Wk9 In-Depth Notes on Corporate Finance - Capital Structure

Why Debt Policy Matters

• Capital Structure - I: In perfect capital markets with no frictions, capital structure decisions (debt policy) seem irrelevant. However, financial managers do worry about debt policy, as actual markets are not frictionless.
• Reasons Debt Policy Matters:
  • Corporate and Income Taxes: Tax implications on interest versus income affect firm value.
  • Costs of Bankruptcy and Financial Distress: Higher debt increases bankruptcy risks and associated costs.
  • Conflict of Interest: Debt creates conflicts, particularly between debt holders and equity holders.

Industry Debt Levels

• 2020 Data on Debt Ratios: Different industries show varied borrowing patterns.
  • High Debt Issuers: Telecoms, retailers, utilities.
  • Low Debt Issuers: Drug companies, computer software.
• Debt Policy Relevance: Variability in debt levels across industries challenges the idea that capital structure is irrelevant.

MM Propositions in a World with Corporate Taxation

• Key Concept: In the presence of corporate taxes, debt policy is crucial; a firm's value increases with more debt.
• Tax Treatment: Interest on debt is tax-deductible, leading to different effective tax burdens.

Unlevered vs. Levered Firms

• Unlevered Firm:
  • Taxable income = EBIT.
  • Total tax liability: ext{Tax Liability} = ext{EBIT} imes T_C.
• Levered Firm:
  • Taxable income = ext{EBIT} - r_D D.
  • Tax advantages from interest deductions lead to lower total taxes compared to unlevered firms.

Value of Unlevered and Levered Firms

• Value Formulas:
  • Unlevered Firm: VU = rac{ ext{EBIT} (1 - TC)}{r_A}.
  • Levered Firm: VL = VU + (D imes T_C), where D is the amount of debt.
• Key takeaway: The tax shield from debt (i.e., D imes T_C) increases firm value.

Tax-Deductible Interest

• Tax Shields: Firms gain tax benefits from interest because these expenses reduce taxable income. The annual tax shield is calculated as: ext{Annual Tax Shield} = TC imes rD imes D.
• Example: If a firm borrows 1,000 at 8 ext{ } interest, the tax shield equals 17 given a tax rate of 21 ext{ }.

Market Value Balance Sheets

• Normal vs. Expanded:
  • Normal balance sheets account for taxes, expanded sheets reflect pre-tax values and include government tax claims as liabilities.
• Impacts: Leveraged firms pay less in total taxes, enhancing equity holders' value.

Costs of Financial Distress

• Definition: Costs arising from bankruptcy or negative impacts on business decisions due to high debt levels.
• Direct Costs: Legal fees, administrative costs from liquidation, often substantial (3%-20% of firm value).
• Indirect Costs: Include damaged relations with suppliers, loss of key personnel, or risky behavior by management.
• Firms tend to limit their debt because of these costs despite tax advantages.

Trade-Off Theory of Optimal Capital Structure

• Theory: Firms must balance between the tax benefits of debt and the costs associated with financial distress, thus determining an optimal debt level.
• Optimal Capital Structure: Found where value from tax shields equals the costs from financial distress.

Limited vs. Unlimited Liability

• Limited Liability: Shareholders can exit from responsibility in case of bankruptcy, affecting decision-making.
• Example Comparison: Ace Limited can default without further losses, while Ace Unlimited's shareholders must cover losses beyond assets.

Summary of Pecking-Order Theory

• Information Asymmetry: Managers have better information than investors which affects financing choices. The preference order for financing is:
  • 1st: Internal funds (retained earnings)
  • 2nd: Debt
  • 3rd: Equity
• Growth Companies: Tend to use more internal financing because they have fewer needs for debt or equity due to available cash flows.

Implications of Pecking-Order Theory

1. Preference for internal finance over debt or equity.
2. Adjusting dividends based on investment opportunities.
3. If external financing is needed, safest options (debt) are chosen first.
4. The most profitable firms tend to use less debt due to available internal funds.

Important Factors in Capital Structure Determination

• Tax Impact: High taxable income encourages debt financing.
• Asset Risk: Firms with tangible assets can handle more debt; firms with intangible assets should limit debt due to higher financial distress risks.
• Operating Income Stability: Firms with volatile earnings require higher equity financing to offset risks.