Principles of Managerial Finance

Sixteenth Edition, Global Edition

Chapter 13
Capital Structure

Copyright © 2022 Pearson Education, Ltd.

Learning Goals (1 of 2)

LG 1 Describe capital structure, financial leverage,

recapitalization, and the tradeoffs associated with
changing capital structure.
LG 2 Explain Modigliani & Miller Propositions One and Two
and the impact of using financial leverage if capital
markets are perfect.
LG 3 Discuss the impact of corporate and personal taxes on
the M&M Propositions.

Copyright © 2022 Pearson Education, Ltd.

Learning Goals (2 of 2)

LG 4 Discuss the tradeoff of benefits and costs that arise

from using financial leverage, particularly those related
to taxes and bankruptcy costs.
LG 5 Discuss how the use of debt affects agency costs.
LG 6 Discuss the pecking-order and signaling theories.

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (1 of 13)
• Capital structure is simply the mix of long-term debt and equity
securities that a firm uses to finance its activities
• Optimal Capital Structure
– One that minimizes the weighted average cost of capital (WACC)
and maximizes firm value
• Financial Leverage
– Borrowed funds that impose a fixed financial cost on the firm and
magnify the effects of changes in underlying business conditions
on the returns that shareholders earn
 A firm that uses debt financing is a levered firm
 A firm that relies on equity to finance its activities is an
unlevered firm

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (2 of 13)
• Business Risk
– Risk that stems from a firm’s business activities but not
its financing strategy
• Recapitalization
– A pure change in a firm’s financing mix not tied to
capital raising to fund new investments.

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (3 of 13)
• Electric Motor Corporation (EMC) Example
– Currently unlevered capital structure (i.e., no debt)
– 1,000,000 shares of outstanding common stock
– This year, and every year in foreseeable future, investors
expect net operating profits (NOP) of $18 million
– Based on EMC’s business risk, shareholders expect a 10%
return
– For now we will ignore taxes, so EMC’s net income is equal
to its NOP
Firm value = $18,000,000 ÷ 0.10 = $180,000,000

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (4 of 13)
• Electric Motor Corporation (EMC) Example
– Stock Price = $180,000,000 ÷ 1,000,000 = $180
– EPS = $18,000,000 ÷ 1,000,000 = $18
– If EMC pays out all earnings as a dividend, then
shareholders receive $18 on their $180 investment
 ROE = $18 ÷ $180 = 0.10 or 10%

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (5 of 13)
• Electric Motor Corporation (EMC) Example
– Proposal: Issue bonds and use the proceeds to buy back some of
the outstanding stock
 Sell $90 million worth of bonds paying 7% and use proceeds to
repurchase half of EMC’s outstanding common stock
 This recapitalization would shift its mix of financing from 100%
equity to an equal mix of equity and debt
– Buying back half its outstanding stock will leave 500,000
shares outstanding
– Ignoring taxes for now, annual net income will be $18
million less interest expense of $6.3 million ($90 million ×
0.07), or $11.7 million

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (6 of 13)
• Electric Motor Corporation (EMC) Example
– Proposal: Issue bonds and use the proceeds to buy
back some of the outstanding stock
 EPS = $11,700,000 ÷ 500,000 = $23.40
 ROE = $23.40 ÷ $180 = 0.13 or 13%

Copyright © 2022 Pearson Education, Ltd.

Table 13.1 EMC’s Earnings Per Share
and Return on Equity Under Unlevered
and Levered Capital Structures for
Three Economic Scenarios

Copyright © 2022 Pearson Education, Ltd.

Figure 13.1 Financial Leverage Effect
on EPS Sensitivity to Changes in Net
Operating Profit

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (7 of 13)
• Electric Motor Corporation (EMC) Example
– We can calculate the expected net income, EPS, and
ROE if we assign probabilities to each economic
scenario
– If there is a one-third chance that each outcome will
occur, then using the information from Table 13.1, we
can calculate the expected values of EMC’s net
income, EPS and ROE under each capital structure

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (8 of 13)
• Electric Motor Corporation (EMC) Example
– Unlevered 100% Equity Financing
 Expected unlevered net income = (1/3) $9,000,000
+ (1/3) $18,000,000 + (1/3) $27,000,000 =
$18,000,000
 Expected unlevered EPS = (1/3) $9 + (1/3) $18 +
(1/3) $27 = $18
 Expected unlevered ROE = (1/3) 5% + (1/3) 10% +
(1/3) 15% = 10%

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (9 of 13)
• Electric Motor Corporation (EMC) Example
– Levered 50-50 Equity and Debt Financing
 Expected levered net income = (1/3) $2,700,000 +
(1/3) $11,700,000 + (1/3) $20,700,000 =
$11,700,000
 Expected levered EPS = (1/3) $5.40 + (1/3) $23.40
+ (1/3) $41.40 = $23.40
 Expected levered ROE = (1/3) 3% + (1/3) 13% +
(1/3) 23% = 13%

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (10 of 13)
• While substituting debt for equity increases shareholders’
expected returns, it also increases the risk they face
• Financial Risk
– Risk that stems from the fixed expense financial
leverage imposes, an expense the firm must cover
regardless of business conditions
• Degree of Financial Leverage
– A numerical measure of the firm’s financial leverage
Percentage change in EPS
DFL = (13.1)
Percentage change in NOP

Copyright © 2022 Pearson Education, Ltd.

Example 13.1 (1 of 3)

We have already seen that when EMC’s operating profit is

$12.6 million, its earnings per share are the same ($12.60)
whether the firm has leverage or not. Let’s consider this the
base case and see what happens to EPS when NOP moves.
Specifically, suppose NOP moves from $12.6 million to $18
million, an increase of about 43%. Table 13.1 shows that
EPS increases to $18 if the firm has no debt, which is also
an increase of 43%, so the DFL equals 1.0.

$18.00  $12.60
$12.60 43%
DFL all equity    1.0
$18, 000, 000  $12, 600, 000 43%
$12, 600, 000

Copyright © 2022 Pearson Education, Ltd.

Example 13.1 (2 of 3)

Now consider what happens if NOP increases 43% from

$12.6 million to $18 million if the firm’s financing mix is 50-50
equity and debt. Table 13.1 shows that EPS increases to
$23.40, a jump of about 86% (from base of $12.60 per
share). Now the degree of financial leverage is 2.0.

$23.40  $12.60
$12.60 86%
DFL5050mix    2.0
$18, 000, 000  $12, 600, 000 43%
$12, 600, 000

Copyright © 2022 Pearson Education, Ltd.

Example 13.1 (3 of 3)

If you repeat these calculations for a scenario in which

NOP falls from $12.6 million to $9 million (the recession
scenario), you’ll find that DFL equals 1.0 in the all-equity
case and 2.0 in the case with equal proportions of debt and
equity. That is, financing the business with 50% debt
makes the change in EPS twice the change in NOP,
whether NOP is rising or falling.

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (11 of 13)
• It’s also possible to calculate the degree of financial
leverage for a base level of NOP using Equation 13.2
NOP
DFL for base level NOP = (13.2)
 1 
NOP - I -  PD 
 1 T 

– Where
 PD is the preferred stock dividend
 T is the tax rate

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (12 of 13)
• Because a levered capital structure increases risk for
shareholders, they will require a higher return (i.e., risk
premium) as compensation
• Consequently, whether adding debt to a firm’s capital
structure increases its stock price depends on the balance
between two effects: the increase in cash flows that
shareholders expect versus the higher discount rate they
use to value those cash flows

Copyright © 2022 Pearson Education, Ltd.

13.1 Financial Leverage and Its
Effects (13 of 13)
• In path breaking work, Franco Modigliani and Merton Miller
described conditions under which these effects exactly
offset each other
– A firm’s value is unrelated to its capital structure
– Adding debt to or subtracting it from a firm’s capital
structure will have no impact on the firm’s value

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (1 of 13)
• Modigliani and Miller (M&M) Research
– Changes in the debt-equity mix merely altered the distribution of a
firm’s cash flows between stockholders and lenders
– A capital structure shift had no effect on firm value
– They proved their point in the context of a perfect market, which
means:
1) Investors and firms face no market frictions such as taxes or
transaction costs
2) Investors and firms can borrow and lend at the same rate
3) Investors and firms have access to the same information—
there are no asymmetries

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (2 of 13)
• Real-world capital markets do not satisfy these conditions, but there
are two reasons why M&M’s conclusions remain significant
– 1) M&M helped managers see the market imperfections that
influence optimal capital structure decisions
– 2) M&M’s argument rests on the no-arbitrage principal, also called
the law of one price, which says that identical assets cannot sell at
different prices
 Opportunities to earn a risk-free profit should be very scarce in
well-functioning markets
 Arbitrage
– Simultaneously buying and selling the same asset at
different prices to earn an instant, risk-free profit

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (3 of 13)
• Proposition One: Value is Independent of Financing Mix
– Proposition One
 States that a firm’s value depends on the present value of the
cash flows generated by its assets and not on how those cash
flows are divided among investors through a capital structure
choice.

NOP
V = (E + D) = (13.3)
rA

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (4 of 13)
• Proposition One: Value is Independent of Financing Mix
– Proposition One: Firm Value is Independent of Capital
Structure
 Consider example in which two firms are alike in
every way except their capital structures
 M&M say that the values of these two firms must be
equal to prevent arbitrage
 Table 13.2 summarizes key facts for two such firms,
NoDebtCo and DebtCo

Copyright © 2022 Pearson Education, Ltd.

Table 13.2 Values for NoDebtCo and
DebtCo Under Proposition One
NoDebtCo DebtCo

Net operating profit (NOP) $2,000,000

$2,000,000
Less: Interest paid (0.05 × D) 0
625,000
Net income [NOP - (0.05 × D) ] $2,000,000
$1,375,000

Required return on assets (rA) 8.0% 8.0%

Total firm value (NOP ÷ rA) $25,000,000 $25,000,000
Shares outstanding 400,000 200,000
Market value of equity (E) $25,000,000 $12,500,000
Interest rate on debt (rd) N/A 5.0%
Market value of debt (D) $0 $12,500,000
Price per share $62.50 $62.50
Earnings per share $5.00 $6.88
Required return on equity (ru or rl) 8.0% 11.0%

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (5 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 In Table 13.2, both firms are worth $25 million, but
that value is distributed differently between debt and
equity investors
 Now consider what might happen if Proposition One
were not true and one firm is more valuable than the
other (Table 13.3)

Copyright © 2022 Pearson Education, Ltd.

Table 13.3 Values for NoDebtCo and
DebtCo That Violate Proposition One
NoDebtCo DebtCo

Net operating profit (NOP) $2,000,000

$2,000,000
Less: Interest paid (0.05 × D) 0
625,000
Net income 3NOP - (0.05 × D) 4 $2,000,000
$1,375,000

Total firm value (E + D) $25,000,000 $26,250,000

Shares outstanding 400,000 200,000
Market value of equity (E) $25,000,000 $13,750,000
Interest rate on debt (rd) N/A 5.0%
Market value of debt (D) $0 $12,500,000
Price per share $62.50 $68.75
Earnings per share $5.00 $6.88
Required return on equity (ru or rl) 8.0% 10.0%

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (6 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 Under the assumptions of a perfect market, investors can
easily profit from this situation
– An investor could earn an arbitrage profit by selling
DebtCo shares and buying the less expensive NoDebtCo
stock.
– To accomplish the arbitrage, the investor engages in the
following transactions:
Sell 1,000 DebtCo shares +$ 68,750
Borrow $62,500 @ 5% +$ 62,500
Purchase 2,000 NoDebtCo shares -$125,000
Funds remaining $6,250
Copyright © 2022 Pearson Education, Ltd.
13.2 Capital Structure Irrelevance in
Perfect Markets (7 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 What did these transactions accomplish?
– Initially the investor owns 0.5% of DebtCo’s
equity
– After making these transactions, the investor
owns 0.5% of NoDebtCo’s equity but also has
outstanding personal debt of $62,500
– The investor uses $62,500 in homemade
leverage to cover half the cost of buying 0.5% of
NoDebtCo’s shares
Copyright © 2022 Pearson Education, Ltd.
13.2 Capital Structure Irrelevance in
Perfect Markets (8 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 Homemade leverage
– Refers to an investor’s ability to substitute personal
borrowing for corporate debt
 Homemade leverage allows an investor to replicate the return
of a levered firm while investing in an unlevered company
– Holding 0.5% of DebtCo’s levered stock is equivalent to
holding 0.5% of NoDebtCo’s unlevered stock and
financing half of that investment with personal debt

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (9 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 There is an arbitrage opportunity because after selling DebtCo
shares, borrowing money and buying NoDebtCo stock, the
investor has $6,250 in cash left over.
 That $6,250 represents the arbitrage profit
 This opportunity cannot survive in the market for long
 As investors sell DebtCo’s overvalued shares to buy
NoDebtCo’s comparatively undervalued stock, the price of
DebtCo shares will fall and that of NoDebtCo shares will rise
 Soon the market will reach a new equilibrium in which the total
market values of the two firms are identical—just as
Proposition One predicts.

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (10 of 13)
• Proposition One: Value is Independent of Financing Mix
– Using Homemade Leverage to Prove Proposition One
 The important takeaway is that the profit-seeking
activities of investors will ensure that Proposition
One holds
 Under perfect markets assumptions, investors can
undo any changes in the firm’s capital structure with
their own homemade leverage
 A firm can choose any capital structure it likes
without affecting its total market value

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (11 of 13)
• Proposition Two: WACC is Independent of Financing Mix
– Proposition Two
 States that the expected return on a levered firm’s equity, rl,
increases with the debt-to-equity ratio in a way that leaves the
weighted average cost of capital unchanged.

D
rl  rA  (rA  rd )  (13.4)
E

 E   D 
rA  ri    +rd    (13.5)
 E  D   E  D 

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (12 of 13)
• Proposition Two: WACC is Independent of Financing Mix
– Under Proposition Two, the WACC does not depend on
capital structure, and the term rA is a constant
– If the WACC is not influenced by leverage, then neither
is the value of the firm, which is just the present value
of future cash flows discounted at the WACC
– That’s the connection between Propositions One and
Two

Copyright © 2022 Pearson Education, Ltd.

13.2 Capital Structure Irrelevance in
Perfect Markets (13 of 13)
• Proposition Two: WACC is Independent of Financing Mix
– Calculating WACC for NoDebtCo and DebtCo

 $25, 000, 000   $0 

WACC NoDebtCo  0.08    0.05    0.08or 8%
 $25, 000, 000  $0   $25, 000, 000  $0 
 $12,500, 000   $12,500, 000 
WACCDebtCo  0.11   0.05    0.08or 8%
 $12,500, 000  $12,500, 000   $12,500, 000  $12,500, 000 

Copyright © 2022 Pearson Education, Ltd.

Figure 13.2 M&M Proposition Two–
The Case of Perfect Capital Markets

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (1 of 11)

• Corporate Taxes
– Corporate tax laws in the United States allow firms to
deduct interest payments as a business expense
– Dividends to shareholders are not deductible
– The interest deduction reduces the firm’s tax bill
– Intuitively, this tax advantage for debt should mean that
managers can increase firm value by issuing debt

Copyright © 2022 Pearson Education, Ltd.

Table 13.4 Income Statements for
NoDebtCo and DebtCo with Corporate
Income Taxes
NoDebtCo DebtCo

Net operating profit (NOP) $2,000,000 $2,000,000

Less: Interest paid (0.05 × D) 0 625,000
Taxable income [NOP - (0.05 × D)] $2,000,000 $1,375,000
Less: Corporate Tax at 21% 420,000 288,750
Net income $1,580,000 $1,086,250
Total income to investors (interest on
$1,580,000 $1,711,250
bonds + net income)
Value of tax shield (Tc × rd × D = Tc
$0 $131,250
× interest paid)

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (2 of 11)

• Corporate Taxes
– The corporate income tax creates a governmental
claim on a firm’s cash flow, and the value of that claim
is the present value of taxes that the firm pays.
– By using debt, DebtCo reduces its tax bill and the value
of the government’s claim
– By shunning debt, NoDebtCo maximizes the stream of
taxes that it pays, and in doing so maximizes the value
of the claim that government holds
– Higher tax payments mean that NoDebtCo has less
cash to pay to its investors, which reduces the value of
that company

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (3 of 11)

• Corporate Taxes
– A modified version of equation 13.3 allows us to calculate the
value of NoDebtCo, by adjusting the numerator of the equation to
account for taxes

NOP  (1  Tc )
Vu = (13.6)
rU

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (4 of 11)

• Corporate Taxes
– In a perfect market without taxes, NoDebtCo’s market
value was $25,000,000
– With taxes, NoDebtCo’s value is
VNoDebtCo = $1,580,000 ÷ 0.08 = $19,750,000
– The 21% corporate profits tax causes the company’s
value to drop by 21% ($5,250,000), which is a transfer
of wealth from NoDebtCo’s shareholders to the
government

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (5 of 11)

• Corporate Taxes
– By borrowing money and paying interest that is tax deductible,
NoDebtCo can shelter some of its cash flows from taxation, which
increases its value
– Debt Tax Shields
 Tax savings created by tax-deductible interest expenses on
debt

rd  D  Tc
PV (Debt tax shields)=  D  Tc (13.6)
rd

VL  VU  PV (Debt tax shields) (13.6)

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (6 of 11)

• Corporate Taxes
– Applying Equation 13.7 to DebtCo, the present value of
their tax shield is
$12,500,000 x 21% = $2,625,000
– Applying Equation 13.8, the value of DebtCo is
$19,750,000 + $2,625,000 = $22,375,000
– By making interest tax deductible, the government has
given DebtCo a $2,625,000 subsidy to borrow money
rather than use all-equity financing

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (7 of 11)

• Corporate Taxes
– Ultimately, shareholders reap the tax benefits of debt
financing
– Interest deductions reduce the payments owed to the
government and increase the cash flows available to
shareholders (shareholders are the residual claimants
and receive all cash flows left after all debts and taxes
are paid)
– In this example, the $2,625,000 increase in firm value
is reflected in a $2,625,000 increase in the value of the
firm’s common stock

Copyright © 2022 Pearson Education, Ltd.

Figure 13.3 The Effect of Leverage on
Firm Value with and without Corporate
Taxes

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (8 of 11)

• Personal Taxes
– In a perfect market, capital structure doesn’t matter at
all, but with corporate taxes in place, the optimal capital
structure is 100% debt
– Companies usually do not maximize leverage
 Most companies are neither at 0% or 100% debt
– Why do real-world capital structures not conform to the
theory?

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (9 of 11)

• Personal Taxes
– Debt enjoys a tax advantage at the corporate level and
a disadvantage at the personal level
 Interest payments that individuals receive are often
taxed as ordinary income
 Dividends and capital gains are taxed at lower rates

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (10 of 11)

• Personal Taxes
– Gains from Leverage
  (1  Tc )  (1  Tps )  
GL  1    D (13.9)
  1  Tpd  
Where
Tc = tax rate on corporate profits
Tps = personal tax rate on income from stock
(dividends and capital gains)
Tpd = personal tax rate on income from debt (interest
income)
D = market value of a firm’s outstanding debt

Copyright © 2022 Pearson Education, Ltd.

13.3 M&M and Taxes (11 of 11)

• Personal Taxes
– Equation 13.9 shows that financial leverage can
increase, decrease, or have no effect on firm value
depending on the tax code

Copyright © 2022 Pearson Education, Ltd.

Example 13.2 (1 of 5)

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), which
established a 21% flat corporate tax, corporations faced a
progressive income tax system with a top marginal rate of
35%. To get a sense for the impact tax law changes can
have on the tradeoff between equity and debt financing,
consider the following situation before and after the TCJA.
In a given year, a certain firm is capable of earning net
operating profit of $5 million by operating assets financed
entirely with either equity or debt. With all-equity financing,
the firm will pay out all after-tax operating profit as a dividend
to stockholders, and with all debt, the firm will distribute the
entire pre-tax operating profit to debtholders in the form of
interest payments.
Copyright © 2022 Pearson Education, Ltd.
Example 13.2 (2 of 5)

Before the TCJA, net operating profit of $5 million was

subject to an average corporate tax rate of 34%, the
personal tax rate on dividends was 20%, and the personal
tax rate on interest income was 39.6%. After the TCJA, a net
operating profit of $5 million is subject to a corporate tax rate
of 21%, the personal tax rate on dividends is 20%, and the
personal tax rate on interest income is 37%. The Table 13.5
summarizes the differences.

Copyright © 2022 Pearson Education, Ltd.

Table 13.5 The Effects of Corporate and
Personal Taxes Before and After the Tax
Cuts and Jobs Act of 2017
Before the TCJA After the TCJA
Tc 34.0% 21.0%
Tps 20.0% 20.0%
Tpd 39.6% 37.0%

All-equity financed
Net operating profit $5,000,000 $5,000,000
Less: Corporate Tax at Tc 1,700,000 1,050,000
Net income $3,300,000 $3,950,000

Dividend payout $3,300,000 $3,950,000

Less: Personal Tax at Tps 660,000 790,000
Net income $2,640,000 $3,160,000

All-debt financed
Net operating profit $5,000,000 $5,000,000

Interest paid to debtholders $5,000,000

Less: Personal Tax at Tpd $5,000,000
1,980,000
After-tax personal income 1,850,000
$3,020,000
$3,150,000

Copyright © 2022 Pearson Education, Ltd.

Example 13.2 (3 of 5)

Before the tax law change, if the firm’s operations were

entirely equity financed, it paid out after-tax operating profit
of $3,300,000 as a dividend. After paying the 20% personal
tax rate on dividend income, stockholders earned aftertax
personal income of $2,640,000. If the firm’s operations were
entirely debt financed, the entire $5 million in operating profit
flowed to debtholders, escaping corporate taxes. After
paying the 39.6% personal tax rate on interest income,
debtholders had after-tax personal income of $3,020,000.
The difference was $380,000 in favor of debt financing.

Copyright © 2022 Pearson Education, Ltd.

Example 13.2 (4 of 5)

Immediately after the TCJA, if the firm’s operations were

entirely equity financed, it paid out a larger after-tax
operating profit of $3,950,000 as a dividend. Having paid the
20% personal tax rate on dividend income, stockholders had
after-tax personal income of $3,160,000. If the firm’s
operations are entirely debt financed, the entire $5 million in
operating profit flowed directly to debtholders. After paying
the 37% personal tax rate on interest income, debtholders
had after-tax personal income of $3,150,000. This is a
difference of $10,000 in favor of equity financing. In fact, this
understates the advantage of equity financing under both the
TCJA and the subsequent CARES Act because both laws
impose a limit on how much interest a firm can deduct for tax
purposes in a given year.
Copyright © 2022 Pearson Education, Ltd.
Example 13.2 (5 of 5)

Notice that under the new tax law both equity and
debtholders receive more cash, but on the whole the large
reduction in the corporate tax rate reduced the value of debt
tax shields sufficiently to tilt things in favor of equity
financing. With the corporate tax rate now a fixed 21%, the
tradeoff between equity and debt financing will vary as
function of the personal tax rates on dividend and interest
income. This example illustrates how by changing the
corporate and personal tax rates, legislatures change the
relative benefits of using debt and equity financing.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (1 of 11)
• We have already learned that in a perfect capital market a
firm’s capital structure choice does not matter, but that
prediction does not align with what executives say—
namely, that they place great importance on financing
decisions and believe that they have a significant impact
on firm value.
• This suggests that markets are imperfect in some
important way.
– Taxes are one such imperfection.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (2 of 11)
• In principle, even though personal tax considerations can
partially or fully offset the corporate tax advantage that
debt enjoys, it is not clear that executives routinely take
into account the personal tax positions of their
shareholders when making capital structure decisions.
• Because most firms do not lever up as much as they
could, there must be other costs of debt that managers
think about besides the personal tax costs.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (3 of 11)
• Figure 13.4 offers a conceptual framework to understand
how managers trade off debt’s benefits and costs
– Marginal benefits fall and marginal costs rise as debt
increases

Copyright © 2022 Pearson Education, Ltd.

Figure 13.4 Trading Off the Benefits
and Costs of Debt to Find Optimal
Capital Structure

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (4 of 11)
• The Declining Marginal Tax Benefit of Debt
– The tax benefit of debt will eventually fall as debt rises
 With higher debt and higher interest expense, the
chance that the firm will experience a loss, and
therefore miss or postpone the benefit of a tax
deduction, goes up.

Copyright © 2022 Pearson Education, Ltd.

Example 13.3 (1 of 2)

In March 2020, the ride-sharing service, Uber, reported its

financial results for the quarter. The company’s income
statement showed interest expense of $217 million. For a
profitable company, that level of interest would save $45.6
million in taxes (21% × $217 million), but unfortunately Uber
was not profitable.

Copyright © 2022 Pearson Education, Ltd.

Example 13.3 (2 of 2)

Business tax laws permit firms to “carry forward” losses and

deduct them against income in future years, provided that
the losses do not exceed 80% of income in any future year.
Thus, although Uber’s interest payments would not save the
company taxes in 2020, it was possible that some tax
savings might arrive in future years. Of course, due to the
time value of money, tax savings today are worth more than
future tax savings. In addition, Uber’s past results portend
future losses, as the company’s only profit came from selling
off part of its business and not from ordinary operations.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (5 of 11)
• The Declining Marginal Tax Benefit of Debt
– At the margin, the benefit of borrowing more declines
as leverage increases
– Just as the benefits of additional debt fall the more debt
a firm uses, the incremental costs of debt rise as
leverage increases

Copyright © 2022 Pearson Education, Ltd.

Figure 13.5 How the Probability of
Losses Rises with Debt

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (6 of 11)
• The Increasing Marginal Cost of Debt: Bankruptcy
– Bankrupt
 When a firm cannot meet its debt obligations
– Bankruptcy
 The legal process through which firms may
reorganize or liquidate and address creditors’ claims

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (1 of 7)

Sunnybrook, New York has awarded one-year road

maintenance contracts to two companies—Lo Road and Hi
Road. The value of these contracts depends on the amount
of snowfall during the upcoming winter. If snowfall is above
average, each company will earn a fee, net of maintenance
costs, of $450,000, and if snowfall is below average, each
will net $100,000. It is equally likely that the snowfall in
Sunnybrook will be above or below average.

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (2 of 7)

To finance the costs of maintaining Sunnybrook’s roads, both

companies issued short-term bonds that mature in one year,
but Hi Road borrowed more money (and used more
leverage) than Lo Road. Lo must pay $53,000 in principal
and interest in one year and Hi must pay $135,000. If the
winter snowfall is below average, Hi will declare bankruptcy
because it will not be able to pay its bond obligation in full. If
this happens, Hi’s stockholders will lose their investment and
its bondholders will receive the $100,000 management fee.

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (3 of 7)

Hi’s bondholders are promised a 10% return and its

stockholders require a 13.5415% rate of return. Lo’s
bondholders and stockholders are both willing to accept
slightly lower returns because Lo uses less financial
leverage. Lo’s bondholders receive an 8% return and its
stockholders have a required return of 13%. With the
simplifying assumption that neither company pays taxes, the
following table details the payoffs to stockholders and
bondholders for both firms.

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (4 of 7)

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (5 of 7)

The equity, E, and debt, D, values for Lo and Hi, equal the
present value of the expected payoffs to each investor group
found using the required returns to discount cash flows. The
firm value, V, is equal to the sum of values for equity and
debt: V = E + D. Remember that there is an equal (50%)
probability of above- and below-average snowfall.
ELo = [(0.5 × $397,000) + (0.5 × $47,000)] ÷ 1.13
= $222,000 ÷ 1.13 = $196,460
DLo = [(0.5 × $53,000) + (0.5 × $53,0000] ÷ 1.08
= $53,000 ÷ 1.08 = $49,074
VLo = $196,460 + $49,074 = $245,534
Copyright © 2022 Pearson Education, Ltd.
Example 13.4 (6 of 7)

EHi = [(0.5 × $315,000) + (0.5 × $0)] ÷ 1.135415

= $157,500 ÷ 1.135415 = $138,716
DHi = [(0.5 × $135,000) + (0.5 × $100,000)] ÷ 1.1
= $117,500 ÷ 1.1 = $106,818
VHi = $138,716 + $106,818 = $245,534
We see that higher financial leverage means that Hi’s
bondholders and stockholders bear more risk. However, if Hi
goes bankrupt, ownership transfers at no cost from
stockholders to bondholders.

Copyright © 2022 Pearson Education, Ltd.

Example 13.4 (7 of 7)

As a result, both Hi and Lo are worth $245,534, and the fact

that one firm borrows more than the other is irrelevant when
bankruptcy is costless. It is also worth noting that the
weighted average cost of capital for maintaining roads is
12% for both firms. Given the M&M propositions, it is not
surprising that Hi’s WACC is the same as Lo’s.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (7 of 11)
• The Increasing Marginal Cost of Debt: Bankruptcy
– Investors take into account expected bankruptcy costs
when they decide what they are willing to pay for a
firm’s securities
– The more a firm borrows, the higher is the likelihood of
bankruptcy, and the higher are expected bankruptcy
costs
– This is one reason why the marginal cost of using debt
increases with more leverage, as shown in Figure 13.4

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (8 of 11)
• The Increasing Marginal Cost of Debt: Bankruptcy
– Direct Bankruptcy Costs
 Include fees paid to lawyers, accounting firms, investment
banks, and consultants engaged in bankruptcy proceedings
– Indirect Bankruptcy Costs
 Often exceed direct bankruptcy costs and include the loss of
customers and suppliers, the time that distracted managers
devote to the bankruptcy process rather than running the
business, the departure of key employees, and lost investment
opportunities.
– Because bankruptcy costs decrease a firm’s value and because
using more debt raises the likelihood of bankruptcy, bankruptcy
costs create a deterrent to using debt

Copyright © 2022 Pearson Education, Ltd.

Example 13.5 (1 of 4)

Reconsider Lo Road and Hi Road, two firms that operate the

same type of business using different amounts of debt. In
addition to the assumptions made previously, suppose that if
Hi must file for bankruptcy due to meager snowfall, the
process will be costly. Hi will not simply hand over the full
$100,000 management fee to bondholders. Instead,
because of bankruptcy costs, only $60,000 will remain to
satisfy lenders’ claims. In other words, the process of
transferring ownership from Hi’s stockholders to its creditors
is expensive and consumes $40,000 of value.

Copyright © 2022 Pearson Education, Ltd.

Example 13.5 (2 of 4)

Lo Road Hi Road
Above Below Above Below
average average average average
snowfall (P = snowfall snowfall snowfall
Item 0.5) (P = 0.5) (P = 0.5) (P= 0.5)
Cash flow at contract
$450,000 $100,000 $450,000 $100,000
expiration
Bankruptcy Costs
$0 $0 $0 $40,000

Payments to bondholders
$53,000 $53,000 $135,000 $60,000
(interest and principal)
Distributions to
$397,000 $47,000 $315,000 $0
stockholders

Copyright © 2022 Pearson Education, Ltd.

Example 13.5 (3 of 4)

Under these new conditions, the expected value of debt and

equity securities are no longer the same for each company.
Bankruptcy costs reduce the value of the firm with more
debt.
ELo = [(0.5 × $397,000) + (0.5 × $47,000)] ÷ 1.13
= $222,000 ÷ 1.13 = $196,460
DLo = [(0.5 × $53,000) + (0.5 × $53,000)] ÷ 1.08
= $53,000 ÷ 1.08 = $49,074
VLo = $196,460 + $49,074 = $245,534

Copyright © 2022 Pearson Education, Ltd.

Example 13.5 (4 of 4)

EHi = [(0.5 × $315,000) + (0.5 × $0)] ÷ 1.135415

= $157,500 ÷ 1.135415 = $138,716
DHi = [(0.5 × $135,000) + (0.5 × $60,000)] ÷ 1.1
= $97,500 ÷ 1.1 = $88,636
VHi = $138,716 + $88,636 = $227,352
A costly bankruptcy reduces overall firm value of Hi Road by
$18,182.

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (9 of 11)
• A Capital Structure Tradeoff Model
– Bankruptcy costs affect firms’ decisions regarding
leverage
– Going bankrupt triggers costs that reduce value, so
managers (and investors) can estimate expected
bankruptcy costs by multiplying the cost if bankruptcy
occurs times the probability that the firm goes bankrupt
– With an estimate of expected bankruptcy costs in mind,
managers can weigh that against debt’s tax benefits

Copyright © 2022 Pearson Education, Ltd.

Figure 13.6 Capital Structure Tradeoff
Model Incorporating Taxes and
Bankruptcy Costs

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (10 of 11)
• A Capital Structure Tradeoff Model
– Figure 13.6 illustrates the tradeoff between the tax
benefits of debt and the increasing expected
bankruptcy costs that accompany higher leverage
– The optimal capital structure occurs when the marginal
value of tax benefits equals (i.e., is just offset by) the
marginal increase in expected bankruptcy costs. At that
point, firm value is at a maximum
VL = VU + PV (Debt tax shields) – PV (Bankruptcy costs)
(13.10)

Copyright © 2022 Pearson Education, Ltd.

13.4 Trading Off Debt’s Benefits and
Costs (11 of 11)
• Asset Characteristics and Bankruptcy Costs
– Indirect bankruptcy costs, which tend to be more important
than direct costs, are likely to differ from one firm to another
– The type of assets that a firm uses to conduct its business
influences its capital structure
 Companies whose assets are tangible and are regularly
traded in secondary markets should be less fearful of
bankruptcy than companies whose assets are largely
intangible
 These firms tend to borrow more heavily than firms with
few tangible assets
 Examples: trucking companies, construction firms, and
some retail establishments

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (1 of 8)
• Agency Costs
– Managers act as agents of the stockholders
– The owners give the managers authority to manage the
firm for the owners’ benefit
– The agency problem created by this arrangement
extends not only to the relationship between owners
and managers, but also to that between owners and
lenders

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (2 of 8)
• Agency Costs
– Agency Costs of Outside Equity
 When one person owns all of a company’s stock and
manages the company, there is no separation between
ownership and control
– The owner bears all the costs, and reaps all the
benefits, of her actions
 Once the original owner sells stock to other investors
(so-called outside equity), she bears just a fraction of the
cost of her actions that reduce firm value
– This creates an incentive to engage in behavior that
is harmful to outside shareholders

Copyright © 2022 Pearson Education, Ltd.

Example 13.6 (1 of 2)

The founder of an equipment rental company in Pittsburgh,

Pennsylvania, must travel to Komatsu headquarters in
Tokyo, Japan for certification on its super-large hydraulic
excavator. First-class airfare on American Airlines is a sky-
high $12,944, whereas main cabin airfare is a more
grounded $882. If the founder buys a first-class ticket,
assuming there is no additional benefit to the firm if the
founder flies in first class rather than the main cabin, the
equipment rental company’s value falls by $12,062 ($12,944
- $882).

Copyright © 2022 Pearson Education, Ltd.

Example 13.6 (2 of 2)

If the founder owns 100% of the company, then her personal

wealth bears the full incremental cost of the first-class ticket.
However, if outside investors own half of the company, then,
in effect, they pay for half of the incremental cost (or $6,031).
To put this in more general terms, suppose an entrepreneur
owns some fraction, X%, of a firm’s shares, and outside
investors own the rest, (1 – X)%. If the founder wants to
enjoy perks like first-class air travel, she personally bears X
% of the cost while other shareholders pay for the rest
through a reduction in the value of the shares that they hold.
The greater the fraction of the firm earned by outside
shareholders, the stronger is the incentive for the founder (or
other managers) to consume perks.

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (3 of 8)
• Agency Costs
– Agency Costs of Outside Equity
 Investors are aware of these incentives and they will pay less
for the shares in the first place based on their expectation that
managers will subsequently consume perks at their expense
 The founder will ultimately bear the cost of the perk
consumption, which creates a disincentive to sell stock to
outsiders
 Debt offers a (partial) solution to this problem
– Selling debt allows a firm to raise the capital it needs
without selling as much outside equity as would otherwise
be necessary
– The obligation to meet principal and interest payments
acts as a restraint on managers
Copyright © 2022 Pearson Education, Ltd.
13.5 Other Factors That Influence
Capital Structure Choices (4 of 8)
• Agency Costs
– Agency Costs of Outside Equity
 Bonding Mechanism
– Managers use of debt to commit to not exploiting outside
shareholders, who will then pay a higher price for the
firm’s shares
 Debt subjects firms to direct monitoring by credit-rating
agencies, banks, and public capital markets
 Debt also puts a limit on how much value managers can
destroy through incompetence or lack of effort
 Managers who use debt also risk being replaced, which
reduces the agency costs of the manager-stockholder
relationship

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (5 of 8)
• Agency Costs
– Agency Costs of Outside Debt
 A deteriorating financial situation can give managers
troublesome incentives to exploit bondholders
 Asset Substitution Problem
– Promising to invest in a safe asset
commensurate with a low return but then
substituting a riskier asset that offers the
prospect of a big payoff that will mostly benefit
shareholders

Copyright © 2022 Pearson Education, Ltd.

Example 13.7 (1 of 4)

J. R. Ewing Inc. has $100 million in bonds outstanding that

mature in 90 days. These bonds were issued a long time ago
when Ewing was financially strong. Now the company is
losing money, but its managers believe that the firm can
recover once the economy rebounds. Despite its losses, the
firm has $80 million in cash on hand that it can invest in one
of two projects. Or it can simply hold the cash in reserve to
pay the bondholders as much as possible in 90 days. The
first investment costs $80 million and will almost certainly
pay off $81.5 million in 90 days. This is a quarterly return of
1.88%, or an annual return of almost 8%. Because it entails
very little risk, it is a positive-NPV project that is worth
undertaking, but it will not be enough to fully repay the
maturing bonds.
Copyright © 2022 Pearson Education, Ltd.
Example 13.7 (2 of 4)

The second investment is a huge risk. It also requires $80

million, but it offers a 40% chance of a $120 million payoff
and a 60% chance of $40 million. Its expected payoff is only
$72 million, so it has a negative NPV. The firm should reject
it, and managers would do so if not for the outstanding debt.
If the project generates a low payoff, the firm will go
bankrupt, but it is headed there anyway. The high payoff,
though unlikely, is sufficient to repay the bondholders and
allow the firm to continue as a going concern.

Copyright © 2022 Pearson Education, Ltd.

Example 13.7 (3 of 4)

Managers have perverse incentives here. Bondholders

prefer that the managers either undertake the low-risk
project or just sit on the cash reserve. But that is not what
shareholders want. They will lose everything if bondholders
aren’t paid. Thus, the shareholders are “playing with the
bondholders’ money.” If it succeeds, the risky project will
generate enough cash to pay off the creditors and leave
shareholders in control. If not, shareholders hand the firm
over to bondholders—the same result achieved by playing it
safe.

Copyright © 2022 Pearson Education, Ltd.

Example 13.7 (4 of 4)

Shareholders have everything to gain and nothing to lose

from swapping a riskier asset for a safer one, and their agent
(the manager) controls the firm’s investment policy.
Bondholders can insist on restrictive covenants that protect
them to some degree against asset substitution, but these
offer only a partial solution.

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (6 of 8)
• Agency Costs
– Agency Costs of Outside Debt
 Underinvestment Problem
– An agency problem that occurs when managers
pass up a good investment opportunity because
undertaking it would benefit lenders rather than
shareholders.

Copyright © 2022 Pearson Education, Ltd.

Example 13.8 (1 of 2)

J.R. Ewing Inc. is on the verge of bankruptcy because when

its $100 million in bonds come due in 90 days, it will probably
not have the money to pay them. Assume that a very
profitable short-term investment opportunity comes along.
Perhaps a financially distressed supplier agrees to sell its
inventory to Ewing at a deep discount if Ewing can pay cash
today. The inventory costs $90 million, but Ewing can sell it
for $190 million in 90 days, raking in $100 million profit, just
enough to pay off its debt. The company has $80 million in
cash on hand, so to take advantage of this opportunity,
shareholders must pitch in (i.e., the company can sell new
shares or cut dividends) another $10 million.

Copyright © 2022 Pearson Education, Ltd.

Example 13.8 (2 of 2)

Accepting this project maximizes the value of the firm

because of the investment’s enormous NPV. However,
shareholders reject the idea. They would contribute an extra
$10 million to make the investment, but the rewards all go to
creditors.

Copyright © 2022 Pearson Education, Ltd.

Matter of Fact

Leverage Around the World

A study of the use of long-term debt in 42 countries found
that firms in Argentina used more long-term debt than firms
in any other country. Relative to their assets, firms in
Argentina used almost 60% more long-term debt than did
U.S. companies. Indian firms were heavy users of long-term
debt as well. At the other end of the spectrum, companies
from Italy, Greece, and Poland used very little long-term
debt. In those countries, firms used only about 40% as much
long-term debt as did their U.S. counterparts.

Copyright © 2022 Pearson Education, Ltd.

13.5 Other Factors That Influence
Capital Structure Choices (7 of 8)
• Asymmetric Information
– A situation in which all economic agents do not share the
same knowledge
– The Pecking-Order Theory
 Financial Slack
– Refers to excess financial resources and includes a
firm’s cash and marketable securities holdings in
addition to its unused debt capacity
 Pecking-Order Theory
– A hierarchy of financing that begins with retained
earnings, which is followed by debt financing and
finally external equity financing.
Copyright © 2022 Pearson Education, Ltd.
13.5 Other Factors That Influence
Capital Structure Choices (8 of 8)
• Asymmetric Information
– Signaling Theory
 Signal
– A financing action by management that reflects its
view of the firm’s stock value; generally, debt
financing is a positive signal that management
believes the stock is undervalued, and a stock issue
is a negative signal that management believes the
stock is overvalued.
 Signaling theory predicts that a firm’s stock price should
rise when it issues debt and fall when it issues equity,
and this is exactly what happens in the real world much
of the time
Copyright © 2022 Pearson Education, Ltd.
Review of Learning Goals (1 of 10)

• LG 1
– Describe capital structure, financial leverage,
recapitalization, and the tradeoffs associated with changing
capital structure
 Capital structure refers to the mix of debt and equity
securities that a firm has issued to finance its activities.
 Financial leverage refers to a firm’s use of borrowed
funds, such as bank loans or bond issues
 A firm that uses debt financing (i.e., financial leverage) is
a levered firm, whereas a firm that relies only on equity
to finance its activities is an unlevered firm.
 Recapitalization refers to a significant change in a firm’s
capital structure.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (2 of 10)

• LG 1 (Cont.)
– Describe capital structure, financial leverage,
recapitalization, and the tradeoffs associated with changing
capital structure
 Because adding debt to the capital structure increases the
overall risk that shareholders bear, they will demand a higher
return (i.e., risk premium) as compensation for the additional
risk.
 Therefore, whether the addition of debt to a firm’s capital
structure increases its stock price depends on the relative
importance of two offsetting effects: the increase in expected
cash flows to shareholders versus the increased discount rate
that shareholders will apply to these cash flows.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (3 of 10)

• LG 2
– Explain Modigliani and Miller Proposition One and Two and
the impact of using financial leverage if capital markets are
perfect
 Modigliani and Miller (M&M) showed that capital structure is
irrelevant in a world of frictionless capital markets.
 Their Proposition One states that the leverage choice does not
affect a firm’s value.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (4 of 10)

• LG 2 (Cont.)
– Explain Modigliani and Miller Proposition One and Two and
the impact of using financial leverage if capital markets are
perfect
 M&M’s Proposition Two says that, even though the cost of
debt is less than the cost of equity, the WACC does not
decrease when a firm reduces equity and adds debt to its
capital structure.
 This is because more debt increases the cost of equity, which
exactly offsets the advantage of replacing some equity with
debt.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (5 of 10)

• LG 3
– Discuss the impact of corporate and personal taxes on the
M&M Propositions
 In a world with tax-deductible interest payments and only
company-level taxation of operating profits, the optimal
corporate strategy is to use the maximum possible leverage.
 This minimizes the government’s claim on profits and
maximizes income flowing to private investors.
 When governments impose taxes at both the corporate and
personal levels, debt’s tax advantage usually is lower than
when there is a corporate income tax only; in some cases,
higher personal taxes on interest income may lead to a net tax
disadvantage for debt.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (6 of 10)

• LG 4
– Discuss the tradeoff of benefits and costs that arise from
using financial leverage, particularly those related to taxes
and bankruptcy costs
 CFOs claim that capital structure decisions are very important.
Conceptually, the optimal debt ratio occurs where debt’s
marginal benefits and costs are equal.
 The tax benefits of incremental debt fall as leverage increases
because larger interest expense makes it more likely that a
firm will lose money, and a firm that loses money must defer
realizing the debt tax shield.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (7 of 10)

• LG 4 (Cont.)
– Discuss the tradeoff of benefits and costs that arise from
using financial leverage, particularly those related to taxes
and bankruptcy costs
 If bankruptcy resulted in a costless transfer of ownership from
shareholders to creditors, then bankruptcy would have no
important consequence for a firm’s capital structure. It is
because the bankruptcy process triggers large direct and
indirect costs that bankruptcy creates a cost to using debt.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (8 of 10)

• LG 5
– Discuss how the use of debt affects agency costs
 Creditors know that corporate managers, who operate their
firms in the interests of shareholders, have incentives to
expropriate creditor wealth through the firm’s investment
policy.
 Asset substitution is one way managers do that. It involves
promising to invest in a safe asset to obtain a return reflecting
this risk, but then investing instead in a riskier asset that offers
a higher expected return.
 Creditors protect themselves from these problems in several
ways, especially by inserting restrictive covenants into loan
agreements.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (9 of 10)

• LG 5 (Cont.)
– Discuss how the use of debt affects agency costs
 There are several important agency costs inherent in the
relationship between corporate managers and outside
investors and creditors.
 In some cases, using financial leverage can help overcome
these agency problems; in others, using leverage worsens the
problems.
 The modern tradeoff model of corporate leverage predicts that
a firm’s optimal debt level is set by trading off the tax benefits
of increasing leverage against the increasingly severe
bankruptcy costs and agency costs of heavy debt usage.

Copyright © 2022 Pearson Education, Ltd.

Review of Learning Goals (10 of 10)

• LG 6
– Discuss the pecking-order and signaling theories
 The pecking-order theory predicts that managers will minimize
the need to secure outside financing—for example, by
retaining profits to build up financial slack.
 These same managers will use the safest source of funding,
usually senior debt, when they must secure outside financing.
 The signaling theory predicts that managers will select their
firms’ leverage levels to signal that the firm is strong enough to
employ high debt and still fund its profitable investment
opportunities.

Copyright © 2022 Pearson Education, Ltd.