Corporate Finance I

Capital Structure

Ernst Maug
University of Mannheim
http://cf.bwl.uni-mannheim.de
maug@corporate-finance-mannheim.de
Tel: +49 (621) 181-1951
 Overview

→ Taxes have no impact on company financing

- if all forms of financing are taxed at the same rate.
→ In most countries:
- Dividends are paid from after-tax income.
- Interest is paid from pre-tax income (tax deductible).
- → Leverage has an influence on firm value.
→ This lecture:
- Weighted average costs of capital (WACC) with taxes
- Adjusted Present Value (APV)
- Levered and unlevered betas in the presence of taxes

© 2021 Ernst Maug Corporate Finance I 2

 Getting started
Types of income distribution

→ There are three forms of distributing the company’s income:

- Dividends and share repurchases
- Retained earnings (i.e. capital gains)
- Interest payments
→ Firm can determine how to pay out income:
- Choose leverage, dividend policy
→ If interest is taxed at a lower rate than dividends
- higher leverage increases company value.
→ Effect of leverage differs:
- Across countries: different tax systems
- Across legal forms of the firm (partnership, corporation, etc.)

© 2021 Ernst Maug Corporate Finance I 3

 Getting started
US and German tax system

US Germany*)
Type of
Corporate Personal Corporate Personal
income
Dividends Corporate tax Personal income Corporate tax Capped
rate tax, corporate tax rate (15%) witholding tax
not credited (25%)
Retained Corporate tax Capital gains tax Corporate tax Capped
earnings / rate (20%) rate (15%) witholding tax
capital gains (25%)
Interest income Not taxed Personal income Not taxed (except Capped
tax local tax) witholding tax
(25%)

*) Numbers do not include solidarity surcharge

© 2021 Ernst Maug Corporate Finance I 4

 Getting started
A stylised tax system

→ An exact analysis would incorporate all these taxes.

→ However:
- Tax laws often change.
- Formulae would differ from country to country.
→ Therefore, we consider a stylised tax system where
- Dividends and retained earnings are taxed at a flat rate TC.
- Interest payments are not taxed.
- Ignore personal taxes

© 2021 Ernst Maug Corporate Finance I 5

 Getting started
Assumptions

→ There is a flat tax rate on corporate earnings TC.

→ Dividends are paid from after-tax income.
→ Interest is paid from pre-tax income.
- Interest payments are tax-deductible.
→ Each project and each firm has a given, fixed debt capacity.
- Amount of debt a firm can borrow against the assets
- We treat the firm’s leverage as constant.

© 2021 Ernst Maug Corporate Finance I 6

 Valuation and intrinsic value

„We define intrinsic value as the discounted value of

the cash that can be taken out of a business during its remaining life. Anyone
calculating intrinsic value necessarily comes up with a highly subjective figure
that will change both as estimates of future cash flows are revised and as
interest rates move. Despite its fuzziness, however, intrinsic value is all-
important and is the only logical way to evaluate the relative attractiveness of
investments and businesses.“

Warren E. Buffett, Chairman‘s Letter, Berkshire Hathaway Annual Report 1994.

© 2021 Ernst Maug Corporate Finance I 7

 Two ways to value a company

→ First step: forecast future cash flows

→ Method 1: Adjust discount rate (WACC)
- Forecast cash flows for 100% equity-financed firm, not adjusted for financing
effects
- Discount these at (after-tax) WACC
- WACC adjusts for tax shields
- We denote the after-tax WACC as: rWACC

→ Method 2: Adjust cash flows (APV)

- Cash flows adjusted for financing effects
- Discount at (pre-tax) weighted average cost of capital (not adjusted for taxes)
- We denote the pre-tax WACC as: rOA

→ Do not mix up the two methods!

© 2021 Ernst Maug Corporate Finance I 8

 Method 1: WACC with taxes

→ WACC is used to discount unlevered cash flows.

- Tax shield of interest is ignored in unlevered cash flows.
- Adjust discount factor instead
→ Expected return on debt for investors is rD.
- Only (1 – TC)rD is effectively paid by the firm.
- TC rD is paid by the government (via tax savings of the firm).
→ Define leverage and pre-tax weighted average cost of capital:
- L = D/V = D/(D+E)
- rOA = (1-L)*rE + L*rD.
→ Then the after-tax weighted average cost of capital (WACC) is:
rWACC 1 L rE LrD TC LrD
rOA TC LrD

© 2021 Ernst Maug Corporate Finance I 9

 WACC with taxes

→ For WACC, you subtract the effect of taxes:

rWACC rOA TC · L· rD

→ With WACC, you consider tax savings from leverage by adjusting the cost of
capital downward.
→ Value company by discounting cash flows to the unlevered firm at rWACC.
→ Investors receive rOA = rWACC + L∙rD∙TC:
- rWACC from the company
- L∙rD∙TC from the government as a tax subsidy for using debt instead of equity

© 2021 Ernst Maug Corporate Finance I 10

 Three formulae for WACC

Formula Assumptions

Modigliani-Miller rWACC rOA 1 TC · L Debt level fixed in €s, FCFs

constant perpetuity

Miles-Ezzel (annual) 1 rOA Debt fixed as proportion

rWACC rOA TC L· rD of firm value, adjusted
1 rD
annually

Miles-Ezzel (continous) rWACC rOA TC · L· rD Debt fixed as proportion

of firm value, adjusted
continuously

© 2021 Ernst Maug Corporate Finance I 11

 WACC: The perpetuity model reconsidered

→ Reconsider the perpetuity model from lecture 4 (cash flow example from lecture 2)
→ Assumptions and results:
- FCFU2009: €4.18
- FCFL2009: €4.77
- Nominal growth rate: 4.55%
→ Assumptions about cost of capital:
- rOA 7.00%
- rD 4.00%
- TC 38%
- Target leverage 20%
→ See spreadsheets on website:
- Value Drivers - PerpetuityModel.xls

For calculations see Value Drivers - PerpetuityModel.xls, tab “DCF Model”.

© 2021 Ernst Maug Corporate Finance I 12

 WACC and the perpetuity model
WACC / Value

Modigliani-Miller rWACC = 7.00% ( 1 − 0.38  0.20 ) = 6.47%

U
FCF2009 €4.18
V2008 = = = €217.81
rWACC − G 0.0647 − 0.0455

1.07
Miles-Ezzel (annual) rWACC = 7.00% − 0.38   0.20  4.00% = 6.69%
1.04
U
FCF2009 €4.18
V2008 = = = €195.47
rWACC − G 0.0669 − 0.0455

Miles-Ezzel (continous) rWACC = 7.00% − 0.38  0.20  4.00% = 6.70%

U
FCF2009 €4.18
V2008 = = = €194.67
rWACC − G 0.0670 − 0.0455

© 2021 Ernst Maug Corporate Finance I 13

 Method 2: Adjusted present value

Firm value with leverage is now:

VL = VU + PV(Tax shield) - PV (Costs of financial distress)
Costs of financial distress
= costs of bankruptcy x probability of bankruptcy

→ The probability of bankruptcy increases with the debt ratio, hence higher debt
ratios imply higher expected costs of financial distress.
→ The optimum debt ratio trades off increases in the costs of distress against
increases in the tax shield.

© 2021 Ernst Maug Corporate Finance I 14

 The costs of financial distress

A firm which is unable, or expects to be unable, to meet its debt obligations is in

financial distress; this is costly:
→ Direct costs (legal fees, administrator):
- Usually small (typically 3%-5% of the market value of the firm, more for smaller
firms)
→ Costs from losses on asset values in a “fire sale”
→ Losses from business opportunities:
- Consumer confidence
- Growth options
→ Losses from constraints on conducting business during corporate
reorganizations:
- Indirect costs can be substantial (10% - 37% of the value of the firm).

© 2021 Ernst Maug Corporate Finance I 15

 The trade-off theory
A Graphical Presentation

Firm Value

PV(Cost of Distress)

PV(Tax shields)
VU

Debt Ratio
Optimum

© 2021 Ernst Maug Corporate Finance I 16

 What is optimal leverage?

→ Question: Do firms underlever and choose positions to far too the left of the
optimum?
- Yes: Graham (2000) finds that debt policy is generally conservative
▪ Potential reason: Managers fear for their jobs and are willing to give up some
tax savings (i.e., sacrifice shareholder value to the government)
- No: Molina (2005) finds that expected costs of financial distress are of the same
order of magnitude as the tax benefits from additional debt
→ Conventional procedure:
- multiply
▪ costs of distress (say 20% of firm value)
▪ by probability of bankruptcy (say 5%)
- obtain expected costs of default of 0.2*0.05=0.01 – only 1% of value
- compare with benefits of debt finance (e.g., 3% of value)

© 2021 Ernst Maug Corporate Finance I

 Optimal leverage: Bankruptcy risk is systematic

→ Problem (Almeida and Philippon, 2007):

- bankruptcy happens when times are bad
- investors put a higher value on a dollar or Euro on those scenarios where the market
portfolio is worth less → this is systematic risk or market risk!
- result: probabilities of financial distress are low (say, 5% for a BBB-rated bond), but
risk-averse investors value the costs “as if” this probability would be about 21%
→ Take-away: beware of claims that your firm needs more debt!

© 2021 Ernst Maug Corporate Finance I

 Adjusted present value

→ APV values a company (or a project) in two steps:

- First, calculate the value of the operating assets OA by discounting with the cost of
capital rOA:
▪ May be obtained from unlevering of betas
- Second, calculate the value of the tax shield TXS from future expected tax savings
(TS1, TS2, TS3,…) and the systematic risk of these tax savings, TXS.
- Finally, add the two:

 FCFtU TSt 
VL =   t
+ 
t 
t =1  (1 + rOA ) (1 + rTXS ) 
→ Likewise adjust the value for additional sources of value, e. g. subsidies

© 2021 Ernst Maug Corporate Finance I 19

 Adjusted present value
Example: The case of LBO valuation

→ Assume Locust Brothers, a private equity boutique, want to purchase T-Offline.

→ T-Offline‘s has current free cash flows of 100, which are expected to grow at 5%
over the next 4 years, and at 3% afterwards.
→ Locust would conduct an LBO (leveraged buyout) and issue debt so that total
debt would be 1000 in year 0.
→ The average cost of debt of T-Offline after the LBO are 8%. The cost of capital is
12%.
→ In years 1, 2, 3, and 4 a total of 200 would be repaid in each year.
→ In year 4 T-Offline‘s debt level would be 200 and stay at that level in perpetuity.
→ The tax rate is 40%.

© 2021 Ernst Maug Corporate Finance I 20

 Adjusted present value
Example: The case of LBO valuation (2)

→ Step 1: Calculate present value of unlevered cash-flows:

0 1 2 3 4 5+
FCFU 100 105 110 116 122 125
Terminal Value 1391

€105 €110 €116 €122 €125

PV (FCF U ) = + + + + = €1225
1.12 1.12 1.12 1.12 (0.12 − 0.03)1.12
2 3 4 4

For calculations see Capital Structure.xls tab “LBO”.

© 2021 Ernst Maug Corporate Finance I 21

 Adjusted present value
Example: The case of LBO valuation (3)

→Step 2: Calculate tax shields and the present value of tax shields (assume: r TXS=rD).

Year 0 1 2 3 4 5+
Debt 1000 800 600 400 200 200
Interest 80 64 48 32 16
Principal repayment 200 200 200 200 0
Debt repayment 280 264 248 232 16
Tax shield 32 26 19 13 6
Terminal value Tax shield 80
PV(Tax shield) 135

→ Step 3: Add the two present values:

- APV = €1,225.34 + €135.03 = €1,360.37

For calculations see Capital Structure.xls tab “LBO”.

© 2021 Ernst Maug Corporate Finance I 22

 Special case: Compressed APV

→ Assume the tax shield has the same risk as the company itself. Then the APV
formula simplifies:
- rTXS = rOA
- This implies:

 FCFtU Int t TC    FCFtU + Int t TC 
APV =   t
+  =  
t  t

t =1  (1 + rOA ) (1 + rTXS )  t =1  (1 + rOA ) 

 FCFt L 
=  t 
t =1  (1 + rOA ) 

→ The unlevered cash flow and the tax shield are „compressed.“
→ APV, compressed APV and DCF-WACC will result in different values
- if you make different assumptions about the tax shield.

© 2021 Ernst Maug Corporate Finance I 23

 WACC vs. APV (1)

→ Use WACC to discount unlevered cash flows:

- Tax subsidy to debt financing considered through lower cost of capital estimate
→ Use APV to discount cash flows to the unlevered firm and tax shields separately:
- Tax subsidy to debt financing considered by adjusting cash flows
→ Are these approaches consistent?

© 2021 Ernst Maug Corporate Finance I 24

 WACC vs. APV (2)

→ Consider perpetuity model

→ Discount unlevered cash flows using WACC (Miles-Ezzel, continuous)
FCF1U €4.18
VL = E + D = = = €194.67
rWACC − g 0.0670 − 0.0455

→ Use compressed APV, discount levered cash flows

FCF1L FCF1U rDTC D €4.18 + €0.59
VL = = €194.67
rOA g rOA g 0.070 − 0.0455

→ Is this generally true?

For calculations see 01 PerpetuityModel.xls, tab “DCF Model”.

© 2021 Ernst Maug Corporate Finance I 25

 WACC vs. APV (3)

→ Check: Multiply APV-valuation through by denominator of the RHS

VL rOA g FCF1U rD TC D
→ Subtract the tax savings from both sides
 D 
 VL  rOA − rDTC − g  = FCF1U
 VL 

→ Rearrange
FCF1U FCF1U
 VL = =
D
rOA − rDTC − g rWACC − g
VL
→ Obtain WACC-valuation → Yes, this is generally true!

© 2021 Ernst Maug Corporate Finance I 26

 WACC vs. APV (4)

→ This works because of special assumptions:

- Constant leverage, firm in steady state
- Continuous rebalancing of debt to main leverage
- Perpetual growth
→ Not a general conclusion:
- Then WACC cannot be used so easily.
- Need to adjust WACC each period if capital structure changes
- APV is more robust

© 2021 Ernst Maug Corporate Finance I 27

 Levering and unlevering betas
Market-value balance sheet

→ Consider the market value balance sheet from:

- Tax shield is an asset that yields positive cash-flows TSt in future periods t = 1, 2, …
- The systematic risk of these cash-flows is TXS.
Assets Liabilities and Equity
Operating Assets OA Equity E
Tax shield TXS Debt D

→ This is a balance sheet, so we have OA = E + D – TXS. Then we have:

E D TXS
→ General unlevering formula: OA = E + D − TXS
OA OA OA
OA D TXS
→ General relevering formula:  E = OA −  D + TXS
E E E
→ TXS is unknown, need to make assumptions.

© 2021 Ernst Maug Corporate Finance I 28

 Case 1: No tax shields

→ Assume that interest payments, dividends, and capital gains are all taxed in the
same way.
- TXS = 0
- OA = E + D
E D
OA = E + D
D +E D +E
D
 E = OA + (OA −  D )
E
→ See lecture 3.

© 2021 Ernst Maug Corporate Finance I 29

 Case 2: Hamada assumptions

→ Hamada assumptions:
- Current debt D will be rolled over. It is perpetual and fixed.
- Debt is risk-free, i.e. D = 0
- Tax shield will be fully utilized.
▪ Future earnings will be higher than interest payments.
→ Value of the tax-shield:
- Firm must pay D rF in interest each period.
- This generates a tax saving of TC D rF per period.
- Future tax savings are certain, i.e. TXS = 0.
- The present value of the tax shield is:

TC DrF TC DrF
TXS =  = = TC D
t =1 (1 + rF )
t
rF

© 2021 Ernst Maug Corporate Finance I 30

 Levering and unlevering betas
Hamada assumptions (2)

→ We therefore obtain:
E E
OA = E = E
OA E + D − TC D
 D
  E = 1 + (1 − TC )  OA
 E

→ With TC = 0, we get the no-tax formula.

→ Interpreting this equation:
- βOA does not change with leverage.
- Equity beta increases less with increasing leverage the larger the corporate tax rate.

© 2021 Ernst Maug Corporate Finance I 31

 Questioning Hamada's assumptions
Risky tax-shields (1)

→ Taxes of the unlevered company might be lower than the tax-shield:

- i.e. earnings are negative.
- tax-shield cannot be fully used in such a period.
→ Sometimes losses can be carried forward
- but present value of tax savings will be lower in any case.
→ This source of uncertainty
- reduces the expected value of tax savings TSt.
- is likely to result in positive systematic risk, TXS > 0.

© 2021 Ernst Maug Corporate Finance I 32

 Questioning Hamada's assumptions
Risky tax-shields (2)

→ The company might retire the debt at some point T in the future, so that TSt = 0
for all t > T.
- Then, the present value of the tax-shield is lower than TCD.
→ If firms retire debt in bad times (constant leverage).
- Tax shields TSt are correlated with the market, βTXS > 0.
→ If firms retire debt in good times:
- Pay down very high debt after an LBO
- βTXS will be lower (unlikely that βTXS < 0)
→ This discussion shows that
- Hamada’s assumptions are very special.
- There are good arguments for βTXS > 0.

© 2021 Ernst Maug Corporate Finance I 33

 Case 3: The Miles-Ezzel model

→ Miles & Ezzel propose another set of specific assumptions:

- They also assume that earnings are always positive
▪ i.e. βD = 0 and the tax-shield can always be fully utilized.
→ If the debt level is updated continuously (see WACC discussion above)
- debt D is perfectly correlated with OA.
- TSt have the same systematic risk as the cash-flows generated by the operating
assets OA.

© 2021 Ernst Maug Corporate Finance I 34

 Levering and unlevering betas
The Miles-Ezzel model (2)

→ Plug the values TXS = OA and D = 0 into the general unlevering formula
E TXS E E
OA = E − OA  OA = E = E
OA OA OA + TXS E +D

→ Last step uses OA+TXS = D + E. The relevering formula is:

 D
 E = 1 +  OA
 E

→ These are the formulae for levering/unlevering if there are no taxes!

→ Taxes do not reduce the impact of leverage on E under the Miles-Ezzel
assumptions.

© 2021 Ernst Maug Corporate Finance I 35

 Hamada vs. Miles-Ezzel

→ Reconsider example from lecture 3:

- Recall that A&B was excluded
Miles-
Company Leverage Equity Beta Hamada
Ezzel
P&C 35% 1.30 0.845 0.975
H&M 32% 1.10 0.748 0.852
X&Y 28% 1.20 0.864 0.967
Average 0.819 0.931
Relevered (C&A) 30% 1.170 1.178
→ Observations:
- Miles-Ezzel values are the same as unlevered values.
- Hamada leads to substantially higher asset betas.

For calculations see Capital Structure.xls tab “Unlevering betas”.

© 2021 Ernst Maug Corporate Finance I 36

 Levering and unlevering betas
Which model should be used?

→ Both, Hamada and Miles-Ezzel maintain rather special assumptions.

→ For a typical firm in the steady state, the truth lies somewhere between the two
models:
- Firms typically maintain a constant leverage in the long run
- but they do not update quickly (transaction costs).
- Miles-Ezzel probably closer
→ This is not true for highly levered firms:
- E.g., after an LBO
- In distress or after a turn-around
- Use the APV method to value the tax-shield and the firm.

© 2021 Ernst Maug Corporate Finance I 37

 Unlevering and relevering betas: – A roadmap
Hamada Miles-Ezzel
Yes No
 D TXS=0?  D
E = 1 + (1 − TC )  OA E =  1 +  OA
 E  E 

Relever betas → E

Unlever betas → OA

Hamada Miles-Ezzel
Yes No
E TXS=0? E
OA = E OA = E
E + D − TC D E +D

Note: when unlevering or relevering, always use the capital structure of the same
firm for which you are calculating the unlevered/relevered beta!
© 2021 Ernst Maug Corporate Finance I 38
 DCF Valuation – Listed companies – A roadmap
1. Run regression → E

2. CAPM → cost of equity rE

3. Value equity by discounting

No Yes
3. Unlever beta. → OA Value equity? dividends (DDM) or flows to
equity using rE.

4. Cost of capital from CAPM:→ rOA

4. Add debt to obtain value of
company. → Done.
No Yes
Method=WACC?

5. Add tax shields to unlevered 5. Adjust cost of capital for tax

cash flows, value company with shields using WACC-formula.
APV. → Done. Value company with DCF-WACC.
→ Done.

© 2021 Ernst Maug Corporate Finance I 39

 DCF Valuation – Unlisted companies – A roadmap
1. Identify comparable companies

2. For all comparable companies:

1. Run regressions → E
2. Unlever betas → OA

3. Average asset betas → OA

4. Cost of capital from No Yes

Value equity? 4. Relever beta → E
CAPM → rOA

5. Cost of equity from

CAPM → rE
No Yes
Method=WACC?
6. Value equity by discounting
dividends (DDM) or flows to
equity using rE. → Done.
5. Add tax shields to unlevered 5. Calculate WACC.
cash flows, value company with Value company with
7. Add debt to obtain value of
APV. → Done. DCF-WACC. → Done.
company. → Done.
© 2021 Ernst Maug Corporate Finance I 40