How Much Should a Firm Borrow?

• Student Presentations
• Why M & M Does Not Hold
– Corporate Taxes
– Personal Taxes
– Financial Distress
• Pecking Order of Financing Choices
 Corporate Taxes
• Debt provides a tax shield
– Interest is tax deductible
– Government’s share of income declines
– Value of bondholders’ and stockholders’ share
increases
 Present Value of Tax Shield
• Present value of tax shield
n
Tc (rD D)
PV (Tax Shield )  
t 1 (1  rD )
t

• If debt is assumed to be a perpetuity

Tc (rD D)
PV (Tax Shield )   Tc D
rD
Table 18.1: Comparison of Unlevered Firm
and Levered Firm with $1000 of Debt at 8%
Compute the present value of the tax shield for a firm in the
35% tax bracket on the following debt issue:

1 year $1,000,000 loan at 8%

A) $25,926
B) $28,000
C) $35,000
D) $350,000
E) None of the above
Compute the present value of the tax shield for a firm in the
35% tax bracket on the following debt issue:

$1,000,000 perpetuity loan at 8%

A) $28,000
B) $80,000
C) $324,074
D) $350,000
E) None of the above
 Claims on Firm
• Bondholders: Debt
• Government: Taxes
• Equityholders: Remainder of firm value
 M&M and Taxes
Value of firm = Value of all-equity-financed firm
+ PV(tax shield)
 Pfizer Balance Sheet 2004 and Adjusted for
$1 billion Debt for Equity Trade
Book values
A Net working capital 10,752 7,144 Long-term debt
21,460 Other long-term liabilities
C Long-term assets 86,900 69,048 Equity
T Total assets 97,652 97,652 Total value
U
Market values
A
Net working capital 10,752 7,144 Long-term debt
L PV interest tax shield 2,500 21,460 Other long-term liabilities
Long-term assests 283,373 268,021 Equity
Total assets 296,625 296,625 Total value

A
D
J
U
S
T
E
D
What’s Wrong with Pfizer’s CFO?
• Should also consider personal taxes
• Cost of financial distress
 Corporate and Personal Taxes
Let Tp  Personal tax on int erest
TpE  Personal tax on equity income

Relative tax advantage of debt vs. equity

1  Tp

(1  TpE )(1  Tc )

If the relative advantage is > 1, debt is preferred

If the relative advantage is < 1, equity is preferred
 Example – Advantage to Debt
Assume dividends are 40% of earnings
Each dollar of earnings generates $0.40 in
dividends and $0.60 in capital gains
Marginal investor is in the 35% tax bracket on
interest and 15% on dividends and capital
gains
Deferral of capital gains reduces capital gains
rate in half (to 7.5%)
TpE  (.4 x15)  (.6 x7.5)  10.5%
 Example - continued

Interest Equity Income

Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corporate tax 1 0.65
Personal tax at Tp = .35 and Tpe = .105 0.35 0.068
Income after all taxes $0.675 $0.582

Advantage to debt= $ .068

Calculate the relative tax advantage of debt with personal and
corporate taxes where:
TC = (Corporate tax rate) = 35%;
TpE = Personal tax rate on equity income = 30% ;
Tp = Personal tax rate on interest income = 20% :

A) 0.76
B) 1.16
C) 1.35
D) 1.76
E) None of the above
Given the following information, leverage will
add how much value to the unlevered firm per
dollar of debt?
Tc = 34% Tp = 30% TpE=20%
A) $0.66
B) $0.25
C) -$0.66
D) -$0.34
E) None of the above
 Costs of Financial Distress
Value of firm = Value of all-equity-financed firm
+ PV(tax shield)
– PV(costs of financial distress)
 Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
 Types of Financial Distress
• Bankruptcy costs
– Direct: legal and court costs
– Indirect: Inefficient operations, creditors,
employees, suppliers, customers
• Financial distress without bankruptcy
• Incentives for a firm in difficulty
– Risk shifting
– Refusing to contribute equity capital
– Taking cash from firm
– Delaying tactics
– Bait and switch on use of funds from debt
 Costs of Financial Distress by
Asset Type
• Tangible assets unaffected by ownership
– Real estate
– Airplanes
• Intangible assets
– Brand image
– Technology
– Human capital
Trade-off Theory of Capital Structure
• Capital structure depends on trade-off between
interest tax shield and financial distress
• High debt firms
– Safe, tangible assets
– High taxable income
• Low debt firms
– Risky, intangible assets
– Unprofitable companies
• Does theory work?
– Yes and no
Pecking Order of Financing Choices
1. Firms prefer internal finance
2. Firms adapt payout targets to investment
opportunities trying to avoid sudden changes
3. Sticky dividend policies and fluctuations in
profitability and investment opportunities
lead to cash flow shifts
4. If external finance is required, firms issue
debt first, then equity
 Tests of Pecking Order
1. Large firms tend to have higher debt ratios
2. Firms with high ratios of fixed assets to total
assets have higher debt ratios
3. More profitable firms have lower debt ratios
4. Firms with higher ratios of book-to-market
values have lower debt ratios
 Next Class
• Thursday, April 12
– Financing and Valuation – Chapter 19
– Problem Set 3