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Chapter 13

Capital Structure
and Leverage

Slides developed by:


Pamela L. Hall, Western Washington University
Background
 Capital structure refers to the mix of a firm’s
debt and equity
 Preferred stock is assumed to be part of a firm’s debt
 Financial leverage refers to using borrowed
money to enhance the effectiveness of invested
equity
 Financial leverage of 10% means the firm’s
capital structure contains 10% debt and 90%
equity

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The Central Issue
 Can the use of debt increase the value of a
firm’s equity
 Specifically, the firm’s stock price
 Under certain conditions changing leverage
increases stock price
 An optimal capital structure maximizes stock price
 The relationship between capital structure and
stock price is not precise nor fully understood

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Risk in the Context of Leverage
 Leverage influences stock price
 Alters the risk/return relationship in an equity investment
 Measures of performance
 Operating income (AKA: EBIT or Earnings Before Interest and
Taxes)
• Unaffected by leverage because it is calculated prior to the
deduction for interest
 Return on Equity (ROE) is Earnings after Taxes ÷ Stockholders’
Equity
 Earnings per Share (EPS) is Earnings after Taxes ÷ number of
shares
• Investors regard EPS as an important indicator of future profitability

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Risk in the Context of Leverage

 Redefining Risk for Leverage-Related


Issues
 Leverage-related risk is variation in ROE and
EPS
• Business risk—variation in EBIT
• Financial risk—additional variation in ROE and
EPS brought about by financial leverage

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Figure 13.1: Business and
Financial Risk

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Leverage and Risk—Two Kinds
of Each
 Relates to a company’s cost structure
 Involves relative use of fixed and variable
costs
 Operating leverage has an influence on a
firm’s business risk

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Financial Leverage

 Under certain conditions financial


leverage can improve a firm’s ROE and
EPS
 However, at other times it may worsen EPS
and ROE

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Table 13.1

As the firm’s debt


ratio rises, both
EPS and ROE rise
dramatically. While
EAT falls, the
number of shares
outstanding falls at
a faster rate as
debt replaces
equity.

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Financial Leverage
 Return on Capital Employed (ROCE)
 Measures the profitability of operations before financing charges
but after taxes on a basis comparable to ROE

EBIT ( 1 - tax rate )


ROCE =
debt + equity
 When the ROCE exceeds the after-tax cost of debt,
more leverage improves ROE and EPS
 When ROCE is less than the after-tax cost of debt,
more leverage makes ROE and EPS worse

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Table 13.2

ABC is now
doing rather
poorly—ROE and
ROCE are quite
low. As the firm
adds leverage,
EPS and ROE
decrease.

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Financial Leverage—Example
Q: Selected financial information for the Albany Corporation follows:

Albany Corporation at $10M Debt


($000 except for per-share amounts)
EBIT $23,700 Debt $10,000
Interest (@12%) 1,200 Equity 90,000
EBT $22,500 Capital $100,000
Example

Tax (@40%) 9,000 Number of shares= 9,000,000


EAT $13,500
Stock price = $10 per share
ROE = EAT ÷ equity = $13,500 ÷ $90,000 = 15%
EPS = EAT ÷ number of shares = $13,500 ÷ 9,000,000 = $1.50

The treasurer feels debt can be traded for equity without immediately affecting the price of the stock or
the rate at which the firm can borrow. Management believes it is in the best interest of the company and
its stockholders to move the firm’s EPS from its current level up to $2.00 per share. However, no
opportunities are available to increase operating profit (EBIT) above the current level of $23.7 million.
Will borrow more money and retiring stock raise Albany’s EPS, and if so what capital structure will
achieve an EPS of $2.00?

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Financial Leverage—Example
A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently:
23.7M ( 1 - 0.40 )
ROCE = = 14.2%
Example

$100.0M
The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% <
14.2%, trading equity for debt will increase EPS.
Using trial and error, you can determine that $45 million of debt is the
approximate amount of debt that makes the firm’s EPS equal $2.00.

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An Alternate Approach
 Using ratios and information from financial
statements we can solve for unknown values
 EPS = ROE × Book Value per share
 ROE = EAT ÷ Equity
 EAT = [EBIT – Interest] (1 – tax rate)
 Interest = kd (Debt)
 Therefore, EAT = [EBIT – (kd)(Debt)](1 – tax rate)
 Equity = Total Capital – Debt
 EPS = [[EBIT – (kd)(Debt)](1 – tax rate)] ÷ Total
Capital – Debt
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An Alternate Approach
 Using the previous example everything is known
except Debt
 If we set EPS to $2 we can solve for the value of
Debt
$23.7M - (.12)(Debt)(1 - .4)
$2 = [ $10]
$100.0M - Debt
Debt = $45,156,25 0

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Financial Leverage and
Financial Risk
 Financial leverage is a two-edged sword
 Multiplies good results into great results
 Multiples bad results into terrible results

 ROE and EPS for leveraged firms


experience more variation
 Financial risk is the increased variability in
financial results that comes from
additional leverage

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Putting the Ideas Together—
The Effect on Stock Price
 Leverage enhances performance while it
adds risk, pushing stock prices in opposite
directions
 Enhanced performance makes the expected
return on stock higher, driving up the stock’s
price
 The increased risk drives down the stock’s
price
• Which effect dominates, and when?

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Real Investor Behavior and the
Optimal Capital Structure
 When leverage is low an increase in debt
has a positive effect on investors
 At high debt levels concerns about risk
dominate and adding more debt
decreases the stock’s price
 As leverage increase its effect goes from
positive to negative, which results in an
optimum capital structure

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Figure 13.2: The Effect of
Leverage on Stock Price

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Finding the Optimum—A
Practical Problem
 There is no way to determine the exact optimum
amount of leverage for a particular company at
a particular time
 Appropriate level tends to vary according to
• Nature of a company’s business
• If firm has high business risk it should use less leverage
• Economic climate
• If the outlook is poor investors are likely to be more sensitive to
risk
 As a practical matter the optimum capital
structure cannot be precisely located

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The Target Capital Structure

 A firm’s target capital structure is


management’s estimate of the optimal
capital structure
 An approximation or best guess as to the
amount of debt that will maximize the firm’s
stock price

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The Effect of Leverage When Stocks
Aren’t Trading at Book Value
 We’ve assumed that changes in leverage
involve purchasing equity at book value
 If this is not the case, things are more
complex
 Repurchasing stock at prices other than book
value will have the same general impact on
ROE, but not necessarily for EPS
• However the important point is the direction of the
stock price change, not the exact amount

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The Degree of Financial Leverage
(DFL)—A Measurement
 Financial leverage magnifies changes in EBIT
into larger changes in ROE and EPS
 The degree of financial leverage (DFL) relates
relative changes in EBIT to relative changes in EPS
% ∆ EPS Somewhat
DFL = or % ∆ EPS = DFL × % ∆ EBIT tedious
% ∆ EBIT
 An easier method of calculating DFL is:
EBIT
DFL =
EBIT - Interest

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The Degree of Financial Leverage
(DFL)—A Measurement—Example
Q: Selected income statement and capital information for the Moberly Manufacturing Company
follow ($000):

Capital
Revenue $5,580 Debt $1,000
Cost/expense 4,200 Equity 7,000
EBIT $1,380 Total $8,000
Example

Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest
on its debt and anticipates that it can borrow as much as it reasonably needs at that rate.
The income tax rate is 40%
Moberly is interested in boosting the price of its stock. To do that management is
considering restructuring capital to 50% debt in the hope that the increased EPS will have
a positive effect on price. However, the economic outlook is shaky, and the company’s
CFO thinks there’s a good chance that a deterioration in business conditions will reduce
EBIT next year. At the moment Moberly’s stock sells for its book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of
financial leverage to assess the increase in risk that will come along with it.

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The Degree of Financial Leverage
(DFL)—A Measurement (Example)
A: Since the equity is trading at book value, this is a relatively simple example.

Current Proposed
Capital
Debt $1,000 $4,000
Equity 7,000 4,000
Total $8,000 $8,000
Example

Shares outstanding 700,000 400,000

Current Proposed
EBIT $1,380 $1,380
Interest (15% of debt) 150 600 If business conditions
EBT $1,230 $780 remain unchanged, a
Tax (@40%) 492 312 higher EPS will result
EAT $738 $468 with the addition of
EPS $1.054 $1.170 debt.

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The Degree of Financial Leverage
(DFL)—A Measurement—Example
A: Next, calculate DFL:
$1,380
DFLCurrent = = 1.12
Example

$1,380 - $150
$1,380
DFLProposed = = 1.77
$1,380 - $600

EPS will be much more volatile under the proposed plan. EPS will
change by a factor of 1.77 vs. 1.12.

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EBIT-EPS Analysis
 Managers need a way to quantify and analyze
the tradeoffs between risk and results when
changing leverage levels
 Provides a graphical portrayal of the trade-off
 Involves graphing EPS as a function of EBIT for each
leverage level
 Portrays the results of leverage and helps to
decide how much to use

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Figure 13.3: EBIT – EPS Analysis for ABC
Corporation
(from Table 13.1, Columns 1 and 2)

It is
important to
determine When examining the ABC
the Corporation you can see that
indifference the 50% Debt and No
point, which Leverage lines intersect. At
occurs when the point of intersection ABC
the two is indifferent between the two
plans offer plans. However, to the left of
the same the intersection the 50% Debt
EBIT. plan is preferable, but to the
right of the point the No
Leverage plan is preferable.

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Operating Leverage
 Terminology and Definitions
 Risk in Operations—Business Risk
• Variation in EBIT
 Fixed and Variable Costs and Cost Structure
• Fixed costs don’t change with the level of sales, while
variable costs do
• Fixed costs include rent, depreciation, utilities, salaries
• Variable costs include direct labor, direct materials, sales
commissions
• The mix of fixed and variable costs in a firm’s operations is
its cost structure
 Operating Leverage Defined
• Refers to the amount of fixed costs in the cost structure

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Breakeven Analysis

 Used to determine the level of activity a


firm must achieve to stay in business in
the long run
 Shows the mix of fixed and variable cost
and the volume required for zero
profit/loss
 Profit/loss generally measured by EBIT

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Breakeven Analysis

 Breakeven Diagrams
 Breakeven occurs at the intersection of
revenue and total cost
• Represents the level of sales at which revenue
equals cost

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Figure 13.5: The Breakeven
Diagram

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Breakeven Analysis
 The Contribution Margin
 Every sale makes a contribution of the
difference between price (P) and variable cost
(V)
• Ct = P – V
 Can be expressed as a percentage of
revenue
• Known as the contribution margin (CM)
• CM = (P – V) ÷ P

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Breakeven Analysis—Example

Q: Suppose a company can make a unit of product for $7 in


variable labor and materials, and sell it for $10. What are the
Example

contribution and contribution margin?

A: The contribution per unit is $3, or $10 - $7, while the


contribution margin is $3 ÷ $10, or 30%.

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Breakeven Analysis
 Calculating the Breakeven Sales Level
 EBIT is revenue minus cost, or
• EBIT = PQ – VQ – FC
 Breakeven occurs when revenue (PQ) equals
total cost (VQ + FC), or
• QB/E = FC ÷ (P – V)
• Breakeven tells us how many units have to be sold to
contribute enough money to pay for fixed costs
• Can also be expressed in terms of dollar sales
• SB/E = P(FC) ÷ (P – V) or FC ÷ CM

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Breakeven Analysis—Example
Q: What is the breakeven sales level in units and dollars for a
company that can make a unit of product for $7 in variable costs
and sell it for $10, if the firm has fixed costs of $1,800 per
Example

month?

A: The breakeven point in units is $1,800 ÷ ($10 - $7) = 600 units.


The breakeven point in dollars is $10 per unit times 600 units, or
$6,000, which could also be calculated as $1,800 ÷ 0.30. Thus,
the firm must sell 600 units per month to cover fixed costs.

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The Effect of Operating
Leverage
 As volume moves away from breakeven, profit or loss
increases faster with more operating leverage
 The Risk Effect
 More operating leverage leads to larger variations in EBIT, or
business risk
 The Effect on Expected EBIT
 Thus, when a firm is operating above breakeven, more
operating leverage implies higher operating profit
• If a firm is relatively sure of its operating level, it is in the firm’s best
interests to trade variable costs for fixed cost (assuming the firm is
operating above breakeven)

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Figure 13.6: Breakeven Diagram at
High and Low Operating Leverage

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The Effect of Operating
Leverage—Example
Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10,
and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs of
$1,500 and also sells its product for $10 a unit. Both firms are at the same
breakeven point. What variable cost must Firm B have if it is to achieve the
same breakeven point as Firm A? State the trade-off at the breakeven point.
Which structure is preferred if there’s a choice?
Example

A: Both firms have a breakeven point of 500 units (Firm A: $1,000 ÷ $2). We need
to solve the breakeven formula for Firm B’s variable costs per unit:

QB/E FirmB = FC ÷ (P – VB) Thus, at breakeven, a $1


differential in contribution
500 units = $1,500 ÷ ($10 – VB) makes up for a $500
VB = $7 difference in fixed cost.

The preferred structure depends on volatility—if sales are expected to be highly


volatile, the lower fixed cost structure might be better in the long run.

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The Degree of Operating Leverage
(DOL)—A Measurement
 Operating leverage amplifies changes in
sales volume into larger changes in EBIT
 DOL relates relative changes in volume
(Q) to relative changes in EBIT
% ∆ EBIT Q(P - V)
DOL = or
%∆Q Q(P - V) - FC

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The Degree of Operating Leverage
(DOL)—A Measurement
Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs
are $7 per unit and fixed costs are $600 per month. Evaluate the degree of
operating leverage when sales are 5% and then 50% above the breakeven level.

A: First, compute the breakeven volume: $600 ÷ ($10 - $7) = 200 units.
Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200
x 1.50 or 300 units. DOL at 210 units is:
Example

210($10 - $7)
DOLQ=210 = = 21
210($10 - $7) - $600
DOL at 300 units is:

Note that DOL decreases


300($10 - $7) as the output level
DOLQ=300 = =3
300($10 - $7) - $600 increases above
breakeven.

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Comparing Operating and
Financial Leverage
 Financial and operating leverage are similar in that both can
enhance results while increasing variation
 Financial leverage involves substituting debt for equity in the firm’s
capital structure
 Operating leverage involves substituting fixed costs for variable
costs in the firm’s cost structure
 Both methods involve substituting fixed cash outflows for variable
cash outflows
 Both kinds of leverage make their respective risks larger as the
levels of leverage increase
 However, financial risk is non-existent if debt is not present, while
business risk would still exist even if no operating leverage existed
 Financial leverage is more controllable than operating leverage

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The Compounding Effect of
Operating and Financial Leverage
 The effects of financial and operating leverage
compound one another
 Changes in sales are amplified by operating leverage
into larger relative changes in EBIT
 Which in turn are amplified into still larger relative changes in
ROE and EPS by financial leverage
• The effect is multiplicative, not additive
 Thus, fairly modest changes in sales can lead to dramatic
changes in ROE and EPS
 The combined effect can be measured using degree of
total leverage (DTL)
 DTL = DOL × DFL

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Figure 13.9: The Compounding Effect of
Operating Leverage and Financial Leverage

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The Compounding Effect of Operating
and Financial Leverage—Example
Q: The Allegheny Company is considering replacing a manual production process
with a machine. The money to buy the machine will be borrowed. The
replacement of people with a machine will alter the firm’s cost structure in favor
of fixed costs, while the loan will move the capital structure in the direction of
more debt. The firm’s leverage positions at expected output levels with and
without the project are summarized as follows:
DOL DFL
Example

Current 2.0 1.5


Proposed 3.5 2.5
The economic outlook is uncertain and some managers fear a decline in sales of
as much as 10% in the coming year. Evaluate the effect of the proposed project
on risk in financial performance.

A: The firm’s current DTL is 2 x 1.5, or 3, meaning a 10% decline in sales could
result in a 30% decline in EPS. Under the proposal, the DTL will be much
higher: 8.75, or 3.5 x 2.5, meaning a 10% drop in sales could lead to a 87.5%
drop in EPS.

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Capital Structure Theory

 Does capital structure affect stock price


and the market value of the firm?
 If so, is there an optimal structure that
maximizes either or both?
 Results indicate that capital structure
does impact stock prices but there’s no
way to determine the optimal structure
with any precision

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Background—The Value of the
Firm
 Notation
 Vd = market value of the firm’s debt
 Ve = market value of the firm’s stock or equity
 Vf = market value of the firm in total
• Vf = V d + V e
 Investors’ returns on the firm’s securities will be
 Kd = return on an investment in debt
 Ke = return on an investment in equity
 Theory begins by assuming a world without taxes or
transaction costs, so investors’ returns are exactly
component capital costs
 Ka = average cost of capital

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Background—The Value of the
Firm
 Value is Based on Cash Flow Which Comes
from Income
 Earnings ultimately determine value because all cash
flows paid to investors come from earnings
 Dividends and interest payments are both
perpetuities
• The firm’s market value is the sum of their present values
annual interest paid to bondholders total annual dividend paid to stockholders
Vf = +
kd ke
which is equivalent to saying
Returns drive value Operating Income
Vf =
in an inverse ka
relationship.

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Figure 13.10: Variation in Value and
Average Return with Capital Structure

The value of the firm


and the firm’s stock
price reach a
maximum when the
average cost of capital
is minimized.

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The Early Theory by Modigliani
and Miller (MM)
 Restrictive Assumptions in the Original
Model
 In 1958 MM published their first paper on
capital structure
• Included numerous restrictions such as
• No income taxes
• Securities trade in perfectly efficient capital markets with
no transaction costs
• No costs to bankruptcy
• Investors and companies can borrow as much as they
want at the same rate

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The Early Theory by Modigliani
and Miller (MM)
 The Assumptions and Reality
 Realistically income taxes exist
 Realistically the costs of bankruptcy are quite
large
 Realistically individuals cannot borrow at the
same rate as companies and interest rates
usually rise as more money is borrowed

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The Early Theory by Modigliani
and Miller (MM)
 The Result
 Under MM’s initial set of restrictions, value is
independent of capital structure
 As cheaper debt is added the cost of equity
increases because of increased risk
• However the weight of the more expensive equity
is decreasing while the weight of the cheaper debt
is increasing, leading to a constant weighted
average cost of capital

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Figure 13.11: The
Independence Hypothesis

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The Early Theory by Modigliani
and Miller (MM)
 The Arbitrage Concept
 Arbitrage means making a profit by buying and selling the same
thing at the same time in two different markets
 MM proposed that arbitrage by equity investors would hold the
value of the firm constant as debt levels changed
• Equity investors could sell shares in a leveraged firm and buy
shares in an unleveraged firm by borrowing money on their own
 Interpreting the Result
 The MM result implies that leverage affects value because of
market imperfections
• Such as taxes and transaction costs (including bankruptcy)

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Relaxing the Assumptions—
More Insights
 Financing and the U.S. Tax System
 Tax system favors debt financing over equity
financing
• Interest expense on debt is tax deductible while
dividends on stock are not

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Table 13.4

The All Equity firm


pays more taxes
because it receives
no interest expense
deduction.

Total payments to
investors are higher
for the leveraged
company.

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Relaxing the Assumptions—
More Insights
 Including Corporate Taxes in the MM
Theory
 When taxes exist operating income (OI) must
be split between investors and the
government
• This lowers the firm’s value compared to what it
would be if no taxes existed
• Amount of reduction depends on the firm’s use of
leverage
• Use of debt reduces taxable income which reduces
taxes

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Including Corporate Taxes in
the MM Theory
 In the MM model with taxes interest provides a
tax shield that reduces government’s share of
the firm’s earnings
 When a firm uses debt financing the government’s
take is reduced by (corporate tax rate × interest
expense) every year
• Present value of tax shield = (corporate tax rate × interest
expense) ÷ kd
• Since interest is the amount of debt (B) times the interest
rate on the debt, the above equation can be written as
corporate tax rate x B x kd
PV of tax shield = = TB
kd

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Including Corporate Taxes in
the MM Theory
 Having debt in the capital structure
increases a firm’s value by the magnitude
of that debt times the tax rate
 The benefit of debt accrues entirely to
stockholders because bond returns are
fixed

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Figure 13.12: MM Theory with
Taxes
In the MM model with taxes
value increases steadily as
leverage is added. Thus, the
firm’s value is maximized with
100% debt. Note that kd remains
constant across all levels of
debt.

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Including Bankruptcy Costs in
the MM Theory
 As leverage increases past a certain point,
investors begin raising their required rates of
return
 The probability of bankruptcy failure increases
 Eventually the weighted average cost of capital
will be minimized and the firm value will be
maximized
 The MM model with taxes and bankruptcy costs
concludes that an optimal capital structure exists

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Figure 13.13: MM Theory with
Taxes and Bankruptcy Costs

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An Insight into Mergers and
Acquisitions
 In many mergers one company buys the
stock of another company called the
target
 The buying company needs to buy shares
of the target company at a premium over
the current market price
 Paying twice the current market value for a
target firm is not unheard of
 Why do companies do this?

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An Insight into Mergers and
Acquisitions
 One argument is that target firms may be
underutilizing their debt capacity
 Thus, a restructuring of capital may raise the value of
the target firm
 Acquiring firms often raise the cash needed to
buy the target firm’s shares with debt
 The resulting merged business ends up with more
debt than the individual firms had before the merger
• May theoretically be justified if adding debt adds value

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