1

Prof. Thomas J. Chemmanur

MF807

Topic Note 10

1. When does the financing mix (capital structure) matter?

Till now, we talked about situations in which the financing choice of the firm is irrelevant. When will

capital structure matter? As a general rule, we can say that the capital structure of the firm will affect firm

value whenever markets are imperfect. In this lecture, we will briefly review the impact of several kinds of

market imperfections on firm value, and discuss how corporate financial managers should go about making

their capital structure decisions to maximize firm value. We will therefore introduce market imperfections one

by one into a perfect capital market and study the effect these will have on firm value.

2. Capital structure can matter if the firm can tap an unsatisfied clientele of investors

When we talked about the Modigliani-Miller Proposition-I, we argued that firm value is irrelevant

because all the firm is doing is to split up its total cahs flow stream into two different cashflow streams: cash

flow to debt and cash flow to equity. Hence the sum of the values of these two streams (ie., the sum of the

value of debt and the value of equity) should be the same as that of the value of the unlevered firm. However,

this will not be the case if the firm can issue a new kind of security (ie., a financial innovation) which offers a

financial service which was till then unavailable to investors because of market imperfections. In this case, if

there exists a clientele of investors who want this service, these investors with an unsatisfied demand will be

willing to pay a premium for that security (in other words, the firm will have to pay only a lower expected

return to raise capital from selling this security than the rate of return corresponding to the risk of this

security). This is why, corporate financial managers are always looking for financial innovations: they may

offer the firm a cheaper way of raising capital. Examples of such financial innovations are money market

accounts (which were enormously popular when they were first introduced), floating rate notes (these are

medium-term bonds whose interest payments vary corresponding to short-term interest rates) etc. However, as

more and more firms start offering the same innovation, the unsatisfied clientele vanishes, and that security

will no longer be at a premium, and there will no longer be any advantage to the firm in issuing that security.
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Thus, studies have found that, most of the time, only the firm which first introduces a new security gets a

bargain from raising capital using that security. Copy cat firms do not seem to get any bargains in financing,

since the clientele is already satisfied by the time they get around to issuing these securities; they might as well

have stuck to ordinary stocks and bonds. Thus, raising firm value by financing projects with exotic new

securities is a tall order for most corporate managers.

3. Capital structure can matter when there are taxes

Let us now consider the impact of taxes on firm value. We will first look at the effect of corporate

taxes alone. As before, consider two firms, which are identical except for their capital structures. Let us

assume that the mean operating income (Earnings Before Interest and Taxes, EBIT) of either firm, Y =

1000,000. The first firm is financed by 100% equity (unlevered firm); the second firm is financed partly by

equity and partly by debt: assume that the firm has debt of face value $5000,000 at 10% interest per year, for

ever (ie., the debt is a perpetuity).

Unlevered firm Levered firm

Operating Income, Y 1000,000 1000,000

Interest --- 500,000

Taxable Income 1000,000 500,000

Tax (at Tc = 34%) 340,000 170,000

Net Income 660,000 330,000

To simplify matters, assume ßA = 0. Then, ßEU = 0 and ßEL =0, so that if the risk-free rate is 10%, we

can use this to discount all cashflows.

Value of the unlevered firm, VU = EU = 660,000/0.1 = 6,600,000

Value of the levered firm = Market value of debt + Market value of equity

Market Value of Debt, DL = Interest payments/r_D = 500,000/0.1 = 5,000,000

Market Value of equity, EL = Cashflow to equity/r_E = 330,000/0.1 = 3,300,000

Therefore value of levered firm, VL = 5,000,000 + 3,300,000 = 8,300,000

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Thus, the value of the levered firm is $1,700,000 higher than that of the unlevered firm. Why is this? Because

the levered firm is able to save money on taxes compared to the unlevered firm: because the interest payments

on debt is deductible from corporate taxable income. Let us compute the present value of this tax savings per

year:

Tax savings from debt per year = 170,000

Present Value of tax savings = 170,000/0.1 = 17000,000

(In general, use the expected return on debt as the discounting rate to compute this present value of the debt

tax shield).

The amount of corporate tax savings possible from having a certain amount of debt is usually

referred to as the debt tax shield. Thus,

Value of the Levered Firm VL = Value of the Unlevered firm VU + Present Value of Debt Tax shield for

the Levered Firm

The above result is a general result, applicable to all kinds of debt (ie., not only to the specific kind

of debt we have assumed in the above example). Further, for the special case where the debt is a perpetuity,

we can show that:

Present Value of corporate debt tax shield = T c (r_D.D)/r_D = Tc.D

(Here D is the market value of debt, which is the same as the face value of debt in this case, r _D is the

expected return on debt which is the same as the coupon rate in this case). Thus, if the only relevant market

imperfection is corporate tax, we can write (for the special case of permanent debt:

(1) V L = V U + T c .D

The above result brings up a puzzle: clearly, higher the debt, higher the present value of debt tax

shield (you would think). So why don't all firms have very high proportions of debt in their capital structure

(close to 100% debt)? But the fact is, many companies (eg: advertising firms, drug manufacturers) have

almost no debt! The answer here is in two parts: (1) On closer examination, the value of the debt tax shield

may not be as high as we think it is (2) There may be costs to having debt. Let us examine the first point
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next.

4. Two factors which may reduce the present value of the debt tax shield

a. The impact of taking the effect of personal taxes into account

In the discussion so far, we considered only corporate taxes. The fact is that in the real world, not

only corporations pay taxes: individuals also pay taxes. We therefore have to take into account the impact of

personal taxes also on the advantage from leverage. The tax rates on individual income from stocks and bonds

are sometimes different from each other. Let us consider the following example of a company with $1

expected operating income. Assume that this income can be paid to investors either as interest income (by

financing the firm with debt) or as equity income (financing the firm with equity).

Paid out as

Interest income Equity Income

Operating Income 1 1

Less Corporate tax at 34% 0 .34

Net income after corp tax 1 .66

Less personal tax (at 0.40

for interest income and .09

for equity income) .40 .0594

After-tax income to investor .60 .6006

Surprise! There is actually a small advantage to paying out the $1 as equity income from the

investors point of view! Of course, the above example was cooked up to make this point by assuming a large

differential in the personal tax rates on interest income and equity income. The truth is less spectacular: while

we can say that figuring in the effect of personal taxes lessens the gain in firm value obtained from having

debt in a firm's capital structure, it still exists in most cases.

We can derive the following general formula for the increase in value of the firm with debt (we will

not bother with the details of the derivation of this formula here):
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(1 - T c )(1 - T E )
(2) V L = V U + [1 - ]D
(1 - T D )

Here TE and TD are the effective personal tax rates on debt and equity income respectively. The above

expression applies strictly only if the debt on the firm is perpetual debt. However, it gives us a feel for the size

of the tax shield from debt under different assumptions about T E and TD. We can think of the second term on

the right as the gain from leverage in a world with corporate and personal taxes since it represents how much

higher the value of the levered firm is compared to the unlevered firm.

Case 1: If T E = TD, the above equation reduces to, VL = VU + Tc.D. ie., the gain from leverage is the same as

in the case where there was only corporate taxes in the economy.

Case 2: If TE < TD, the expression on right is smaller than before,

ie., VL < VU + Tc.D. Thus, the gain from leverage may still be there, but it is much smaller than if we merely

considered corporate taxes. This reflects the current tax law in the U.S., where capital gains, which constitute

a significant portion of the income from equity (and also dividends), are taxed at a much lower rate (around

15%) than interest payments on bonds, which are taxed as ordinary income. (The numerical example above is

an extreme (and rather unrealistic) case of this, where T D = 0.4 and TE = 0.09. In this case, VL < VU ! )

Case 3: if TE > TD, then VL > VU + Tc.D, and the benefit of debt is even higher than in the case where we

considered corporate taxes alone. This, however, has never been the case under U.S. tax law.

Thus, under current personal tax rates, there is still an advantage to the corporation in issuing debt,

even after we consider personal taxes.

b. Possible wastage of debt tax shields

There is a second reason why the benefit to issuing debt may not be as high as we thought at first: the

company may not be able to fully use the tax shield it gets from issuing debt. There may be many years in

which the company may not make a high enough profit, so it may not have enough income to shelter from
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taxes (you can carry the tax shield forward, but you lose some value since you get benefits only later).

Further, the firm may have other tax-shields like depreciation tax shields also, which accentuate the problem

since the operating income may not be high enough to utilize the entire extent of tax shields the firm has.

Remember, tax shields add value to the firm only if you can convert them into actual savings in tax-dollars!

Thus, it does not make sense to increase the debt in the capital structure beyond a certain extent, since, higher

the level of debt, higher the chance that the firm may not be able to fully utilize the debt tax shield involved.

Taking into account the two effects we discussed above: (a) the effect of personal taxes and (b) the

possibility of wastage of debt tax shields, we can conclude that while there may be a net tax advantage to

having debt, it is not as large as Tc.D. Thus we can write,

*
(3) V L = V U + T D,

Where T* is some fraction less than TC (i.e, 0 < T* < Tc). The problem, however, is in estimating T *!

Remember also that the formula (3) applies only to the special case of permanent debt. A more general

formula is: VL = VU + PV of {interest payment on debt x T*}.

5. Capital structure can matter if there are costs to financial distress

When a company issues debt, it essentially enters into a contract with debt holders promising them to pay

certain specific amounts (interest payments and face value) at specific points in time. Clearly, if the amount of

debt issued is very small compared with the various possible levels of operating income of the firm, then there

is zero probability that the firm will not be able to meet its payment obligations, and the debt is riskless.

However, if the size of the debt obligations of the company are significant compared to the possible

levels of operating income, and there is a chance that in certain states of the world the company may not be

able to pay up its obligations to its debt holders, the debt is risky. In case the firm is unable to meet its debt

obligations, the company can declare bankruptcy, in which case debt holders will take over control of the

company. For a given level of operating income, the higher the level of debt, the higher the chance that the
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firm cannot honor its obligations to debt holders (i.e., higher the chance that the firm goes bankrupt). Notice

that, just the fact that higher debt increases the chance of bankruptcy has no effect on firm value. In

fact, the company will go on running even after bankruptcy, the only change will be that all cashflows will

now go to the former debt holders in the firm (who take over control)! In fact, if bankruptcy is costless, the

value of the levered firm is exactly the same as that of the unlevered firm, even if the level of debt is so high

that the chances of bankruptcy are significant.

To illustrate this, consider the following example of two firms which are otherwise identical (for

instance, they have the same probability distribution of operating income) except for the fact that one is

unlevered (100% equity) and the other is financed partly by debt (perpetual debt with a promised interest of

500,000 per year) and partly equity:

Oper Income Prob Cashflow to debt Cashflow to equity

Y holders in the levered firm holders in the levered

1000,000 0.1 500,000 500,000

300,000 0.9 300,000 0

Assume for simplicity that the firm has no systematic risk: ßA = ßEU = ßEL= 0. Then, if the risk-free

rate is 10%, we can discount all cashflows at this rate.

Expected cashflow to equity holders in unlevered firm = 0.1(1000,000) + 0.9 (300,000) = 370,000.

Value of unlevered firm, VU = Value of equity in the unlevered firm,EU = 370,000/0.1 = 3,700,000

Expected cashflow to equity holders in levered firm = 500,000(0.1) + 0(0.9) = 50,000

Value of equity in levered firm, EL = 50,000/0.1 = 500,000

Expected cashflow to debt holders in levered firm = 500,000(0.1) + 300,000(0.9) = 320,000

Value of debt in the levered firm, DL = 320,000/0.1 = 3,200,000

Value of levered firm, VL = EL + DL = 500,000 + 3200,000 = 3,700,000

Thus value of unlevered firm = value of levered firm, so that firm value is unaffected so long as bankruptcy is

costless.
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The problem, however, is that in most cases, debt holders do not get to take over the entire cashflow

of the healthy firm if the firm goes bankrupt. The threat of bankruptcy, and the bankruptcy process itself, robs

the firm of a certain proportion of the operating income, which can be thought of as the costs of financial

distress. These costs may consist of direct costs of bankruptcy, like legal and administrative costs of the

bankruptcy process, loss of income to the firm because of loss of confidence by consumers who switch to

competing products, etc. Or they may consist of indirect costs, which are incurred even if the firm doesn't go

bankrupt. Examples of indirect costs are unwillingness of customers, suppliers, employees etc. to enter into

long-term relationships with the firm ("it will probably go bankrupt soon, and then who knows what will

happen?"), loss in the incentives of corporate management to take advantage of positive NPV growth options,

("if the debt holders are likely to take over the firm, why bother to put in more money ?"), possible incentives

to pay a liquidating dividend (instead of investing money in new projects, pay it out as dividends!), or

increased incentives for risk shifting (taking on highly risky projects in the hope that they pay off and can save

the firm from bankruptcy, even though they are negative NPV projects: if they pay off, well and good; if they

don't, the firm would probably go bankrupt any way, so on average, shareholders gain). The last three cases I

cited here are examples of costs associated with incentive problems which may exist within a firm even when

there is a low chance of bankruptcy: however these problems, and the costs associated with them, get much

worse as the probability of bankruptcy goes up and we will therefore include them also as costs of financial

distress. The size of bankruptcy costs differ with the nature of the type of business that the firm is

engaged in. For example, the bankruptcy costs associated with a chain of grocery stores are somewhat low: if

the firm cannot meet interest payments on its debt, management may declare bankruptcy, and the lenders

takeover and sell it to a new operator (or, less likely, manage it themselves). In this case, the costs of

bankruptcy could be very small: perhaps only the legal and court fees, and some administrative expenses.

However, if it is a drug manufacturer that goes bankrupt, the loss in value can be very high: as the chances of

bankruptcy go up, the company may cut down on R&D expenses for developing new drugs, thus losing the

NPV from these opportunities. A number of the most talented (and hence sought after) employees may leave

the firm for competing concerns. Consumers may lose confidence in the firm and switch to competing brands.
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Thus, by the time the firm actually goes bankrupt, the operating cashflow (and hence value) of the firm that

the debt holders get to take over may be far less than that of the same firm before bankruptcy. It is this

possible leakage in operating income (and hence in firm value) that can occur as a by-product of

bankruptcy that makes corporate managers wary of jacking up debt in those industries where bankruptcy

costs are high. Thus, while debt may have a net tax advantage, managers have to trade-off this tax advantage

against the present value of expected costs of financial distress. Taking this trade-off into account, we can

now modify the formula for the value of the levered firm to be,

Value of levered firm = Value of unlevered firm + Present Value of debt tax shield - Present Value of

costs of financial distress

Example problem to be worked out in class

The Wallace Corporation is curently an all equity firm worth $12 million. Wallace's corporate tax
rate is 40%. Management is considering issuing debt (Debt would be used to buy back an equal value of
equity). The firm's analysts have estimated that bankruptcy (if it occurs at all) will occur 10 years from now
and will cost the company $8 million at that time; further, the probability of bankruptcy would increase with
leverage according to the following schedule (only columns (1), (2) and (3) are part of the question; All
figures in millions of dollars):

Value of Debt PV of Probability Expected bankr Present Value

Tax Shiled of bankr costs of bankr costs .

2 0.8 0.01 0.08 .0308

2.5 1 0.25 2.0 .7710
4 1.6 0.6 4.8 1.8504
6 2.4 0.8 6.4 2.4672

(Assume that the debt on the company will be a perpetuity).

a) Taking into account bankruptcy costs as well as the effect of debt tax shields, what is the level of debt that
the company should choose (among the possible levels given above) to maximize firm value? (Use a
discounting rate of 10% to discount bankruptcy costs)

b) What is the right level of debt (among the different levels given above) if you ignore bankruptcy costs?
(Assume that both debt and equity income are taxed alike at the personal level).

Solution:
a) Part of the solution is given in Coloumns (2),(3), (5) of the table above. For each debt level, compute the
expected bankruptcy costs, and the present value of bankruptcy costs.

eg: D = 2 million
Present value of tax shields = 0.8
Expected bankruptcy cost = 8(0.01) + 0 (1 - 0.01) = 0.08
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Present Value of bankruptcy costs = 0.08 [PVIF corresp 10%,10yrs]
= 0.08 (.3855) = 0.0308
Value of the levered firm at this debt level = VU + PV of debt tax shield - PV of bankruptcy costs = 12 + 0.8 -
0.0308 = 12.77.

Working similarly, Value of levered firm at Debt of 2.5 million = 12 + 1 - 0.7710 = 12.229.
(It is easy to check that firm value is even lower for higher levels of debt).

Thus, the firm should issue $2 million debt since firm value is maximized at this level of debt ($12.77
million). Thus, the firm has increased value by 0.83 million by replacing $2 million of equity with debt.

b) If bankruptcy costs are zero, the firm should issue the highest possible level of debt: ie, the optimal debt is
$6 million.

The above example illustrates an important point: it is not only the size of the bankruptcy costs that

matter but also the probability of going bankrupt as well (which depends on the riskiness of the firm's

operating income) since the expected bankruptcy cost is the product of the two. Thus, in general, firms with

high business risk generally issue less debt. (Bankruptcy costs provide a rationale for firm managers trying to

diversify a company's business: ie., why a firm in the tobacco industry may go into the food products

business. The riskiness of the cashflows of the "diversified" company are likely to be less than if the firm

operated in only one industry, for any given level of debt, so that expected bankruptcy costs will be less for

such a diversified firm. In the absence of market imperfections, firm managers should not worry about

diversifying at the firm level: any diversification can be done by stockholders, by holding stock in different

companies, as we saw when we learned the theory of risk and return.)

6. Capital structure can matter when there are costs imposed by asymmetric information and/or "issue costs"

(like investment banker fees).

When we studied efficient markets, we learned that in practice, the financial markets are not strong

form efficient: ie., all information available to insiders are not reflected in market prices. This fact can

sometimes be costly for a firm trying to raise equity capital to invest in projects. For example, assume that the

management of a software company has news that one of their programmers has just developed an exciting

new software program which they feel will have an NPV of $500,000. Assume further the without the new
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product, the value of this firm is $1000,000. The firm is currently all equity financed, and has 50,000 shares

outstanding.

Current price per share (without the new product) = $ 1000,000/50,000 = $20/share.

Now, assume that the investment required for this project is $600,000, to pay for testing this software,

marketing etc. The problem before management is this: how should we raise the $600,000? Let us see what

will happen to firm value if they issue new equity. If the firm cannot convince outside investors about their

having this new product, investors will pay only the current price ($20/share) for the newly issued shares of

the company. In that case, how many shares will they have to sell? 600,000/20 = 30,000.

In this setting, managers feel that they are giving these shares away at a bargain. This is because,

once the information about the new product comes out, total firm value = Value of firm without new

product + NPV of new product + amount raised by selling equity = 1000,000 + 500,000 + 600,000 =

2,100,000.

Price per share = 2,100,000 / New number of shares = 2,100,000/80,000 = $26.25 per share

The firm could instead finance this project from "internal financing". Internal financing refers to

funds internally generated within the firm and is defined as accumulated retained earnings (net income minus

dividends) plus depreciation. Let us compute the value of the firm and price per share if the firm finances this

projects from internally generated funds:

Value of the firm = Value of the firm without new product + NPV of new product = 1,500,000

Price per share = 1,500,000/50,000 = $30/share

Thus, while the firm used up some available cash by using internal financing, the price per share after the

information about the new product gets revealed wil be $30 instead of $26.25, so that current stock holders

are much better off (by $3.75 for each share they own) if the firm uses internal financing instead of issuing

new equity! This loss in value which can come from issuing equity is sometimes referred to as "asymmetric

information costs of financing with equity". This cost arises when management is forced to issue new equity

in a situation in which the firm's shares are undervalued. (This is perhaps the reason why firm managers

worry about the 'timing of equity issues': issuing equity at the 'wrong time' can be very costly for the firm).
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Such asymmetric information costs also exist for risky debt, but they are much smaller than for equity (they

are zero for riskless debt: in general, riskier the security, larger the asymmetric information costs of

financing).

In the absence of asymmetric information, the firm could have sold new equity to outsiders at $30 per

share because, in this case, outside investors would also know about the new product developed by the firm.

Consequently, the price per share even after the new equity financing will be $30 per share (you can check

this by repeating the above computation), so that stockholders are indifferent between financing the project

using internal funds or new equity financing. It is therefore asymmetric information which makes equity

financing costly.

Another important cost of issuing equity and to a lesser extent, debt, are issue costs: investment

banker fees and other transactions costs involved in issuing and selling these securities. Clearly, these "issue

costs" are zero for internal financing.

Summary

We have talked about the different costs involved in financing projects with three different sources:

debt, equity and internal financing. Debt has an important benefit: it confers an important source of tax

savings to the firm. It has also an important cost: the probability of bankruptcy goes up with debt, and, if

there are costs to financial distress, this can reduce the value of the firm. Selling equity is not always the

answer: the costs of issuing equity can be high, particularly when the firm's shares are undervalued in the

stock market. Financing projects with internally generated funds has obviously none of these costs. Thus, in

practice, firms prefer to finance projects with internal financing if possible or, if not, with debt. At the same

time, managers usually do not exhaust all internal funds, or even borrow up to the hilt, because they prefer to

maintain some 'financial slack' (which can be thought of as project financing capacity which can be put into

effect quickly without issuing equity: this consists of cash, marketable securities,, or unused debt capacity).

This financial slack helps them finance good projects without being forced to sell equity at the "wrong time".

Thus, often, firms may choose to finance a given project with equity even when they have internally financing

available, if firm managers feel that the moment is ripe to raise equity financing, thus reserving their available
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internal funds for financing future projects. Thus, in practice, firms use a combination of debt and equity to

finance their projects depending on (1) size of tax savings they can hope to obtain from issuing debt (2) risk of

the business they are operating in (4) Type of business (asset type), which affects the size of potential costs of

financial distress (5) Extent of asymmetric information in the capital markets about the true value of the firm

(6) Issue costs (7) Extent of financial slack the firm wants to maintain.

Appendix: Taking market Imperfections into account in capital budgeting

1. Adjusted Present Value (APV)

When we studied capital budgeting, we studied formulae for the cost of capital: (1) The weighted

average cost of capital (2) Asset beta method. Both these methods took into account the effect of the debt tax

shields, by adjusting the discount rate for the effect of the deductibility of interest payments from corporate

tax. However, if other market imperfections, like the costs of financial distress, issue costs, and asymmetric

information costs are also significant, it is useful to take market imperfections into account using the

Adjusted Present Value Approach (instead of adjusting the discount rate). The following steps are involved

in using APV for capital budgeting:

Step (1): Compute the "base case NPV" of the project, using as the discounting rate, the expected return on

the assets of the firm, r_A. (For example, if we are using the asset beta method, plug the asset beta into the

CAPM to get r_A. If you are using the weighted average cost of capital, use r_A = (E/V)r_E + (D/V)r_D.

(Unlike in the adjusted discount rate method we learned earlier, do not make any adjustments to the

discount rate at this stage for the effect of the debt tax shield).

Step (2): Adjust the NPV computed above for the impacts of market imperfections: e.g.: tax shield effects,

effects of the costs of financial distress, asymmetric information costs, issue costs:

APV of the project = Base Case NPV + Present Value of incremental debt tax shield due to project -

Present value of incremental bankruptcy costs - Asymmetric information and issue costs etc.

Step (3): Accept the project only if APV greater than zero: i.e., make sure that the project increases the
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value of the firm after taking into account the effect of financing.

To decide on the right form of financing the project, compute firm value using several alternative

scenarios, and pick that financing mix that maximizes the value of of equity in the firm (in other words, pick

that financing mix that gives the highest APV for the project).

Example Problem to be worked out in class:

Consider a project lasting 1 year only. The initial outlay is $1000 and the expected inflow is $1200. The
opportunity cost of capital is r_A = 20%. The borrowing rate is r_D = 10%, and the net tax shield per dollar of
interest is T* = 0.20.
(a) What is the project's base case NPV?
(b) What is its APV if the firm borrows 30% of the project's required investment? (Assume that the remainder
is equity financed: asssume no cost to equity financing at this stage).
(c) How will your answer to (b) change if 10% of equity proceeds goes toward flotation costs?
(Assume that the amount raised has to be enough to pay this flotation cost as well)

2. Effective cost of capital under alternative forms of financing

Let us now integrate what we have learned about financing under capital market imperfections with

what we know about the cost of capital. We know that if capital markets are perfect, the financing mix doesn't

matter: the cost of capital to be used in evaluating a project is then r_A, the return on the company as a whole

(if all projects in the company have the same risk) or the return corresponding to the riskiness of the specific

project (which will be the case, for instance, if different projects in the firm are in different industries). Thus,

the cost of internal financing is also r_A (internal financing is not free, as some people seem to think!).

What happens to the cost of capital if we introduce market imperfections? We can still use r_A as the

cost of capital, provided we include the effects of financing also in some manner. This is what we are doing

when we compute the APV. If the APV is higher than the base case NPV, the effective cost of capital

applicable to this project (inclusive of financing effects) is lower than r_A; if APV is less than the base case

NPV (as is often the case), then, the effective rate of return required from this project is higher than r_A.

Thus, by making the APV the criterion for accepting/rejecting this project, we are in effect applying a

cost of capital to the project which incorporates the effect of market imperfections into account. Thus, the

APV method allows us to discount project cashflows at a cost of capital corresponding to the riskiness of the

project, except that we are also taking into account the effects of costs imposed on the firm by market
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imperfections, which in turn depend on how the project is financed.1

INTERNAL VERSUS EXTERNAL FINANCING: HISTORICAL TREND

SOURCESOF LONG-TERM

FINANCING (%)
Internal Financing 76.5 78.7 77.3 70.2 78.7 96.1 83.5 86.8

External

Financing

1
Incidentally, if corporate tax effects are the only significant market imperfection, APV =
Base Case NPV + PV of the Debt tax shield generated by the project. In that case, the APV
method and the adjusted discount rate method should give more or less the same answer
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Net new long-term 0.0 3.3 4.5 9.6 6.0 13.3 -4.1 19.8
borrowing
Net new stock 23.5 18.0 18.2 20.2 15.3 -9.4 20.6 -6.6

issues
100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Data are derived from Value Line Selection and Opinion. “Industrial Composite Financial Results” (February

13,1987) and Board of Governors of the Federal Reserve System, Division of Research and Statistics. Flow

of Funds Accounts.

Internal financing comes from internally generated cash flow and is defined as net income plus depreciation

minus dividends. External financing is new long-term bond and new shares of equity net of buy-backs.