Fin5203 Module 8 Fl22

Financial Management
Module 8
Capital Structure
Professor Jian Cai

Capital Structure
Part (I): Cost of Capital
Part (II): Perfect Markets
Part (III): Taxes and Bankruptcy
2 FIN 5203 / Jian Cai / Fall 2022

Capital Structure (I):
Cost of Capital

Outline
 WACC without taxes
 WACC with taxes
 Business vs. financial risk
 Divisional/Project WACC

Cost of Capital: Introduction
 We value projects and companies by forecasting and

discounting Free Cash Flows:
 Future Free Cash Flows matter!
 Continuation Value has big impact, too.
 The choice of discount rate (denominator) reflects the

riskiness of FCF (numerator).
 The choice of discount rate is also known as the choice

of cost of capital.

Firm’s Cost of Capital (I)
 Each firm has a cost of capital.
 The cost of capital is determined by the riskiness of a

firm’s FCFs/investments.
 Whenever a firm engages in riskier projects, its cost of

capital will increase.
 A riskier firm’s stock has a higher expected return.
 A riskier firm must pay a higher interest rate on debt such
as bonds (coupon vs. yield?).

Firm’s Cost of Capital (II)
 In our analysis we often assume that the firm’s capital

structure (debt/equity ratio) is constant.
 A firm’s cost of capital reflects the required return on

the entire firm’s assets, which sum up to its total
capital (debt + equity).
 Thus, the cost of capital reflects:

 The cost of debt
 The cost of equity
 The relative weights of debt and equity

WACC without Taxes
 Weighted Average Cost of Capital (WACC):

The cost of capital of a firm with equity and debt in the
capital structure is the weighted average:
D E
WACC = RD + RE
V V
 Value of the firm = Debt + Equity
 D and E are market values of Debt and Equity.
 This does NOT include the effect of taxes.

WACC with Taxes
 Interest paid on debt is tax deductible in the U.S.

 Thus, the effective cost of debt is reduced.
E D D
WACC = RE + RD − RDτ C
V V V
E D
= RE + RD (1 − τ C )
V V
 τC is the corporate tax rate.

WACC with Preferred Stock
 The WACC for a firm with common equity, preferred

equity, and debt is:
E D P
WACC= RE + RD (1 − τ C ) + RP
V V V
 Firm value: V = E + D + P
 Firms can have more types of debt and equity.
 The formula above can be modified to include
additional terms, provided all weights sum to 1.

Cost of Debt: RD
 Cost of debt: Return lenders require on risky debt

 If the company has existing bonds outstanding, the
yield to maturity (not the coupon rate) on the bonds is
the cost of debt.
 If the firm has bank debt, the rate charged by the
bank is the cost of debt.
 Comparable firms: Different debt ratings have different

costs of debt.

Corporate Bond Ratings
Moody’s S&P Quality of Issue
Aaa AAA Highest quality. Very small risk of default.
Aa AA High quality. Small risk of default.
A A High-Medium quality. Strong attributes, but potentially

vulnerable.
Baa BBB Medium quality. Currently adequate, but potentially
unreliable.
Ba BB Some speculative element. Long-run prospects
questionable.
B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default.
Ca CC High speculative quality. May be in default.
C C Lowest rated. Poor prospects of repayment.
D - In default.

Cost of Preferred Stock: RP
 Preferred stock pays a fixed dividend.
 The cost of preferred stock is the dividend yield on the

preferred stock:
D
RP =
P

Cost of Equity: RE
 Cost of equity: Return shareholders require on their

investment in equity
 Estimation methods:
DIV1
 Dividend Growth Model P0 =
RE − g
 CAPM E [RE ] = RF + β (E [RM ] − RF )
 Comparable firm’s cost of equity if the firm whose WACC
we are estimating is not public

The Weights in WACC
 Use weights based on market value or if publicly known,

you can use target capital structure weights.
 For equity, market value is the number of shares

outstanding times the price per share.
 For debt, market value is the present value of the

coupon and principal payments discounted at the
current cost of debt (not the coupon rate).
 Most people just use the book value of debt (if the market
value is not available or hard to obtain).

In-class Exercise (I): WACC with Taxes
 Tattoo Charlie’s Inc. has 2 million shares outstanding.

The stock sells for $10 per share. The firm has $5
million par value of debt outstanding (priced to yield
11%) which is publicly traded and is recently quoted at
93% of par. The risk free rate is 5%, and the market
risk premium is 6%. Tattoo Charlie’s has an equity beta
of 1.35. If the corporate tax rate is 34%, what is the
WACC of Tattoo Charlie’s?

Solution to In-class Exercise (I):
WACC with Taxes
 MV of Equity = $10 × 2 million = $20 million

 MV of Debt = $5 million × 93% = $4.65 million
 V = D + E = $4.65 + $20 = $24.65 million
 RE = RF + β × (RM – RF) = 5% + 1.35 × 6% = 13.1%
 RD = 11%
 WACC = (20/24.65) × 13.1%
+ (4.65/24.65) × 11% × (1 – 34%)
= 11.9983% ≈ 12%

More on Cost of Equity:
Re-arranging WACC
 Re-arranging WACC (without tax):

D E
WACC = RAssets = RDebt + REquity
D+E D+E
 To get the cost of equity
D
REquity = RAssets + (RAssets − RDebt )
E
Expected Expected Debt to Expected Expected
return on = return on + equity × return on – return on
equity assets ratio assets debt

Business vs. Financial Risk
 Hence, there are two sources of systematic risk in the

firm’s cost of equity, RE:
1. The business risk of the firm’s equity =

Nature of the firm’s operating activities:
RAssets (or RFirm)
2. The financial risk of the firm’s equity =

Firm’s financial policy or capital structure:
(D/E) × (RAssets – RD)

Equity and Asset Betas (I)
 Similarly, βAsset measures business risk, the inherent or

fundamental risk of a business relative to the S&P 500.
 βE includes both business and financial risk, where

financial risk is the risk created by having “Other
People’s Money” (i.e., debt) in the firm’s capital
structure.

Equity and Asset Betas (II)
 An asset beta is the beta of the asset returns of the

firm, reflecting only the business risk of the firm’s
assets (a.k.a. “unlevered” beta).
 An equity beta is the beta of the firm’s stock returns,
reflecting business and financial risk of the firm’s
equity (a.k.a. “levered” beta).
 Without taxes, we have:
D  E 
β Assets =  × β Debt  +  × β Equity 
V  V 

Equity and Asset Betas (III)
 So without taxes, a “levered” equity beta βE is

D+E D D
βE = β Asset − β D = β Asset + (β Asset − β D )
E E E
 Since equity beta reflects both the business and financial
risk of the firm’s equity, if a firm changes its capital
structure, the risk associated with its equity changes.
 In this case, we have to first solve the asset beta (or
unlevered beta) implied by the original capital structure,
then use asset beta to find the new “levered” equity beta.
 This is the “unlever/relever” or “pure play” approach.

In-Class Exercise (II): Leverage without Taxes
 The capital structure of Leverage, Inc., is comprised of

20% equity and 80% debt. Given this capital structure,
Leverage’s common stock has a beta of 1.8 and its debt
has a beta of 0.6. Leverage doesn’t pay any taxes.
 Now Leverage changes its debt-equity mix to 50% equity

and 50% debt. Assume its debt beta falls to 0.3 after
the change.
1. What is the firm’s equity beta after the change?

2. If the firm reduces its debt to zero, what will the equity
beta be after this change?

Solution to In-Class Exercise (II):
Leverage without Taxes
1. Calculate βAssets first:

 βAssets = (D/V) × βDebt + (E/V) × βEquity
 βAssets = 0.80 × 0.6 + 0.20 × 1.8 = 0.84
 βAssets stays same after capital structure change.
Calculate βEquity:
 βEquity = βAssets + (D/E) × (βAssets – βDebt)
 βEquity = 0.84 + (0.5/0.5) × (0.84 – 0.3) = 1.38

Solution to In-Class Exercise (II):
Leverage without Taxes
2. Zero debt. Firm issues new equity to retire debt.

 βEquity = 0.84 + (0/1) × (0.84 – 0.3) = 0.84

Project Cost of Capital
 A project’s cost of capital is the same as the expected

return on an asset of comparable risk.
 If the project has the same risk as the firm, use the
firm’s cost of capital.
 Example: HP is developing a new printer
 If the project has different risk than the firm, you must
find an asset of comparable risk.
 Example: Barns & Nobel (BKS) develops food products

Division Cost of Capital
 WACC is a combination (i.e., weighted average) of its

divisional costs of capital.
 If you use the firm’s WACC to evaluate all projects

across divisions, then the riskier division will receive
most of the funds. Why?
 You are ignoring the specific riskiness of the cash flows

you are valuing in each division.

Private Firm’s Cost of Capital
 For a firm that is not publicly traded, we cannot use the

dividend growth model or the CAPM to calculate the
cost of equity.
 Use a firm of similar risk to determine the cost of equity.
 Use the rate the bank charges the firm for its cost of
debt, or use a comparable firm’s cost of debt.
 Use the private firm’s capital structure.

Key Points
 The cost of capital used to discount a project’s,

division’s, or company’s future cash flows should reflect
the riskiness of those cash flows commensurately.
 The cost of capital is based on a weighted average of

the types of capital the firm issued (e.g., debt, preferred
stock, and common equity).

Capital Structure (II):
Perfect Markets

Outline
 Optimal capital structure
 Modigliani and Miller Proposition I & II

in a world with perfect markets

Optimal Capital Structure
 What is the optimal capital structure for a firm?

 The choice/mix of debt and equity which maximizes
overall firm value
 How can a firm find optimal capital structure?

 Look at trade-off between costs and benefits of debt
 Benefits of debt?
 Costs of debt?

Do Firms Care about Capital Structure?
“Capital Structure is a … part of a much larger, value

creating equation. At Sears, as in most companies,
creating shareholder value is the main governing
objective…. There is considerable effort aimed at
achieving the lowest long-term cost of capital by
managing the capital structure…. That leads to a
discussion in which we determine our … target capital
structure…. I can tell you we have dug seriously into
the capital structure question.”
- Alice Peterson, Vice-President and
Treasurer of Sears

How does Capital Structure Affect Firm Value?
 The value of any company is the sum of the firm’s future

free cash flows discounted at the firm’s cost of capital.
 Does capital structure impact FCF (free cash flow)?

 Interest expense is not part of FCF.
 Distributions to shareholders are not part of FCF.
 FCF is based on investments in operations.
 Investment and financing decisions are separate corporate decisions,
but both have an impact on firm value.
 Does capital structure impact WACC (cost of capital)?

 The cost of capital is the return investors require on their investment
in the company.
 Do investors require a greater return from more levered companies?

M&M’s Capital Structure Theory
Is there an Optimal Capital Structure?
 Point of departure: Perfect Markets (Modigliani & Miller)

 Assume no market imperfections. That is,
 No corporate/personal taxes
 No bankruptcy/default risk
 No agency/incentive problems
 No asymmetric information problems
 Once we understand the perfect markets, we will relax
each of these assumptions and determine how things
change.

Capital Structure and Cost of Capital
 Recall: In this perfect world, the cost of capital is the

weighted average of the cost of equity and the cost of
debt (or any other securities).
D E
WACC = RD + RE
V V
 E=MV of Equity D=MV of Debt
 V=Total MV of the Firm = E + D
 Most people use the BV of debt as a proxy for the MV
of debt because the MV of debt is not readily
available.
Modigliani and Miller Proposition I:
Irrelevance of Capital Structure
 In this perfect world, does capital structure affect value?

 That is, does it alter a firm’s WACC?
 Franco Modigliani and Merton Miller won the Nobel Prize

in Economics in part for their answer to this question.
 No, it doesn’t in a world with perfect markets. Why?
 Assume I am holding $10 for you. If I put $5 in my
left pocket and $5 in my right pocket, do you care?
Does it change the value of your $10?
 Homemade Leverage: Investors can borrow on their
own and invest in an unlevered firm or invest in a
levered firm.

Modigliani and Miller Proposition I: Intuition
 Basic idea/intuition: “The size of a pizza doesn’t

change no matter how you divvy up the pie.”
40% Debt 60% Equity 60% Debt 40% Equity

Capital Structure and Cost of Capital
 Why does value remain constant in this perfect world?

 If the cost of equity is greater than the cost of debt, and
you add more debt, shouldn’t the WACC decrease?
 No. Because the cost of equity increases precisely by
the offsetting amount with more debt in the capital
structure.
D
RE = RAssets + (RAssets − RD )
E
 But WACC as a whole is left unaffected.
D E
WACC = RD + RE
V V
Types of Risk
 Recall from Part (I): The cost of equity depends on the
firm’s systematic risk.
 There are 2 sources of systematic risk.
 The business risk of the firm’s equity: RAsset or βAsset
 The financial risk of the firm’s equity:
(D/E)×(RAssets–RD) or (D/E)×(βAsset–βD)
D D
RE = RAsset + ( RAsset − RD ) or β E = β Asset + ( β Asset − β D )
E E
 The cost of capital, WACC, also depends on the firm’s
systematic risk.
D E D E
WACC = RD + RE β Asset = β D + β E
V V V V
Modigliani and Miller Proposition II:
Cost of Equity and Financial Leverage
D
RE = RAsset + ( RAsset − RD )
E
RE
Cost of Capital (%)
RAssets
RD
D
E
In-Class Exercise (III):
Changing Leverage Ratio in Tax-Free World
 In this perfect world, Leverage Inc. has a debt to equity ratio

of 0.4, an equity beta of 1.1, a 12.8% cost of equity, and its
debt yields 4%. Suppose the risk-free rate is 4% and the
market risk premium is 8%. Suppose the firm repurchases
stock and finances the repurchase with debt so that its debt
to equity ratio changes to 0.6.
 What is the firm’s new (levered) equity beta?
 What is the firm’s new cost of equity?
 What is the old/new WACC?
 What is the change in the required equity return
because of the firm’s business risk?
 What is the change in the required equity return
because of the firm’s financial risk?

Solution to In-Class Exercise (III):
 To begin, notice that βD=0 since RD=Rf.

 So, we can calculate the asset beta using:
βE = βA + D/E (βA – βD) (EB)
 βE = (1 + D/E) βA b/c βD=0
 βA = βE / (1 + D/E) Rearranging
βA = 1.1/(1 + 0.4) = 0.7857
 βA is unaffected by capital structure change.
 Using the (EB) expression once again:
βE = βA + D/E (βA – 0)
βE = 0.7857 + 0.6 (0.7857) = 1.2571

 New cost of equity based on CAPM:

RE = Rf + βE (E[Rm] – Rf)
RE = 4%+ 1.2571 (8%) = 14.06%
 Changes in capital structure weights:
Old: 1 + D/E = 1.4 ⇒ E/V = 71.43%
New: 1 + D/E = 1.6 ⇒ E/V = 62.50%
 Because τC=0, we have WACC = RA:
Old: 71.43% (12.80%) + 28.57% (4%)
New: 62.5% (14.06%) + 37.5% (4%)
WACC is equal to 10.29% in both cases.

 In general, we know that:

∆RE = ∆Business Risk + ∆Financial Risk
 In case of Leverage Inc., we’ve got:
∆Business Risk = 0
∆Financial Risk = ∆RE
 The business risk of Leverage Inc. doesn’t change with
D/E – this is an M&M assumption.
 Thus: ∆Financial Risk = 14.06% – 12.8% = 1.26%
 The change in required equity return is solely
attributable to financial risk.

In-Class Exercise (III):
Summary of the Solution
 Old equity beta is given βE=1.1.

 Find debt beta: βD (by CAPM if not given).
 Find asset beta: βA (by unlevering βE).
 New equity beta: βE (by relevering βA).
 Find new cost of equity RE (by new βE & CAPM).
 The reciprocal of 1+D/E is equal to E/V.
 The other weight D/V is equal to 1–E/V.
 Calculate WACC using previous results.
 Change in RE is due to financial risk.

Key Points
 In the “perfect” world of Modigliani and Miller with no

market frictions, firm value is invariant to capital
structure. This is what we call the Capital Structure
Irrelevance Theorem.
 Cost of equity increases as leverage (i.e., debt
in firm’s capital structure) increases.
 WACC remains unchanged in this perfect world when
leverage increases absent any frictions.
 Frictions (e.g., taxes) will be introduced next.

Capital Structure (III):
Taxes and Bankruptcy

Outline
 WACC with taxes and bankruptcy cost
 Incorporating changes in leverage
 Value of levered firm: V(L)

 Value of unlevered firm: V(U)
 Value of tax benefits, bankruptcy costs, etc.

M&M with Market Imperfections
 In a perfect world, capital structure influences financial

risk and, thus, the cost of equity.
 But it doesn’t change the cost of capital (WACC) and
levered firm value equals unlevered firm value:
V(L) = V(U)
which is the result of Modigliani & Miller (M&M).
 But the real world is far from perfect…

 Violation of Value Invariance Principle:
V(L) ≠ V(U)
Thus, firm value depends on firm leverage!

Five Market Imperfections
 Taxes: Corporate (1) and Personal (3)
 Interest on debt is tax deductible for corporations.
 Shareholders and bondholders have different personal tax rates.
 Bankruptcy/Default Risk (2)

 Debt increases the probability of financial distress.
 Possible loss of firm value in the “near” future due to restructuring.
 Agency Problems (4)

 Debt alters shareholder incentives: bondholder-shareholder conflicts.
 Debt alters managers incentives: manager-shareholder conflicts.
 Asymmetric Information (5)

 Investors don’t observe the true quality of the firm.
 Debt issuance decision conveys information and hence signals value.

Market Imperfection 1:
Corporate Taxes
 Modifying M&M: Corporate Taxes

 Go back to the money in my right and left pocket.
 Let’s pretend that my right pocket is a magic pocket and
will turn 1 dollar into 1 dollar and 25 cents.
 Now, if I am holding your $10, do you care if I hold it in my
right or left pocket?
 Debt is like the right pocket and the “magic” is taxes.
 Interest is tax deductible. Dividends are not.
 So, a firm can keep money from the government by having
more debt rather than equity.

M&M with Corporate Taxes
 M&M recognize the impact of corporate taxes and show:

E D
WACC = RE ( L ) + RD (1 − τ C )
V V
D
=RE ( L ) R (U ) + ( R (U ) − RD ) (1 − τ C )
E
 R(U) is the cost of capital for the Unlevered Firm.
 R(L) is the cost of capital for the Levered Firm.
Permanent
 What does this imply for firm value? debt in $
assumed
M&M with Corporate Taxes
 As a result firm value is increasing in the amount of debt:
( L ) V (U ) + τ C D
V=
 V(U) is the value of the Unlevered Firm.
 V(L) is the value of the Levered Firm.
 D is the value of debt and τC is corporate tax rate.
 This implies that firms should have 100% debt to
maximize the value of the tax shield. However, other
costs and benefits of debt should be considered…

Corporate Taxes and Cost of Capital (WACC)
 WACC with corporate taxes only accounts for one benefit

and none of the cost of debt.
 We often use this equation in our analysis:
E D
WACC = RE ( L ) + RD (1 − τ C )
V V
 But now: WACC ≠ R(U)
 It is crucial to recognize other costs and benefits to debt

⇒ Firm will in fact not have 100% debt.

Corporate Taxes and Cost of Equity (RE)
 Corporate taxes reduce firm’s financial risk:

D
RE = R (U ) + ( R (U ) − RD ) (1 − τ C )
E
Note that R(U) is the same as RA !
 Similarly, we can restate the relationship between beta

and leverage incorporating taxes:
D Permanent
β E = β A + ( β A − β D )(1 − τ C ) debt in $
E assumed

Changing the Capital Structure
 Using WACC with Taxes to value the firm requires that

the firm does not change its capital structure.
 If the firm’s leverage changes, however, then the WACC

with Taxes inevitably changes, too!
 Again, you must unlever and relever the firm’s beta
each time the leverage changes.
 You must also change the weights in your WACC
formula each time the leverage changes.

In-Class Exercise (IV):
Changing Leverage Ratio in “Tax World”
 Assume that in an imperfect world with corporate taxes, Leverage

Inc. has a debt to equity ratio of 0.4, an equity beta of 1.4, and a
15.2% cost of equity. The risk-free rate is 4%, the market risk
premium is 8%, the cost of debt is 4%, and the corporate tax rate
equals 34%. Suppose the firm repurchases stock and finances the
repurchase with debt so that its debt to equity ratio changes to 0.6.
 What is the old/new WACC?
 What’s the change in return required due to the firm’s business risk?
 What is the change in return required due of the firm’s financial risk?

Overview of One Solution
 Old equity beta is given: βE=1.4.

 Find debt beta: βD (by CAPM if not given).
 Find asset beta: βA (by unlevering βE).
 New equity beta: βE (by relevering βA).
 Find new cost of equity RE (by βE & CAPM).

Solution to In-Class Exercise (IV):
 First,RD=Rf=4% implies that βD=0.

 So, we can calculate the asset beta using:
βE = βA + D/E (βA – βD)(1 – τC) (EB)
 βE = [1 + D/E (1 – τC)] βA
 βA = βE / [1 + D/E (1 – τC)]
βA = 1.4 / [1 + 0.4 (1 – 0.34)] = 1.1076
 M&M: βA invariant to changes in leverage.
 Using the (EB) expression once again:
βE = βA + D/E (βA – 0)(1 – τC)
βE = 1.1076 + 0.6 (1.1076)(0.66) = 1.5462


RE = 4% + 1.5462 (8%) = 16.37%
 Changes in capital structure weights:
Old: 1 + D/E = 1.4 ⇒ E/V = 71.43%
New: 1 + D/E = 1.6 ⇒ E/V = 62.50%
 Because τC > 0, WACC ≠ R(U). WACCs are:
Old: 71.43%(15.20%) + 28.57%(4%)(.66) = 11.61%
New: 62.50%(16.37%) + 37.50%(4%)(.66) = 11.22%
R(U) = Rf + βA (E[Rm] – Rf) = 12.86% ≠ WACC

 In general, we know that:

∆RE = ∆Business Risk + ∆Financial Risk
 In case of Leverage Inc., we’ve got:
∆Business Risk = 0
∆Financial Risk = ∆RE
 The business risk of Leverage Inc. doesn’t change with
D/E – this is an M&M assumption.
 Thus: ∆Financial Risk = 16.37% – 15.2% = 1.17%.
 The change in required equity return is solely
attributable to financial risk.

Overview of An Alternative Solution
 Find R(U) immediately by unlevering R(L).

 This is the old equity return: RE = R(L). Use R
instead of β
 Find new cost of equity by relevering R(U).


Alternative Solution to In-Class Exercise (IV):
begin, find R(U) given D/E=40%:

 To
R(L) = R(U) + D/E [R(U) – RD](1–τC)
 R(L) = R(U)[1+D/E (1–τC)] – D/E (1–τC)RD
 R(U) = [R(L)+D/E(1–τC)RD]/[1+D/E(1–τC)]
 Subbing in the numbers yields:
R(U) = [.152+0.4(1–0.34)(.04)]/[1+0.4(1–0.34)]
R(U) = 12.86% (matches CAPM result!)
 Use the first equation again to get R(L)=RE:
R(L) = 0.1286 + 0.6(0.1286–0.04)(1–0.34) = 16.37%

Conclusions of M&M with Corporate Taxes
 Keep other assumptions of a perfect M&M world, by

adding corporate taxes, the value of the firm increases
as the amount of debt in the capital structure increases.
 All-debt would be optimal capital structure.
 Cost of equity increases as leverage increases.
 WACC will decrease as debt in the capital structure

increases.

In-Class Exercise (V):
Risky Debt in “Tax World”
 Assume that in an imperfect world with corporate taxes, Leverage

Inc. has a debt/equity ratio of 0.4, an equity beta of 1.4, and a
15.2% cost of equity. The risk free rate is 4%, the market risk
premium is 8%, the debt beta is 0.2, and the corporate tax rate
equals 34%. Suppose the firm repurchases stock and finances
the repurchase with debt so that its debt to equity ratio changes
to 0.6 and debt beta increases by 0.1 to 0.3.
 What is the firm’s current cost of debt?
 What is the firm’s asset (unlevered) beta?
 What is the firm’s new cost of debt?

Solution to In-Class Exercise (V):
we need to find RD using the CAPM:

 First,
RD = Rf + βD (E[Rm] – Rf)
As βD=0.2, RD = 4% + (0.2)(8%) = 5.6%
 Now, we can calculate the asset beta using:
βE = βA + D/E (βA – βD)(1 – τC) (EB)
 Subbing in numbers directly to speed up things:
βE = βA + (0.4)(βA – 0.2)(1 – 34%)
 βE = βA [1+(0.4)(0.66)] – (0.4)(0.2)(0.66)
 βA = (1.4 + 0.0528) / 1.264 = 1.1494
 M&M: βA invariant to changes in leverage

Solution to In-Class Exercise (V):
 Use (EB) with new D/E ratio and new debt beta:
βE = βA + D/E (βA – βD)(1 – τC)
βE = 1.1494 + (0.6)(1.1494 – 0.3)(0.66)
βE = 1.4858
RE = 4% + (1.4858)(8%) = 15.89%
 New cost of debt based on CAPM:
RD = Rf + βD (E[Rm] – Rf)
RD = 4% + (0.3)(8%) = 6.4%

Market Imperfection 2:
Bankruptcy Costs (Default Risk)
 How does bankruptcy costs affect WACC?

 The cost of debt increases with increases in leverage due
to bankruptcy costs.
 The WACC increases with increases in leverage due to
bankruptcy costs (ignoring other imperfections).
 Combining bankruptcy costs with corporate taxes leads to
an optimal leverage ratio.
 WACC decreases as long as the benefits of the corporate
tax shield outweigh the costs of bankruptcy.
 WACC increases when the costs of bankruptcy outweigh
the benefits of the corporate tax shield.

Value Additivity and Firm Valuation
 Value Additivity: Value of A + Value of B = Value of (A+B)
Imagine A and B are two separate firms. Then,
PV(A, A’s Cost of Capital)
+ PV(B, B’s Cost of Capital)
= PV(A+B, (A+B)’s Cost of Capital)
 Value of the levered firm V(L) =
Value of the unlevered firm + Firm Value due to having debt
V(U) + Tax Benefits of Debt: TB(L)
– Bankruptcy Costs of Debt: BC(L)
 Value the firm as a whole V(L) or in parts V(U)+TB(L)–BC(L):
 Value the levered firm using WACC as discount rate, or
 Value the firm as if it was unlevered at the unlevered cost of
capital, and add any benefits or subtract any costs to the firm
due to having debt.

Value the Firm as a Whole
 To value the firm as a whole: PV(A+B)
 Cost of capital for levered firm (A+B): WACC
 Discount FCF and terminal value at firm’s WACC
E D
WACC = RE ( L ) + RD (1 − τ C )
V V

Valuing the Firm in Parts
 To value the firm in parts: PV(A) + PV(B)

 Firm value without debt (= unlevered firm)
FCF and terminal value discounted at the cost of
capital for the unlevered firm R(U)
 Firm value added by debt (≠ value of debt)
Must consider all of the costs and benefits of debt to
derive the firm’s optimal capital structure
 Corporate/Personal taxes
 Bankruptcy costs
 Agency problems
 Asymmetric Information

Firm Value Added by Debt:
Corporate Taxes Only
 What is the value of having debt considering only the

impact of corporate taxes?
 Assuming the firm has a perpetual debt:
 Debt tax shield = Interest Paid × Corporate Tax Rate
= (Debt × RD) × τC
 PV(tax shield) = (Debt × RD) × τC / RD
 Value Added = TB(L) = PV(Tax Shield) = Debt × τC
 If a firm issued $1,000 consol bonds, and its τC is 35%,

what’s the firm value added by debt?

Firm Value Added by Debt:
Corporate Taxes and Default Risk
 Financial distress reduces the value of the firm by the

PV of the expected bankruptcy (restructuring) costs:
PV(Bankruptcy Costs) = BC(L) =
Estimated Default Costs × Probability of Default
 Considering only corporate taxes and bankruptcy cost:

Firm Value Added by Corporate Debt:
+ TB(L) – BC(L)
+ Debt × τC – PV(Bankruptcy Cost)
 If estimated default costs are $500, and the probability

of defaults is 5%, what’s the firm value added by debt?

Expected Bankruptcy Costs
 Expected default costs:

 Direct costs: Legal and administrative
 Only 1% of market value 7 years prior (Warner, 1977)
 Indirect costs: Disruption of normal activities
 Example: Business lost due to pending bankruptcy
 12% of market value 3 years prior (Altman, 1984)
 Probability of default:
 See Moody’s or S&P’s Bond Ratings
 If no rating available ⇒ find comparable company

Optimal Capital Structure
V(L) = V(U) + TB(L) – BC(L)
PV(Tax Shield)
Firm Value
PV(Bankruptcy Costs)
Levered Firm Value V(L)
Unlevered Firm Optimal

Value V(U) or Capital
All-Equity Value Structure
Debt Ratio
L = D/V
Five Market Imperfections
 Taxes: Corporate (1) and Personal (3)
 Interest on debt is tax deductible for corporations.
 Shareholders and bondholders have different personal tax rates.
 Bankruptcy/Default Risk (2)

 Debt increases the probability of financial distress.
 Possible loss of firm value in the “near” future due to restructuring.
 Agency problems (4)

 Debt alters shareholder incentives: bondholder-shareholder conflicts.
 Debt alters managers incentives: manager-shareholder conflicts.
 Asymmetric information (5)

 Investors don’t observe the true quality of the firm.
 Debt issuance decision conveys information and hence signals value.

Key Points
 There are benefits and costs of debt.
 As leverage increases, both tax benefits and bankruptcy

costs increase. Absent other market imperfections,
combining bankruptcy costs with corporate interest tax
shield leads to an optimal leverage ratio.
 More generally, firms choose capital structure that

maximizes value and hence achieves the lowest long-
term cost of capital.
 In the presence of market imperfections, WACC ≠ R(U).

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Financial Management

Professor Jian Cai

Part (I): Cost of Capital

Part (II): Perfect Markets

Part (III): Taxes and Bankruptcy

2 FIN 5203 / Jian Cai / Fall 2022

3 FIN 5203 / Jian Cai / Fall 2022

 WACC without taxes

 WACC with taxes

 Business vs. financial risk

4 FIN 5203 / Jian Cai / Fall 2022

 We value projects and companies by forecasting and

 The choice of discount rate (denominator) reflects the

 The choice of discount rate is also known as the choice

5 FIN 5203 / Jian Cai / Fall 2022

 Each firm has a cost of capital.

 The cost of capital is determined by the riskiness of a

 Whenever a firm engages in riskier projects, its cost of

6 FIN 5203 / Jian Cai / Fall 2022

 In our analysis we often assume that the firm’s capital

 A firm’s cost of capital reflects the required return on

 Thus, the cost of capital reflects:

7 FIN 5203 / Jian Cai / Fall 2022

 Weighted Average Cost of Capital (WACC):

8 FIN 5203 / Jian Cai / Fall 2022

 Interest paid on debt is tax deductible in the U.S.

9 FIN 5203 / Jian Cai / Fall 2022

 The WACC for a firm with common equity, preferred

10 FIN 5203 / Jian Cai / Fall 2022

 Cost of debt: Return lenders require on risky debt

 Comparable firms: Different debt ratings have different

11 FIN 5203 / Jian Cai / Fall 2022

Aa AA High quality. Small risk of default.

A A High-Medium quality. Strong attributes, but potentially

Ca CC High speculative quality. May be in default.

C C Lowest rated. Poor prospects of repayment.

12 FIN 5203 / Jian Cai / Fall 2022

 Preferred stock pays a fixed dividend.

 The cost of preferred stock is the dividend yield on the

13 FIN 5203 / Jian Cai / Fall 2022

 Cost of equity: Return shareholders require on their

14 FIN 5203 / Jian Cai / Fall 2022

 Use weights based on market value or if publicly known,

 For equity, market value is the number of shares

 For debt, market value is the present value of the

15 FIN 5203 / Jian Cai / Fall 2022

 Tattoo Charlie’s Inc. has 2 million shares outstanding.

16 FIN 5203 / Jian Cai / Fall 2022

 MV of Equity = $10 × 2 million = $20 million

17 FIN 5203 / Jian Cai / Fall 2022

 Re-arranging WACC (without tax):

18 FIN 5203 / Jian Cai / Fall 2022

 Hence, there are two sources of systematic risk in the

1. The business risk of the firm’s equity =

2. The financial risk of the firm’s equity =

19 FIN 5203 / Jian Cai / Fall 2022

 Similarly, βAsset measures business risk, the inherent or

 βE includes both business and financial risk, where

20 FIN 5203 / Jian Cai / Fall 2022

 An asset beta is the beta of the asset returns of the