Chap 017

Randolph W.
Westerfield
Jeffrey Jaffe
Ram Kumar Kakani
CORPORAT
E FINANCE
Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights reserved.
Stephen A. Ross
10/E
17-1
Capital Structure: Limits to the Use of

Debt
Chapter
17
17-2
bankruptcy
Understand the theories that address the
level of debt a firm carries
Tradeoff
Signaling
Agency Cost
Pecking Order
Define the costs associated with
Know real world factors that affect the
debt to equity ratio

17-3
17.2 Description of Financial Distress Costs

17.3 Can Costs of Debt Be Reduced?
17.4 Integration of Tax Effects and Financial Distress
Costs
17.5 Signaling
17.6 Shirking, Perquisites, and Bad Investments: A Note
on Agency Cost of Equity
17.1 Costs of Financial Distress
17.7 The Pecking-Order Theory

17.8 Personal Taxes
17.9 How Firms Establish Capital Structure
17-4
The possibility of bankruptcy has a negative
effect on the value of the firm.

However, it is not the risk of bankruptcy
itself that lowers value.

Rather, it is the costs associated with
bankruptcy.
Bankruptcy risk versus bankruptcy cost
It is the stockholders who bear these costs.
17-5
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business (e.g., lost sales)
Agency Costs
Direct Costs
Selfish Strategy 1: Incentive to take large risks

Selfish Strategy 2: Incentive toward underinvestment
Selfish Strategy 3: Milking the property
17-6
What happens if the firm is liquidated today?
The bondholders get Rs.200; the shareholders get

nothing.
Assets
BVMVLiabilities
BVMV
Cash
Rs.200 Rs.200
LT bondsRs.300 Rs.200
Rs.0
Fixed AssetRs.400Rs.0
Equity Rs.300
Total
Rs.600Rs.200
Total
Rs.600 Rs.200
17-7
The Gamble
Probability
Payoff
Win Big
10% Rs.1,000
Lose Big 90% Rs.0
Cost of investment is Rs.200 (all the firms cash)
Required return is 50%
Expected CF from the Gamble = Rs.1000 0.10
+ Rs.0 = Rs.100
Rs.100
NPV = Rs.200 +
(1.50)
NPV = Rs.133
17-8
PV of Stocks Without the Gamble = Rs.0
Rs.30
PV of Bonds With the Gamble:Rs.20 =
(1.50)
Expected CF from the Gamble

To Bondholders = Rs.300 0.10 + Rs.0 = Rs.30
To Stockholders = (Rs.1000 Rs.300) 0.10 +
Rs.0 = Rs.70
PV of Bonds Without the Gamble = Rs.200
Rs.70
PV of Stocks With the Gamble: Rs.47 =
(1.50)
17-9
guarantees Rs.350 in one period.

Cost of investment is Rs.300 (the firm only has Rs.200
now), so the stockholders will have to supply an
additional Rs.100 to finance the project.
Required return is 10%.
Rs.350
NPV = Rs.300 +
(1.10)
NPV = Rs.18.18
Consider a government-sponsored project that
Should we accept or reject?

17-10
To Bondholder = Rs.300
To Stockholder = (Rs.350 Rs.300) = Rs.50
PV of Bonds Without the Project = Rs.200
PV of Stocks Without the Project = Rs.0
PV of Bonds With the Project:
PV of Stocks With the Project:
Rs.272.73 =
Rs.54.55
Expected CF from the government

sponsored project:
Rs.300
(1.10)
Rs.50
(1.10)
Rs.100
17-11
dividend to the shareholders. This leaves

the firm insolvent, with nothing for the
bondholders, but plenty for the former
shareholders.
Such tactics often violate bond indentures.
Liquidating dividends
Suppose our firm paid out a Rs.200
Increase perquisites to shareholders and/or
management
17-12
Debt Consolidation:
If we minimize the number of parties,
contracting costs fall.
Protective Covenants
17-13
advantage of debt and the costs of

financial distress.
It is difficult to express this with a precise
There is a trade-off between the tax
and rigorous formula.
17-14
Value of firm under

MM with corporate
taxes and debt
Present value of tax

shield on debt
VL = VU + TCB
Maximum
firm value
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
0
B
Value of firm (V)
Debt (B)
Optimal amount of debt
17-15
another claim on the cash flows of the firm.

Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
VT = S + B + G + L
Taxes and bankruptcy costs can be viewed as just
The essence of the M&M intuition is that V T depends
on the cash flow of the firm; capital structure just

slices the pie.
17-16
where the marginal subsidy to debt equals

the marginal cost.
Investors view debt as a signal of firm value.
Firms with low anticipated profits will take on a low
level of debt.
Firms with high anticipated profits will take on a
high level of debt.
The firms capital structure is optimized
A manager that takes on more debt than is
optimal in order to fool investors will pay the

cost in the long run.
17-17
the owners than if he is one of the hired help.

While managers may have motive to partake in
perquisites, they also need opportunity. Free cash

flow provides this opportunity.
The free cash flow hypothesis says that an increase
in dividends should benefit the stockholders by

reducing the ability of managers to pursue wasteful
activities.
An individual will work harder for a firm if he is one of
The free cash flow hypothesis also argues that an
increase in debt will reduce the ability of managers

to pursue wasteful activities more effectively than
dividend increases.
17-18
debt rather than equity if internal financing

is insufficient.
Rule 1
Use internal financing first
Rule 2
Issue debt next, new equity last
The pecking-order theory is at odds with
Theory stating that firms prefer to issue
the tradeoff theory:
There is no target D/E ratio

Profitable firms use less debt
Companies like financial slack
17-19
must pay taxes. Thus, personal taxes must

be considered in determining the optimal
capital structure.
Individuals, in addition to the corporation,
17-20
shareholder), which suggests a stockholder

receives the net amount:
(1-TC) x (1-TS)
Interest payments are only taxed at the
Dividends face double taxation (firm and
individual level since they are tax deductible by

the corporation, so the bondholder receives:
(1-TB)
17-21
primarily by debt (avoiding double tax).

The firm is indifferent between debt and
equity when:
(1-TC) x (1-TS) = (1-TB)
If TS= TB then the firm should be financed
17-22
Changes in financial leverage affect firm value.

Stock price increases with leverage and vice-versa; this
is consistent with M&M with taxes.

Another interpretation is that firms signal good news
when they lever up.

There
are differences in capital structure across

industries and even through time.
Most corporations have low Debt-Asset ratios.
There is evidence that firms behave as if they had a
target Debt-Equity ratio.
17-23
Since interest is tax deductible, highly profitable
firms should use more debt (i.e., greater tax benefit).

Types of Assets
The costs of financial distress depend on the types of
assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating
income have a high probability of experiencing
financial distress.
Taxes
17-24
bankruptcy?
Define the selfish strategies stockholders
may employ in bankruptcy.
Explain the tradeoff, signaling, agency
cost, and pecking order theories.
What factors affect real-world debt levels?
What are the direct and indirect costs of
17-25

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Randolph W.

Capital Structure: Limits to the Use of

Define the costs associated with

Know real world factors that affect the

debt to equity ratio

17.2 Description of Financial Distress Costs

17.1 Costs of Financial Distress

17.7 The Pecking-Order Theory

The possibility of bankruptcy has a negative

effect on the value of the firm.

itself that lowers value.

Bankruptcy risk versus bankruptcy cost

It is the stockholders who bear these costs.

Legal and administrative costs

Selfish Strategy 1: Incentive to take large risks

What happens if the firm is liquidated today?

The bondholders get Rs.200; the shareholders get

PV of Stocks Without the Gamble = Rs.0

Expected CF from the Gamble

guarantees Rs.350 in one period.

Consider a government-sponsored project that

Should we accept or reject?

Expected CF from the government

dividend to the shareholders. This leaves

Increase perquisites to shareholders and/or

contracting costs fall.

advantage of debt and the costs of

There is a trade-off between the tax

and rigorous formula.

Value of firm under

Present value of tax

Value of firm (V)

Optimal amount of debt

another claim on the cash flows of the firm.

Taxes and bankruptcy costs can be viewed as just

The essence of the M&M intuition is that V T depends

on the cash flow of the firm; capital structure just

where the marginal subsidy to debt equals

The firms capital structure is optimized

A manager that takes on more debt than is

optimal in order to fool investors will pay the

the owners than if he is one of the hired help.

perquisites, they also need opportunity. Free cash

in dividends should benefit the stockholders by

An individual will work harder for a firm if he is one of

The free cash flow hypothesis also argues that an

increase in debt will reduce the ability of managers

debt rather than equity if internal financing

The pecking-order theory is at odds with

Theory stating that firms prefer to issue

the tradeoff theory:

There is no target D/E ratio

must pay taxes. Thus, personal taxes must

Individuals, in addition to the corporation,

shareholder), which suggests a stockholder

Dividends face double taxation (firm and

individual level since they are tax deductible by

primarily by debt (avoiding double tax).

If TS= TB then the firm should be financed

Changes in financial leverage affect firm value.

is consistent with M&M with taxes.

when they lever up.

are differences in capital structure across

Most corporations have low Debt-Asset ratios.