu
customers are interested in,
not its balance sheet.
In our example, all of the cash flows to you, the owner, whether
it is an all-equity firm
or a 50% debt–50% equity firm. You will be receiving the same
cash flow stream whether
all the cash comes in the form of dividends, or part of the return
is dividend income and
part is interest income. Since there are no taxes or transaction
costs, you see no advantage
in receiving interest income or dividend income. As the sole
owner, you receive identical
cash flow and bear identical risk with either capital structure;
therefore, your business will
have the same value with either structure. To put it another way,
the components of value
(the size and riskiness of expected cash flows) are determined
by the left-hand (assets)
side of the financial balance sheet and are reflected in the
values of the right-hand (equity
and liabilities) side claims. Thus, it is the left-hand side that is
critical to a firm’s valuation.

29. It follows that in a perfect capital market, capital structure has
no impact on value. This
is the irrelevance proposition we referred to at the beginning of
this section. It means that
when capital markets are perfect, managers need not waste their
time worrying about
right-hand-side decisions. One capital structure is as good as
another, and they all result
in the same value for owners.
Irrelevance is probably easiest to understand by recognizing
that both cash and risk flow
from the left-hand side of the balance sheet (from assets and the
products those assets
produce) to the right-hand side of the balance sheet (to financial
claims, such as debt and
equity). Capital structure simply determines how these cash
flows and risk are distributed
to claimants. A good analogy is that of a pie: A firm’s capital
budgeting determines the
size of the pie, while capital structure determines who gets the
pieces of the pie. Capital
structure has no impact on the size of the pie (i.e., the value of
the firm) in a perfect world.
byr80656_08_c08_185-216.indd 188 3/28/13 3:34 PM
CHAPTER 8Section 8.1 Perfect Capital Markets
Leverage and the Risk of Common Stock
The term financial leverage is used to describe the proportion of
debt used in a firm’s capital

30. structure. An all-equity firm is unleveraged. The term leverage
is used in finance because the
presence of debt in a firm’s capi-
tal structure has a magnifying
effect on financial performance.
Just as a lever in physics magni-
fies strength, financial leverage
can make good cash flows to
shareholders even better (and
poor cash flows to shareholders
even worse). To demonstrate this
property of leverage, we extend
the doughnut shop example.
Suppose your doughnut com-
pany, The Whole Doughnut Inc.,
required $1 million in financing.
The firm can be financed either
using half debt and half equity
or all equity. The company can
borrow $500,000 at an inter-
est rate of 6%. As you consider
the two financing alternatives,
your market research consultant has identified three possible
cash flow scenarios for the
coming year: a best case of $170,000; an expected level of cash
flows of $100,000; and a
worst-case scenario, when cash flows total only $30,000. Table
8.1 shows the return on the
common-stock investment for both the unleveraged (all-equity)
financial structure and
the firm leveraged by borrowing $500,000.
Table 8.1: The effect of financial leverage
Worst case Expected Best case

31. A. Total investment $1,000,000 $1,000,000 $1,000,000
B. Operating cash
flows
$30,000 $100,000 $170,000
C. Return on total
investment
(B 4 A)
3% 10% 17%
All Equity
D. Payments on
fixed claims
$0 $0 $0
E. Total residual
cash flow (B 2 D)
$30,000 $100,000 $170,000
(continued)
Leo Cullum/The New Yorker
Collection/www.cartwoonbank.com
byr80656_08_c08_185-216.indd 189 3/28/13 3:34 PM
www.cartoonbank.com

32. CHAPTER 8Section 8.1 Perfect Capital Markets
Table 8.1: The effect of financial leverage (continued)
Worst case Expected Best case
F. Equity investment $1,000,000 $1,000,000 $1,000,000
G. Return on equity
(E 4 F)
3% 10% 17%
Leveraged Firm
H. Payments to fixed
claims (6% of
500,000)
$30,000 $30,000 $30,000
I. Residual cash flow
(B 2 H)
$0 $70,000 $140,000
J. Equity investment $500,000 $500,000 $500,000
K. Return on equity
(I 4 J)
0% 14% 28%
In Table 8.1 we’ve calculated returns to shareholders under
three scenarios: the worst case,
when the project only produces total cash flow of $30,000; the

33. expected case, when the
project produces total cash flow of $100,000; and the best case,
when the project produces
total cash flow of $170,000. Returns are found for both the all-
equity (unleveraged) firm
and the leveraged firm financed with $500,000 of debt and
$500,000 of equity.
Look at rows D through G first. This shows that for the all-
equity–financed firm the ROE
(return on equity) ranges from 3% under the worst-case scenario
to 17% for the best-case
scenario. The all-equity firm has an expected ROE of 10%.
Rows H through K show results
for the same firm when financed with a mix of debt and equity.
For the leveraged com-
pany the ROE ranges from 0% under the worst-case scenario to
28% for the best-case sce-
nario, with an expected ROE of 14%. The leveraged firm has a
higher expected ROE, but
twice the range of possible ROEs compared to the all-equity
firm. The table demonstrates
a tradeoff between risk and return using financial leverage.
With debt financing, all else
being equal, shareholders have a higher expected return, but
they also have higher return
variability.
This result makes economic sense. We know that risk-averse
investors require a higher
expected return if they anticipate being exposed to more risk or
variability. In our example
(Table 8.1), the 3% increase in the expected return to equity
investors will just compensate
investors for the greater risk created by leverage, leaving stock
prices, and thereby firm

34. value, unchanged.
This section has shown that capital structure is irrelevant in
perfect capital markets. But
markets in the real world are not perfect. Therefore, in the
following section, we relax the
perfect market assumptions to better reflect reality.
byr80656_08_c08_185-216.indd 190 3/28/13 3:34 PM
CHAPTER 8Section 8.1 Perfect Capital Markets
A Closer Look: Leverage
Leverage increases the impact of positive (and nega-
tive) results. Known in the United Kingdom as gear-
ing, the analogy to mechanical advantage in physics
holds true: With a little leverage the fruits of your
effort can have a more dramatic impact on outcome.
The strategy of leveraging a brand name in order to
maximize the benefit from a hard-won positive image
and reputation did not go unnoticed by Richard Bran-
son, the entrepreneurial founder of Virgin Records.
The Virgin brand is now associated with records,
soft drinks, an airline, railroads, financial services,
wines, mobile phones, energy, automobiles, and
more. Disney, on the other hand, may have wanted
to distance its famous brand name from its venture
into more mature movies than the traditional fam-
ily entertainment usually associated with the Disney
name. To avoid any possible negative leverage, the
firm chooses to produce movies for the new market
under alternative brand names, such as Miramax and
Touchstone, rather than Disney Pictures.

35. Spencer Platt/Staff/Getty Images
The Virgin brand has been leveraged and
is now associated with a wide variety of
products and services.
Although leverage has its benefits, it also has a downside. Keep
in mind that debt must
be repaid, whereas equity is conceptually a perpetual security
that never matures. A firm
that is unable to make the scheduled principal and interest
payments to its lenders faces
bankruptcy. Bankruptcy can be very costly, disruptive, and may
cause ownership of the
company to pass from stockholders to creditors. Another
downside of debt is that its
leveraging action also affects the firm when things are bad—in
other words, it magnifies
“bad outcomes” in the same fashion that it magnifies “good
times.” The earnings of a lev-
eraged firm, therefore, are much more variable than those of a
company that does not use
debt in its capital structure. These risks associated with
leverage are known as financial
risks. A company’s capital structure is chosen by assessing
these benefits and risks associ-
ated with borrowing money.
Capital Market Imperfections and Capital Structure
To better reflect capital structure’s effect on the firm in the real
world, we will relax the
perfect market assumptions that were made at the beginning of
the chapter.

36. We now introduce imperfections into our model of capital
markets. These imperfections
in capital markets will make the environment in our example
more realistic and more
complicated. As with any real-world decision that involves
uncertainty, capital structure
choice will involve pros and cons, or tradeoffs between the
potential benefits of leverage
and its potential adverse effects. Let’s begin by relaxing the
assumption of no leakages.
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CHAPTER 8Section 8.1 Perfect Capital Markets
Taxes and Leverage
In the real world, all cash flows that could flow to claimants do
not. There are leakages.
Just as physical friction reduces our ability to do physical labor,
frictions in capital mar-
kets lower the cash flows to investors. The most obvious
leakage or friction is that of taxes.
Interest payments made by the corporation are paid before
corporate income taxes, and
dividend payments are paid after corporate income taxes. Thus,
the firm may reduce
taxes paid to the government by using more debt in its capital
structure. A corporation
could conceptually avoid taxes altogether by financing
exclusively with debt. If all cash
flows were distributed to claimants in the form of interest
payments, the government
would collect no corporate taxes, because all interest would be

37. paid before taxes. On the
other hand, a corporation financed solely with equity would pay
taxes before any distri-
butions could be made to its suppliers of capital because
dividends would be paid after
taxes. Few firms are all-equity financed, and none are all-debt
financed. The Internal Rev-
enue Service would probably claim that an all-debt financing
scheme was a tax-avoidance
strategy and would impose taxes on that portion of the debt they
felt was de facto equity.
Normally, corporations have a mix of debt and equity, so let’s
look at this choice in light
of corporate taxation.
Table 8.2 shows cash flows to claimholders of The Whole
Doughnut Inc. when the firm
is unleveraged and when it is leveraged with $500,000 of debt
bearing a 6% interest rate.
We have assumed a 30% corporate tax rate. As the table shows,
the unleveraged firm pays
$30,000 in taxes to the government, whereas the levered firm
pays only $21,000. With debt
financing, the leakage to the government is $9,000 less, and
cash flows to investors are
$9,000 greater compared to the unleveraged financing model.
The $9,000 is the tax savings
resulting from the interest being a tax-deductible expense. We
could compute the interest
tax savings directly as the interest expense times the tax rate
($9,000 5 $30,000 3 0.30).
Table 8.2: The effects of taxes on cash flows
Unlevered $500,000 of 6% debt

38. A. Expected operating cash
flow
$100,000 $100,000
B. Interest payments to
debtholders (6%)
$0 $30,000
C. Cash flow after interest
payments (A 2 B)
$100,000 $70,000
D. Corporate taxes
(30% of C)
2$30,000 2$21,000
E. Cash flow to residual
claims (C 2 D)
$70,000 $49,000
F. Total cash flows to all
claimants (B 1 E)
$70,000 $79,000
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CHAPTER 8Section 8.1 Perfect Capital Markets

39. Increasing leverage reduces taxes, which increases the cash
flows available to investors
and thereby the value of the firm. Figure 8.2 illustrates this
result. This conclusion is not
difficult to understand if we return to the pie analogy. When
taxes (or other leakages) are
introduced into otherwise perfect markets, then a piece of the
cash flow pie is effectively
given to a third party. By avoiding taxes through debt financing,
less of the pie is distrib-
uted to third parties, leaving more cash flows available for
distribution to the capital sup-
pliers. In either case, leveraged or unleveraged, the
corporation’s risk is entirely borne by
these capital suppliers, so firm value will be directly linked to
the amount of cash security
holders can claim. Minimizing taxes will increase cash flows
and will therefore increase
the value of the company.
Figure 8.2: The impact of leverage on firm value in a perfect
capital market with
corporate income taxes
The upper horizontal line in Figure 8.2 represents the
irrelevance of leverage when capi-
tal markets are perfect. Regardless of the debt–equity mix that
the corporation chooses
for its capital structure, firm value remains unchanged. The
upward-sloping line shows
the benefits of leverage. As more debt is incorporated into the
firm’s capital structure,
a greater proportion of operating cash flows is distributed
before taxes are paid. The
deductibility of interest payments allows the firm to distribute
more of its cash flows, a

40. characteristic known as the tax shield of debt. This benefit
increases firm value as the
firm uses more debt.
The conclusion reached by studying Figure 8.2 is that a firm
should use almost no equity
in its capital structure. Indeed, in the 1980s some firms did
leverage themselves to such
an extent that debt represented 70%, 80%, and even 90% or
more of their capital. Yet the
Debt’s
tax shield
Impact of taxes
on value
Firm value
with interest
paid before
taxes
Irrelevance
of leverage
in perfect
markets with
no taxes
Firm value if
interest were
paid after taxes
F
ir
m

41. v
a
lu
e
Financial leverage (debt/equity)
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CHAPTER 8Section 8.1 Perfect Capital Markets
majority of corporations did not follow the lessons of Figure
8.2, choosing instead to keep
a more moderate level of debt in their financing mix. The
average debt ratio among U.S.
firms is around 32%. (See the Web Resources at the end of the
chapter for more informa-
tion.) Why don’t firms take full advantage of the debt tax
shield? We answer that question
in the next section as we study a second leakage, bankruptcy
costs.
Bankruptcy Costs and Leverage
As more and more debt is added to a firm’s capital structure,
that debt becomes riskier
because interest payments are fixed. If a company performs
poorly, it may decide not to
pay dividends to stockholders, but it must pay interest to debt
holders. Bonds and loans
are contractual agreements, so if these claimants are not paid on
time and in full, they
can bring legal action against the company. As debt levels rise,

42. smaller variations in per-
formance can leave a company unable to service its debt. The
possibility of default on
mandatory debt service payments increases with debt levels. A
default that cannot be
corrected or negotiated can lead to bankruptcy. Therefore, the
probability of bankruptcy
increases as debt increases.
Figure 8.3 is a stylized graph of our firm’s cash flows under
different economic condi-
tions over time. Figure 8.3(a) shows our firm with $500,000 of
debt, which carries a 6%
interest rate and, therefore, requires $30,000 of annual interest
payments. These required
payments are represented by the dotted horizontal line. Because
the cash flows never dip
below that line, we know the firm can make its interest
payments regardless of the future
economic scenario. Thus, at this level of leverage, our firm’s
debt is riskless.
Figure 8.3: How the likelihood of bankruptcy changes as more
debt is introduced into a
firm’s capital structure
Economic
conditions
Economic
conditions
Economic
conditions
Debt is riskless because cash

43. flows never fall below $30,000.
(a) $500,000 debt at 6% yields $30,000 interest payment.
(b) $700,000 debt at 6% yields $42,000 interest payment.
(c) $700,000 debt at 8% yields $56,000 interest payment.
$30,000 interest
$42,000 interest
$56,000 interest
Potential financial distress; thus, debt is
not risk free and lenders won’t lend at 6%.
Risky debt results in
higher rate of interest.
Cash
flow
Cash
flow
Cash
flow
Required interest
payment
Required interest
payment
Required interest

44. payment
$170,000
$100,000
$30,000
$170,000
$100,000
$30,000
$170,000
$100,000
$30,000
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CHAPTER 8Section 8.1 Perfect Capital Markets
Figure 8.3: How the likelihood of bankruptcy changes as more
debt is introduced into a
firm’s capital structure (continued)
Now, suppose that the firm chooses to take greater advantage of
debt’s tax shielding ben-
efits by borrowing a greater proportion of its capital. Suppose
the firm borrows $700,000.
At that level of debt, the loan would no longer be riskless. Even
at a 6% interest rate, lend-

45. ers stand the chance of not being paid under certain economic
conditions because the cash
flow curve falls below the $42,000 threshold in Figure 8.3(b).
Knowing this, lenders will
require a higher interest rate to compensate them for this risk,
say 8%. Figure 8.3(c) shows
the interest payment threshold of $56,000 when $700,000 is
borrowed at 8%. The shaded
areas illustrate potential cash shortfalls when the conditions
turn out to be poor for the
firm’s business.
If the economy turns sour and cash flows are insufficient to
cover interest payments, the
firm stands a chance of being unable to pay its contractual
interest (or other fixed obliga-
tions). Firms unable to meet their fixed claims are in default,
and this may lead to bank-
ruptcy. Some firms may avoid default during these shortfalls by
keeping a cash reserve on
hand or having other sources of capital that can be tapped to
meet these obligations. They
may borrow funds to make the payments, sell off assets, or sell
more stock. However, if
the shortfall is extreme, the firm may be unable to raise more
cash and could be forced
into bankruptcy.
Bankruptcy has many forms, but for our purposes it may be
characterized as the transfer
of control of assets from the residual claimants (i.e.,
shareholders) to fixed claimants (i.e.,
lenders). A simple example will help illustrate bankruptcy and
its impact. Suppose a bank
lends someone the cash to purchase an automobile. The bank is
a fixed claimant and the

46. borrower is the owner of the car. Let’s say the owner is unable
to make the payments the
loan requires and is in default. This is like bankruptcy in that
the borrower must transfer
ownership of the vehicle to the fixed claimant (the bank). If this
is done without friction,
as in a perfect market setting, then there is no loss in the value
of the automobile or the
bank’s claim.
However, we know that the bank incurs some costs when
repossessing a car. It pays law-
yers to do the legal paperwork, the state charges fees to transfer
the car’s title, and so on.
These are the direct costs of this transfer. Additionally, the
car’s owner may have neglected
Economic
conditions
Economic
conditions
Economic
conditions
Debt is riskless because cash
flows never fall below $30,000.
(a) $500,000 debt at 6% yields $30,000 interest payment.
(b) $700,000 debt at 6% yields $42,000 interest payment.
(c) $700,000 debt at 8% yields $56,000 interest payment.
$30,000 interest

47. $42,000 interest
$56,000 interest
Potential financial distress; thus, debt is
not risk free and lenders won’t lend at 6%.
Risky debt results in
higher rate of interest.
Cash
flow
Cash
flow
Cash
flow
Required interest
payment
Required interest
payment
Required interest
payment
$170,000
$100,000
$30,000
$170,000

48. $100,000
$30,000
$170,000
$100,000
$30,000
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CHAPTER 8Section 8.1 Perfect Capital Markets
to maintain the vehicle in an effort to conserve cash. He may
not have had the oil changed,
or had new tires put on, although they were needed, all in an
effort to save money and
avoid default. Once the bank has possession of the car, this
deferred maintenance must
be done at a cost to the bank. Bank officers will also spend
considerable time doing in-
house paperwork, making phone calls, and so on in order to take
possession of the car
and to pay the advertising costs associated with selling the
automobile. These activities
are costly and represent the indirect costs of the transaction.
Both the direct and indirect
costs of transferring ownership of the car represent frictions in
this transaction, and they
effectively lower the value of the car to the bank.
Similarly, corporate bankruptcies are never frictionless. It is

49. never the case that residual
claimants recognize that the firm cannot meet its fixed claims
and transfer their ownership
rights to fixed claimants with no cost. There are always costs to
the bankruptcy procedure.
The direct costs of bankruptcy include attorney’s fees and court
fees. Indirect bankruptcy
costs include management’s time spent on paperwork, phone
calls, meetings, and so on,
time that could otherwise be spent on more productive
activities. Furthermore, some key
employees may conclude that, given the firm’s financial
distress, now is a good time to
take another job, which is also costly to the corporation.
Customers may stay away from
the firm’s products because they fear that the firm’s guarantees
will not be honored as
a result of the bankruptcy. Suppliers may also be less willing to
sell inventory to a com-
pany facing bankruptcy. Distressed airlines, for example, often
find demand for their ser-
vices declines as customers worry about deferred aircraft
maintenance or canceled flights.
These represent bankruptcy’s indirect costs.
All of these costs lower the firm’s cash flows in the event of
bankruptcy. Imagine that The
Whole Doughnut began experiencing financial distress because
of difficulty in making
interest payments. It is possible that the shop would try to
conserve cash by reducing
labor costs. The money saved could be used to meet interest
payments on the firm’s debt.
However, the shop’s regular customers may begin to notice that
they must wait longer

50. to be served, that the shop isn’t as clean as it used to be, and
that employees aren’t as
friendly because they’re stressed from too much work. In short,
The Whole Doughnut
could lose business—lowering cash flows—as a result of the
cost-cutting strategy brought
on by financial distress. Had The Whole Doughnut not used
leverage in its capital struc-
ture, these financial difficulties and their accompanying
negative impact on firm value
could have been avoided.
Figure 8.4 is similar to Figure 8.3, but it shows the reduction of
cash flows in the event
of bankruptcy. It is important to note that the expected cash
flow for the firm is no lon-
ger $100,000. The friction caused by financial distress lowers
the cash available to claim-
ants in several potential economic conditions. Recognizing this,
investors incorporate
these costly outcomes into their cash flow estimates, lowering
their estimate of the firm’s
expected cash flow. They may also require a higher return
because of the greater vari-
ability of cash flows given potential bankruptcy costs. The
value of the firm must decline
because expected cash flows are lower and/or risk is higher.
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CHAPTER 8Section 8.1 Perfect Capital Markets
Figure 8.4: Forecasted cash flows across economic conditions,
showing the impact of

51. potential bankruptcy costs
The reduction in expected cash flows are one of the expected
costs of bankruptcy. Like
all expected values, expected bankruptcy costs are the
likelihood of bankruptcy times the
potential costs. If there is very little or no debt in the firm’s
capital structure, the corpora-
tion will not be in danger of default, and no potential
bankruptcy costs will be included
when investors value the firm. This occurs because the
probability of bankruptcy is zero
or close to zero. Yet, as more debt is added, the likelihood that
these costs will be incurred
becomes greater, and the expected value of bankruptcy costs
rise, lowering firm value.
Figure 8.5 shows the impact of bankruptcy costs on firm value
as leverage increases.
Best case
= $170,000
“Old” expected cash
flow of $100,000
“New” expected
cash payment
$56,000 required
interest payment
Worst case
= $30,000
Expected cash
flow is reduced by

52. the introduction of
bankruptcy costs.
Costs of
bankruptcy
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CHAPTER 8Section 8.1 Perfect Capital Markets
Figure 8.5: Leverage’s effect on firm value with taxes and
bankruptcy costs entering the
analysis
The lesson that should be learned from this discussion is that as
leverage increases, so
does the likelihood of incurring bankruptcy costs or costs
associated with financial dis-
tress. These potential costs reduce firm value, partially
offsetting the tax benefit of debt.
This is the first tradeoff mentioned earlier: Managers must
balance the tax advantage of
debt against the potential for costly bankruptcy. Leveraging the
firm reduces the leakages
to the government (lowers taxes), while increasing potential
leakages to third parties in
the case of bankruptcy proceedings or financial distress
(lawyers fees, court costs, custom-
ers lost to competitors, etc.).
Debt’s
tax shield
Impact of taxes

53. on value
Leverage’s
impact with
taxes
Leverage’s
impact with
taxes and
bankruptcy
costs
F
ir
m
v
a
lu
e
Leverage
Expected
bankruptcy
costs
Demonstration Problem 8.1: Leverage’s Effect on Return and
Risk
You have $10,000 to invest. You may choose to invest the
$10,000 in a project that will pay one of
two equally likely amounts in 1 year, either $15,000 or $8,000.
As an alternative, you could borrow

54. an additional $10,000 at 10% interest and invest a total of
$20,000 in the project, which would then
have equally likely payoffs of either $30,000 or $16,000. Find
the expected return for both alternative
investment strategies and then comment on the relative returns
and risk of the leveraged versus the
unlevered approach. (continued)
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CHAPTER 8Section 8.1 Perfect Capital Markets
Demonstration Problem 8.1: Leverage’s Effect on Return and
Risk (continued)
Solution
20,000
A. Amount
borrowed
$0 $10,000

55. B. Equity $10,000 $10,000
C. Gross cash
flow
$15,000 $8,000 $30,000 $16,000
D. Loan payoff 0 0 11,000 11,000
E. Cash to equity $15,000 $8,000 $19,000 $5,000
F. Return on
equity
50% 220% 90% –50%
G. Expected
return
(0.5)(50%) 1 (0.5)(220%) (0.5)(90%) 1 (0.5)(250%)
5 15% 5 20%
Leverage increases the average return by 5%, but the risk also

56. increases.
Now repeat Demonstration Problem 8.1, this time assuming the
interest rate is 18%.
20,000
A. Amount
borrowed
$0 $10,000
B. Equity $10,000 $10,000
C. Gross cash
flow
$15,000 $8,000 $30,000 $16,000
D. Loan payoff 0 0 11,800 11,800
E. Cash to equity $15,000 $8,000 $18,200 $4,200
F. Return on

57. equity
50% 220% 82% 258%
G. Expected
return
(0.5)(50%) 1 (0.5)(220%) (0.5)(82%) 1 (0.5)(258%)
5 15% 5 12%
The higher interest rate increases the interest owed from
$11,000 to $11,800. The average return
drops to 12%. In this case the use of leverage is clearly
detrimental because the 18% interest rate on
the debt is below the investment’s expected return of 15%.
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CHAPTER 8Section 8.1 Perfect Capital Markets
Information Asymmetry and Agency Costs
When capital markets are perfect, no information gap exists

58. between corporate insiders
and outsiders. All market participants have the same, or
symmetric, information. In such
conditions no agency problem would exist because investors
would observe the problem
(excessive perquisite consumption, growth for growth’s sake,
shirking behavior, etc.) and
take remedial action. When we drop the assumption of
symmetric information, we get a
much more realistic view of how corporations conduct their
affairs.
Asymmetric information means that corporate managers know
more about many of the
firm’s activities than do most corporate owners—the outside
shareholders. Under these
conditions agency problems can arise and be quite costly. How
does leverage affect agency
problems? The answer lies in the discipline of debt.
To understand the discipline of debt, first consider the nature of
the manager–stockholder
agency problem. Managers control corporate expenditures and
oversee their own efforts.
They may choose to invest cash in wasteful purchases—

59. unneeded corporate jets, luxury
offices, and so on—and they may choose to play a lot of golf
and take 2-hour lunches, or
they may pursue low-risk projects designed more to ensure their
employment than to
create shareholder value. These resources, corporate cash, and
managerial effort, could
be put to better, wealth-producing use. In sum, agency problems
can be costly for the
corporation. Now consider bankruptcy, the likelihood of which
increases with leverage.
In the event of bankruptcy, or financial distress that could lead
to bankruptcy, managers
are often fired, demoted, or forced to retire early. These
consequences of bankruptcy are
especially costly to managers who have most of their “wealth”
linked to their jobs (e.g.,
their human capital and financial capital).
Shareholders, who also suffer from bankruptcy’s costs, are not
impacted to the same
degree as managers because investors’ portfolios are
diversified. Managers, with so much
depending on their careers, are highly motivated to avoid
bankruptcy.

60. What do you suppose managers might do when a firm’s leverage
increases? Their fear
of bankruptcy causes managers to become more frugal,
conserving cash to minimize the
chances of a default. They may tend to play less golf and work
harder to avoid financial
distress. They waste less money, including excessive
perquisites, and they waste less time.
This is the discipline of debt.
The use of leverage increases the likelihood of financial
distress, threatening manage-
ment’s job security. In order to minimize the chance of default,
managers of highly lev-
eraged firms work hard to cut wasteful pursuits, reducing
agency costs and increasing
firm value. The discipline of debt argument states that firms
become more efficient and
therefore more valuable as leverage increases. Figure 8.6
illustrates the effect of debt’s
discipline on firm value.
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61. CHAPTER 8Section 8.1 Perfect Capital Markets
Figure 8.6: Leverage and firm value when (1) markets are
perfect, (2) taxes are introduced,
(3) with bankruptcy costs included, and (4) considering the
discipline of debt
Harvard Professor Emeritus Michael C. Jensen, who developed
this theory of the dis-
cipline of debt, argued that the agency cost problem would be
particularly severe in
companies with lots of cash flow and limited growth or
investment opportunities. Such
companies have lots of cash for managers to spend, but few
value-creating investments
to make. Industries that fit this description include the tobacco
or cigarette industry and,
when oil prices are high, the oil and gas industry. Debt reduces
the cash available for
managers to spend by requiring that it be paid to lenders.
Dividends, being somewhat
discretionary, usually don’t have the same agency cost reducing
effect that debt has.

62. Information Asymmetry and Signaling with Debt
Knowing that leverage may lead to financial distress and
possibly the loss of their jobs,
you might ask why a manager would ever take on more debt
financing. With information
asymmetry, outside stockholders must estimate firm value
without all the information
that inside managers have. Rational investors will typically
assign at best an average
value (but more likely a lower value) to aspects of a business
about which they are uncer-
tain. Managers don’t want their companies undervalued (they
own stock in the company
and their performance is often related to share price). Issuing
debt helps address this
undervaluation problem.
Debt may be viewed as management’s signal of the firm’s future
cash flow prospects.
When firms take on greater leverage, the managers, whose
decision it was to increase
leverage, must believe that the firm’s future cash flows are
sufficiently large and steady
enough to make higher interest payments. Thus, such leveraging

63. decisions signal man-
agement’s faith in the corporation’s cash flow–producing
capabilities. Because leverage is
increasing, the signal to outsiders is that the firm has a greater
capacity for servicing its
1. Irrelevance in a
perfect market
F
ir
m
v
a
lu
e
Leverage
Taxes lower cash flows and
thus lower firm value.

64. Expected bankruptcy costs
increase with leverage,
lowering value.
Interest payments, being tax deductible,
lower taxes and therefore increase firm value.
3. With tax
and costs of
bankruptcy
4. With taxes,
bankruptcy costs, and
the discipline of debt
The discipline of debt increases
cash flows as waste is cut,
increasing firm value.2. W
ith
deb
t’s
tax

65. sh
ield
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CHAPTER 8Section 8.1 Perfect Capital Markets
debt, meaning management expects cash flows to increase.
Therefore, the corporation’s
value will increase in the opinion of outsiders, based on the
signal from management.
Why don’t managers simply announce that cash flow prospects
have improved? An
announcement would convey the same information as the
leveraging signal. The differ-
ence between the announcement and taking on more debt is the
faith outsiders put in the
information. In other words, announcements have less
credibility than increasing lever-
age. Why? There is little penalty for announcements that turn
out to be false. Managers

66. are generally not fired, demoted, or subjected to having their
pay slashed because they
weren’t entirely forthcoming about a firm’s future prospects. In
fact, managers’ announce-
ments are often seen in the same light as politicians’. No one
takes them too seriously.
(This is true of managers’ (and politicians’) positive
announcements. Negative announce-
ments are usually taken seriously because they are made only
when things are so bad that
there is no possibility of “glossing over them”). On the other
hand, a leveraging signal is
credible because of its penalty for managers—the possible loss
of a job if the firm can’t
meet its debt payments.
Consider the opposite signal, increasing the equity base.
Suppose a firm issued and sold
additional stock using the funds to pay off debt. Such action
reduces fixed claims on cash
flows, thereby reducing the likelihood of financial distress.
Perhaps management feels
the firm’s future cash flows may be more variable or are at a
lower level than they have
been in the past. In order to reduce the chance of default, the

67. management of the firm has
reduced leverage, signaling to stockholders that the firm has
less value. A second similar
argument is that the firm’s management has sold stock to raise
funds because with their
inside information they feel that the stock’s value is currently
too high. If the value is too
high, it is a good time to sell some stock to raise funds before
the market discovers its
error and lowers equity’s price. In both cases, the signal is
clear: Firm value is too high in
light of management’s information. Leverage, therefore, may be
a credible signal of man-
agement’s superior information about firm value: Increasing
leverage signals increasing
value and vice versa.
Clearly, there are tradeoffs to consider when deciding which
capital structure should be
used to finance the firm’s investments. Tax benefits are
partially offset by bankruptcy
costs, which tend to be offset by the discipline of debt. Debt
may also be viewed as a sig-
nal of the firm’s future prospects, given the inside information
of management. Note that

68. there are no formulas in this chapter that let us solve for the
optimal degree of leverage.
Instead, managers must evaluate the characteristics of the firm
and its environment in
order to arrive at the best estimate of the firm’s optimal capital
structure. The next section
outlines the factors that should be considered in making that
decision.
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CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity
8.2 Determinants of the Target Capital Structure or Debt
Capacity
So far we have discussed what is often called the tradeoff
theory of capital structure. The tradeoff theory argues that
companies have an optimal level of debt (a mix of debt and
equity that maximizes value). This optimum point is a tradeoff
between the
tax and agency cost reduction benefits of debt and its

69. bankruptcy costs. This optimum
point becomes the target capital structure that companies strive
to maintain. Another way
to look at the target capital structure is as the company’s debt
capacity, or the maximum
amount of debt that can safely be serviced. Debt capacity
implies that debt is a valuable
resource and that a company that does not utilize its capacity to
borrow may not be maxi-
mizing value for shareholders. In this section we discuss the
characteristics that determine
a company’s debt capacity, beginning with those suggested by
the tradeoff theory—taxes,
potential bankruptcy costs, agency costs, and signaling—and
then adding some other fac-
tors that also appear important to companies.
Taxes
Tax rates vary among states, countries, and industries. In
addition, some firms may be
more adept than others at sheltering income from taxes. The
higher the tax bracket in
which a firm finds itself, the greater the tax-shielding benefit of
debt will be for that corpo-

70. ration, and the more leverage the firm should employ in its
capital structure. On the other
hand, firms with large tax-loss carryforwards or high
depreciation expense will garner
less benefit from leverage’s tax shield and will choose lower
levels of debt. This is also
true for startup firms that have not yet reached profitability and
therefore pay no taxes.
Bankruptcy Costs
Two considerations must be given to bankruptcy: the likelihood
of default and the costs
of bankruptcy.
Cash Flow Levels and Variability
To estimate the likelihood of default, a firm must estimate the
level of expected cash flows
and their variability. Figure 8.7 depicts a sine-wave model of
three firms’ future cash
flows. Firm A has a greater debt capacity than either Firm B or
C. Firm A’s expected level
of cash flows is $200,000, and its minimum level is $75,000.
Thus, Firm A could take on
fixed obligations of $75,000 per year that would be virtually

71. riskless. Firms B and C, on
the other hand, both have expected cash flows of $125,000 that
could fall to $30,000 and
2$50,000, respectively. Firm B could carry more debt than Firm
C because its cash flows
are less variable. Any amount of debt taken on by Firm C would
carry a risk premium,
because, in some economic conditions, the firm would produce
a cash flow deficit.
byr80656_08_c08_185-216.indd 203 3/28/13 3:34 PM
CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity
Figure 8.7: Three firms’ forecasted cash flows across economic
conditions and their
respective debt capacity
Probably the most important factor in determining cash flow
characteristics such as those
stylized in Figure 8.7 is the type of product market in which the
firm competes. Utilities,

72. for example, operate in markets where product demand is
relatively price-inelastic. Con-
sumers and businesses use a certain level of energy, regardless
of the economic climate.
Utilities often have regional monopolies, meaning that they are
the only suppliers of natu-
ral gas, electricity, or water in a given area. Utilities, therefore,
traditionally have high
degrees of leverage in their capital structure. Extremely cyclical
businesses would be more
uncertain of their level of future cash flows. Producers of
nonessential luxury goods may
find that product demand varies radically with economic
conditions. Such firms would
carry lower proportions of debt than utilities with their more
stable cash flows.
A second factor that impacts a firm’s ability to avoid
bankruptcy is its mix of operational
fixed costs and variable costs, a mix known as its operating
leverage. Fixed costs do not
vary with production. These are costs such as rent or salaried
workers. Variable costs are
dependent on the firm’s activity. Variable costs include raw
materials, labor, and sales

73. commissions. The higher the percentage of a firm’s costs that
are fixed, the more likely
Cash flow
Economic
conditions
Expected
cash flow of
$125,000
Expected
cash flow of
$125,000
Expected
cash flow of
$200,000
$0

74. Minimum
$75,000
Minimum
$30,000
Minimum
$50,000
Firm C: Lowest debt capacity
Firm B: Debt capacity higher than firm C
but lower than Firm A
Firm A: Highest debt capacity
byr80656_08_c08_185-216.indd 204 3/28/13 3:34 PM
CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity
there will be financial distress in an economic downturn. When
economic times are good,

75. fixed costs have the opposite effect: They benefit the firm when
activity increases. Firms
may substitute fixed costs for variable costs many times in their
operating structure in
the same way they substitute debt for equity in their capital
structure. For example, a
firm may choose to lease a delivery truck (a fixed cost), or it
may hire a carrier to deliver
goods as needed (a variable cost). Just as added debt increases
financial leverage, more
fixed operating costs increase operating leverage. Both types of
leverage tend to magnify
the firm’s performance and risk: Leverage makes good times
better, and it makes bad
times worse.
To illustrate operating leverage, consider two retail clothing
stores. One store pays its
salesperson a salary of $2,000 a month, a fixed cost. The other
store pays its salesperson
a 50% commission on sales, a variable cost. Now, consider two
possible economic envi-
ronments: bad times and good times. In bad times both firms
sell $1,000 worth of goods
in a month; in good times both stores sell $5,000 worth of goods

76. in a month. Which store
has more operating leverage? Which store is more likely to
default on its payments to its
sales staff? Which store could maintain a higher degree of
financial leverage? As shown
in Table 8.3, clearly, the store with lower operating leverage
(lower fixed costs) has greater
debt capacity.
Table 8.3: The effect of operating leverage (high fixed costs) on
profitability
Good times Bad times
Sales $5,000 $1,000
Low operating leverage store:
Salary $0 $0
Commissions $2,500 $500
Operating profit (or loss) $2,500 $500
High operating leverage store:

77. Salary $2,000 $2,000
Commissions $0 $0
Operating profit (or loss) $3,000 ($1,000)
Cost of Distress
The costs of bankruptcy are also a determinant of corporate
borrowing capacity. Recall
that bankruptcy is essentially the transfer of asset ownership
from residual claimants to
fixed claimants. The frictions associated with such a transfer
are somewhat predictable.
We know, for example, that ease of transfer or sale of an asset
is dependent on several
characteristics of that asset. The liquidity, or nearness to cash,
of the firm’s assets also
affects the level of expected bankruptcy costs. As a general
rule, tangible assets are more
easily sold (more liquid) than intangible assets (such as patents,
goodwill, or copyrights).
Businesses whose assets are primarily land, buildings, and
equipment will have lower

78. byr80656_08_c08_185-216.indd 205 3/28/13 3:34 PM
CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity
bankruptcy costs than those whose value depends on intangibles
such as the firm’s repu-
tation or the brand value of its products. Cash and marketable
securities are easily and
almost costlessly transferred from owner to owner, while work-
in-progress inventory is
often sold in financial distress yielding $0.50 or less per dollar
invested. Asset specificity
adds to its cost of transfer, lowering its liquidity. An abandoned
nuclear power plant, in
spite of its tangible nature, has almost no use other than as a
nuclear power plant—thus
its use is highly specific. Although such a plant may have cost
billions of dollars, almost
no one would be willing to receive it as a gift—free of charge.
In fact, most of us would
require compensation just for accepting such a gift. In a
bankruptcy, such an asset would

79. have a very high transfer cost. A delivery truck used in business
can be more easily sold
because it can be used in a variety of ways. Such a vehicle’s use
is not highly specific—a
characteristic that enhances its marketability.
To summarize, bankruptcy’s impact on leverage depends on the
likelihood of its occur-
rence and the costs associated with the procedure should it
occur. Evaluation of these
considerations involves analysis of the firm’s future cash flow–
generating capacity and of
the nature of the assets underlying the business. It is no wonder
that lenders look at two
factors when considering the debt capacity of a borrower: the
primary source of repay-
ment (cash flow) and the collateral (the assets backing the loan)
that could be sold as a
secondary source of repayment. Firms (or individuals) with high
and steady cash flows
who hold assets easily marketed for their full value can borrow
more than those without
these characteristics. By borrowing more, they are able to take
greater advantage of debt’s
tax-shielding benefit.

80. Agency Problems
Companies whose cash flows are high but that are in a mature
stage, with few positive
NPV projects in which to invest, find themselves with excess
cash on hand. They are flush
with free cash flow (cash not needed to fund promising
projects). In such firms the poten-
tial for wasted money and time is greater than in firms in their
formative stage. Manag-
ers of large companies with widely dispersed ownership are less
likely to be held closely
accountable for their actions because no single stockholder
owns enough stock to present
a threat to incumbent management. In the 1980s, for example,
even future presidential
candidate Ross Perot was unable to redirect General Motors’s
strategy despite being the
firm’s largest shareholder. When combined, excessive free cash
flow and widely dispersed
ownership are ingredients that foster wasted resources. These
firms may benefit from the
discipline of debt. Leveraging upward puts more pressure on
management to perform

81. effectively and efficiently. More free cash flow is guaranteed to
be paid out as fixed claims
increase, reducing the potential for discretionary expenditures
like excessive perquisites.
In such cases, adding leverage can add to firm value.
Signaling
Another consideration is the use of leverage as a credible signal
to outside sharehold-
ers and analysts. If, for example, managers are confident that
the firm’s performance is
improving, then a strong signal would be to borrow funds and
use the proceeds to repur-
chase some shares. More debt signals the ability to produce the
cash necessary to meet a
higher level of fixed claims in order to avoid default.
Additionally, insiders would direct
byr80656_08_c08_185-216.indd 206 3/28/13 3:34 PM
CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity

82. the firm to repurchase shares when the share price is below its
value—in other words,
when buying one’s own shares is a positive NPV investment.
Transaction Costs
The empirical evidence doesn’t support the notion that
companies constantly fine-tune
their capital structure to be at or near their optimal mix of debt
and equity. Observers see
companies going years between security issues that would bring
them back toward their
historical debt ratios. Transaction or issuance costs may explain
this slow response.
There are two types of costs associated with issuing securities
in the public capital mar-
kets: direct and indirect costs. Direct costs are the fees paid to
lawyers, accountants, and
investment bankers; listing fees paid to exchanges; printing,
advertising, and marketing
costs; and management time spent on the issuance process
rather than on other activities.
Indirect fees are underpricing of security issues by underwriters

83. and any reactions in the
price of existing securities to the announcement of a new issue.
We will discuss both types
of costs in more detail in a moment. First, let’s introduce some
definitions:
• New equity IPO is the very first issuance of stock for a
company; it is the company’s
initial public offering (IPO). Determining the market value of
an IPO is difficult, so
underwriters tend to underprice these issues severely. This leads
to large indirect
issuance costs in addition to the high direct costs. More on this
below.
• Seasoned equity is an issue of more common stock being
offered to the public by
a company that already has publicly traded common stock
outstanding. These
new shares will dilute existing ownership, so some shares of
stock have preemp-
tive rights, which give existing shareholders the right to buy
shares in any new
stock issues to maintain their original proportional ownership.
Most states do not

84. require companies to include preemptive rights in their articles
of incorporation,
so this right is not guaranteed. Seasoned equity offerings are
valued based on the
market value of the existing shares, so underwriter underpricing
occurs much
less frequently than in IPOs.
• Convertible bonds have both a debt and equity component.
While the debt portion
is relatively easy to value, the equity portion can be complex,
increasing the cost
of issuance.
• Straight debt (i.e., nonconvertible debt) is relatively easy to
value, as we saw in the
first weeks of the class. Once the bond issue is rated and a
coupon rate set, it is a
standard PV exercise.
Table 8.4 shows the direct costs for various sizes and types of
securities. These data are
from the period 1990–1994, so note that they are dated.
byr80656_08_c08_185-216.indd 207 3/28/13 3:34 PM

85. CHAPTER 8Section 8.2 Determinants of the Target Capital
Structure or Debt Capacity
Table 8.4: Issuance costs for various types of corporate
securities
Amount issued (in millions)
New equity
IPO
Seasoned
equity
Convertible
bonds
Straight
bonds
, $40 12.2% 8.8% 7.4% 2.9%
, $40 to $100 8.5% 5.5% 3.5% 2.1%

86. . $100 6.8% 4.0% 2.6% 2.2%
Weighted average 11.0% 7.1% 3.8% 2.2%
Table 8.4 shows some clear patterns. First, notice that smaller
issues cost more than larger
issues of the same type of security. This suggests that there are
fixed costs associated with
the underwriting and issuance process. Second, the more
difficult a security is to value,
the higher the costs. Equity for a new firm is the most difficult
to value because the com-
pany has a limited track record, may be offering a new product
in a relatively new market,
and may have some untested managers (which implies that
venture capital or private
equity costs will be higher still, since those valuations would be
more complex than those
for companies ready to go public). Seasoned equity is simpler
because there is an existing
stock price, but the value of the stock (new and existing) will
depend on what the com-
pany will do with the proceeds. If investors are not confident
that managers will make

87. good use of this pot of money, then they will push share prices
down (increase indirect
issuance costs). Bonds are the simplest security to value and
have the lowest costs. Valu-
ation therefore entails not simply setting the price at or just
below current market value,
but it must also include some analysis of the prospects of the
firm making good use of the
proceeds of the issuance.
A Closer Look: Level of Debt for the Average Firm by Industry
This table shows the level of debt for the average firm in a
variety of industries. Can you spot any
pattern regarding what the relatively low debt industries have in
common versus the higher debt
industries?
Industry Capital structure
Water utility 45% debt
Semiconductor 7.7% debt
Restaurant 11.3% debt

88. Oil/gas distribution 37% debt
Packaging and containers 34% debt
byr80656_08_c08_185-216.indd 208 3/28/13 3:34 PM
CHAPTER 8Section 8.3 The Pecking-Order Theory
As we discussed earlier in this chapter, pricing equity (both
IPOs and seasoned equity)
is complicated by the presence of asymmetric information—
managers know more about
the value of the firm’s assets and growth prospects than outside
investors do. Consider
a company that has a positive NPV project that it wants to
finance. It could offer debt or
equity. When will it offer equity? If you are the CEO and you
work for the benefit of exist-
ing shareholders, you will only offer equity if it is fairly or
overpriced. That means that
sometimes investors are paying too much for new stock
offerings. To combat this, they

89. will only buy new shares at a discount, so we see new shares
selling at a discount to the
price of the shares immediately before the new stock offering is
announced. This notion
is supported by the facts that seasoned equity offerings tend to
happen after share price
has been rising during the year previous (consistent with the
stock being overvalued) and
after the issuance of a seasoned equity offering, the stock
performance for the next 5 years
is subpar. That investors tend to underprice new equity issues is
an indirect cost of issuing
equity. The high costs of equity issuance give companies a good
reason to avoid issuing
equity and have led to the development of an alternative theory
of how companies make
their debt–equity decisions.
8.3 The Pecking-Order Theory
So far this chapter has argued that firm value can be maximized
at some target amount of debt; that is, that companies have an
optimal capital structure they should pursue. The pecking-order
theory of capital structure takes an entirely different view of
how

90. companies choose their financing mix. This theory, developed
by Stuart Myers of MIT,
argues that the costs of issuing securities in the capital market,
especially equity, is so high
that companies try to avoid those costs. Companies try to fund
as much of their invest-
ment as possible from internal sources (e.g., retained earnings).
When external funds have
to be used, companies issue safe debt; if more funds are needed
for investment in produc-
tive assets, risky debt is issued; and finally, if the company
doesn’t want to bear too much
bankruptcy risk, equity is issued. There is no target debt level
as in the previous models.
Instead, companies consider internally generated cash flow,
their investment opportu-
nities, and the costs associated with security issuance. Figure
8.8 summarizes the main
points of the theory.
byr80656_08_c08_185-216.indd 209 3/28/13 3:34 PM
CHAPTER 8Section 8.4 Financial Flexibility

91. Figure 8.8: Pecking-order theory
Companies want to avoid issuing equity unless it is absolutely
necessary—the direct and
indirect costs are very high. Debt issues, particularly high-rated
or relatively safe debt,
will have the absolute lowest costs of all sources of external
finance. Retained earnings
have no issuance costs whatsoever, so they are at the top of the
pecking order.
8.4 Financial Flexibility
Companies appear to have debt targets somewhat lower than
expected. Some econo-mists argue that this allows a company to
maintain financial flexibility. Flexibility is most easily thought
of as the ability to raise funds for investment (and for paying
dividends) during periods when cash generation is low. The
notion of financial flexibility
also explains why companies sometimes issue debt and exceed
their estimated target debt
levels and then slowly adjust back toward the target. In a survey
of about 250 global com-
panies, researchers found that financial flexibility is considered

92. extremely important; in
fact, flexibility manifested as the ability to continue making
investments and paying divi-
dends represents the second- and fourth-ranked determinants,
respectively, of debt levels.
Another aspect of financial flexibility is maintaining a high
credit rating. Having a high
credit rating means that a firm can issue debt at a reasonable
cost at any time, which
supports flexibility. As an example, A Closer Look: Moody’s
Long-Term Corporate Obligation
Ratings elaborates on this topic.
Internal Resources
(retained earnings)
External Resources
(issue safe debt)
External Resources
(issue risky debt)
Equity

93. byr80656_08_c08_185-216.indd 210 3/28/13 3:34 PM
CHAPTER 8Summary
A Closer Look: Moody’s Long-Term Corporate Obligation
Ratings
Moody’s long-term obligation ratings are opinions of the
relative credit risk of fixed-income obliga-
tions with an original maturity of 1 year or more. They address
the possibility that a financial obliga-
tion will not be honored as promised. Such ratings use Moody’s
Global Scale and reflect both the
likelihood of default and any financial loss suffered in the event
of default:
Aaa: Obligations rated Aaa are judged to be of the highest
quality with minimal
credit risk.
Aa: Obligations rated Aa are judged to be of high quality and
are subject to very low
credit risk.

94. A: Obligations rated A are considered upper-medium grade
and are subject to low
credit risk.
Baa: Obligations rated Baa are subject to moderate credit risk.
They are considered
medium grade and as such may possess certain speculative
characteristics.
Ba: Obligations rated Ba are judged to have speculative
elements and are subject to
substantial credit risk. Bonds classified as Ba or below are often
called “junk” bonds.
B: Obligations rated B are considered speculative and are
subject to high credit risk.
Caa: Obligations rated Caa are judged to be of poor standing
and are subject to very
high credit risk.
Ca: Obligations rated Ca are highly speculative and are likely
in, or very near, default,
with some prospect of recovery of principal and interest.

95. C: Obligations rated C are the lowest-rated class of bonds and
are typically in
default, with little prospect for recovery of principal or interest.
Note: Moody’s appends numerical modifiers 1, 2, and 3 to each
generic rating classification from Aa
through Caa. The modifier 1 indicates that the obligation ranks
in the higher end of its generic rating
category; the modifier 2 indicates a midrange ranking; and the
modifier 3 indicates a ranking in the
lower end of that generic rating category.
Summary
Debt acts like a lever. When the firm is doing well, financial
leverage increases the return to stockholders. When times are
tough, it magnifies the negative effect on shareholders’ returns.
The more leverage, the greater the magnifying effect. Thus,
while leverage can increase expected returns, it also increases
variability or risk. In perfect
capital markets, these two effects just offset one another,
leaving value unchanged.
In reality, market imperfections exist that make the capital

96. structure choice similar to a bal-
ancing act between the benefits of debt and its effects that harm
value. Debt may increase
cash flows to claimants by avoiding corporate taxes, by limiting
agency problems, and by
sending a positive signal to outsiders. On the other hand, added
leverage increases the
likelihood of a costly bankruptcy.
byr80656_08_c08_185-216.indd 211 3/28/13 3:34 PM
CHAPTER 8Key Terms
Although there is no precise method for finding the optimal
capital structure of a firm,
certain characteristics of corporations help to guide managers
toward an appropriate tar-
get structure. First, firms with high taxable income operating in
areas with high corpo-
rate tax rates should consider higher leverage than unprofitable
firms. Next, corporations
with widely dispersed ownership and excess free cash flow may
find that leverage low-

97. ers potentially wasteful cash expenditures. Leverage may also
be used as a signal of the
increased debt capacity of the borrower. Finally, firms may
deviate from optimal target
debt levels to maintain financial flexibility.
These benefits of leverage must be balanced against the
corporation’s potential bank-
ruptcy costs. Firms with more volatile cash flows are in greater
jeopardy of experiencing
financial distress than firms with stable cash flows. Therefore,
businesses should consider
the stability of their income when targeting their debt level.
Should a firm have financial
difficulty, those with highly liquid or marketable assets should
experience lower bank-
ruptcy costs than those whose assets are unique or specific to
their current use. Firms with
illiquid, highly specific assets have higher potential bankruptcy
costs and must carefully
consider their levels of debt.
Key Terms
asset specificity The use of a capital good

98. for a very specific purpose.
asymmetric information The situation
in which corporate managers know more
about many of the firm’s activities than do
most outside shareholders.
bankruptcy costs The expenses and
opportunity costs associated with bank-
ruptcy and financial distress, including
direct costs (such as lawyer fees and court
costs), as well as indirect costs (such as
loss of sales, the time of executives who
must deal with the process, and the poten-
tial loss of key employees who may seek
employment elsewhere).
debt capacity The optimal amount of debt
that a firm is able to take on.
financial flexibility The firm’s ability to
raise new funds for investment even when
cash flows are slow; can mean a firm does
not borrow all the way to its limit, or may
mean that the firm keeps some extra cash

99. on hand to meet unforeseen needs.
financial risk The possibility that share-
holders will lose money when they invest
in a company that has debt, if the compa-
ny’s cash flow proves inadequate to meet
its financial obligations.
leveraging The act of using various finan-
cial instruments or borrowed capital, such
as margin, to increase the potential return
of an investment.
pecking-order theory The theory that
firms choose their capital structure by
following a prioritized list of methods for
raising capital; according to this theory,
there is no targeted level of debt.
perfect capital markets Markets where
there is no information asymmetry, no
transaction costs, and no taxes, and in
which the choice of capital structure has no
effect on the overall value of the firm; capi-
tal structure is said to be irrelevant when

100. markets are perfect.
byr80656_08_c08_185-216.indd 212 3/28/13 3:34 PM
CHAPTER 8Web Resources
signal An action taken by management
that is interpreted by outsiders as revealing
something about the firm that is otherwise
unobservable because of information asym-
metry, such as the issue of more debt, which
signals that the firm has better future pros-
pects that increase its debt capacity.
target capital structure The optimum
financing mix chosen by the firm to fund
its assets and operations; usually includes
a mix of debt and equity.
tax shield of debt The saving in taxes
realized because interest on debt is tax
deductible.

101. tradeoff theory of capital structure
A theory stating that firms have a capi-
tal structure that considers the tradeoff
between advantages of debt (the tax
shield of debt and the discipline of debt)
and debt’s disadvantages (the costs
associated with bankruptcy and financial
distress).
Web Resources
Capital structure irrelevance was demonstrated for perfect
markets by Franco Modigli-
ani and Merton Miller in one of the most important articles ever
written in economics.
They both received Nobel prizes, in part for their capital
structure studies. See “The
Cost of Capital, Corporation Finance and the Theory of
Investment,” American Economic
Review, 48 (June 1958), available at
http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20
phd%20program/fin%20
635/3/modiglianimiller1.pdf.
Find business tax information at

102. http://raw.rutgers.edu/.
See “Corporate Financing and Investment Decisions When
Firms Have Information That
Investors Do Not Have” by Stewart C. Myers and Nicholas S.
Majluf (1984), from the
Journal of Financial Economics, 13(2), pages 187–221. The
article is available online at
http://www.nber.org/papers/w1396.pdf?new_window51.
In a well-known 1980 study (“The Effects of Capital Structure
Policy Change on Security
Prices: A Study of Exchange Offers,” Journal of Financial
Economics, 8, 158–159;
http://www.sciencedirect.com/science/article/pii/0304405X8090
015X), Masulis found
that 69% of the firms had positive market responses to their
announced decision to
increase leverage, while only 11% of firms announcing leverage
decreases saw the value
of their equity increase.
The discipline of debt argument was developed by Michael
Jensen in his May 1986
article “Agency Cost of Free Cash Flow, Corporate Finance, and

103. Takeovers,” published
in the American Economic Review, 76(2). You can find it
online at
http://ssrn.com/abstract599580 or
http://dx.doi.org/10.2139/ssrn.99580.
Students interested in agency problems or corporate takeover
battles are advised to read
Bryan Burough and John Helyar’s book Barbarians at the Gate,
the story of the battle for
control of RJR Nabisco, which led to one of the largest
corporate takeovers in history
(visit
http://en.wikipedia.org/wiki/Barbarians_at_the_Gate:_The_Fall
_of_RJR_Nabisco).
byr80656_08_c08_185-216.indd 213 3/28/13 3:34 PM
http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20
phd%20program/fin%20635/3/modiglianimiller1.pdf
http://student.bus.olemiss.edu/files/jeggington/ole%20miss%20
phd%20program/fin%20635/3/modiglianimiller1.pdf
http://raw.rutgers.edu/
http://www.nber.org/papers/w1396.pdf?new_window51
http://www.sciencedirect.com/science/article/pii/0304405X8090

104. 015X
http://ssrn.com/abstract599580 or
http://dx.doi.org/10.2139/ssrn.99580
http://en.wikipedia.org/wiki/Barbarians_at_the_Gate:_The_Fall
_of_RJR_Nabisco
CHAPTER 8Critical Thinking and Discussion Questions
Henri Servaes and Peter Tufano’s book, The Theory and
Practice of Corporate Capital Struc-
ture, Deutsche Bank, was published in January 2006. It is
available for download at
http://faculty.london.edu/hservaes/Corporate%20Capital%20Str
ucture%20-%20Full%20
Paper.pdf.
For more information on capital structure, read the February
2011 article by DeAngelo,
DeAngelo, and Whited, published in the Journal of Financial
Economics, 99(2), and avail-
able at
https://msbfile03.usc.edu/digitalmeasures/deangelo/intellcont/D
DW%20JFE%202011%20
final%20version-1.pdf.

105. To access extensive financial information about virtually any
company, explore
http://finance.yahoo.com.
New York University Professor Aswath Damodar maintains data
concerning average
debt ratios at
http://pages.stern.nyu.edu/~adamodar/.
Critical Thinking and Discussion Questions
1. Name four examples of frictions, or cash flow leakages, that
exist in imperfect
capital markets.
2. Consider the following:
a. If fixed claimants (bondholders) supply half of a
corporation’s capital and
residual claimants (stockholders) supply the other half of the
capital, will
these two classes of claimants each be exposed to half the
firm’s total risk?
Why or why not?

106. b. Will each class of claimants receive half of the firm’s cash
flows? Explain,
using your answer to part a, and what you know about the risk
and return
relationship.
3. Suppose a savings and loan must foreclose on an individual’s
house because the
homeowner is unable to meet the mortgage payments. What
costs will poten-
tially lower the value of the house to the savings and loan? Can
you think of both
direct and indirect costs in this example of financial distress?
4. Which of the following hotels could potentially carry a
greater proportion of debt
in its capital structure and why? Both Hotel A and Hotel B have
the same cost,
have the same expected cash flows, their cash flows are equally
risky, and they
are located across the street from one another; but Hotel A is
built so that it could
be easily converted to a nursing home and Hotel B is built so
that its conversion

107. to another use is impractical.
5. The Gonzales twins are each shopping for a loan. They both
have good payment
records on their other debts and have impeccable character.
They both earn, on
average, $40,000 each year. Hector Gonzales is a carpenter and
Juan Gonzales is a
nurse. Which twin do you think has the greater debt capacity,
and why?
byr80656_08_c08_185-216.indd 214 3/28/13 3:34 PM
http://faculty.london.edu/hservaes/Corporate%20Capital%20Str
ucture%20-%20Full%20Paper.pdf
http://faculty.london.edu/hservaes/Corporate%20Capital%20Str
ucture%20-%20Full%20Paper.pdf
https://msbfile03.usc.edu/digitalmeasures/deangelo/intellcont/D
DW%20JFE%202011%20final%20version-1.pdf
https://msbfile03.usc.edu/digitalmeasures/deangelo/intellcont/D
DW%20JFE%202011%20final%20version-1.pdf
http://finance.yahoo.com
http://pages.stern.nyu.edu/~adamodar/

108. CHAPTER 8Practice Problems
Practice Problems
1. Firm A has a high degree of operating leverage. All of its
operating expenses
are fixed at $12,500 a month. Firm B utilizes no operating
leverage. Its operat-
ing expenses are all tied to sales, equaling 60% of total
revenues. Suppose both
Firm A and Firm B have sales of $20,833 in June, $30,000 in
July, and $15,000 in
August. Find the operating cash flows for each firm for each of
the 3 months.
Which has more variable operating cash flows? Which firm
could take on more
financial leverage?
2. Consider the following:
a. Suppose there is a one-third probability that a firm will have
an operating
cash flow of $100,000 next year. There is a one-third chance
that the firm will
have an operating cash flow of $150,000, and a one-third chance

109. of it having
an operating cash flow of $200,000. You may purchase all of
the stock in the
firm (50,000 shares) if you wish. The corporate income tax rate
is 40%. What
will be next year’s cash flows per share on the potential stock
purchase under
each of the three outcomes?
b. Now, suppose the firm leverages itself. You can still
purchase all of the firm’s
securities ($1,600,000 of bonds paying 10% interest and 10,000
shares of stock).
Corporate income tax rates are still 40%. What will be your
total cash flow for
these investments next year under each outcome for the
leveraged firm?
c. Should operating cash flows fall below the level required to
make interest
payments, the firm will be forced to file bankruptcy papers,
which will cost
the firm $10,000, to be paid before distributions to claimants.
How does this
potential bankruptcy cost affect the total expected cash flows on

110. your claim?
(Hint: Recall that E(CF) 5 P
1
(CF
1
) 1 P
2
(CF
2
) 1 P
3
(CF
3
) where P
1
, P
2

111. , and P
3
denote probabilities that the cash flows CF
1
, CF
2
, and CF
3
will occur, respec-
tively.) How does the expected cash flow for part c compare
with the expected
cash flow calculated using the answers to part b of this
problem?
3. Suppose you buy some vacant land as an investment. You can
invest $50,000
of your own money. The land is selling for $5,000 an acre. You
can buy either a
10-acre parcel or a 20-acre parcel. If you buy the smaller parcel,

112. you will invest
only your own funds. If you decide on the larger parcel, you
will borrow $50,000
at an 8% interest rate and fund the balance of the purchase price
with your money.
Ignore taxes in this problem. If you hold the land for 1 year,
what is the percentage
return on your $50,000 out-of-pocket investment for both
strategies when
a. you sell the land for $4,500/acre.
b. you sell the land for $5,100/acre.
c. you sell the land for $5,500/acre.
d. Why didn’t using leverage raise your return in part b? After
all, the value of
the land increased.
byr80656_08_c08_185-216.indd 215 3/28/13 3:34 PM
CHAPTER 8Practice Problems
4. The Whole Doughnut is expected to produce operating cash
flows of

113. $200,000 a year in perpetuity. If the firm was financed using
100% equity, calcu-
late the total annual dividends paid by the firm, assuming The
Whole Doughnut
pays all of its after-tax cash flows out as individuals.
Operating Cash Flows
2 Taxes (25%)
5 After-Tax Cash Flows
5 Total Dividends Paid
Now, suppose the firm is financed with $500,000 of 6% debt,
and the balance is
financed by equity. Again, no operating cash is retained. What
will be The Whole
Doughnut’s total cash flows to claimants?
Operating Cash Flow
2 Interest Payments

114. Cash Flow Before Taxes
2 Taxes (25%)
5 After-Tax Cash Flows
5 Total Dividends
1 Interest Payments
5 Total Cash Flows to Claimants
5. Frank Baez hates to pay taxes and decides to change the
capital structure of the
firm he manages in order to avoid taxation. The firm currently
has earnings
before taxes of $3,000,000 and is in the 34% tax bracket.
Presently, all of the firm’s
financing is in the form of equity. Frank intends to issue
$10,000,000 worth of 9%
bonds and trade each bond for a portion of each shareholder’s
stock. The interest
payment s on the bonds are tax deductible. If the firm pays out
all of its after-tax
earnings as dividends, how much more cash will stockholders

115. receive as a group
under Frank’s plan?
byr80656_08_c08_185-216.indd 216 3/28/13 3:34 PM
Learning Objectives
Upon completion of Chapter 6 you will be able to:
• Understand the importance of incremental after-tax cash
flows.
• Be able to estimate incremental after-tax cash flows.
• Be able to calculate the tax consequences on an asset sale.
• Understand why sunk costs do not matter in capital budgeting.
• Know the three categories of cash flows typically seen in an
investment proposal.
Relevant Cash Flows for

116. Capital Budgeting
6
iStockphoto/Thinkstock
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CHAPTER 6Section 6.1 How to Compute Cash Flows
A company’s very first goal is staying financially healthy; a
bankrupt company helps no one, neither owners nor employees
nor customers. Financial health requires that bills and debts be
paid in full and on time. This is done with cash. Cash
is what lets a company keep its doors open and the lights on.
Cash keeps the machines
running, the raw materials flowing into factories, and the
finished goods flowing out.
In Chapter 2 we explained why cash flow is more important
than accounting profits. We
repeat that message here because it is so important. A company
cannot pay its employ-

117. ees, suppliers, banks, or tax agencies with net income. Those
entities only accept cash. In
Chapter 2 we also explained why cash flow and accounting
profit (net income or profit
after tax) differ. As a quick reminder, it has to do with how
revenue is recognized, how
costs are matched to sales, and how some costs are allocated
over time via depreciation.
In this chapter we expand the discussion of cash flow to exactly
which type of cash flows
we use when analyzing investment opportunities or determining
a company’s financial
health. We draw on accounting, tax rules, and economic theory
to arrive at the appropri-
ate cash flows for financial analysis. In a corporate setting,
investment analysis is called
capital budgeting: the decision about how to best budget
investment capital to create
wealth for shareholders.
6.1 How to Compute Cash Flows
We discussed how to use accounting statements to estimate cash
flows in Chapter 2. There we showed a simple approach that

118. gave a reasonable approximation in most cases and a more
complete approach. The simple approach just added
depreciation expense back to net income to find an estimate of
cash flow. This approach is
usually fairly close to the exact value because depreciation is
usually the primary account
that causes net income and cash flow to differ.
The more complete approach begins with net income and
subtracts increases in assets and
adds increases in liabilities. Note that depreciation expense will
be included in changes in
fixed assets or property, plant, and equipment (PP&E), so is not
treated separately as it was
in the simple approach. If you are not comfortable with
translating accounting data into
cash flows, be sure to review the more detailed description of
the process in Chapter 2.
The appropriate cash flows for evaluating a corporate
investment decision are incremen-
tal after-tax cash flows. We will explain this definition in some
detail as the chapter pro-
gresses. For now, let’s look at the logic underlying each portion
of this expression.

119. Incremental: This is similar to the concept of marginal in
microeconomics. Economists
make decisions by comparing marginal costs and marginal
revenues. Recall that a prod-
uct’s marginal cost is the cost of making one more unit of the
product. If the marginal cost
is less than the marginal revenue (the price the unit will be sold
for), then the company
produces and sells that additional unit of production. Production
continues as long as
marginal cost is below marginal revenue. In finance we have
adopted the concept under-
lying marginal analysis to evaluate corporate investment
proposals. We compare the
additional cash flow that the proposed project or product will
generate to the additional
costs that the investment requires.
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CHAPTER 6Section 6.1 How to Compute Cash Flows

120. After-tax: When we evaluate a project proposal, we do so from
the perspective of the
owners of the company. If the company is publicly traded, this
means we evaluate from
the shareholders’ perspective. Owners receive their return from
after-tax dollars. That is,
shareholders have a claim on after-tax profits. These are often
referred to as residual cash
flows because they are left after all other obligations have been
paid. We will see that taxes
can have a large effect on cash flows, so they cannot be
ignored.
Cash flows: As we discussed at the very beginning of this
chapter (and in Chapter 2), it is
cash that allows a company to pay its obligations—wages to
employees, bills from suppli-
ers, taxes, etc.—and remain financially viable.
Incremental Cash Flows
The use of incremental cash flows builds on the concept of
marginal costs and revenues in
economics. In corporate finance we don’t deal with individual
units of production, but

121. rather with investments in assets and other expenditures
(training, marketing, R&D, etc.)
to make new products or services, to expand production of
existing product lines, or to
reduce costs. In these situations we are dealing with a set of
expenditures, sometimes total-
ing millions or even billions of dollars. The underlying concept
is the same as in economics:
If additional revenues exceed additional costs, then the
investment should be pursued.
To make revenues and outlays (cash inflows and outflows)
comparable, we apply the pres-
ent value tools from Chapter 4 to translate all cash flows into
today’s dollars. If the present
value of cash inflows exceeds the present value of costs, then
the investment is said to have
a positive net present value, and so it is wealth-creating and
should be accepted. You will
learn more about actually computing a net present value in
Chapter 7. In this chapter we
focus on the most important input in the net present value
computation: cash flows.
The With-and-Without Principle

122. To determine incremental cash flows, we imagine the company
with and without the
proposed investment. The cash flows that the company
generates without the proposed
investment act as a baseline against which to identify changes
in cash flows. We subtract
the cash flows without the project from the company’s cash
flows if the project is accepted.
This difference is the incremental cash flow from the proposed
project.
You might ask how the with-and-without approach differs from
just measuring the pro-
posed product’s revenue and costs. If you add up all the costs of
designing, producing,
marketing, and distributing a new product, there is a good
chance that some of the costs
will not be incremental. Examples include sunk costs, allocation
of overhead, and canni-
balism of sales.
Sunk Costs
Consider research and development costs for a product. Before a
proposal can be submit-

123. ted for funding, money has to be spent designing the product. It
might seem like these
costs should be included in the proposal. But including them is
incorrect. They are sunk
costs. It doesn’t matter whether or not the new product is
pursued; these funds have been
byr80656_06_c06_141-160.indd 143 3/28/13 3:32 PM
CHAPTER 6Section 6.1 How to Compute Cash Flows
spent and cannot be recovered. In respect to these R&D
expenditures, the company is no
different with or without the project; in either case the money
has been spent. Another
common type of sunk cost is marketing research.
Basically, anything that is spent prior to the proposal being
submitted and analyzed can-
not be recovered, so it is a sunk cost.
Allocation of Overhead
Managerial accounting classes typically dedicate several weeks

124. to the allocation of over-
head costs. There are several approaches for doing this. If you
thought that cost account-
ing was challenging, we have good news for you: In finance we
do not allocate overhead.
If a cost is truly overhead and fixed, then the with-and-without
principle will not identify
it as incremental. Whether or not the proposed project is
accepted, the company will incur
the cost.
Let’s look at some examples. Sometimes factory floor space is
allocated by square feet
or square meters utilized by a project. Almost always, the rent
or lease expense for this
area has to be paid whether or not the new project is accepted.
Applying the with-and-
without concept means that if rent or lease payments do not
change, no floor space cost is
incremental to the project. We discuss a possible exception to
this rule under opportunity
costs below.
Salaried managers may have some portion of their time
allocated to a new project, but