1. Principles of
Chapter 18 Corporate Finance
Tenth Edition
How Much Should
a Corporation
Borrow?
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2. 18-2
Topics Covered
Corporate Taxes
Corporate and Personal Taxes
Cost of Financial Distress
Pecking Order of Financial Choices

3. 18-3
Capital Structure & Corporate Taxes
Financial Risk - Risk to shareholders resulting from
the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.

4. 18-4
Capital Structure & Corporate Taxes
The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.
Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598
Total income to both bondholders and
stockholders $0+650=$650 $80+598=$678
Interest tax shield (.35 x interest) $0 $28

5. 18-5
Capital Structure & Corporate Taxes
28
PV (tax shield) $350
.08
Interest payment return on debt X amount borrowed
rD D
rcorporatetax rate X interest payment
PV (tax shield)
expected return on debt
TC (rD D)
TC D
rD

6. 18-6
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies
Diaper Co. The company has no debt. The
company’s annual cash flow is $900,000 before
interest and taxes. The corporate tax rate is 35%
You have the option to exchange 1/2 of your
equity position for 5% bonds with a face value of
$2,000,000.
Should you do this and why?

7. 18-7
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company
has no debt. The company’s annual cash flow is $900,000 before interest
and taxes. The corporate tax rate is 35% You have the option to exchange
1/2 of your equity position for 5% bonds with a face value of $2,000,000.
Should you do this and why?
($ 1,000 s) All Equity 1/2 Debt Total Cash Flow
EBIT 900 900 All Equity = 585
Interest Pmt 0 100
Pretax Income 900 800
*1/2 Debt = 620
Taxes @ 35% 315 280
(520 + 100)
Net Cash Flow 585 520

8. 18-8
Capital Structure & Corporate Taxes
PV of Tax Shield = D x rD x Tc
= D x Tc
(assume perpetuity)
rD
Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
PV Tax Shield = $2,000,000 x .35 = $700,000

9. 18-9
Capital Structure & Corporate Taxes
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield = 700,000
Firm Value with 1/2 Debt = $12,400,000

10. 18-10
Capital Structure & Corporate Taxes
Merck Balance Sheet, December 2008
(figures in $millions)
Book values
Net working capital 4,986.2 3,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 18,758.3 Equity
Total assets 32,877.0 32,877.0 Total value
Market values
Net working capital 4,986.2 3,943.3 Long-term debt
PV interest tax shield 1,380.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,928.3 Equity
Total assets 79,047.0 79,047.0 Total value

11. 18-11
Capital Structure & Corporate Taxes
Merck Balance Sheet, December 2008 (figures in $millions)
(w/ $1 billion Debt for Equity Swap)
Book values
Net working capital 4,986.2 4,943.3 Long-term debt
10,175.4 Other long-term liabilities
Long-term assets 27,890.8 17,758.3 Equity
Total assets 32,877.0 32,877.0 Total value
Market values
Net working capital 4,986.2 4,943.3 Long-term debt
PV interest tax shield 1,730.2 10,175.4 Other long-term liabilities
Long-term assests 72,680.6 64,278.3 Equity
Total assets 79,397.0 79,397.0 Total value

12. 18-12
C.S. & Taxes (Personal & Corp)
Operating Income ($1.00)
Paid out as Or paid out as
interest equity income
Corporate Tax None Tc
Income after $1.00 $1.00 – Tc
Corp Taxes
Personal Taxes . Tp TpE (1.00-Tc)
Income after All $1.00 – Tp $1.00–Tc-TpE (1.00-Tc)
Taxes =(1.00-TpE)(1.00-Tc)
To bondholders To stockholders

13. 18-13
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-Tp
(1-TpE) (1-Tc)
Advantage
RAF > 1 Debt
RAF < 1 Equity

14. 18-14
C.S. & Taxes (Personal & Corp)
Example
Interest Equity Income
Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corpotare tax 1 0.65
Personal tax at Tp = .35 and TpE = .125 0.35 0.081
Income after all taxes $0.650 $0.569
Advantage to debt= $ .081

15. 18-15
C.S. & Taxes (Personal & Corp)
Another Example
Interest Equity Income
Income before tax $1 $1
Less corporate tax at Tc =.35 0 0.35
Income after corpotare 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

16. 18-16
C.S. & Taxes (Personal & Corp)
Today’s RAF & Debt vs Equity preference.
1-.33
RAF = = 1.23
(1-.16) (1-.35)
Why are companies not all debt?

17. 18-17
Capital Structure
Structure of Bond Yield Rates
r
Bond
Yield
D
E

18. 18-18
WACC w/o taxes (traditional view)
r Includes Bankruptcy Risk
rE
WACC
rD
D
V

19. 18-19
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

20. 18-20
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress

21. 18-21
Financial Distress
Maximum value of firm
Costs of
financial distress
Market Value of The Firm
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt

22. 18-22
Default Payoff Scenarios

23. 18-23
Ace Limited Example
Total payoff to Ace Limited security holders. There is a $200
bankruptcy cost in the event of default (shaded area).

24. 18-24
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Book Values)
Net W.C. 20 50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets 100 100 Total liabilities

25. 18-25
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Market Values)
Net W.C. 20 25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets 30 30 Total liabilities
 Why does the equity have any value ?
 Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.

26. 18-26
Conflicts of Interest
Circular File Company has may invest $10 as
follows.
Now Possible PayoffsNext Year
$120 (10% probabilit y)
Invest $10
$0 (90% probabilit y)
 Assume the NPV of the project is (-$2).
What is the effect on the market values?

27. 18-27
Conflicts of Interest
Circular File Company value (post project)
Circular File Company (Market Values)
Net W.C. 10 20 Bonds outstanding
Fixed assets 18 8 Common stock
Total assets 28 28 Total liabilities
 Firm value falls by $2, but equity holder gains $3

28. 18-28
Conflicts of Interest
Circular File Company value (assumes a safe
project with NPV = $5)
Circular File Company (Market Values)
Net W.C. 20 33 Bonds outstanding
Fixed assets 25 12 Common stock
Total assets 45 45 Total liabilities
 While firm value rises, the lack of a high potential payoff
for shareholders causes a decrease in equity value.

29. 18-29
Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch

30. 18-30
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.

31. 18-31
Trade Off Theory & Prices
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices;
repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.

32. 18-32
Issues and Stock Prices
 Why do security issues affect stock price?
The demand for a firm’s securities ought to
be flat.
 Any firm is a drop in the bucket.
 Plenty of close substitutes.
 Large debt issues don’t significantly depress
the stock price.

33. 18-33
Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue when
shares are overpriced.
Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.
If external finance is required, firms issue debt first andequity as a
last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.

34. 18-34
Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).

35. 18-35
Web Resources
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