Chapter 16

Debt Policy

Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved

 Topics Covered

16.1 How Borrowing Affects Value in a Tax

Free Economy
16.2 Debt and the Cost of Equity
16.3 Debt, Taxes and the WACC
16.4 Costs of Financial Distress
16.5 Explaining Financing Choices

16- 2
 Value and Capital Structure

Assets Liabilities and Stockholders’ Equity

Value of cash flows from

Market value of debt
firm’s real assets and
operations Market value of equity

Value of Firm Value of Firm

16- 3
Average Book Debt Ratios

16- 4
 Value and Capital Structure

Capital structure - The mix of long-term debt

and equity financing

Restructuring - Process of changing the firm’s

capital structure without changing its real
assets

16- 5
 M&M (Debt Policy Doesn’t Matter)
 Modigliani & Miller
– When there are no taxes and capital markets
function well, the market value of a company does
not depend on its capital structure
– In other words, financial managers cannot increase
value by changing the mix securities used to finance
the company

16- 6
 M&M (Debt Policy Doesn’t Matter)
Assumptions
 By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
– Investors do not need choice OR
– There are sufficient alternative securities
 Capital structure does not affect cash flows e.g...
– No taxes
– No bankruptcy costs
– No effect on management incentives

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 M&M (Debt Policy Doesn’t Matter)

Example
River Cruises - All Equity Financed
Data
Number of shares 100,000
Price per share $10
Market value of shares $1 million
Outcome State of the Economy
Slump Expected Boom
Operating income $75,000 $125,000 $175,000
Earnings per share $.75 $1.25 $1.75
Return on shares 7.5% 12.5% 17.5%

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 M&M (Debt Policy Doesn’t Matter)

Example – continued
50% debt
Data
Number of shares 50,000
Price per share $10
Market value of shares $500,000
Market value of debt $500,000
Outcome State of the Economy
Slump Expected Boom
Operating income $75,000 $125,000 $175,000
Interest $50,000 $50,000 $50,000
Equity earnings $25,000 $75,000 $125,000
Earnings per share $.50 $1.50 $2.50
Return on shares 5% 15% 25%
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M&M (Debt Policy Doesn’t Matter)

Borrowing increases EPS for River Cruises

16- 10
 M&M (Debt Policy Doesn’t Matter)

Example
River Cruises - All equity financed, debt replicated
by investors

Outcome State of the Economy

Slump Expected Boom
Earnings on two shares $1.50 $2.50 $3.50
Less interest at 10% $1.00 $1.00 $1.00
Net earnings on investment $.50 $1.50 $2.50
Return on $10 investment 5% 15% 25%

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 M&M (Debt Policy Doesn’t Matter)

Example
River Cruises – Firm debt at 50%, investor can
unwrap debt

Outcome State of the Economy

Slump Expected Boom
Earnings on one share $.50 $1.50 $2.50
Plus interest at 10% $1.00 $1.00 $1.00
Net earnings on investment $1.50 $2.50 $3.50
Return on $10 investment 7.5% 12.5% 17.5%

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River Cruise’s “Value Pie”

16- 13
 C.S. & Corporate Taxes

 Operating Risk (business risk) – Risk in the

firm’s operating income
 Financial Risk - Risk to shareholders resulting
from the use of debt
 Financial Leverage - Debt financing to amplify
the effects of changes in operating income on the
returns to stockholders
 Interest Tax Shield- Tax savings resulting from
deductibility of interest payments

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 Cost of Capital

16- 15
 Weighted Average Cost of Capital
r

rE WACC with no
bankruptcy risk

WACC

rD
D
V
16- 16
MM’s Proposition II (w/fixed interest rate)
r

rE

rA

rD

D
V
16- 17
 MM’s Proposition II (w/risky debt)
r

rE

rA

rD

Risk free debt Risky debt

D
V
Includes Bankruptcy Risk
16- 18
 C.S. & Corporate Taxes

River Cruise DOES create value in a corporate tax

environment by using debt financing. This is done by
maximizing the cash flows to both equity and
bondholders.

All Equity All Debt

EBIT $192,308 $192,308
Interest payment 0 50,000
Pretax income $192,308 $142,308
Taxes at 35% 67,308 49,808
Net cash flow $125,000 $92,500

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 C.S. & Corporate Taxes

River Cruise DOES create value in a corporate tax

environment by using debt financing. This is done by
maximizing the cash flows to both equity and
bondholders.
All Equity All Debt
Total Cash Flow
EBIT $192,308 $192,308
Interest payment 0 50,000 All Equity = 125,000
Pretax income $192,308 $142,308 *1/2 Debt = 142,500
Taxes at 35% 67,308 49,808 (92,500 + 50,000)
Net cash flow $125,000 $92,500

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 Capital Structure

PV of tax shield 
(assume perpetuity)

Example:
 

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 C.S. & 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 $10,000, before interest and taxes. The
corporate tax rate is 35%. You have the option to
exchange part of your equity position for 6%
bonds with a face value of $50,000.

Should you do this? Why?

16- 22
 C.S. & 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 $10,000, before interest and
taxes. The corporate tax rate is 35%. You have the option to exchange
part of your equity position for 6% bonds with a face value of $50,000.

All Equity ½ Debt

EBIT $10,000 $10,000
Interest payment 0 3,000
Pretax income $10,000 $7,000
Taxes at 35% 3,500 2,450
Net cash flow $6,500 $4,550

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 C.S. & 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 $10,000, before interest and
taxes. The corporate tax rate is 35%. You have the option to exchange
part of your equity position for 6% bonds with a face value of $50,000.

All Equity ½ Debt

EBIT $10,000 $10,000 Total Cash Flow
Interest payment 0 3,000 All Equity = 6,500
Pretax income $10,000 $7,000 *1/2 Debt = 7,550
Taxes at 35% 3,500 2,450 (4,550 + 3,000)
Net cash flow $6,500 $4,550

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 Capital Structure

16- 25
 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

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 Financial Distress
Maximum value of firm

PV costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of all
equity financed
firm

Optimal amount
of debt
Debt
16- 27
 Financing Games

 The First Game: Bet the Bank’s Money

 The Second Game: Don’t Bet Your Own
Money
 These games demonstrate an inherent
conflict between shareholders and
bondholders

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 Financing Games

 Risk shifting - Firms threatened with default

are tempted to shift to riskier investments
 Debt overhang - Firms threatened with
default may pass up positive-NPV projects
because bondholders capture part of the
value added
 Loan covenant - Agreement between firm
and lender requiring the firm to fulfill certain
conditions to safeguard the loan

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 Financial Choices
 Trade-off Theory - Debt levels are chosen to balance
interest tax shields against the costs of financial
distress
 Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient
 Costs of financial distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy
 Financial Slack - Ready access to cash or debt
financing
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