Finance School of Business

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School of Business

Administration

University of Miami

Capital Structure:

Taxes & Financial Distress

FIN 613

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Notes Outline

In these lecture notes we will learn the background necessary

to choose the optimal capital structure of a firm based on tax

and bankruptcy considerations.

Specifically, in this lecture we will:

›Define capital structure

›Describe the conditions under which capital structure is irrelevant

›Analyze the effect of taxes on the capital structure decision

›Analyze the effect of bankruptcy costs/financial distress on the

capital structure decision

›Describe the (tax shield–bankruptcy cost) trade-off theory of

capital structure

›Make predictions of the (tax shield–bankruptcy cost) trade-off

theory of capital structure

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What Is Capital Structure?

Capital Structure is the mix of different securities a firm uses to

raise capital

The optimal capital structure is the particular combination of

securities that maximizes the firm’s overall market value, its

Total Market Capitalization

›One goal of the CFO and Treasurer is to find the Optimal Capital

Structure

›We will focus primarily on the optimal mix of equity and debt

Capital Structure is one of the oldest—and still unsolved—

questions of modern finance

›In fact, one often hears that modern finance began with the first

economics-based theory of capital structure, the famed

Modigliani and Miller paper (1958)

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The amount of debt in a firm’s capital structure is called its

leverage

Letting D be the market value of debt and Ethe market value

of equity, leverage can be measured as the ratio of debt to

value:

Or, debt to equity

𝐷

𝐷 + 𝐸 =𝐷

𝑉

𝐷

𝐸

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Empirically, leverage is an

important consideration:

The average proportion of debt in the capital structure of

firms in the S&P 500 has been relatively stable, ranging 30-50%

of total capital for more than 35 years despite major

economic events

A large proportion of firms target a leverage ratio and

periodically rebalance their capital structure to return to

that target ratio

However, debt as a percentage of total capital varies

widely by industry, as the following table from Brealey,

Myers, and Allen (2014) shows:

Also see:

http://biz.yahoo.com/p/industries.html;_ylt=A0LEVvwI7qVUSHoAJxoP

xQt.;_ylu=X3oDMTBzajE3bzE3BHNlYwNzcgRwb3MDMTAEY29sbwNiZjEE

dnRpZAM-

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Not only is leverage targeted, but that target varies greatly

with the business activities of the firm and its assets

Let’s take a look at a subset of industries:

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Capital Structure for Selected Industries

Above Average

Leverage

Below Average

Leverage

Airlines

Software

Hotels & Resorts

Semiconductors

Utilities

Biotechnology

Question: Why do you think each of the industries in the

previous table are in the above- or below-average leverage

category?

Issues to consider:

›Likelihood of Bankruptcy

How stable are the cash flows? (Stable cash flows are necessary to

maintain large amounts of debt)

How dependent are the cash flows upon a product development

lifecycle?

How sensitive is the product demand to the business cycle?

›Value of Assets (Collateral) in Bankruptcy

Could the assets of the firms in the industry be efficiently

liquidated/sold without a fire sale?

How standard/attractive and, hence, easily marketed are the

assets?

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Can Capital Structure Be Irrelevant?

Financing decisions don’t matter in perfect capital markets:

›Prices of securities are efficient/fairly priced

›There is never a loss of firm cash flows to outsiders/third parties

No Taxes

No costs to financial distress/bankruptcy costs

›There are no “agency costs/benefits”

Managers always act in the shareholders’ interest and maximize

shareholder wealth

Shareholders don’t seek to gain at the expense of bondholders

›There is no “asymmetric information”

Corporate insiders have no information advantage over outside

market investors

Consequently, most of the critical issues affecting the

leverage decision can be captured by adjusting a firm’s

unlevered value, VU, for market imperfections

Our focus will be on the trade-off theory of capital structure

that captures the critical imperfections of:

›Taxes

›Costs of financial distress/bankruptcy

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Notation

As the returns to the firm (ROA) vary, the returns to leveraged

equityholders (ROE) vary more

Consequently, with debt financing, shareholders will demand

rU= The all-equity or unlevered cost of capital (Brealey, Myers, and Allen

denote this as r)

rE= The equity cost of capital (rUequals this value when the firm is all

equity)

rD= The cost of debt capital