1

Capital Structure:
Limits to the Use of Debt
Chapter 16
2
MM Proposition I with taxes:
V
L
= V
U
+ T
C
B
It implies that firm should maximize its value by borrowing an
infinite amount.
In Reality
However, as the debt/equity ratio rises, the probability that the
firm could not be able to pay the interest and principal to
bondholders increases.
In principal, a firm is in bankruptcy when the value of its assets
equals the value of the debt.
When this occurs, the value of equity is zero and the shareholders
turn over control of the firm to the bondholders.
In a perfect world, there are no costs associated with this transfer
of ownership. In the real world, it is expensive to go bankruptcy.


3
Costs of Bankruptcy
Direct Bankruptcy Costs
Legal and administrative costs (e.g. lawyers, accounting, expert
witnesses)






Indirect Bankruptcy Costs
The difficulties of running a business that is experiencing
financial distress.
Since shareholders and bondholders are different groups. In the
financial distress, shareholders may engage in
Selfish strategy 1: Incentive to take large risks
Selfish strategy 2: Incentive toward under-investment
Selfish Strategy 3: Milking the property
The above three Selfish strategies are called as agency cost of equity.
4
Integration of Tax Effects and Financial Distress Costs
Tax effects: A firm borrows because the valuable interest tax shield
Financial Distress Costs: A firm can not borrow an infinite amount
because of bankruptcy risk
At a relative low debt level, the benefit from debt outweighs the cost
At a relative high debt level, the cost from debt outweighs the benefit
It suggests that an optimal capital structure exists somewhere between these
extremes.

The Value of a levered firm:

V
L
= V
U
+ T
C
B PV [expected costs of financial distress]

Conclusion:
The firm should borrow up to the point where the tax benefit from an extra dollar
in debt is exactly equal to the cost that comes from the increased probability of
financial distress.
5
The Optimal Capital Structure and the Value of the Firm
Value of
the firm
(V
L
)
Total Debt (B)
(B/S) *
Optimal Leverage Ratio
Present value of tax
shield on debt Financial
distress costs
Actual firm value
V
U
= Value of firm
with no debt
V
L
= V
U
+ T
C
B
Maximum
firm value V
L
*
V
U
6
The Optimal Capital Structure and the Cost of Capital
Cost of
capital
(%)
Debt/equity ratio (B/S)
r
U
WACC
r
B
(1 T
C
)
r
S
r
U
WACC*
Minimum
cost of capital
WACC = (S/V) r
S
+ (B/V) r
B
(1-T
C
) +Premium for Costs of Financial Distress

(B/S) *
Optimal Leverage Ratio
7
Personal Taxes: The Miller Model
The Miller Model shows that the value of a levered firm
can be expressed in terms of an unlevered firm as:
B
T
T T
V V
B
S C
U L

(

+ =
1
) 1 ( ) 1 (
1
Where:
T
S
= personal tax rate on dividends.
T
B
= personal tax rate on interests.
T
C
= corporate tax rate
Note: Both personal taxes and corporate taxes are included. Assuming the
cash flows in perpetuity. Bankruptcy costs and agency costs are ignored.
8
Effect of Financial Leverage on Firm Value with
Both Corporate and Personal Taxes
Debt (B)
V
U

1
2
3
4
B
T
T T
V V
B
S C
U L

(

+ =
1
) 1 ( ) 1 (
1
9
Example:
Nortel anticipates a perpetual pretax earning stream of $100,000
and faces a 45% corporate tax rate. Investors discount the earning
after corporate taxes at 15 percent. The personal tax rate on
dividend is 30% and the personal tax rate on interest is 47%.
Nortel currently has an all equity capital structure but is
considering borrowing $120,000 at 10%. Calculate the value of
the levered Nortel firm.
Answer: The value of the all equity firm is:
Vu =____


The value of the levered firm is: VL = ______