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Lecture 6: Debt Policy
 Changing a firm’s capital structure should not affect its
value to shareholders.
 This chapter analyzes several possible financing
scenarios and provides an overview of the effects of
taxes and costs of financial distress on a firm.
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Does Borrowing Affect Value?
A company’s choice of capital structure does not increase the value of the firm.
•Capital Structure – The mix of long-term debt and equity financing.
•On the balance sheet, the value of the cash flows on the left determines the value of the firm,
and therefore determines the values on the right.
• If the firm alters its capital structure, overall value should not change.
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MM’s Irrelevance Proposition
The value of a firm does not depend on its capital
structure.
If this holds, can financial managers increase the value
of the firm by changing the mix of securities used to
finance the company?
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MM’s Irrelevance Proposition
 Assumptions of MM’s argument:

“Well functioning” capital markets

Efficient capital markets

No taxes (therefore no distortion)

Ignore costs of financial distress
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MM’s Irrelevance Proposition
Example: An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share. It considers a restructuring
that would issue $4 million in debt to repurchase 400,000 shares. How does this affect overall firm value?
•Restructuring – Process of changing the firm’s capital structure without changing its real assets.
•Note: In the example above, since the value of the firm is the same in both situations, common shareholders are no better or worse off in
either.
•
Shares still trade at $10 each
•
Overall value of equity falls to $6,000,000 but shareholders also receive $4,000,000.
Before Restructuring:
After Restructuring:
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How Borrowing Affects EPS
Ceteris paribus, borrowing will increase earnings per share. However, this isn ’t a source of
value to shareholders.
Shareholders can easily replicate a firm’s
borrowing on their own if they choose.
•As long as investors can borrow or lend on their own account on the same terms as the firm,
they are not going to pay more for a firm that borrows on their behalf.
• The value of the firm after the restructuring must be the same as before.
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How Borrowing Affects Risk and
Return

Debt financing does not affect the operating risk of the firm.
• Operating Risk – Risk in firm’s operating income.
• Financial Risk – Risk to shareholders resulting from the use of debt.
• Ex: with only half the equity to absorb the same amount of operating risk, risk per share must
double.
•
Financial Leverage – Debt financing to amplify the effects of changes in operating income on the
returns to stockholders.

Debt financing does affect the financial risk of the firm.
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How Borrowing Affects Risk and
Return
The circles on the left assume “River Cruises” has no debt. The circles on the right reflect a proposed
restructuring that splits firm value 50-50. Shareholders get more than 50% of expected operating
income, but only because they bear additional financial risk.
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Debt and the Cost of Equity
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Debt and the Cost of Equity:
Example
What is the expected return on equity for a firm with a 14%
expected return on assets that pays 9% on its debt, which
totals 30% of assets?
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MM’s Proposition II
Debt increases financial risk and causes
shareholders to demand higher rates of return.
• MM’s Proposition II – The required rate of return on equity increases as the firm’s debt-equity ratio
increases.
• Once the implicit cost of debt is recognized, debt is no cheaper than equity. The return that
investors require on their assets is unaffected by the firm’s borrowing decision.
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Debt and Taxes
Debt financing advantage: the interest that a firm pays
on debt is tax deductible.
Interest tax shield – Tax savings resulting from
deductibility of interest payments.
Interest tax shield:
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Perpetual Tax Shield
If the tax shield is perpetual, then:
• Interest tax shield – Tax savings
resulting from deductibility of
interest payments.
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Perpetual Tax Shield: Example
What is the present value of the tax shields for a firm that
anticipates a perpetual debt level of $12 million at an interest
rate of 4% and a tax rate of 35%?
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Tax Shield and Shareholders’
Equity
When accounting for taxes, borrowing increases firm
value and shareholders’ wealth.
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Taxes and WACC
Recall that the WACC takes into account the required after-tax
rate of return
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Taxes and WACC: Example
What is the expected rate of return to shareholders if the firm
has a 35% tax rate, a 10% rate of interest paid on debt, a 15%
WACC, and a 60% debt-asset ratio?
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Costs of Financial Distress
Investors factor the potential for future distress into their
assessment of current value.
Overall Market
Value if all + PV tax
=
Value
shield
equity financed
–
PV costs of
financial distress
• Costs of Financial Distress – Cost arising from bankruptcy or distorted business decisions before
bankruptcy.
• Trade-off Theory – Debt levels are chosen to balance interest tax shields against the costs of financial
distress.
• At some point, additional borrowing causes the probability of financial distress to increase rapidly and the
potential costs of distress begin to take a substantial bite out of firm value.
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Bankruptcy Costs
If there is a possibility of bankruptcy, the current market value
of the firm is reduced by the present value of all court expenses.
• Bankruptcy costs vary with different types of assets.
• Some assets, like good commercial real estate, can pass through bankruptcy and
reorganization largely unscathed.
• The greatest losses are from intangible assets that are linked to the continuing prosperity of
the firm.
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Financial Distress Without
Bankruptcy
Even if a firm narrowly escapes bankruptcy, this does not
mean that costs of financial distress are avoided.
Stockholders may be tempted to play games at the
expense of creditors

Betting the Bank’s Money

Not Betting Your Own Money
Loan Covenant: Agreement between a firm and lender requiring
the firm to fulfill certain conditions to safeguard the loan.
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Explaining Financing Choices
 The Trade-off Theory
• Debt levels are chosen to balance interest tax shields
against the costs of financial distress.
 A Pecking Order Theory:
• Firms prefer to issue debt rather than equity if internal
finance is insufficient.
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Financial Slack
Financial Slack: Ready access to cash or debt financing.
Financial managers usually place a very high
value on having financial slack.
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Two Faces of Financial Slack
 Benefits
• Long run value rests more on capital investment and
operating decisions than on financing.
• Most valuable to firms with positive-NPV growth
opportunities
 Drawbacks
• Too much financial slack may lead to lazy management.
• Managers may try to increase their own perks or engage
in empire-building.
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