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Chapter 12:Capital Structure

Theory and Taxes

Corporate Finance, 3eGraham, Smart, and Megginson

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The term capital structure refers to the mix of debt and equity securities that a firm uses to finance its activities.

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Capital Structure

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The fundamental principle of financial leverage: Substituting debt for equity

increases expected returns to shareholders—measured by earnings per share or ROE—but also increases the risk of those returns.

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Financial Leverage

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When firms borrow money, we say that they use financial leverage. A firm with debt on its balance sheet is a

levered firm. A firm that finances its operations entirely

with equity is an unlevered firm.

Can be either positive or negative, depending on the returns a firm earns on the money it borrows.

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Financial Leverage

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The Modigliani & Miller Propositions

Modigliani and Miller (M&M) argument: Capital structure decisions do not affect firm value.Managers who operate in imperfect

markets can see more clearly how market imperfections might lead them to choose one capital structure over another.

M&M’s argument rests on the principle of no arbitrage.

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The M&M Capital Structure ModelFirst model to show that capital structure

decision may be irrelevant Assumes perfect markets, no taxes or

transactions costs

Key insight

Firm value is determined by:

Cash flows generated

Underlying business risk

Capital structure merely determines how cash flows and risks are allocated between bondholders and stockholders.

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Assumptions of the M&M Capital Structure Model

Capital markets are perfect – neither firms nor investors pay taxes or transactions costs.

Investors can borrow and lend at the same rate that corporations can.

There are no information asymmetries.

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In perfect markets, a firm’s total market value equals the value of its assets and is independent of the firm’s capital structure.

The value of the assets equals the present value of the cash flows generated by the assets.

Proposition leads to the conclusion that a firm’s capital structure does not matter – popularly known as the “irrelevance proposition”

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M&M Proposition I

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M&M Proposition I

Use arbitrage arguments to prove Proposition I.

Proposition I: Market value of a firm is driven by two factors: cash flow and risk (determines the discount rate).

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Proposition II and the WACCThough debt is less costly for firms

to issue than equity, issuing debt causes the required return on the remaining equity to rise.

Based on the core finance principle that investors expect compensation for risk, shareholders of levered firms demand higher returns than do shareholders in all-equity companies.

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Proposition II and the WACCProposition II says that the expected

return on a levered firm’s equity (rl) rises with the debt-to-equity ratio:

Proposition II rearranged is the WACC:

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The M&M Model with Corporate TaxesFirms can treat interest payments to

lenders as a tax-deductible business expense.

Dividend payments to shareholders receive no similar tax advantage.

Intuitively, this should lead to a tax advantage for debt, meaning that managers can increase firm value by issuing debt.

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The M&M Model with Corporate and Personal Taxes

Miller: Debt’s tax advantage over equity at the corporate level might be partially or fully offset by a tax disadvantage at the individual level.

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Bond Market Equilibrium with Corporate and Personal Taxes

Wouldn’t taxable investors also demand a higher interest rate to compensate them for taxes due?

Yes, but Miller explains that interest rates do not rise immediately for two reasons: 1. Some investors, such as endowments and

pension funds, do not have to pay taxes on interest income.

2. Investors who do not enjoy this tax-exempt status can buy municipal bonds, which pay interest that is tax free.

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Nondebt Tax Shields (NDTS)

Companies with large amounts of depreciation, investment tax credits, R&D expenditures, and other nondebt tax shields should employ less debt financing than otherwise equivalent companies with fewer such shields.

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How Taxes Should Affect Capital Structure

1. The higher the corporate income tax rate, Tc, the higher will be the equilibrium leverage level economy-wide. An increase in Tc should cause debt ratios to increase for most firms.

2. The higher the personal tax rate on equity-related investment income (dividends and capital gains), Tps, the higher will be the equilibrium leverage level. An increase in Tps should cause debt ratios to increase.

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How Taxes Should Affect Capital Structure

3. The higher the personal tax rate on interest income, Tpd, the lower will be the equilibrium leverage level. An increase in Tpd should cause debt ratios to fall.

4. The more nondebt tax shields a company has, the lower will be the equilibrium leverage level.

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