MM Propositions: Capital Structure & Risk

• MM Proposition 1 states that a firm's value is independent of its capital structure in a perfect market (no taxes), but leverage impacts the risk investors bear.
• Higher leverage increases risk for investors, requiring higher returns, while unlevered firms have lower risk and returns.
• Leveraged firms face financial distress in declining markets.

Debt Financing Considerations

• Smaller debt amounts can be beneficial if returns exceed costs in a strong economy.
• Raising substantial debt can lead to significant losses in a declining economy.
• Debt can be beneficial due to tax advantages.
• Optimal leverage occurs when the present value of benefits equals the present value of costs.

Risk and Risk Premiums

• Debt's return has no systematic risk, so its risk premium is zero.
• Leveraged equity has higher systematic risk and risk premium than unlevered equity.
• Leverage increases equity risk even without default risk.

MM Proposition 2

• As debt increases, the cost of equity also increases.
• In perfect capital markets, a firm's WACC is independent of capital structure and equals the equity cost of capital for unlevered firms.
• Risk changes with cost of equity and debt, with stakeholders bearing risk.
• Cost of debt changes only with high leverage, when debtholders charge higher interest for protection.
• Cost of equity increases with leverage as shareholders demand higher returns.
• WACC remains constant because increased cost of equity offsets the benefits of cheaper debt (without taxes).
• Cost of capital of levered equity equals the cost of capital of unlevered equity plus a premium for the debt-equity ratio.
• For unlevered firms, cash flows go to equity holders.
• For levered firms, project (Ra) equals the firm’s weighted average cost of capital.

Corporate Taxes and Interest Tax Shield

• Debt provides tax savings due to tax-deductible interest payments.
• Leveraged firms have a tax shield from interest payments.
• MM Proposition 1 with corporate taxes states that firm value increases with debt due to tax savings.
• More debt leads to more tax savings up to the point of financial distress.

Interest Tax Shield Details

• The interest tax shield equals the tax savings from deducting interest payments.
• Levered firms can benefit from raising debt, but excessive debt can be harmful.
• The value of a levered firm exceeds that of an unlevered firm due to the present value of tax savings from debt.

Tax Shield with Permanent Debt

• Future interest payments are uncertain due to changes in tax rates, debt amount, interest rates, and firm risk.
• Assuming a firm borrows debt D and keeps it permanently, with a constant marginal tax rate Tc, the annual tax shield is Tc × Rf × D, valued as a perpetuity.
• If debt is fairly priced, its market value equals the present value of future interest payments.

WACC with Taxes

• With tax-deductible interest, the after-tax borrowing rate is Rd(1 − Tc).
• WACC considers tax.
• For levered firms, Rd considers (1 - Tc).
• The cost of debt after tax is lower.
• WACC is lower with more debt for levered firms.
• Debt is cheaper than equity due to the tax shield.
• WACC decreases as debt increases because bondholders take less risk than stockholders.
• The tax shield reduces the cost of debt.

Increasing Debt

• WACC increases with too much debt due to increased risk.
• Firm value may decrease.

Firms with No Debt

• Some firms are fully equity financed, because the operating performance is better.
• From equity holders the earning potentials will be greater.
• From debt holders point of view, cost of debt is not high because probability of liquidation is low.

Personal Taxes and the Interest Tax Shield

• Investors pay attention to after-tax cash flows.
• Personal taxes reduce cash flows to investors and can offset corporate tax benefits.
• Operating income paid as interest (to bondholders) incurs no corporate tax, but personal tax (Tp) applies.

Operating Income

• Operating income paid as equity income (to stockholders) incurs corporate tax.
• TpE is calculated based on $1, rather (1 - Tc), because they will receive imputation credits and don't have to pay corporate tax.

Debt Financing

• Bondholders pay personal tax (Tpd) on interest income.
• Equity holders pay personal tax (Tpe) on dividends.
• If Tpd > Tpe, equity becomes more attractive than debt.

Relative Advantage Formula (RAF)

• RAF < 1: Company has a relative advantage in raising debt, so increase debt.
• VL is greater than VU, indicating a positive tax shield benefit.
• RAF > 1: Company has a relative advantage in equity financing, so cut down debt.
• Positive tax shield benefit until the tax shield is at least positive.

Optimal Debt Financing Level

• RAF = 1 maximizes tax shield benefits.

Debt and Taxes – Miller 1977

• Maximum cost of debt a company can afford is Rd = Re / (1 - Tc). If the cost of debt is higher than that threshold, they will stop raising debt.
• Investor debt depends on return.
• Rd = Required rate of Return / (1-Tpd)
• If investors buy more debt, they want more return.

Limits to the Tax Benefit of Debt

• To receive full benefits, firms need taxable earnings and should avoid 100% debt financing.
• Maximize benefits when debt equals EBIT.
• Optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT.
• With uncertainty regarding EBIT, there is a risk that interest will exceed EBIT

Growth and Debt

• Higher growth rates will impact optimal leverage ratio.

Growth rate

• The higher the growth rate, the higher the value of equity. As a result, the more EBIT you have, the more capacity you be able to raise the debt. Will result in the optimal proportion of debt in the firm’s capital structure D/(E+D)​ will be lower, the higher the firm’s growth rate.

Financial Distress

• Direct costs: Administrative expenses, disruption of operations, loss of consumer confidence.
• Indirect costs: Conflicts between stakeholders, negative perception by financial markets, weakened position against competitors.
• The firm is forced to take actions that it would not otherwise choose.

Leverage

• The risk of bankruptcy increases.
• The probability of default increases.
• The PV of bankruptcy costs increases.

Financial Distress - Agency Costs:

• Agency Costs arise when there are conflicts of interest between the firms stakeholders.
• The two major stakeholders --> Shareholders and Debtholders
• The debt holders do not care about profit, but whether the company has the ability to pay the debt.

Agency Cost of Leverage:

• For debtholders, they will charge cost of debt based on the risk (they are risk-adverse and do not like high volatility) - this is because the probability of bankruptcy is higher.

Who Pays for Financial Distress Costs

• In distress, the debtholders pay for the financial distress costs, as the shareholders can decide to walk away if the company looses.
• Debt holders recognize that if the project fails and the firm defaults, they will not be able to get the full value of the assets.

Static Trade-Off Theory with MM

• The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.
• Firms target an optimal debt ratio and adjust gradually towards it.

Static Trade-off Theory

• If they raise too much debt, they try to suppress the debt, the company will be too risky.
• The financial distress and agency costs will reduce the value of the firm.
• PV of Benefits of Debt > PV of Cost of Debt (VL > VU)
• Also explains industry differences.
• States that firms with too much debt should issue stock or sell assets.

Failures of Static Trade-Off Theory:

• Most profitable firms borrow the least.
• Imputation tax countries have debt ratios similar to US with classical tax system – tax shields no value in imputation countries.
• Firms do not have well-defined debt ratios.
• Leads to Pecking Order.