Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 CHAPTER EIGHTEEN 488 HOW MUCH SHOULD A FIRM BORROW? Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 IN CHAPTER 17 we found that debt policy rarely matters in well-functioning capital markets. Few fi- nancial managers would accept that conclusion as a practical guideline. If debt policy doesn’t matter, then they shouldn’t worry about it—financing decisions should be delegated to underlings. Yet fi- nancial managers do worry about debt policy. This chapter explains why. If debt policy were completely irrelevant, then actual debt ratios should vary randomly from firm to firm and industry to industry. Yet almost all airlines, utilities, banks, and real estate de- velopment companies rely heavily on debt. And so do many firms in capital-intensive industries like steel, aluminum, chemicals, petroleum, and mining. On the other hand, it is rare to find a drug company or advertising agency that is not predominantly equity-financed. Glamorous growth companies rarely use much debt despite rapid expansion and often heavy requirements for capital. The explanation of these patterns lies partly in the things we left out of the last chapter. We ig- nored taxes. We assumed bankruptcy was cheap, quick, and painless. It isn’t, and there are costs associated with financial distress even if legal bankruptcy is ultimately avoided. We ignored po- tential conflicts of interest between the firm’s security holders. For example, we did not consider what happens to the firm’s “old” creditors when new debt is issued or when a shift in investment strategy takes the firm into a riskier business. We ignored the information problems that favor debt over equity when cash must be raised from new security issues. We ignored the incentive ef- fects of financial leverage on management’s investment and payout decisions. Now we will put all these things back in: taxes first, then the costs of bankruptcy and financial dis- tress. This will lead us to conflicts of interest and to information and incentive problems. In the end we will have to admit that debt policy does matter. However, we will not throw away the MM theory we developed so carefully in Chapter 17. We’re shooting for a theory combining MM’s insights plus the effects of taxes, costs of bankruptcy and fi- nancial distress, and various other complications. We’re not dropping back to the traditional view based on inefficiencies in the capital market. Instead, we want to see how well-functioning capital markets respond to taxes and the other things covered in this chapter. 489 18.1 CORPORATE TAXES Debt financing has one important advantage under the corporate income tax sys- tem in the United States. The interest that the company pays is a tax-deductible ex- pense. Dividends and retained earnings are not. Thus the return to bondholders es- capes taxation at the corporate level. Table 18.1 shows simple income statements for firm U, which has no debt, and firm L, which has borrowed $1,000 at 8 percent. The tax bill of L is $28 less than that of U. This is the tax shield provided by the debt of L. In effect the government pays 35 percent of the interest expense of L. The total income that L can pay out to its bondholders and stockholders increases by that amount. Tax shields can be valuable assets. Suppose that the debt of L is fixed and per- manent. (That is, the company commits to refinance its present debt obligations when they mature and to keep rolling over its debt obligations indefinitely.) It looks forward to a permanent stream of cash flows of $28 per year. The risk of these flows is likely to be less than the risk of the operating assets of L. The tax shields Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 depend only on the corporate tax rate 1 and on the ability of L to earn enough to cover interest payments. The corporate tax rate has been pretty stable. (It did fall from 46 to 34 percent after the Tax Reform Act of 1986, but that was the first mate- rial change since the 1950s.) And the ability of L to earn its interest payments must be reasonably sure; otherwise it could not have borrowed at 8 percent. 2 Therefore we should discount the interest tax shields at a relatively low rate. But what rate? One common assumption is that the risk of the tax shields is the same as that of the interest payments generating them. Thus we discount at 8 percent, the expected rate of return demanded by investors who are holding the firm’s debt: In effect the government itself assumes 35 percent of the $1,000 debt obligation of L. Under these assumptions, the present value of the tax shield is independent of the return on the debt . It equals the corporate tax rate times the amount borrowed D: Of course, PV(tax shield) is less if the firm does not plan to borrow permanently, or if it may not be able to use the tax shields in the future. ϭ T c 1r D D2 r D ϭ T c D PV1tax shield2ϭ corporate tax rate ϫ expected interest payment expected return on debt ϭ r D ϫ D Interest payment ϭ return on debt ϫ amount borrowed T c r D PV1tax shield2ϭ 28 .08 ϭ $350 490 PART V Dividend Policy and Capital Structure Income Statement Income Statement of Firm U of Firm L Earnings before interest and taxes $1,000 $1,000 Interest paid to bondholders 0 80 Pretax income 1,000 920 Tax at 35% 350 322 Net income to stockholders $ 650 $ 598 Total income to both bondholders and stockholders $0 ϩ 650 ϭ $650 $80 ϩ 598 ϭ $678 Interest tax shield (.35 ϫ interest) $0 $28 TABLE 18.1 The tax deductibility of interest increases the total income that can be paid out to bondholders and stockholders. 1 Always use the marginal corporate tax rate, not the average rate. Average rates are often much lower than marginal rates because of accelerated depreciation and other tax adjustments. For large corpora- tions, the marginal rate is usually taken as the statutory rate, which was 35 percent when this chapter was written (2001). However, effective marginal rates can be less than the statutory rate, especially for smaller, riskier companies which cannot be sure that they will earn taxable income in the future. 2 If the income of L does not cover interest in some future year, the tax shield is not necessarily lost. L can carry back the loss and receive a tax refund up to the amount of taxes paid in the previous three years. If L has a string of losses, and thus no prior tax payments that can be refunded, then losses can be carried forward and used to shield income in subsequent years. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 How Do Interest Tax Shields Contribute to the Value of Stockholders’ Equity? MM’s proposition I amounts to saying that the value of a pie does not depend on how it is sliced. The pie is the firm’s assets, and the slices are the debt and equity claims. If we hold the pie constant, then a dollar more of debt means a dollar less of equity value. But there is really a third slice, the government’s. Look at Table 18.2. It shows an expanded balance sheet with pretax asset value on the left and the value of the government’s tax claim recognized as a liability on the right. MM would still say that the value of the pie—in this case pretax asset value—is not changed by slic- ing. But anything the firm can do to reduce the size of the government’s slice ob- viously makes stockholders better off. One thing it can do is borrow money, which reduces its tax bill and, as we saw in Table 18.1, increases the cash flows to debt and equity investors. The after-tax value of the firm (the sum of its debt and equity values as shown in a normal market value balance sheet) goes up by PV(tax shield). Recasting Pfizer’s Capital Structure Pfizer, Inc., is a large successful firm that uses essentially no long-term debt. Table 18.3(a) shows simplified book and market value balance sheets for Pfizer as of year-end 2000. Suppose that you were Pfizer’s financial manager in 2001 with complete re- sponsibility for its capital structure. You decide to borrow $1 billion on a perma- nent basis and use the proceeds to repurchase shares. Table 18.3(b) shows the new balance sheets. The book version simply has $1,000 million more long-term debt and $1,000 million less equity. But we know that Pfizer’s assets must be worth more, for its tax bill has been reduced by 35 percent of the interest on the new debt. In other words, Pfizer has an increase in PV(tax shield), which is worth . If the MM the- ory holds except for taxes, firm value must increase by $350 million to $296,247 mil- lion. Pfizer’s equity ends up worth $289,794 million. T c D ϭ .35 ϫ $1,000 million ϭ $350 million CHAPTER 18 How Much Should a Firm Borrow? 491 Normal Balance Sheet (Market Values) Asset value (present value Debt of after-tax cash flows) Equity Total assets Total value Expanded Balance Sheet (Market Values) Pretax asset value (present Debt value of pretax cash flows) Government’s claim (present value of future taxes) Equity Total pretax assets Total pretax value TABLE 18.2 Normal and expanded market value balance sheets. In a normal balance sheet, assets are valued after tax. In the expanded balance sheet, assets are valued pretax, and the value of the government’s tax claim is recognized on the right-hand side. Interest tax shields are valuable because they reduce the government’s claim. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 Now you have repurchased $1,000 million worth of shares, but Pfizer’s equity value has dropped by only $650 million. Therefore Pfizer’s stockholders must be $350 million ahead. Not a bad day’s work. 3 MM and Taxes We have just developed a version of MM’s proposition I as corrected by them to re- flect corporate income taxes. 4 The new proposition is 492 PART V Dividend Policy and Capital Structure Book Values Net working capital $ 5,206 $ 1,123 Long-term debt Long-term assets 16,323 4,330 Other long-term liabilities 16,076 Equity Total assets $ 21,529 $ 21,529 Total value Market Values Net working capital $ 5,206 $ 1,123 Long-term debt 4,330 Other long-term liabilities Market value of long- term assets 290,691 290,444 Equity Total assets $295,897 $295,897 Total value TABLE 18.3(a) Simplified balance sheets for Pfizer, Inc., December 31, 2000 (figures in millions). Notes: 1. Market value is equal to book value for net working capital, long-term debt, and other long-term liabilities. Equity is entered at actual market value: number of shares times closing price on December 29, 2000. The difference between the market and book values of long-term assets is equal to the difference between the market and book values of equity. 2. The market value of the long-term assets includes the tax shield on the existing debt. This tax shield is worth 35 ϫ 1,123 ϭ $393 million Book Values Net working capital $ 5,206 $ 2,123 Long-term debt Long-term assets 16,323 4,330 Other long-term liabilities 15,076 Equity Total assets $ 21,529 $ 21,529 Total value Market Values Net working capital $ 5,206 $ 2,123 Long-term debt 4,330 Other long-term liabilities Market value of long-term assets 291,041 289,794 Equity Total assets $296,247 $296,247 Total value TABLE 18.3(b) Balance sheets for Pfizer, Inc., with additional $1 billion of long-term debt substituted for stockholders’ equity (figures in millions). Notes: 1. The figures in Table 18.3(b) for net working capital, long-term assets, and other long-term liabilities are identical to those in Table 18.3(a). 2. Present value of tax shields assumed equal to corporate tax rate (35 percent) times additional long-term debt. 3 Notice that as long as the bonds are sold at a fair price, all the benefits from the tax shield go to the shareholders. 4 Interest tax shields are recognized in MM’s original article, F. Modigliani and M. H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48 (June 1958), pp. 261–296. The valuation procedure used in Table 18.3(b) is presented in their 1963 article “Cor- porate Income Taxes and the Cost of Capital: A Correction,” American Economic Review 53 (June 1963), pp. 433–443. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 In the special case of permanent debt, Our imaginary financial surgery on Pfizer provides the perfect illustration of the problems inherent in this “corrected” theory. That $350 million came too easily; it seems to violate the law that there is no such thing as a money machine. And if Pfizer’s stockholders would be richer with $2,123 million of corporate debt, why not $3,123 or $17,199 million? 5 Our formula implies that firm value and stockholders’ wealth continue to go up as D increases. The optimal debt policy appears to be embarrassingly extreme. All firms should be 100 percent debt- financed. MM were not that fanatical about it. No one would expect the formula to apply at extreme debt ratios. There are several reasons why our calculations overstate the value of interest tax shields. First, it’s wrong to think of debt as fixed and perpet- ual; a firm’s ability to carry debt changes over time as profits and firm value fluc- tuate. 6 Second, many firms face marginal tax rates less than 35 percent. Third, you can’t use interest tax shields unless there will be future profits to shield—and no firm can be absolutely sure of that. But none of these qualifications explains why firms like Pfizer not only exist but also thrive with no debt at all. It is hard to believe that the management of Pfizer is simply missing the boat. Therefore we have argued ourselves into a corner. There are just two ways out: 1. Perhaps a fuller examination of the U.S. system of corporate and personal taxation will uncover a tax disadvantage of corporate borrowing, offsetting the present value of the corporate tax shield. 2. Perhaps firms that borrow incur other costs—bankruptcy costs, for example—offsetting the present value of the tax shield. We will now explore these two escape routes. Value of firm ϭ value if all-equity-financed ϩ T c D Value of firm ϭ value if all-equity-financed ϩ PV1tax shield2 CHAPTER 18 How Much Should a Firm Borrow? 493 5 The last figure would correspond to a 100 percent book debt ratio. But Pfizer’s market value would be $301,524 million according to our formula for firm value. Pfizer’s common shares would have an ag- gregate value of $279,995 million. 6 The valuation of interest tax shields is discussed again in Section 19.4. Our calculation here adheres to Chapter 19’s “Financing Rule 1,” which assumes that debt is fixed regardless of future performance of the project or the firm. 18.2 CORPORATE AND PERSONAL TAXES When personal taxes are introduced, the firm’s objective is no longer to minimize the corporate tax bill; the firm should try to minimize the present value of all taxes paid on corporate income. “All taxes” include personal taxes paid by bondholders and stockholders. Figure 18.1 illustrates how corporate and personal taxes are affected by lever- age. Depending on the firm’s capital structure, a dollar of operating income will Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 accrue to investors either as debt interest or equity income (dividends or capital gains). That is, the dollar can go down either branch of Figure 18.1. Notice that Figure 18.1 distinguishes between , the personal tax rate on inter- est, and , the effective personal rate on equity income. The two rates are equal if equity income comes entirely as dividends. But can be less than if equity in- come comes as capital gains. In 2001 the top rate on ordinary income, including in- terest and dividends, was 39.1 percent. The rate on realized capital gains was 20 per- cent. 7 However, capital gains taxes can be deferred until shares are sold, so the top effective capital gains rate can be less than 20 percent. The firm’s objective should be to arrange its capital structure so as to maximize after-tax income. You can see from Figure 18.1 that corporate borrowing is better if ( ) is more than ; otherwise it is worse. The relative tax advantage of debt over equity is This suggests two special cases. First, suppose all equity income comes as divi- dends. Then debt and equity income are taxed at the same effective personal rate. But with , the relative advantage depends only on the corporate rate: Relative advantage ϭ 1 Ϫ T p 11 Ϫ T pE 211 Ϫ T c 2 ϭ 1 1 Ϫ T c T pE ϭ T p Relative tax advantage of debt ϭ 1 Ϫ T p 11 Ϫ T pE 211 Ϫ T c 2 11 Ϫ T pE 2ϫ 11 Ϫ T c 21 Ϫ T p T p T pE T pE T p 494 PART V Dividend Policy and Capital Structure Corporate tax Operating income $1.00 Paid out as interest Or paid out as equity income None T c Income after corporate tax $1.00 $1.00 – T c Personal tax To bondholder To stockholder T p T pE (1.00 – T c ) 1.00 – T c – T p E (1.00 – T c ) =(1.00 – T p E )(1.00 – T c ) (1.00 – T p ) Income after all taxes FIGURE 18.1 The firm’s capital structure deter- mines whether operating income is paid out as interest or equity income. Interest is taxed only at the personal level. Equity income is taxed at both the corporate and the personal levels. However, , the personal tax rate on equity income, can be less than , the personal tax rate on interest income. T p T pE 7 See Section 16.6 for details. Note that we are simplifying by ignoring those corporate investors, such as banks, which pay top rates on capital gains of 35 percent. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 In this case, we can forget about personal taxes. The tax advantage of corporate borrowing is exactly as MM calculated it. 8 They do not have to assume away per- sonal taxes. Their theory of debt and taxes requires only that debt and equity be taxed at the same rate. The second special case occurs when corporate and personal taxes cancel to make debt policy irrelevant. This requires This case can happen only if , the corporate rate, is less than the personal rate and if , the effective rate on equity income, is small. Merton Miller explored this situation at a time when tax rates in the United States were very different from to- day, but we won’t go into the details of his analysis here. 9 In any event we seem to have a simple, practical decision rule. Arrange the firm’s capital structure to shunt operating income down that branch of Figure 18.1 where the tax is least. Unfortunately that is not as simple as it sounds. What’s , for example? The shareholder roster of any large corporation is likely to include tax-exempt in- vestors (such as pension funds or university endowments) as well as millionaires. All possible tax brackets will be mixed together. And it’s the same with , the personal tax rate on interest. The large corporation’s “typical” bondholder might be a tax- exempt pension fund, but many taxpaying investors also hold corporate debt. Some investors may be much happier to buy your debt than others. For exam- ple, you should have no problems inducing pension funds to lend; they don’t have to worry about personal tax. But taxpaying investors may be more reluctant to hold debt and will be prepared to do so only if they are compensated by a high rate of interest. Investors paying tax on interest at the top rate of 39.1 percent may be par- ticularly unwilling to hold debt. They will prefer to hold common stock or munic- ipal bonds whose interest is exempt from tax. To determine the net tax advantage of debt, companies would need to know the tax rates faced by the marginal investor—that is, an investor who is equally happy to hold debt or equity. This makes it hard to put a precise figure on the tax benefit, but we can nevertheless provide a back-of-the-envelope calculation. One way to estimate the tax rate of the marginal debt investor is to see how much yield in- vestors are prepared to give up when they invest in tax-exempt municipal bonds. As we write this in August 2001, short-term municipals yield 2.49 percent, while similar Treasury bonds yield 3.71 percent. An investor with a personal tax rate of 33 percent would receive exactly the same after-tax interest from the two securities and would be equally happy to hold them. 10 T p T pE T pE T p T c 1 Ϫ T p ϭ 11 Ϫ T pE 211 Ϫ T c 2 CHAPTER 18 How Much Should a Firm Borrow? 495 8 Of course, personal taxes reduce the dollar amount of corporate interest tax shields, but the appropri- ate discount rate for cash flows after personal tax is also lower. If investors are willing to lend at a prospective return before personal taxes of , then they must also be willing to accept a return after per- sonal taxes of , where is the marginal rate of personal tax. Thus we can compute the value after personal taxes of the tax shield on permanent debt: This brings us back to our previous formula for firm value: 9 See M. H. Miller, “Debt and Taxes,” Journal of Finance 32 (May 1977), pp. 261–276. 10 That is, .11 Ϫ .33 2ϫ 3.71 ϭ 2.49 percent Value of firm ϭ value if all-equity-financed ϩ T c D PV1tax shield2ϭ T c ϫ 1r D D2ϫ 11 Ϫ T p 2 r D ϫ 11 Ϫ T p 2 ϭ T c D T p r D 11 Ϫ T p 2 r D Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 To work out how much tax such an investor would pay on equity income, we need to know the proportion of income that is in the form of capital gains and the tax that is paid on these gains. Companies currently (2001) pay out on average 28 percent of their earnings. So for each $1.00 of equity income, $.28 consists of divi- dends and the balance of $.72 comprises capital gains. We assume that by not real- izing these capital gains immediately, investors can cut the effective tax to one-half the statutory rate on realized gains, that is, . 11 Therefore, if our marginal investor invests in common stock, the tax on each $1.00 of equity income is . Now we can calculate the effect of shunting a dollar of income down each of the two branches in Figure 18.1: T pE ϭ 1.28 ϫ .332ϩ 1.72 ϫ .102ϭ .16 20/2 ϭ 10 percent 496 PART V Dividend Policy and Capital Structure 11 For an analysis of the effective rate of capital gains tax, see R. C. Green and B. Hollifield, “The Per- sonal Tax Advantages of Equity,” working paper, Graduate School of Industrial Administration, Carnegie Mellon University, January 2001. 12 For a discussion of these and other tax shields on company borrowing, see H. DeAngelo and R. Ma- sulis, “Optimal Capital Structure under Corporate and Personal Taxation,” Journal of Financial Econom- ics 8 (March 1980), pp. 5–29. 13 For some evidence on the average marginal tax rate of U.S. firms, see J. R. Graham, “Debt and the Mar- ginal Tax Rate,” Journal of Financial Economics 41 (May 1996), pp. 41–73, and “Proxies for the Corporate Marginal Tax Rate,” Journal of Financial Economics 42 (October 1996), pp. 187–221. Interest Equity Income Income before tax $1.00 $1.00 Less corporate tax at 0 .35 Income after corporate tax 1.00 .65 Personal tax at and .33 .107 Income after all taxes $ .67 $ .543 Advantage to debt ϭ $.127 T pE ϭ .16 T p ϭ .33 T c ϭ .35              The advantage to debt financing appears to be about $.13 on the dollar. We should emphasize that our back-of-the-envelope calculation is just that. Econ- omists have come up with differing figures for the tax rate of the marginal debtholder and the effective rate of capital gains tax. These estimates may give higher or lower figures for the tax advantage of debt. Also our calculation of the ben- efits of debt financing assumed that the firm could be confident that it would have sufficient income to shield. In practice few firms can be sure they will show a taxable profit in the future. If a firm shows a loss and cannot carry the loss back against past taxes, its interest tax shield must be carried forward with the hope of using it later. The firm loses the time value of money while it waits. If its difficulties are deep enough, the wait may be permanent and the interest tax shield may be lost forever. Notice also that borrowing is not the only way to shield income against tax. Firms have accelerated write-offs for plant and equipment. Investment in many in- tangible assets can be expensed immediately. So can contributions to the firm’s pension fund. The more that firms shield income in these ways, the lower is the ex- pected shield from corporate borrowing. 12 Even if the firm is confident that it will earn a taxable profit with the current level of debt, it is unlikely to be so positive if the amount of debt is increased. 13 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 Thus corporate tax shields are worth more to some firms than to others. Firms with plenty of noninterest tax shields and uncertain future profits should borrow less than consistently profitable firms with lots of taxable profits to shield. Firms with large accumulated tax-loss carry-forwards shouldn’t borrow at all. Why should such a firm pay a high rate of interest to induce taxpaying investors to hold its debt when it can’t use interest tax shields? All this suggests that there is a mod- erate tax advantage to corporate borrowing, at least for companies that are rea- sonably sure they can use the corporate tax shields. For companies that do not ex- pect corporate tax shields there is probably a moderate tax disadvantage. Do companies make full use of interest tax shields? John Graham argues that they don’t. His estimates suggest that for the typical firm unused tax shields are worth nearly 5 percent of company value. 14 Presumably, well-established compa- nies like Pfizer, with effectively no long-term debt, are leaving even more money on the table. It seems either that managers of these firms are missing out or that there are some offsetting disadvantages to increased borrowing. We will now ex- plore this second escape route. CHAPTER 18 How Much Should a Firm Borrow? 497 14 Graham’s estimates for individual firms recognize both the uncertainty in future profits and the exis- tence of noninterest tax shields. See J. R. Graham, “How Big Are the Tax Benefits of Debt?” Journal of Fi- nance 55 (October 2000), pp. 1901–1941. 18.3 COSTS OF FINANCIAL DISTRESS Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. As we will see, financial distress is costly. Investors know that levered firms may fall into financial distress, and they worry about it. That worry is reflected in the current market value of the levered firm’s securities. Thus, the value of the firm can be broken down into three parts: The costs of financial distress depend on the probability of distress and the mag- nitude of costs encountered if distress occurs. Figure 18.2 shows how the trade-off between the tax benefits and the costs of distress determines optimal capital structure. PV(tax shield) initially increases as the firm borrows more. At moderate debt levels the probability of financial distress is trivial, and so PV(cost of financial distress) is small and tax advantages domi- nate. But at some point the probability of financial distress increases rapidly with additional borrowing; the costs of distress begin to take a substantial bite out of firm value. Also, if the firm can’t be sure of profiting from the corporate tax shield, the tax advantage of additional debt is likely to dwindle and eventually disappear. The theoretical optimum is reached when the present value of tax savings due to further borrowing is just offset by increases in the present value of costs of distress. This is called the trade-off theory of capital structure. Costs of financial distress cover several specific items. Now we identify these costs and try to understand what causes them. Value of firm ϭ value if all-equity-financed ϩ PV1tax shield2Ϫ PV 1costs of financial 1distress2 [...].. .Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 498 V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 18 How Much Should A Firm Borrow PART V Dividend Policy and Capital Structure FIGURE 18. 2 Market value The value of the firm is equal to its value if all-equity-financed plus PV(tax shield) minus PV(costs of financial distress) According to the trade-off... Journal of Financial Economics 8 (June 1980), pp 139–177, and “The Impact of Capital Structure Change on Firm Value,” Journal of Finance 38 (March 1983), pp 107–126 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure 18 How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 CHAPTER 18 How Much Should a Firm Borrow? 521 15 Suppose the trade-off... investors’ tax rates, there is no special advantage to corporate borrowing Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 18 How Much Should A Firm Borrow CHAPTER 18 How Much Should a Firm Borrow? 18. 4 THE PECKING ORDER OF FINANCING CHOICES The pecking-order theory starts with asymmetric information—a fancy... Management, 18: 26–35 (Spring 1989) L Shyam-Sunder and S C Myers: “Testing Static Trade-Off Against Pecking-Order Models of Capital Structure,” Journal of Financial Economics, 51:219–244 (February 1999) Some useful reviews of theory and evidence on optimal capital structure are: M J Barclay, C W Smith, and R L Watts: “The Determinants of Corporate Leverage and Dividend Policies,” Journal of Applied Corporate Finance,. .. privilege As Figure 18. 3 shows, Ace Limited’s stockholders are in better shape than Unlimited’s are The example illuminates a mistake people often make in thinking about the costs of bankruptcy Bankruptcies are thought of as corporate funerals The mourn- Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 18 How Much Should... Borrow CHAPTER 18 How Much Should a Firm Borrow? Payoff to bondholders ACE LIMITED (limited liability) Payoff to bondholders Payoff 1,000 ACE UNLIMITED (unlimited liability) Payoff 1,000 500 Asset value 500 1,000 Asset value 500 1,000 Payoff to stockholders Payoff to stockholders Payoff 1,000 0 Payoff 1,000 500 1,000 Asset value 500 1,000 0 Asset value –500 –1,000 –1,000 FIGURE 18. 3 Comparison of limited... Myers, “Still Searching for Optimal Capital Structure,” Journal of Applied Corporate Finance 6 (Spring 1993), pp 4–14 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure 18 How Much Should A Firm Borrow © The McGraw−Hill Companies, 2003 CHAPTER 18 How Much Should a Firm Borrow? 515 ill-advised acquisitions “The problem,” Jensen says, “is how to motivate... fare in bankruptcy 502 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 18 How Much Should A Firm Borrow CHAPTER 18 How Much Should a Firm Borrow? In all this discussion of bankruptcy costs we have said very little about bankruptcy procedures These are described in the appendix at the end of Chapter 25 Financial... collects a series of empirical studies on the stock price impacts of debt and equity issues and capital structure changes 1 Compute the present value of interest tax shields generated by these three debt issues Consider corporate taxes only The marginal tax rate is Tc ϭ 35 a A $1,000, one-year loan at 8 percent QUIZ Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 518 V Dividend Policy... wallpaper What is the cost of bankruptcy? In this example, probably very little The value of the hotel is, of course, much less than you hoped, but that is due to the lack of 25 We discuss covenants and the rest of the fine print in debt contracts in Section 25.6 507 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 508 V Dividend Policy and Capital Structure 18 How Much Should A Firm . stream of cash flows of $28 per year. The risk of these flows is likely to be less than the risk of the operating assets of L. The tax shields Brealey−Meyers: Principles of Corporate Finance,. what causes them. Value of firm ϭ value if all-equity-financed ϩ PV1tax shield2Ϫ PV 1costs of financial 1distress2 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy. pockets to pay off its bond- holders. The total payoff to both stockholders and bondholders is the same for the two firms. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend