Chapter 16

Capital Structure Policy

Learning Objectives

1. Describe the two Modigliani and Miller propositions, the key assumptions

underlying them, and their relevance to capital structure decisions.

2. Discuss the benefits and costs of using debt financing.

3. Describe the trade-off and pecking order theories of capital structure choice, and

explain what the empirical evidence tells us about these theories.

4. Discuss some of the practical considerations that managers are concerned with when

they choose a firm’s capital structure.

I. Chapter Outline

16.1 Capital Structure and Firm Value

A firm’s capital structure is the mix of financial securities used to finance its

activities.

The mix will always include common stock and will often include debt and

preferred stock.

The firm may have several classes of common stock, for example, with

different voting rights and, possibly, different claims on the cash flows

available to stockholders.

The debt at a firm can be long term or short term, secured or unsecured,

convertible or not convertible into common stock, and so on.

Preferred stock can be cumulative or noncumulative and convertible or not

convertible into common stock.

The fraction of the total financing that is represented by debt is a measure of the

financial leverage in the firm’s capital structure.

A higher fraction of debt indicates a higher degree of financial leverage.

o The amount of financial leverage in a firm’s capital structure is

important because it affects the value of the firm.

A. The Optimal Capital Structure

Managers at a firm choose a capital structure so that the mix of securities

making up the capital structure minimizes the cost of financing the firm’s

activities.

o This mix is the optimal capital structure because the capital

structure that minimizes the cost of financing the firm’s

projects is also the capital structure that maximizes the total

value of those projects and, therefore, the overall value of the

firm.

B. The Modigliani and Miller Propositions

M&M Proposition 1

o States that a firm’s capital structure decisions will have no

effect on the value of the firm if

(1) there are no taxes,

(2) there are no information or transaction costs, and

(3) the firm’s real investment policy is not affected by its

capital structure decisions.

The real investment policy of the firm includes the

criteria that the firm uses in deciding which real

assets (projects) to invest in.

o The market value of the debt plus the market value of the

equity must equal the value of the cash flows produced by the

firm’s assets.

M&M Proposition 1 states that the combined value of the equity and debt

claims (represented by the present value of free cash flows the firm’s

assets are expected to produce in the future) does not change when

changes are made in the capital structure of the firm if no one other than

the stockholders and the debt holders is receiving cash flows.

o Such a change is called a financial restructuring, in which a

combination of financial transactions occur that change the

capital structure of the firm without affecting its real assets.

M&M Proposition 2

o M&M’s Proposition 2 states that the cost of (required return

on) a firm’s common stock is directly related to the debt-to-

equity ratio.

This can be seen by looking at Equation 16.3:

The first source of risk is the underlying risk of the

assets, which is reflected in the expected return on

the firm’s asset and is known as the business risk of

the firm.

It is the risk associated with the

characteristics of the firm’s business

activities.

The second source of risk is the capital structure of

the firm, which reflects the effect of the firm’s

financing decisions on the riskiness of the cash

flows that the stockholders will receive.

Financial risk is associated with required

payments to a firm’s lenders.

What the M&M Propositions Tell Us

o M&M analysis tells us exactly where we should look if we

want to understand how capital structure affects firm value and

the cost of equity.

If financial policy matters, it must be because

(1) taxes matter,

(2) information or transaction costs matter, or

(3) capital structure choices affect a firm’s real

investment policy.

16.2 The Benefits and Costs of Using Debt

A. The Benefits of Debt

The most important benefit from including debt in a firm’s capital

structure stems from the fact that firms can deduct interest payments for

tax purposes but cannot deduct dividend payments.

This makes it less costly to distribute cash to security holders

through interest payments than through dividends.

The total dollar amount of interest paid each year and, therefore, the

amount that will be deducted from the firm’s taxable income is:

D × kDebt

This will result in a reduction in taxes paid (the interest tax shield)

of

D × kDebt × t

where t is the firm’s marginal tax rate that applies to the interest

expense deduction.

If this reduction will continue in perpetuity, the perpetuity model, to

calculate the present value of the tax savings from debt, is:

Since the firm will benefit from the interest tax shield only if it is able to

make the required interest payments, the cash savings associated with the

tax shield are about as risky as the cash flow stream associated with the

interest payments:

The perpetuity model assumes that

(1) the firm will continue to be in business forever,

(2) the firm will be able to realize the tax savings in the years

in which the interest payments are made (the firm’s EBIT will

always be at least as great as the interest expense), and

(3) the firm’s tax rate will remain constant.

B. Other Benefits

Underwriting spreads and out-of-pocket costs are more than three times as

large for stock sales as they are for bond sales.

Debt provides managers with incentives to focus on maximizing the cash

flows that the firm produces since interest and principal payments must be

made when they are due.

o Because managers must make these interest and principal

payments or face the prospect of bankruptcy, this can destroy a

manager’s career.

Debt can be used to limit the ability of bad managers to waste the

stockholders’ money on things such as fancy jet aircraft, plush offices, and

other negative-NPV projects that benefit the managers personally.

C. The Costs of Debt

Financial managers limit the amount of debt in their firms’ capital structures

in part because there are costs that can become quite substantial at high levels

of debt.

o At low levels of debt, the benefits are greater than the costs, and

adding more debt increases the overall value of the firm.

o At some point, the costs begin to exceed the benefits, and adding more

debt financing destroys firm value.

o Financial managers want to add debt just to the point at which the

value of the firm is maximized.

Bankruptcy costs, also referred to as costs of financial distress, are costs

associated with the financial difficulties that a firm might get into because it

uses too much debt financing.

o The term bankruptcy cost is used rather loosely in capital structure

discussions to refer to costs incurred when a firm gets into financial

distress.

o Firms can incur bankruptcy costs even if they never actually file for

bankruptcy.

o Direct bankruptcy costs are out-of-pocket costs that a firm incurs as

a result of financial distress.

They include things such as fees paid to lawyers, accountants,

and consultants.

o Indirect bankruptcy costs are costs associated with changes in the

behavior of people who deal with a firm in financial distress.

Some of this firm’s potential customers will decide to purchase

a competitor’s products because

of concerns that the firm will not be able to honor its

warranties.

parts or service will not be available in the future.

Some investors will demand a lower price to compensate them

for these risks.

When suppliers learn that a firm is in financial distress, they

will worry about not being paid; to protect against losses for

future shipments, they often begin to require cash on delivery.

Employees at a distressed firm will worry that their jobs or

benefits are in danger, and some will start looking for new

jobs.

If the firm enters into the formal bankruptcy process, it incurs

another indirect bankruptcy cost because a bankruptcy judge

must approve all investments made by the firm.

o Agency costs result from conflicts of interest between principals and

agents where one party, known as the principal, delegates its decision-

making authority to another party, known as the agent.

The agent is expected to act in the interest of the principal, but

agents sometimes have interests that conflict with those of the

principal.

Stockholder-manager agency costs occur to the extent that

the incentives of the managers are not perfectly identical to

those of the stockholders, managers will make some decisions

that benefit themselves at the expense of the stockholders.

Using debt financing provides managers with incentives

to focus on maximizing the cash flows that the firm

produces and limits the ability of bad managers to

waste the stockholders’ money on negative-NPV

projects.

o These benefits amount to reductions in the

agency costs associated with the principal-agent

relationship between stockholders and

managers.

While the use of debt financing can reduce agency

costs, it can also increase these costs by altering the

behavior of managers who have a high proportion of

their wealth riding on the success of the firm, through

their stockholdings, future income, and reputations.

o The use of debt increases the volatility of a

firm’s earnings and the probability that the firm

will get into financial difficulty.

o Increased risk causes managers to make more

conservative decisions.

Stockholder-lender agency costs can occur when

investors lend money to a firm and delegate authority to

the stockholders to decide how that money will be used.

o Lenders expect that the stockholders, through

the managers they appoint, will invest the

money in a way that enables the firm to make all

of the interest and principal payments that have

been promised.

o However, stockholders may have incentives to

use the money in ways that are not in the best

interests of the lenders.

o Lenders know that stockholders have incentives

to distribute some or all of the funds that they

borrow as dividends, and so they protect

themselves against this sort of behavior by

including provisions in the lending agreements

that limit the ability of stockholders to pay

dividends and other behavior.

These protections are not foolproof.

o One type of this behavior is known as the asset

substitution problem in which once a loan has

been made to a firm, the stockholders have an

incentive to substitute less risky assets for more

risky assets such as negative-NPV projects.

Another type of behavior is known as the underinvestment problem, and it

occurs in a financially distressed firm when the value that is created by

investing in a positive-NPV project is likely to go to the lenders instead of the

stockholders; therefore the firm forgoes financing and undertaking the project.

16.3 Two Theories of Capital Structure

A. The Trade-Off Theory

o The trade-off theory of capital structure states that managers choose a specific

target capital structure based on the trade-offs between the benefits and the costs

of debt.

The theory says that managers will increase debt to the point at which the

costs and benefits of adding an additional dollar of debt are exactly equal

because this is the capital structure that maximizes firm value.

B. The Pecking Order Theory

o The pecking order theory recognizes that different types of capital have

different costs. This leads to a pecking order in the financing choices that

managers make to choose the least expensive capital first and then move

to increasingly costly capital when the lower-cost sources of capital are no

longer available.

Managers view internally generated funds, or cash on hand, as the

cheapest source of capital.

Debt is more costly to obtain than internally generated funds but is

still relatively inexpensive.

Raising money by selling stock is the most expensive.

C. The Empirical Evidence

o When researchers compare the capital structures in different industries,

they find evidence that supports the trade-off theory.

o Some researchers argue that, on average, debt levels appear to be lower

than the trade-off theory suggests they should be.

o More general evidence also indicates that the more profitable a firm is, the

less debt it tends to have, which is exactly opposite what the trade-off

theory suggests we should see.

This evidence is consistent with the pecking order theory.

o The pecking order theory is also supported by the fact that, in an average

year, public firms actually repurchase more shares than they sell.

o Both the trade-off theory and the pecking order theory offer some insights

into how managers choose the capital structures for their firms, but neither

is able to explain all of the capital structure choices that we observe.

16.4 Practical Considerations in Choosing a Capital Structure

Managers don’t think only in terms of a trade-off or a pecking order but are

concerned with how their financing decisions will influence the practical issues that

they must deal with when managing a business.

Financial flexibility is an important consideration in many capital structure decisions.

o Managers must ensure that they retain sufficient financial resources in the

firm to take advantage of unexpected opportunities as well as unforeseen

problems.

They try to manage their firms’ capital structures in a way that limits

the risk to a reasonable level.

o Managers think about leverage and the effect that interest expense has on the

reported dollar value of net income.

o Managers consider control implications when choosing between equity and

debt financing of the firm.

II. Suggested and Alternative Approaches to the Material

Chapter 16 discusses capital structure and how it affects firm value. It introduces the Modigliani

and Miller (M&M) theory of capital structure as well as the three major assumption required for

the theorem to hold. These assumptions are (1) that neither the firm nor the investor is subject to

taxes, (2) there are no information or transactions costs, and (3) the way in which the firm is

financed does not affect its real investment policy. The theorem shows that the firm value is

unaffected by the firm’s choice of capital structure. The chapter then proceeds to relax the no-tax

assumption to discuss the value of the tax shield to the firm. At that point, the theory predicts that

firms should have greater leverage than what we see in practice. The chapter then discusses the

benefits and costs of leverage, which further relax the assumptions of M&M in order to discuss a

more realistic understanding of capital structure.

The chapter proceeds with two theories of capital structure. Trade-off theory suggests

that firms will adjust their capital structure to maximize the value of the firm. Pecking order

theory suggests that firms will always select the cheapest form of capital to finance a project.

The empirical evidence does not completely support either theory. The chapter concludes with a

practical discussion of capital structure.

This material constitutes a bit of a theoretical discussion with a number of examples to

help the student understand the arguments involved. Although the instructor might view the

material as optional, it does address a financial issue that future business executives will have to

deal with in their careers. As such, the material is recommended for an introductory course

where the students may not be required to take another corporate finance course.

III. Summary of Learning Objectives

1. Describe the two Modigliani and Miller propositions, the key assumptions underlying

them, and their relevance to capital structure decisions.

M&M Proposition 1 states that the value of a firm is unaffected by its capital structure if

the following three conditions hold: (1) there are no taxes; (2) there are no information or

transaction costs; and (3) capital structure decisions do affect the real investment policies

of the firm. This proposition tells us the three reasons that capital structure choices affect

firm value.

M&M Proposition 2 states that the expected return on a firm’s equity increases with

the amount of debt in its capital structure. This proposition also shows that the expected

return on equity can be separated into two parts—a part that reflects the risk of the underlying

assets of the firm and a part that reflects the risk associated with the financial leverage used

by the firm. This proposition helps managers understand the implications of financial

leverage for the cost of the equity that they use to finance the firm’s investments.

2. Discuss the benefits and costs of using debt financing.

Using debt financing involves several benefits. A major benefit is the deductibility of interest

payments. Since interest payments are tax deductible and dividend payments are not,

distributing cash to security holders through interest payments can increase the value of a

firm. Debt is also less expensive to issue than equity. Finally, debt can benefit stockholders in

certain situations by providing managers with incentives to maximize the cash flows

produced by the firm and by reducing their ability to invest in negative-NPV projects.

The costs of debt include bankruptcy and agency costs. Bankruptcy costs arise

because financial leverage increases the probability that a firm will get into financial

distress. Direct bankruptcy costs are the out-of-pocket costs that a firm incurs when it gets

into financial distress, while indirect bankruptcy costs are associated with actions the

people who deal with the firm take to protect their own interests when the firm is in

financial distress. Agency costs are costs associated with actions taken by managers and

stockholders who are acting in their own interests rather than in the best interests of the

firm. When a firm uses financial leverage, managers have incentives to take actions that

benefit themselves at the expense of stockholders, and stockholders have incentives to

take actions that benefit themselves at the expense of lenders. To the extent that these

actions reduce the value of lenders’ claims, the expected losses will be reflected in the

interest rates that lenders require.

3. Describe the trade-off and pecking order theories of capital structure choice, and

explain what the empirical evidence tells us about these theories.

The trade-off theory says that managers balance, or trade off, the benefits of debt against

the costs of debt when choosing a firm’s capital structure in an effort to maximize the

value of the firm. The pecking order theory says that managers raise capital as they need

it in the least expensive way available, starting with internally generated funds, then

moving to debt, then to the sale of equity. In contrast to the trade-off theory, the pecking

order theory does not imply that managers have a particular target capital structure. There

is empirical evidence that supports both theories, suggesting that each helps explain the

capital structure choices made by managers.

4. Discuss some of the practical considerations that managers are concerned with when

they choose a firm’s capital structure.

Practical considerations that concern managers when they choose a firm’s capital

structure include the impact of the capital structure on financial flexibility, risk, net

income, and control of the firm. Financial flexibility involves having the necessary

financial resources to take advantage of unforeseen opportunities and to overcome

unforeseen problems. Risk refers to the possibility that normal fluctuations in operating

profits will lead to financial distress. Managers are also concerned with the impact of

financial leverage on their reported net income, especially on a per-share basis. Finally,

the impact of capital structure decisions on who controls the firm also affects capital

structure decisions.

IV. Summary of Key Equations

Equation Description Formula

16.1 Value of the firm as the sum of the debt and equity values

VFirm = VAssets = VDebt + VEquity

16.2Formula for weighted average cost of capital (WACC) for a firm with only common stock and no taxes

16.3Cost of common stock in terms of the required return on assets and the required return on debt

16.4 Value of the tax savings of debt (upper bound)

VTax-savings debt = D × t

V. Before You Go On Questions and Answers

Section 16.1

1. What is the optimal capital structure for a firm?

The optimal capital structure for a firm is the combination of debt and equity financing,

which minimizes the overall cost of financing the firm’s real activities (projects).

Minimizing the overall cost of financing a firm’s real activities maximizes the value of

its cash flows.

2. What is M&M Proposition 1? M&M Proposition 2?

Modigliani-Miller Proposition 1: The capital structure of a firm does not affect the

firm’s value if the following three assumptions hold:

a. There are no taxes.

b. There are no information or transaction costs.

c. A firm’s capital structure does not affect the firm’s real investment policy.

Modigliani-Miller Proposition 2: The required rate of return on a firm’s equity (cost of

equity) increases as the firm’s debt-to-equity ratio increases.

3. What is the difference between business risk and financial risk?

Business risk reflects the uncertainty associated with the underlying assets of the firm.

The level of business risk is reflected in the required rate of return associated with these

assets. Financial risk represents the uncertainty that fixed debt payments introduce to the

cash flows to the stockholders. The total risk faced by stockholders is affected by both

the business risk of the firm and its financial risk.

4. How can the three conditions specified by M&M help us understand how the capital

structure of a firm affects its value?

M&M identify the three conditions under which the capital structure of a firm would not

affect its value. By examining the three conditions specified by M&M, and how they are

violated in the real world, we can better understand why capital structure does affect firm

value.

Section 16.2

1. What are some benefits of using debt financing?

The benefits of using debt financing are:

The interest tax shield (interest is tax deductable, dividends are not).

The cost of issuing debt (underwriting spreads and out-of-pocket costs) are

lower than the cost of issuing equity.

With more debt, managers have greater incentives to work hard to produce

larger cash flows and thus avoid bankruptcy.

Increased debt limits the manager’s flexibility to spend money on wasteful,

negative NPV projects.

2. What are bankruptcy costs, and what are the two types of bankruptcy costs?

Bankruptcy costs are costs that firms face when they are in financial distress. Direct

bankruptcy costs are out-of-pocket costs, such as the payments that are made to lawyers,

accountants, and consultants, as well as court costs, when a firm gets into financial

distress. Indirect bankruptcy costs result from changes in the behavior of the people that

contract with the firm when they learn that it is in distress. For example, there may be

less demand for a distressed firm’s product because of the concern that the firm will not

exist to provide customer support in the future or suppliers might demand cash on

delivery out of concern that the firm will not be able to pay for supplies.

3. What are agency costs, and how are they related to the use of debt financing?

Agency costs are costs that are incurred when someone delegates decision-making

authority to someone who has different objectives. Agency costs might arise in

relationships between stockholders and the managers they hire because managers do not

have the same incentives as stockholders. For example, when a firm has debt, managers

can have incentives to invest in low-risk projects that do not maximize stockholder value.

Agency costs also arise between stockholders and debt holders. Stockholders, through the

managers they hire, can have incentives to engage in asset substitution, turn down

positive-NPV projects (underinvestment), or pay out excess cash in the form of

dividends.

Section 16.3

1. What is the trade-off theory of capital structure?

The trade-off theory of capital structure postulates that managers set a specific target for

the capital structure of a firm in which they try to achieve the mix of debt and equity that

will minimize the cost of financing the firm’s projects and thereby maximize its value.

2. What is the pecking order theory of capital structure?

The pecking order theory says that, instead of trying to achieve a specified target capital

structure, firms use the cheapest form of capital available at any given time, until it is

used up. According to this theory, the cost of capital from least expensive to most

expensive is:

1. Internally generated funds

2. Debt issue

3. Equity issue

3. What does the empirical evidence tell us about the two theories?

The empirical evidence provides some support for both theories. Studies find that

industries with significant tangible assets tend to have more debt. This is consistent with

the trade-off theory. These companies can generally borrow at a lower rate using their

tangible assets as collateral.

There is also evidence that more profitable firms hold less debt. This is consistent

with the pecking order theory. These companies are capable of financing more projects

with internal funds before taking on debt. The trade-off theory would suggest that more

profitable companies should carry more debt, because they have more to benefit from the

tax shelter of interest payments.

Section 16.4

1. Why is financial flexibility important in the choice of a capital structure?

The choice of capital structure may limit the ability of managers to take advantage of

unexpected opportunities or to deal appropriately with unexpected problems. For

example, suppose the firm learns of a positive-NPV project that is available for only a

short period of time. If the firm already holds significant amounts of debt, lenders may be

unwilling to loan more money to the firm. Raising funds though issuing equity is often a

slow process, and the window of opportunity to accept the project may have passed. A

firm that holds cash or can quickly issue debt (e.g., through a line of credit) has more

flexibility in financing new projects.

2. How can capital structure decisions affect the risk associated with net income?

The more debt a firm carries, the more risk will be associated with the firm’s net income.

This occurs because given a certain level of fluctuating operating income, a larger fixed

debt payments will magnify the effects of the fluctuations on net income.

3. How can capital structure decisions affect the control of a firm?

Issuing new equity reduces the control of the firm’s existing stockholders (assuming the

existing stockholders do not purchase the new issues). In some cases firms may issue debt

rather than equity to prevent the control of existing stockholders from being diluted. For

example, if a firm is 51 percent owned by the founders, the founders may require the

company to issue debt rather than equity to finance a new project. This will prevent the

founder’s ownership from falling to less than 50 percent.

VI. Self Study Problems

16.1 If any of the three assumptions in Modigliani and Miller Proposition 1 are relaxed, which

has the most predictably quantifiable impact on the value of the firm?

Solution:

The assumption with the most measurable impact is that involving taxes. We can directly

measure the present value of the tax shield generated by the interest costs of borrowing.

The impacts of the other two assumptions, though real, are more difficult to predict.

16.2 If we assume that the cash flows for a firm with financial leverage are equal to the cash

flows for the same firm without financial leverage, what can we say about the value of

this firm if its cost of capital does not vary with the degree of leverage utilized either?

Solution:

If the firm’s cash flows and cost of capital are the same, regardless of the amount of

leverage utilized, then we can say that the value of the firm is also unchanged by the

amount of financial leverage.

16.3 Are taxes necessary for the cost of debt financing to be less than the cost of equity

financing?

Solution:

The deduction for interest expense does make debt borrowing more attractive than it

would otherwise be. However, even without the interest deduction benefit, the cost of

debt is less than the cost of equity, because equity is a riskier investment than debt. This

means that the pretax cost to the firm for debt is still lower than the cost of equity.

16.4 You are offered jobs with identical responsibilities by two different firms in the same

industry. One firm has no debt in its capital structure, and the other has 99 percent debt in

its capital structure. Will you require a higher level of compensation from one firm than

from the other? If so, which firm will have to pay you more?

Solution:

The firm with the large amount of debt financing (the 99 percent debt firm) has a higher

probability of entering bankruptcy. Therefore, you should require greater compensation

from that firm.

16.5 You are valuing two firms in the same industry. One firm has a corporate jet for every

executive at the vice president level and above, while the other does not have a single

corporate jet. More than likely, which firm has the greatest stockholder-manager agency

costs?

Solution:

If we can assume that the jets are used largely for the convenience of management, then it

appears that the multijet firm has higher stockholder-manager agency costs than the no-jet

firm. Perhaps the no-jet firm uses more of its cash for positive-NPV projects than the

multijet firm.

VII. Critical Thinking Questions

16.1 List and briefly describe the three key assumptions in Modigliani and Miller’s Proposition

1 that are required for total firm value to be independent of capital structure.

1. There are no taxes. This assumption is necessary in order to avoid creating a tax

benefit when using debt instead of equity to finance firm assets.

2. There are no information or transactions costs for the firm.

a. There are no bankruptcy costs (financial distress) to the firm associated with

increased supplier, employee, and customer expenses due to the firm having a

higher likelihood of not being able to meet its debt obligations. Note that one

interpretation of this assumption is that the firm has a zero probability of not being

able to meet its debt obligations.

b. There are no agency costs. There are no costs associated with the conflict of

interest between managers and stockholders, and there are no costs associated with

the conflict between the interest between stockholders and debt holders of the

firm.

c. There are no market frictions. This means that individuals may borrow and lend at

the same rate that the firm can borrow and lend.

3. The real investment policy of the firm is not affected by its capital structure

decisions. Without this, the assumption that an individual investor could replicate the

actions of the firm does not hold because then the actual investment policy of the firm

would be affected by the capital structure decision. Investors cannot replicate real

investments.

16.2 Evaluate the statement that the weighted average cost of capital (WACC) for a firm

(assuming that all three assumptions of Modigliani and Miller’s propositions hold) is

always less than or equal to the cost of equity for the firm.

If we look at the following WACC formula for a firm (without taxes):

WACC = (E/V) x kcs + (D/V) x kDebt

we see that with 100 percent equity financing, the WACC = kcs. A firm cannot be 100

percent debt-financed, so as D/V approaches 1, then the WACC approaches kDebt. Since

we know that debt is less risky than equity, we know that the WACC in that instance

must be greater than kDebt but less than kcs. Therefore, the WACC must be greater than kDebt

but less than or equal to kcs .

16.3 If the value of the firm remains constant as a function of its capital structure and the three

Modigliani and Miller assumptions apply, how might the overall cost of capital change or

not change as capital structure changes.

If we know that the cash flow produced by a firm is unchanged, and we know that the

value of the asset (the firm) producing that cash flow is unchanged by a firm’s capital

structure changes, we can use a perpetual cash flow valuation model as follows:

Va = CF/kAssets

If we know that Va and CF are unchanged due to capital structure changes; then kAssets

must also remain unchanged.

16.4 Observe the WACC for a firm where taxes are a reality. By taking the formula literally,

explain what a firm’s best course of action would be to minimize its WACC and thereby

maximize the firm value.

WACC = (1 – Tc) x kDebt x (D/V) + kcs x (E/V)

Since we know that kcs > kDebt, then it would make sense to increase D relative to E in

order to raise as much financing as possible with borrowing rather than the more

expensive equity. Therefore, by blindly following the WACC formula, we are led to

believe that more debt will increase the value of the firm from its current valuation. This

highlights the effect of taxes without taking into account the other M&M assumptions.

16.5 The Modigliani and Miller propositions, when the no-tax assumption is relaxed, suggest

that the firm should finance itself with as much debt as possible. If we take that

suggestion to the fullest extent, does that mean it would be practical to finance the firm

with 100 percent debt and no equity?

Even with the list of assumptions required to get this result, a 100 percent debt firm is not

practical. While you might think that there is no residual claimant for the firm’s cash

flows, this is not even true. In fact, a 100 percent debt-financed firm is really a 100

percent equity-financed firm since the debt holders themselves must then be the residual

claimants.

16.6 Crossler Automobiles sells autos in a market where the standard auto comes with a 10-

year/100,000-mile warranty on all parts and labor. Describe how an increased probability of

bankruptcy could affect sales of autos by Crossler.

In a market where a warranty is a significant portion of the cost of an automobile,

purchasing a car where the seller might not be able to completely perform on that

warranty would have negative impact on the firm’s future automobile sales. This would

decrease the amount of cash flow available to the investors of the firm, which would

lower the value of the firm.

16.7 The principal-agent problem occurs because of the divergent interests of the nonowner

managers and stockholders of a firm. Propose a capital structure change that might help

align a portion of these divergent interests.

The managers of a firm would rather work as little as possible, given a set level of

compensation, whereas stockholders would rather compensate the manager for a high

level of effort, with a low effort receiving very little compensation. If the firm’s capital

structure generates a very small probability of bankrupting the firm, then increasing the

proportion of debt in the capital structure would increase the probability of the firm

falling into bankruptcy. This increased probability of bankruptcy, and therefore the

increased chance that the manager will lose his job, would then help to align the interests

of the manager and stockholders by giving the manager an additional incentive to work

harder for the stockholders.

16.8 If a firm increases its debt to a very high level, then the positive effect of debt in aligning

the interests of management with those of stockholders tends to become negative. Explain

why this occurs.

Whereas increasing the debt level for a firm tends to catch management’s attention and

force them to work harder, a very high level of debt can be detrimental. That is, at very

high levels of debt, risk-averse managers begin to minimize the risks that a firm takes on

for the managers’ own job preservation needs. This risk minimization can deter managers

from taking risky, but positive-NPV projects, which are needed to help the firm meet the

very debt obligations that are causing the problem. In addition, the financially risky firm

may also bear costs not previously borne in relationships with employees, suppliers, and

customers.

16.9 Using the Modigliani and Miller framework but excluding the assumptions that there are

no taxes and no information or transaction costs, describe the value of the firm as a

function of the proportion of debt in its capital structure.

With taxes included, we would predict that the firm would take on greater proportions of

debt. Since agency costs (part of the information and transactions cost) are actually

reduced when adding moderate portions of debt, then that would also predict that the firm

value increases as we add moderate levels of debt to the firm. However, agency costs

once again become positive (in total) as very high levels of debt are incurred. This

suggests that at very high levels of debt the value of the firm could be dropping.

Bankruptcy costs (which are also part of the information and transactions cost) are

probably immaterial at low debt levels but can become very high at higher levels of debt.

Therefore, we should predict that by including dropping the three assumptions in the

question, the value of the firm should be increase with additional debt for moderate debt

levels while decreasing for high levels of debt.

16.10 When we observe the capital structure of many firms, we find that they tend to utilize

lower levels of debt than that predicted by the trade-off theory. Offer an explanation for

this effect.

This empirical result is consistent with a firm maintaining a reserve level of debt or high

cash levels in order for it to have ample internally generated funds for new projects. One

explanation would be that firms like to have this “reserve” financing available for new

projects when they are identified. Another explanation is that firms do not have to offer

new investors an explanation for the use of these funds and that makes it less expensive

on an information basis to keep this reserve, compared to having to issue new securities

for the financing of the new projects. Both of these explanations are in line with the

pecking order theory.

VIII. Questions and Problems

BASIC

16.1 M&M Proposition 1: The Modigliani and Miller theory suggests that the value of the

firm’s assets is equal to the value of the claims on those assets and is not dependent on

how the asset claims are divided. The common analogy to the theorem is that the total

amount of pie available to be eaten (the firm) does not depend on the size of each slice of

pie. If we continue with that analogy, then what if we cut up the pie with a very dull knife

such that the total amount of pie available to be eaten is less after it is cut than before it

was cut. Which of the three Modigliani and Miller assumptions, if relaxed, is analogous

to the dull knife? Hint: Think about the process by which investors could undo the effects

of a firm’s capital structure decisions.

Solution:

The inability of individual investors to borrow and lend and at the same rate as firms is

analogous to the dull knife. This friction is part of the no information or transactions costs

assumption. Since the process of rearranging the claims on the firm’s assets is similar to

carving up the firm into different pieces, it is easy to see that such a market friction is

similar to the dull knife in our pie example.

16.2 M&M Proposition 1: Many times, the popular press casually describes the value of a

firm. Describe exactly what is meant when someone is describing the value of the firm

versus the value of the equity of the firm.

Solution:

The value of the firm can be described as either the total market value of all the assets

owned by the firm, or the total market value of all the claims of all the investors in the

firm. In that case, it means that we are valuing all of the equity claims (shares) in the firm

in addition to all of the debt claims (bonds, bank borrowing, etc.) of the firm.

16.3 M&M Proposition 1: Under Modigliani and Miller’s Proposition 1, where all three of

the assumptions remain in effect, explain how the value of the firm changes due to

changes in the proportion of debt and equity utilized by the firm.

Solution:

Under Modigliani and Miller’s Proposition 1, the value of the firm is independent of the

proportion of debt and equity utilized by the firm.

16.4 M&M Proposition 1: Cerberus Security produces a cash flow of $200 and is expected to

continue doing so in the infinite future. The cost of equity capital for Cerberus is 20

percent, and the firm is financed totally with equity. The firm would like to repurchase

$100 in shares by borrowing $100 at a 10 percent rate (assume that the debt will also be

outstanding into the infinite future). Using Modigliani and Miller’s Proposition 1, what is

the value of the firm today, and what will be the value of the claims on the firm’s assets

after the stock repurchase? What will be the rate of return on common stock required by

investors after the share repurchase?

Solution:

Using the 20 percent cost of equity capital, we see that the value of the firm today is

$200/0.2 = $1,000, keeping in mind that the cash flow is expected to be produced into the

infinite future. Note that using M&M Proposition 1, we know that this must be the value

of the firm after the repurchase. The value of the debt claim must be $100 at the time of

the borrowing, so we know that the value of the outstanding equity after the repurchase

must be $1,000 – $100 = $900. Since we know that $10 in cash flow must be paid to the

debt holders each year, we then know that $190 will be available to the stockholders on

an annual basis. This implies that the new cost of equity capital for the firm must be such

that $900 = $190 / kcs, or kcs = 21.11%.

16.5 M&M Proposition 1: A firm financed completely with equity currently has a cost of

capital equal to 15 percent. If Modigliani and Miller’s Proposition 1 holds and the firm is

thinking about changing its capital structure to 50 percent debt and 50 percent equity,

what will be the cost of equity after the change if the cost of debt is 10 percent?

Solution:

It is easy to see that the current cost of capital (also the cost of equity in this case) is 15

percent. Given the proposition, we know that the cost of capital (or WACC) for the firm

must be constant at 15 percent. If we know that the firm can borrow at a 10 percent cost

of capital, with a 50 percent–50 percent debt-equity mix, then we can use the WACC

formula to solve for the new cost of equity capital as follows:

0.15 = 0.5(0.10) + 0.5(kcs)

kcs = 0.20, or 20%

16.6 M&M Proposition 1: Swan Specialty Cycles is currently financed with 50 percent debt

and 50 percent equity. The firm pays $125 each year to its debt investors (at a 10 percent

cost of debt), and the debt has no maturity date. What will be the value of the equity if the

firm repurchases all of its debt and raises the funds by issuing equity? Assume that all of

the assumptions in Modigliani and Miller’s Proposition 1 hold.

Solution:

Since the debt has no maturity date, we can find the value of the current debt claims:

Value = $125 / 0.10 = $1,250. Since debt is 50 percent of the capital structure, then the

value of the entire firm must be 2 x Value of debt = $2,500, which must be the value of

the equity in an all-equity firm.

16.7 M&M Proposition 1: The weighted average cost of capital for a firm, assuming all three

Modigliani and Miller assumptions hold, is 10 percent. What is the current cost of equity

capital for the firm if the cost of debt for the firm is 8 percent, given that the firm is

financed by 80 percent debt?

Solution:

Using the formula given in the text:

kcs = iAssets + (VDebt /Vcs) x (iAssets – iDebt)

ics = 0.10 + (0.8 / 0.2) x (0.10 – 0.08) = 0.18, or 18%

16.8 Interest tax shield benefit: Legitron Corporation has $350 million of debt outstanding at

an interest rate of 9 percent. What is the amount of the tax shield on that debt, just for this

year, if Legitron is subject to a 35 percent marginal tax rate?

Solution:

Legitron will pay $31,500,000 ($350,000,000 × 0.09) in interest this year, which will

shield Legitron from paying a tax amount equal to:

VTax-savings debt = D × t = ($31,500,000 × 0.35) = $11,025,000

Therefore, the amount of this year’ tax shield, due to debt issuance, for Legitron is

$11,025,000.

16.9 Interest tax shield benefit: FAJ, Inc., has $500 million of debt outstanding at an interest

rate of 9 percent. What is the present value of the tax shield on that debt if it has no

maturity and if FAJ is subject to a 30 percent marginal tax rate?

Solution:

The present value of FAJ’s tax shield is:

tc × D = 0.30 x $500,000,000 = $150,000,000

An alternative calculation would be:

(tc × D × kDebt ) / kDebt = (0.30 x $500,000,000 x 0.09) / 0.09 = $150,000,000

16.10 Interest tax shield benefit: Springer Corp. has $250 million of debt outstanding at an

interest rate of 11 percent. What is the present value of the debt tax shield if the debt has

no maturity and if Springer is subject to a 40 percent marginal tax rate?

Solution:

The present value of Springer’s tax shield is:

tc × D = 0.40 × $250,000,000 = $100,000,000

16.11 Interest tax shield benefit: Structural Corp. currently has an equity cost of capital equal

to 15 percent. If the Modigliani and Miller assumptions hold (with the exception of the

assumption that there are no taxes) and the firm’s capital structure is made up of 50

percent debt and 50 percent equity, then what is the weighted average cost of capital for

the firm if the cost of debt is 10 percent and the firm is subject to a 40 percent marginal

tax rate?

Solution:

= (0.5)(0.10)(1-0.4) + 0.5(0.15) = 0.105, or 10.5%

16.12 Practical considerations in capital structure choice: List and describe three practical

considerations that concern managers when they make capital structure decisions.

Solution:

1. Financial flexibility: Managers must minimize the firm’s cost of capital while

also ensuring that the firm has the flexibility to raise new capital quickly to deal

with unexpected problems or to take advantage of unexpected opportunities.

2. Net income risk: Increasing the leverage of a firm increases the risk associated

with a firm’s net income, and the risk of default.

3. Earnings impact: When a project is financed with debt, the interest payments

reduce the accounting dollar value of net income. However, when debt is used, no

new shares of equity are issued, so the company’s earnings per share would be

expected to increase (given a positive-PV project). Although financial theory

suggests that neither of these effects should matter, managers often take them into

account when making financing decisions.

INTERMEDIATE

16.13 M&M Proposition 1: Keyboard Chiropractic Clinics produces $300,000 of cash flow

each year. The firm has no debt outstanding, and its cost of equity capital is 25 percent.

The firm would like to repurchase $600,000 of its equity by borrowing a similar amount

at a rate of 8 percent per year. If we assume that the debt will be perpetual, find the cost

of equity capital for Keyboard after it changes its capital structure. Assume that

Modigliani and Miller Proposition 1 holds.

Solution:

Using the 25 percent cost of equity capital, the value of the firm today is

$300,000/0.25 = $1,200,000

We know that this must be the value of the firm after the repurchase.

The value of the debt claim must be $600,000 at the time of the borrowing, so we know

that the value of the outstanding equity after the repurchase must be

$1,200,000 – $600,000 = $600,000

Since we know that $48,000 ($600,000 × 0.08) in cash flow must be paid to the debt

holders each year, we then know that $252,000 ($300,000 – $48,000) will be available to

the stockholders on an annual basis.

This implies that the new cost of equity capital for the firm must be such that

$600,000 = $252,000 / kEquity, or kEquity = 42.00%

16.14 M&M Proposition 1: Marx and Spender has a current WACC of 21 percent. If the cost

of debt capital for the firm is 12 percent and the firm is currently financed with 25 percent

debt, then what is the current cost of equity capital for the firm? Assume that the

assumptions in Modigliani and Miller’s Proposition 1 hold.

Solution:

Using the WACC formula we can solve for the cost of equity capital for the firm:

0.21 = 0.25(0.12) + 0.75(kcs)

kcs = 0.24, or 24%

16.15 M&M Proposition 1: Evaluate the effect on Modigliani and Miller’s Proposition 1 of

relaxing the assumption that there are no information or transaction costs.

Solution:

No information or transaction costs means, for example, that individuals may borrow and

lend at the same rate that the firm can borrow and lend. If an investor were unable to sell

(or buy) shares by investing (or borrowing) without transactions costs, then some of the

value conserved in the Modigliani and Miller arguments through personal trading would

be dissipated by transaction costs. This dissipation would then negate the conservation of

value proposed by M&M.

16.16 M&M Proposition 1: The weighted average cost of capital for a firm (assuming all three

Modigliani and Miller assumptions) is 15 percent. What is the current cost of equity

capital for the firm if its cost of debt is 10 percent and the proportion of debt to total firm

value for the firm is 0.5?

Solution:

Since D/V = 0.5 ==> D / E = 0.5 / 0.5 = 1

Using the formula given in the text,

kcs = kAssets + (VDebt /Vcs) × (kAssets – kDebt)

= 0.15 + (1) × (0.15 – 0.10) = 0.2, or 20%

16.17 M&M Proposition 2: Mikos Processed Foods is currently valued at $500 million. Mikos

will be repurchasing $100 million of its equity by issuing a nonmaturing debt issue at a

10 percent annual interest rate. Mikos is subject to a 30 percent marginal tax rate. Given

all of the Modigliani and Miller assumptions, except the assumption that there are no

taxes, what value will Mikos have after the recapitalization?

Solution:

Mikos will be worth $500,000,000 plus the present value of the tax shield.

The present value of the tax shield is $100,000,000 x 0.3 = $30,000,000.

Therefore, Mikos will be worth $530,000,000 after the recapitalization.

16.18 M&M Proposition 2: Backwards Resources has a WACC of 12.6 percent, and it is

subject to a 40 percent marginal tax rate. Backwards has $250 million of debt outstanding

at an interest rate of 9 percent and $750 million of equity (market value) outstanding.

What is the expected return of the equity given this capital structure?

Solution:

Using the WACC formula when taxes are included:

WACC = (1-tc) × kd x (D/V) + ke × (E/V)

We can solve for the missing variable:

0.126 = (1-0.4) × 0.09 × (250/ [250 + 750]) + ke × (750/ [250 + 750])

ke = 0.15, or 15%

16.19 The costs of debt: Briefly discuss costs of financial distress to a firm that may arise when

employees believe it is highly likely that the firm will declare bankruptcy.

Solution:

If the employees of a firm understand that the firm has a significant chance of filing for

bankruptcy, then costs to the firm could be manifested in a number of ways, including:

1. Lower productivity due to lower morale and job hunting. This could be as simple as

employees spending time gossiping about what is going to happen to them as well as

employees actively pursing other jobs while on the payroll of the troubled firm.

2. Higher recruiting costs. New employees, understanding that working for the firm is a

risky venture, will seek compensation for this additional risk. Therefore, recruiting

employees will become more expensive due to greater recruiting efforts as well as

greater compensation expense when a new employee is finally located and hired.

16.20 The costs of debt: Santa’s Shoes is a retailer that has just begun having financial

difficulty. Santa’s suppliers are aware of the increased possibility of bankruptcy. What

might Santa’s suppliers do based on this information?

Solution:

Santa’s Shoes is not certain to go into bankruptcy, so its suppliers would still like to do

business with Santa’s as long as it is profitable to do so. Therefore, the suppliers would

still make sales to Santa’s as long as payment for the sales were made at the time of

purchase rather than on credit. This would require Santa’s to maintain a higher cash

balance. This requirement to hold additional cash could be viewed as a cost of financial

distress to Santa’s Shoes.

16.21 Stockholder-manager agency costs: Deficit Corp. has determined that it will come up

short by $50 million on its debt obligations at the end of this year. Deficit has identified a

positive-NPV project that will require a great deal of effort on the part of management.

However, this project is expected to generate only $40 million at the end of the year.

Assume that all the members of Deficit’s management team will lose their jobs if the firm

goes into bankruptcy at the end of the year. Will Deficit take the positive-NPV project? If

it declines the project, what kind of cost will Deficit incur?

Solution:

Managers expect to lose their jobs in one year whether they work hard and take the

project or not. Although there may be a slim chance that the firm will not declare

bankruptcy, management has no incentive to take on the difficult project. This makes the

shortage to the debt holders, as well as the stockholders, greater than it would be if the

firm followed the rule of always accepting positive-NPV projects. This is another

example of agency costs that can arise from financial distress.

16.22 Two theories of capital structure: Use the following table to make a suggestion for the

recommended proportion of debt that the firm should utilize for its capital structure.

Benefit or (cost) No debt 25% debt 50% debt 75% debt

Tax shield $ 0 $10 $20 $30

Agency cost −$10 −$ 5 −$ 5 −$20

Financial distress cost −$ 1 −$ 3 −$10 −$10

Solution:

By totaling the cost and benefits for each proportion of debt we find:

Benefit or (Cost) No debt 25% debt 50% debt 75% debt

Total cost/benefit -$11 $2 $5 $0

Therefore, this firm can maximize firm value by choosing a 50 percent debt capital

structure.

16.23 Two theories of capital structure: Problem 16.22 has reintroduced taxes and information

and transaction costs to the simplified Modigliani and Miller model. If the marginal tax rate

for the firm were to suddenly increase by a material amount, would the capital structure that

maximizes the firm include less or more debt?

Solution:

If we hold all others things equal, then the value of the tax shield would become more

valuable in the scenarios with positive debt amounts. While we cannot say for certain,

given the information in the question, an increase in the tax rate will increase the value of

the tax shield and should increase the amount of debt in the optimal capital structure.

Therefore, it would appear that an increase in the tax rate should motivate firms to

increase their debt levels.

16.24 Two theories of capital structure: Describe the order of financial sources for managers

who subscribe to the pecking order theory of financing. Evaluate that order by observing

the costs of each source relative to the costs of other sources.

Solution:

According to the pecking order theory, the costs, from lowest to highest, are:

1. Internally generated funds (this is essentially retained earnings)—This will

actually be the second most expensive source in this list.

2. New issue debt—This will be the cheapest source in this list.

3. New issue equity—This will be the most expensive source in this list.

It appears that the managers who subscribe to the pecking order theory do not exhaust the

cheapest sources of financing before moving on to more expensive sources.

16.25 Two theories of capital structure: The pecking order theory suggests that managers prefer

to first use internally generated equity to finance new projects. Does this preference mean

that these funds represent an even cheaper source of funds than debt? Justify your answer.

Solution:

That internally generated equity is utilized first as a source of financing does not mean

that the internally generated funds are cheaper than debt. Internally generated funds

belong to stockholders and are therefore really equity financing, which we know to be

more expensive than debt. However, using internally generated funds enables the firm to

avoid the costs associated with borrowing or selling stock (including the costs associated

with the signals that financing announcements send investors), which, in turn, can make

internal funds most attractive.

16.26 The costs of debt: Discuss how the legal costs of financial distress may increase with the

probability that a firm will fall into bankruptcy, even if the firm has not reached the point

of bankruptcy.

Solution:

If a firm is anticipating bankruptcy to a greater extent, then it will increase its legal efforts

to protect the firm from creditors when and if the firm reaches that point. Therefore, the

legal costs of bankruptcy will increase with financial leverage even if the firm has not yet

declared bankruptcy.

ADVANCED

16.27 Operating a firm without debt is generally considered to be a conservative measure.

Discuss how such a conservative approach to a firm’s capital structure is good or bad for

the value of the firm in the absence of information or transaction costs and any effect of

debt on the real investment policy of the firm.

Solution:

In the absence of information or transactions costs and any effect of debt on the real

investment policy of the firm, the value of the firm is increasing in proportion of the debt

in the firm’s capital structure due to the present value of the tax shield on the debt.

Therefore, although operating without debt may be a safer play for investors, it does not

maximize stockholder value, which should be the goal of managers.

16.28 Finite Corp. has $250 million of debt outstanding at an interest rate of 11 percent. What is

the present value of the debt tax shield if the debt will mature in five years (and no new

debt will replace the old debt), assuming that Finite is subject to a 40 percent marginal tax

rate?

Solution:

Finite will pay $27,500,000 ($250,000,000 x 0.11) in interest each year, which will shield

Finite from paying a tax amount equal to $11,000,000 ($27,500,000 x 0.4). The tax shield

will last for five years, so the present value of receiving this amount for the next five

years is:

$11,000,000 × PVIFA(11%, 5) = $11,000,000 × 3.695897 = $40,654,867.19

16.29 The Boring Corporation is currently valued at $900 million, but management wants to

completely pay off its perpetual debt of $300 million. Boring is subject to a 30 percent

marginal tax rate. If Boring pays off its debt, what will be the total value of its equity?

Solution:

Boring will be worth $900 million less the present value of the tax shield on its current

debt. The present value of the tax shield is

$300,000,000 x .3 = $90,000,000

Therefore, Boring will be worth $810 million after the recapitalization, and since it will

be an all-equity firm, that will be the value of the equity.

16.30 If we drop the assumption that there are no information or transaction costs, in addition

to dropping the no-tax assumption, then will the Modigliani and Miller model still

suggest that the firm should take on greater proportions of debt in its capital structure?

Explain.

Solution:

If we only drop the no tax assumption, then it is evident that the firm should always

increase its use of debt within a firm’s capital structure. However, if we drop the no

information or transactions costs assumption, then we are effectively introducing the

possibility that the firm will default on its debt obligations. The higher the level of debt,

the greater the possibility of defaulting and then the greater the interest costs on the debt.

Given this increasing cost of debt, relative to the increased use of debt within a firm’s

capital structure, then we are introducing the possibility that the firm’s overall cost of

capital will increase at some high-debt level capital structure, thereby reducing the value

of the firm. Therefore, by dropping the no information or transactions costs assumption,

the firm will not always increase its use of debt.

16.31 PolyAna Corporation has an abundant cash flow. It is so high that the managers take

Fridays off for a weekly luncheon in Cancun using the corporate jet. Describe how

altering the firm’s capital structure might make the management of this firm stay in the

office on Fridays in order to work on new positive-NPV projects.

Solution:

The root of the problem is that the firm’s management is too comfortable, because their

weekly trip to Cancun is not costly enough to the managers of the firm. PolyAna could

drastically increase the proportion of debt in the firm’s capital structure. This would

decrease the amount of “free” cash that PolyAna’s management could spend on their

weekly outings. If enough debt is placed on this firm, then a cash shortage, or lack of a

large cash surplus, would necessitate that the managers of the firm work on new positive-

NPV projects rather than spend their Fridays in Cancun.

CFA Problems

16.32 Consider two companies that operate in the same line of business and have the same

degree of operating leverage: the Basic Company and the Grundlegend Company. The

Basic Company has no debt in its capital structure, but the Grundlegend Company has a

capital structure that consists of 50 percent debt. Which of the following statements is

true?

a. The Grundlegend Company has a degree of total leverage that exceeds that of

the Basic Company by 50 percent.

b. The Grundlegend Company has the same sensitivity of net earnings to

changes in earnings before interest and taxes as the Basic Company.

c. The Grundlegend Company has the same sensitivity of earnings before

interest and taxes to changes in sales as the Basic Company.

d. The Grundlegend Company has the same sensitivity of net earnings to

changes in sales as the Basic Company.

Solution:

C is correct. The degree of total leverage of the Grundlegend Company exceeds that of the Basic Company, but the extent of the difference depends on the amount of interest expense, not the amount of debt. In the case of financial leverage, it is the interest that acts as a fulcrum.

16.33 According to the pecking order theory,

a. new debt is preferable to new equity.

b. new equity is preferable to internally generated funds.

c. new debt is preferable to internally generated funds.

d. new equity is always preferable to other sources of capital.

Solution:

A is correct. According to pecking order theory, internally generated funds are preferable to both new equity and new debt.

16.34 According to the static trade-off theory,

a. the amount of debt a company has is irrelevant.

b. debt should be used only as a last resort.

c. debt will not be used if a company’s tax rate is high.

d. companies have an optimal level of debt.

Solution:

D is correct. The static trade-off theory indicates that there is a trade-off between the tax shield from interest on debt and the costs of financial distress, leading to an optimal range of debt for a company.

Sample Test Problems

16.1 Valentin’s Acting School produces annual cash flows of $5,000 and is expected to

continue doing so in the infinite future. The cost of equity capital for Valentin’s is 16

percent, and the firm is financed completely with equity. The firm would like to

repurchase as much equity as possible but will not pay more than $500 in interest expense

to service the debt on the borrowing to finance the repurchase. Valentin’s can borrow at a

10 percent rate (assume that the debt will also be outstanding into the infinite future).

Using Modigliani and Miller’s Proposition 1 and all of its assumptions, what will be the

value of each claim on the firm’s assets after the stock repurchase?

Solution:

Using the 16 percent cost of equity capital, we see that the value of the firm today is

$5,000/0.16 = $31,250

Note that using M&M Proposition 1, we know that this must be the value of the firm

after the repurchase.

The value of the debt claim will be

$5,000 = ($500 / 0.1)

at the time of the borrowing, so we know that the value of the outstanding equity after the

repurchase must be

$31,250 – $5,000 = $26,250

16.2 Attic & Garage, Inc., is considering issuing $25 million of debt to repurchase shares of

the firm. If Attic & Garage follows through on the capital restructuring, what is the

present value of the tax shield on that debt if it has no maturity and Attic & Garage is

subject to a 34 percent marginal tax rate?

Solution:

The present value of Attic & Garage’s tax shield will be

tc × D = 0.34 × $25,000,000 = $8,500,000

16.3 GreenBack Landscapers produces an enormous amount of cash each year. The

stockholders of the firm believe that this level of cash flow has left the managers without

much motivation to find new projects. The stockholders have hired a financial consultant

to give them estimates concerning the value of the tax shield, agency costs, and financial

distress costs of the firm, given four alternative capital structure scenarios. Use the

following table to make a suggestion for the recommended proportion of debt that

GreenBack should utilize for its capital structure.

Benefit or (Cost) No debt 25% debt 50% debt 75% debt

Tax shield $ 0 $3 $6 $ 9

Agency cost −$10 −$1 $0 −$ 5

Financial distress −$ 0 −$2 −$4 −$20

Solution:

By totaling the cost and benefits for each proportion of debt, we find:

Benefit or (Cost) No debt 25% debt 50% debt 75% debt

Total cost/benefit −$0 $9 $22 −$29

Therefore, this firm can maximize firm value by choosing a 75 percent debt capital

structure.

16.4 It may be difficult to provide incentives for managers to work hard when the firm is not

experiencing any financial distress. One solution that capital structure theory provides for

that problem is to increase the proportion of debt in the capital structure of the firm. If a

firm is currently financed with 90 percent debt, will additional debt help to further reduce

the agency costs between stockholders and managers?

Solution:

It is unlikely that an additional 5 percent of debt within the capital structure would reduce

the agency costs between the stockholders and management. At such high levels, it is

unlikely that managers are not working hard to meet the firm’s debt obligations. If the

managers of this firm are risk averse, then they could be rejecting positive-NPV, but risky

projects that would add greater value to the firm. In that case we can see that the

additional debt might actually increase the agency costs borne by the stockholders.

16.5 Mayan Imports has recently found a number of new positive-NPV projects that it will

need to finance. Mayan has $100 million of cash on hand. It also has plenty of financial

room to increase its debt as a proportion of its capital structure. If Mayan follows the

pecking order theory, what source would you expect it to use for its projects, which

require $60 million in assets?

Solution:

The pecking order theory suggests that Mayan will utilize its internally generated funds to

finance its projects and that when that source is exhausted, the firm will borrow. Mayan

would then use its cash on hand to finance all of the projects.