Corporate Finance II: Financing Investments and Managing Risk

Professors Heitor Almeida and Stefan Zeume

Module 1: Raising Financing: The Capital Structure Decision

Table of Contents
Module 1: Raising Financing: The Capital Structure Decision ................................................... 1
Lesson 1-0.1: Objectives and Overview ............................................................................................................... 2

Lesson 1-1: Mechanics of Debt and Equity Issuance.......................................................................... 9

Lesson 1-1.1: Mechanics of Debt and Equity Issuance ........................................................................................ 9

Lesson 1-2: Should a Company Issue Debt or Equity?...................................................................... 21

Lesson 1-2.1: Should a Company Issue Debt or Equity? .................................................................................... 21

Lesson 1-3: Two Misconceptions .................................................................................................... 29

Lesson 1-3.1. Two Misconceptions – Part 1 ....................................................................................................... 29
Lesson 1-3.2: Two Misconceptions – Part 2....................................................................................................... 37

Lesson 1-4: Evidence from the Field: Which Type of Capital Do Firms Prefer? ................................. 49
Lesson 1-4.1: Evidence From the Field: Which Type of Capital Do Firms Prefer? ............................................. 49

Lesson 1-5: The Effect of Leverage on Taxes and Profits ................................................................. 58

Lesson 1- 5.1: The Effect of Leverage on Taxes and Profits ............................................................................... 58

Lesson 1-6: Leverage and Personal Taxes........................................................................................ 68

Lesson 1-6.1: Leverage and Personal Taxes ....................................................................................................... 68
Lesson 1-7.1: Leverage and the Risk of Financial Distress ................................................................................. 81

Lesson 1-8: The Trade-off Theory of Capital Structure .................................................................... 92

Lesson 1-8.1: The Trade-off Theory of Capital Structure ................................................................................... 92

Lesson 1-9: Review and Graded Activities..................................................................................... 101

Lesson 1-9.1: Module 1 Review ....................................................................................................................... 101

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-0 Module 1 Objectives and Overview

Lesson 1-0.1: Objectives and Overview

So, let's start talking about how companies finance investments. Corporate Finance 1
was about spending cash, we talked about topics such as the net present value, the
internal rates of return, cost of capital. What we're going to do in this course is, we're
going to talk about how companies raise cash to finance the spending. Issues like debt
financing, equity financing, risk management, so this is going to be the topics we're
going to talk about. After all, cash doesn't grow on trees, so it's very important to think
about how companies raise the cash there that is going to fund their activities.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Which investments are we thinking about? We're going to focus mostly on financing
new investments, such as research and development, R&D, and mergers and
acquisitions, M&A. We have a couple examples in Module 4, where we're going to do
some case studies focused on R&D and M&A. But it's important to notice upfront that
companies also need to raise capital for other activities. For example, refinancing
existing debt, you may want to refinance your debt to lower interest rates, for example.
Debt forces companies to go to capital markets. You might even have to raise capital to
make payments to suppliers in some cases. All right, or you might simply want to
reoptimize your capital structure. Maybe you think you don't have enough debt, you
want to increase your leverage, or you want to reduce your leverage. Debt, again, is
going to force companies to go to capital markets and raise some finance.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

In this module, Module 1, our initial step is going to be to think about the most basic
decision that companies must make. Which is to think about whether companies are
going to raise capital by issuing debt, right, to get a loan from a bank, or to issue a bond
in public markets, or whether companies are going to issue equity. Companies are
going to raise capital by giving ownership to investors and raise capital from investors.
Debt or equity, that's going to be the key topic of Module 1.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

What we'll learn first is we're going to talk about how debt and equity financing affect the
financial statements that we were talking in Corporate Finance I. Right, so we're going
to learn how debt and equity financing change income, cash flow statements, how they
change companies' profits. We're going to compute the net present value of both debt
and equity issuance. Remember that net present value is the key tool that we must
analyze corporate decisions. We can also use NPV to think about that inequity. And
then we're going to talk about true mistakes that practitioners make, that students make,
when they are thinking about capital structure. The first one is that dilution is an illusion.
There is no such thing as dilution. The number of shares outstanding does not matter.
We're going to talk about that. And then we're going to talk about why that issuance is
not mechanically going to reduce the cost of capital. Our math, in this case, the math is
misleading. Usually, math is right, but math can also get, mathematics that I'm talking
about, mathematics can also get you to the wrong place. And here you are going to see
that doing a simple calculation can give you the wrong answer. Then we're going to talk
about the key relationship between debt and systematic risk, right?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

The idea is that debt is going to increase a company's data, which is behind the logic in
a key result in Corporate Finance, which is the Modigliani and Miller proposition. The
Modigliani and Miller proposition is going to show you why issuing that will not
necessarily reduce the cost of capital. Then we're going to move on and talk about
research. As I mentioned in the introduction of this course, this course is going to draw
a lot on the research that we researchers have done about capital structure and other
topics in the last few years. The first issue you're going to learn is that equity issuance
stands to cause a decrease in stock prices. I'm going to show you some data that
shows this. Perhaps because of this effect of equity issuance on stock prices,
companies are reluctant to issue equity to finance projects.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Then we're going to talk about how that affects profits, and one of the key effects is
going to be through taxes. We're going to calculate the effect of leverage on taxes and
how leverage affects our ultimate measure of profitability, which is OPAT, operating
profit after taxes. And then we're going to talk about other effects that might mitigate
disadvantage of that, like personal taxes and cost of financial distress, right? Costs of
financial distress are going to increase with leverage because leverage increases
distress risk.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

And ultimately, what we're going to end up with is a model that we call the tradeoff
theory of capital structure, which balances the costs and benefits of having higher
leverage. And I'm going to show you this model, talk about some data, some recent
research about the trade-off model. And then what we're going to do following up, in
future models of this course, is to try to use the trade-off theory to analyze firms' capital
structure choices in the real world.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-1: Mechanics of Debt and Equity Issuance

Lesson 1-1.1: Mechanics of Debt and Equity Issuance

We will start with the PepsiCo example from corporate finance Part 1. This example
showed up in most of the modules. In fact, you're probably okay not remembering all the
details. But if you have any questions or if there's anything you want to check, you can
always go back to the earlier modules. In this example, we worked on the financial
planning for PepsiCo. We assume that the company will need to invest five billion
dollars in 2022, and another eight billion dollars in 2023. We were sitting in 2021 and we
were wondering, asking ourselves whether PepsiCo could finance this expansion
without issuing new finance. We found that they have sufficient cash for the expansion
plan. But we also discussed that they might not want to deplete all their cash. They
might in fact want to get new financing. This session and the following sessions will be
all about this topic. How can PepsiCo go about raising new finance? What does it mean
for their financial statements?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

On this slide, you see our forecast of PepsiCo's cash flow statement. You have your
three parts, operations, investing, and financing. The key assumption was that they
have capital expenditure of five billion dollars in 2022, and then another eight billion
dollars in 2023. Then we asked whether they could finance these capital expenditures
using only their own cash. Basically, can they finance their expenditures using only their
cash balances? The way we did this is we forecasted cash flows from operations using
a very simple forecasting model. Then we include capital expenditures under these
assumptions, and under the assumption that there's no new financing in the next few
years. You can see that net issuance of stock and net borrowing are both zero in 2022,
and 2023. The answer we got is that PepsiCo would have a negative change in cash of
about $2.9 billion by the end of 2023.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Then we said that if Pepsi does not want to reduce its cash balance by three billion,
maybe because they have a target amount of cash holdings. Well, then they would
need to raise new funds. Due to the expansion plans, the company would need to raise
some money, some new funds. Let's say that the amount that PepsiCo will raise is
seven billion dollars. We talked about this in Module 1 as well. They might want to be
precautious; they might want to raise a little bit more than what is needed just to have a
financial cushion if you like. Here's the new question we will try to answer in this
module. We are going to think about this very important choice that companies must
make when deciding to raise new financing. The choices of whether they should go to
the debt markets or whether they should go and issue new equity. That's the major topic
of this whole module of this session and the sessions that follow.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let's first talk about the mechanics of all of this. We forecasted financial statements
without debt or equity issues in Module 1. Now, let's see what happens to these
forecasted financial statements if the company were to raise seven billion dollars. You
see the financial statements on the slide. We have our financial planning model ready.
What I want to do with you, and I think it's a very useful exercise, is to look at the
financial statements and figure out what will happen after PepsiCo issues debt or equity.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let's start with debt. Suppose that PepsiCo issue seven billion dollars in new debt.
Suppose that the interest rate is 4%, just as before. It doesn't have to be exactly that.
But let's say those are our numbers. This will mean that PepsiCo will pay new interests
of $280 million per year.

The question is, how will a seven billion debt issue affect the financial statements?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

This is the old financial statement on the slide there based on no additional debt issue.
You also see the old interest expense over there and the old EBIT. That's what will be
affected by this new debt issue and let's see how.

The new income statement is going to have an increase in the amount of interest
expense. Specifically, we have 280 million additional interest expense. I have
highlighted this for you. PepsiCo will have to pay additional interest because they raised

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
seven billion dollars to finance the new investment. This higher interest expense will, of
course, reduce the earnings. You pay more interest, and your earnings go down. You
can go back a minute if you'd like, and check against the old income statement.

Let's move from the income statement to the cashflow statement. In terms of the
cashflow statement, our earnings are lower, as you will see in the first line. Then we can
just derive the other items of the cashflow statement. We have lower earnings, so the
cash flows from operations in the first part of this cashflow statement will be lower. Cash
flows from investing stay the same. They are still five billion dollars and eight billion
dollars. The key is in the last part of the cash flow statement. Here, since we borrowed
seven billion dollars in 2022, we have a cash inflow of seven billion dollars. You will see
this in the net borrowing line. Again, it's highlighted in yellow for you, seven billion
dollars from this net issue of debt. Which means that now we have a positive cash flow
from financing. If you recalculate all the numbers, what will happen is that now we have
a positive change in cash. That's really the bottom line, literally, and figuratively. It's the
bottom line, a positive change in cash. They will have a positive change in cash of $6.9
billion in 2022. That will be more than enough to compensate for the capital expenditure
in that year. That's the mechanics for the debt issue. Let's talk about the other
possibility. Let's talk about the equity issue.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Issuing equity means going to the market and selling new shares, at least for public
companies such as Pepsi. What they would do is to sell new shares in the company, in
the marketplace. The current stock price of PepsiCo at the time we did this financial
planning exercise was roughly $173 a share. What that means is that if Pepsi wanted to
sell seven billion dollars’ worth of shares at $173 a piece, they would issue 40.46 million
shares. You can do the math here, it's quite straightforward. Just divide the seven billion
by 173. Let's see how this equity issue affects the financial statements. Let's see what
changes.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Well, if you look at the income statement for a very long time, you will realize that
nothing really changes. There's no interest expense. You don't pay interest on stocks,
so the income statement is going to be the same. Your interest is not changing at all.
That means that your earnings are going to be the same. There is no change in
earnings.

Let's move to the cash flow statement. Here, instead of borrowing, we now have seven

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
billion dollars in a net issuance of stock. It's highlighted in yellow for you, seven billion
dollars stock issuance. That means that PepsiCo is going to the market to raise new
equity, and it's reflected in the cash flow statement. Again, we see that at the bottom of
this cash flow statement, PepsiCo and now has a positive change in cash. The
company has enough funding to finance the capital expenditure. We saw the income
statement; we saw the cash flow statement. It all seems okay so far. Now, PepsiCo has
a positive change in cash in 2022. So, they have enough cash to finance the new
investment.

Profits haven't changed. At this point, you might be wondering about the cost of issuing
new equity. I want to give you a little bit of time to think about that. The cost of issuing
equity. What's the cost of issuing new equity?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Well, the cost of issuing equity is that the number of shares outstanding is going to go
up. We did the calculation just a minute ago. PepsiCo is going to have an increase in
the number of shares outstanding by 40.46 million in this case. The company has more
shares outstanding. What that means is that the profits, which haven't changed, needs
to be split among a larger number of shares. Issuing equity is the same thing as
bringing new owners to the table. If you bring in new owners, if they want their share of
the pie, and the people who already own Pepsi are going to own a smaller fraction of
the pie, then this is what will happen. The cost of issuing equity is that you are issuing
new shares.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Next, you might be thinking about dividends. I'm sure that some of you fall off this
already. The cost of issuing equity is that we are going to increase dividends. That
should be the counterpart of issuing debt and paying interest. So you issue equity and
you increase dividends. Now, you might think that we forgot to increase dividends in our
new income statement. You might think we just forgot about that. Well, it turns out we
didn't really make a mistake. Of course not. If you remember our planning model, we
assumed that dividends are a constant fraction of earnings. We don't need to change
these dividends. Paying dividends is a choice of the company. It's yet another choice. In
principle, it's very unrelated to the choice of issuing equity. If you think about the fact
that PepsiCo wants to bring new money into the company, maybe it doesn't even make
sense for PepsiCo to increase dividends at the same time. Imagine this. PepsiCo raises
equity and then immediately uses some of the proceeds to pay a dividend. Maybe it
wouldn't make sense for PepsiCo to increase dividends at that point. In fact, it's a topic
of its own. In module 2, we're going to spend a lot of time talking about payout policy.
It's exactly the decision of how much dividends to pay. Then we will have to say more
about all of this.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-2: Should a Company Issue Debt or Equity?

Lesson 1-2.1: Should a Company Issue Debt or Equity?

Up to now, we have gone through the financial statements, and we have learned the
mechanics of issuing debt and equity. We saw how issuing debt and issuing equity
affects the financial statements. But we still must make a decision. We need to decide
whether to issue debt or equity. Let's try to make the decision. Rather than flipping a
coin, we will go back to Corporate Finance Part 1. We learned a tool that helps
managers make financial decisions. We saw the net present value concept. We saw
that companies take investments that have positive net present value, NPV. In our case
here, this means the company should issue debt if the NPV of issuing debt is greater
than the NPV of issuing equity. Let's try to apply this idea and see where it takes us. I
will tell you upfront that we will not be able to decide whether debt or equity should be
issued, not in the next few minutes at least. It will, in fact, take us most of this module.
But I think how we start this debate will help us later. Let's start with debt.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

We already figured out that there is a benefit and there is a cost. The cost, of course, is
that you are going to pay interest year after year after year. The interest, in this case, is
$280 million a year. The benefit is that you are going to get seven billion dollars in cash
right now. The four-percent-interest payment, that's what we call the yield to maturity as
you might remember from Module 1. The yield to maturity is also the expected return on
this bond. What this means is that it is very reasonable and, in fact, correct to discount
at 4%. If we are trying to figure out the NPV of the debt issuance, the correct discount
rate should be 4%. Our NPV here is the positive seven billion dollars that we receive
today and then we will discount all of the interest payments at 4%. At the end, say after
five years, you might repay the seven billion dollars.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

If you do the math, the answer you will get is that NPV of issuing a bond is going to be
zero. Does that make sense? Well, let's talk about it.

Let's think about what we've done. The idea here is that if the debt is priced, meaning
that if the interest rate is the same as the discount rate, then what's going to happen is
that the cost of issuing new debt, which is this $280 million annual interest, is going to
be exactly compensating for the benefits. The benefits are the same as the present

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
value of the cost. That's why we have zero NPV. Of course, what's going on here is that
we are relying on the assumption of efficient markets, which we talked about in
Corporate Finance Part 1. We are relying on the assumption that the debt is going to be
priced by the marketplace, that PepsiCo issuing debt exactly at the required rate of
return. Obviously, if the debt is for some reason not priced, then the NPV might not be
zero. Well, in fact, it wouldn't be zero. If PepsiCo can issue debt at a cheaper rate, for
example, then issuing debt has positive NPV. But if you think about it, why would that
be the case? The debt issuance should be correctly priced by the market, otherwise,
bondholders would lose out. Zero NPV is a very reasonable answer to the problem.

Let's do the same exercise for equity. We covered debt, what about equity? Now we
have seven billion dollars of cash coming in and we have the 40.46 million new shares
that are issued at $173. I put a few more numbers here. The first one is the current
market value of equity and the second one is the number of shares outstanding. We're
going to need these numbers in just a moment. Our question is, what is the NPV of an
equity issuance? This is a little bit trickier because we don't really have a counter
product of the interest payments. The cost of issuing equity is that the number of shares
goes up. Here, what we're going to do is we're going to think in terms of stock prices.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Remember that maximizing the net present value is the same thing as maximizing the
stock price. We covered this in Corporate Finance Part 1, maximizing NPV, maximizing
the stock price, it's the same thing. Here, we will try to figure out how an equity issuance
affects the stock price. Let me show you how we do this.

The old stock price is just the old market capitalization before the equity issue divided
by the old number of shares. It's 239.6 billion divided by 1.383 billion, that's $173. Now,

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
we want to calculate the new stock price. If PepsiCo issues new shares, if they get
seven billion dollars in cash, then the cash is going to be owned by the shareholders.
The cash that PepsiCo gets will increase the company's market cap by seven billion
dollars. That's going to be our numerator when we calculate the new stock price. What
I've done in the denominator is I added the number of new shares, the 40.46 million. As
before, to get to the stock price, we just need to divide the market cap by the number of
shares. There are now more shares outstanding. If you do the math, what you get is
that the stock price is $173. We issued equity and the stock price has not changed.

We ask for the NPV of issuing equity. Stock price doesn't change, so NPV of this equity
issuance is zero. That's exactly the same idea that made the NPV of debt equal to zero.
The idea is that new cash that comes into the company exactly compensates for the
issuance of these new shares. The stock price remains constant. As before, this notion
relies on the assumption of efficient markets or at least on the assumption that the
equity is priced. Now, of course, if PepsiCo manages to sell the shares at a higher price,
then all of this will look very different. But why should they be able to do that? Why
would investors pay too much? The bottom line is that issuing equity has zero NPV. You
don't lose money; you don't make money. Up to here, NPV of issuing debt and equity is
zero both times.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

At this point, you might be wondering about the new investment. Our original
assumption was that we raise capital to finance a new investment. What about the NPV
of this new investment? We're just talking about interest payments, shares, cash coming
in, where is the net present value of the new investment? That, of course, should
matter. Think about that question for just a little bit; why are we ignoring the NPV of the
new investment?

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

The answer is that the NPV of the new investment is not incremental. Again, this is a
concept that we talked about in Corporate Finance Part 1. We said that the only cash
flows that matter for the NPV calculation are incremental cashflows, cashflows that
change what happens in the company. Well, here's the thing, in our calculation above,
whether we issue debt or equity does not affect NPV of the investment. If you issue
equity, you take your seven billion dollars, you make an investment. If you issue debt,
you take these seven billion dollars and you make an investment. But NPV of this
investment is the same irrespective of whether you issue debt or equity. NPV of the
investment will not affect the decision of whether PepsiCo is going to issue debt or
equity. In fact, it's safe for us to completely ignore what companies are going to do with
the money. We just must think about the immediate consequences of issuing new
securities. That's a very useful idea that we are going to use later.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-3: Two Misconceptions

Lesson 1-3.1. Two Misconceptions – Part 1

We have made some very good progress so far, now we know how debt and equity
issuance affect the financial statements we also covered the zero NPV idea. What we
haven't done though, is answer our question. As a reminder, our question is whether
PepsiCo should issue debt or equity. And so far, if both have zero NPV then maybe it
doesn't matter. Well, given that we are nowhere near the end of this module, you can
probably guess, that I have a bit more to say about that in equity. But before I say more
about it, I want to talk about two misconceptions, okay? There are two ways that people
think about debt or equity decisions and both ways are incorrect to put it mildly. And it's
important to learn that these misconceptions are out there and why they are wrong,
okay? It's as important as to learn what's wrong, as it is to learn what's right. So, the
goal of this lecture is to tell you about two misconceptions that I think are very important
for you to understand, because real world people have these misconceptions.

So, the first misconception is this notion of dilution, okay? It's a very common argument,
we see it all the time, and it always drives me mad, okay? Because it's wrong, it's the
idea that issuing new equity reduces the stock price because the number of shares
outstanding goes up. So, the dilution story goes as follows, and it's in quotation marks
here, so it's not what I'm saying, okay? It's what other people say, what they say is that
“issuing new equity, reduces the stock price, because of dilution,” okay? Number of

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
shares outstanding goes up and therefore the stock price must come down, that's what
they say.

So why is this wrong? We've already done the math to show why this is wrong, okay?
The true part of the statement is that issuing equity increases the number of shares. But
what the statement is missing is that the company is receiving cash, in exchange for the
stocks. There's cash coming in, and that cash is going to increase the market value of
equity. So, the stock price is market value of equity divided by the number of shares
outstanding. The numerator goes up, the denominator goes up, okay? So, in fact in our
example, nothing happened, the stock price remained constant. There is in fact, no
dilution of the equity is sold at the fair price. That's what we showed in our numerical
example, for PepsiCo, the market value of equity exactly compensates for the increase
in the number of shares outstanding. So, the stock price remains constant, the stock
price does not go down.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

Let me stress this again, because I want all of you to remember from this capital
structure class, okay? Dilution is an illusion, okay? Repeat that with me, repeat it for
yourself remember it, okay? It's a very important thing to remember because this
argument is as common as it is wrong. The second argument is a little bit more
complicated, but it's wrong nonetheless, okay? This is going to take us a little bit more
effort to understand.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

So, the second one has to do with the cost of capital, drawing from Corporate Finance
part 1. One thing we did in Corporate Finance Part One was to compute the back the
weighted average cost of capital for PepsiCo. So, the weighted average cost of capital
is the weighted average of the required return on debt and the required return on equity.
The numbers are on the slide, the required return on debt was 4% we multiply that by 1
minus the tax rate and 14% the leverage ratio. The laboratory issue is debt divided by
the market value of the company. The other component of the back of the weighted
average cost of capital is 1 minus leverage times the required return on equity. So that's
the return that shareholders require when they invest in PepsiCo’s equity. And that
turned out to be 6%. We estimated that using real data, I mean by the time you're
watching this lecture, the numbers might have changed. But those were the numbers
based on real world data, okay? And the problem is that these numbers leave people to
make the following arguments. And quotation marks again, not my words, there's, okay?
When you look at this equation, the required return on that is 4% but there is a tax
benefit of debt, okay? So, the after-tax required return on debt is 4%, times 1 minus
21%, that's 3.2%. Well so far so good, I agree with that, okay.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

But here's where typically goes wrong, the cost of debt is 3.2%, the cost of equity is 6%,
debt is cheaper we should issue debt. Debt is cheaper, okay? This is the key; this is
where people get it wrong. In fact, let's take a step back and do the math on our own, so
we really understand what I'm talking about here. This math is not going to give us the
right answer, okay? But I think it will help us think about this problem.

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Professors Heitor Almeida and Stefan Zeume

So, try to figure out what happens to PepsiCo’s weighted average cost of capital if you
increased the leverage ratio to 40%. It was 14% leverage now it's twice that, okay?

The answer is right there on the slide. Math tells us that the rack is now 4.9%, so all the
changes is the leverage ratio.

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We had 5.6%, now we have 4.9%, okay? That's once you look at this carefully enough,
it's less than 5.6%, okay? So, if you did the math, it would seem to you that the work for
PepsiCo is going down by 0.7% points. Seems right the problem is that some numbers
in this calculation are wrong, and I wouldn't be surprised if you were confused at this
point. As I said, the second illusion is a slightly more complicated one, so here's the
reason we got it wrong. The reason is that as you level up as you increase debt, you
also increased risk.

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In our calculation, we assumed that the required return on debt and equity stay
constant, still 4% and 6%. But let's think about it, if PepsiCo is doubling its leverage
ratio, they need to issue a lot of debt. Will they be able to issue a lot of debt at the same
rate as before? Maybe, but likely not. If Pepsi cause more leverage is the required
return on equity still 6%, or other shareholders going to require a higher return, because
the company has more leverage. The short answer is that shareholders will ask for a
higher return, and we will see why this is the case in the next lesson.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-3.2: Two Misconceptions – Part 2

This is the calculation we did in the previous lesson. We tried to figure out what
happens to the cost of capital for PepsiCo when leverage doubles from 14 to 40
percent. We found that the cost of capital seems to go down from 5.6 to 4.9 percent. But
I spoilt this by telling you already that this calculation is wrong. As it turns out, correcting
this illusion, the illusion that debt is cheaper, and therefore companies should issue
debt, correcting this illusion was motivation for a Nobel Prize. This is cool stuff.

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Professors Heitor Almeida and Stefan Zeume

Back in the '60s, there were two people called Modigliani and Miller, who won the first
Nobel Prize given to researchers in corporate finance. There were others since, but
Modigliani and Miller won the first one attributed to expanding our knowledge in
corporate finance. We love these guys. The motivation for their research was that they
got mad with this mistake that people were making. The mistake we just made. They
got tired of hearing the argument that because debt is cheaper, companies should only
raise debt and it would reduce the cost of capital. What they showed in their research is
that this whole idea is an illusion.

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The key reason all this is an illusion is that the cost of equity and the cost of debt do not
remain constant when you increase leverage. They go up. The cost of debt and the cost
of equity, they go up as you lever up. That's because the company becomes riskier. The
right equation for the WACC doesn’t have a clear answer. The right equation is not what
we had before.

The right equation is right there on the slide. The right equation only knows that

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Professors Heitor Almeida and Stefan Zeume
leverage is going to 40 percent and that one minus leverage is going to 60 percent, and
that the tax rate is still 21 percent. But what the equation does not know, and what the
company cannot control is, what will happen to the required return on debt and what will
happen to the required return on equity. In fact, both will go up. In the end, both will go
up, and because they go up, you don't know what happens to the weighted average
cost of capital.

The reason why risk goes up when the company levers up, goes back to an idea that
we talked about in Corporate Finance Part 1. It's the idea of systematic risk. What
happens is that the increase in debt leads to exposure to market fluctuations, to greater
systematic risk. A high debt company is also going to be a high Beta company. Debt
increases Beta. For us to see why debt increases Beta, what I want to do is move away
from PepsiCo for just a little bit. It would be very hard to use Pepsi here. It would involve
too many numbers that you don't want to look at. I'm going to use a very simple
example here.

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There's a company all equity, and the future holds only two possibilities for that
company. A boom or a downturn, the bust if you like. Here, the boom happens with
probability 75 percent, 0.75, and the downturn with probability 0.25. In the boom, the
company does well, it generates a cash flow of 50. In the bust, this company does
poorly it regenerates a cash-flow of only 30. We can figure out the expected value of
equity today. It's 45. It's really just the weighted average of the cash-flow in the boom
and the cash-flow in the bust. We have done calculations like this one in corporate
finance, earlier in this course. All we do is 0.75 times 50 for the boom, plus 0.25 times
30 for the bust, that's 45. Another way to express this is to express this as a return. The
company has 45 today in a boom, they get 50, that's up 11 percent. In the bust, it goes
from 45 to 30, that's minus 33 percent. Gains, losses expressed in percent. So far, this
was an all-equity company, no interest payments. But let's think about what would
happen if this company had some debt.

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Suppose we have the same company, but the company has 15 in debt. What will
happen to the cash-flow? Now you have to make the debt payment, so your cash-flow is
not 50 in the boom anymore. It's 50 minus 15, it goes down to 35. In the downturn, you
no longer get 30. You get 30 minus 15, that's 15. Our equity value today is also no
longer 45. It's 45 minus 15, that's 30. Here is the key insight. We can calculate returns
once again. Percentage gains. Now with this debt, our gain in the boom is 17 percent. It
used to be 11 percent, now it's 17 percent. That's good news. In the bust, while it's now
minus 50 percent, we go from 30-15. That's minus 50 percent. It used to be minus 33
percent. Now, it's minus 50 percent. That's not good.

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Professors Heitor Almeida and Stefan Zeume

Let me put all of these numbers together in one slide. Without debt, you gain 11
percent, or you lose 43 percent. If you have leverage, what happens is that the
percentage gain increases, but the percentage loss also increases. Debt is increasing
the fluctuation in the value of the company. Well, that's what we call risk, a greater
fluctuation in the value of the company. In this case, it's caused by debt.

The bottom line is that leverage is going to increase systematic risk. There are greater

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losses for shareholders and a downturn. A company that is highly levered is going to
amplify losses for shareholders if times turn bad. That increases with systematic risk
and because systematic risk goes up, shareholders are going to demand a higher return
to hold equity in this company.

Now, we can go back to our WACC calculation and think again of a high debt and a low
debt situation. Just to repeat the point we've made, but I think we understand better
what's going on.

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Professors Heitor Almeida and Stefan Zeume

Because the increase in leverage increases systematic risk, the cost of equity will go up
and the required return on debt will also go up. The end effect on the cost of capital is
not quite clearer.

In fact, what Modigliani Miller show, which seems surprising but true, is that under some
conditions, the cost of capital does not depend on leverage at all. It is constant. It is
always 5.6 percent regardless of leverage in our example. Under some conditions,

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Professors Heitor Almeida and Stefan Zeume
which we will talk about, the right equation is right there on the slide. You don't know
exactly what will happen to the required return on debt and to the required return on
equity.

But what we do know is that the cost of capital for PepsiCo is going to remain the same.
It stays at 5.6 percent. We will talk about the conditions. One of them is that interest
expenses do not reduce your tax burden, which is why I took out the one minus the tax
rate here.

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Professors Heitor Almeida and Stefan Zeume

What are the conditions under which our WACC is exactly 5.6 percent? Well,remember,
we started this lecture trying to figure out what is the NPV of debt and equity. It seemed
that zero NPV would be quite reasonable. The benefits and the costs compensate for
each other. This first condition here is exactly that. The first condition is that debt and
equity must be priced. If debt and equity are priced than issuing debt or issuing equity
generates zero NPV. If NPV is zero, the cost of capital should not change either.
Second condition. Well, second Modigliani Miller relies on the absence of other frictions,
such as the ability to deduct interest payments from taxable income, for instance. This is
a condition that we will talk about quite some more. These conditions do not always
hold. However, Modigliani Miller is an essential benchmark in corporate finance. We
wouldn't have given them a Nobel Prize for this if it didn't make any sense. Remember,
it's a very important benchmark. Last, let me tell you how I like to think about Modigliani
Miller.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

M&M helps us avoid a mechanical argument. The argument that because debt is
cheaper, you should issue debt. That's a mechanical argument. But it overlooks that the
cost of debt and equity go up as leverage goes up. That's exactly what M&M says.There
is no mechanical effect of leverage on the cost of capital. Bottom line, if we really want
to figure out why a company should issue debt or equity, we need to do some extra
work. It's not as easy as grabbing some chocolates from that box of M&M's. We will
have to do a bit more work to figure out why debt and why equity? After that, we might
use some chocolate.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume
Lesson 1-4: Evidence from the Field: Which Type of Capital Do Firms
Prefer?

Lesson 1-4.1: Evidence From the Field: Which Type of Capital Do Firms Prefer?

We must understand better, what is the difference between debt and equity? Why would
companies prefer debt to equity, or equity to debt, right? That's what we're talking
about. We've seen the M&M proposition. The first thing I want to do in this session now
is to talk about research, okay? So that's the first time the mad researcher comes in our
course. I told you he was going to show up a lot, okay? That's the first time we're going
to talk about research on capital structure. That's going to be our starting point to try to
differentiate that from equity, okay.

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And if you think about this, right, the idea we have so far is that issuing debt or equity
should give us zero NPV, right? So, if debt and equity are fairly priced then you should
have a zero NPV, right? But we learned in Corporate Finance One that NPV and stock
price are equivalent concepts, right? So, what researchers have does is they have tried
to follow up on this idea, right? Can we try to measure how stock prices react, right? So,
we can observe data. We can data from the real world, right? And measure how stock
prices change when companies announce large issuances of debt and equity, okay.
And if M&M were right, if the M&M theorem of the M&M result describes, is sufficient to
describe the real world, what would happen is that we would observe a zero reaction,
right? Stock prices should not change when company has issued debt or when
company issue equity.

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 Corporate Finance II: Financing Investments and Managing Risk
Professors Heitor Almeida and Stefan Zeume

What happens? So, what people have done is conducted event studies. We called this
an event study, which is a type of research where we examine the market's reaction to
new information. In these event studies, the new information is about capital structure,
right? So, the company is issuing equity, the company is issuing debt. The research,
there was a lot of research on this topic earlier on in the 1980s when we first could get
data on announcements, and we had good data on stock prices. So many researchers
have studied this topic. And this paper by Eckbo and Masulis that I'm citing here, what it
does, it summarizes the evidence on event studies of capital structure, okay? And this is
95, it's not the current result, but the results continue to hold. If you redo this study
today, I think you would find exactly the same result. All right, what are the results?

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Professors Heitor Almeida and Stefan Zeume

Companies that issue bonds, right, if you measure the stock price reaction to bond
issuance, what happens is that, in fact, you observe a small change, okay. There is no
reaction to issuance of bonds. So, there's a zero change, right. However, when
companies issue equity, their stock prices tend to decline and it's a significant decline,
it's 1.5% to 3% on average, okay. So, issuing equity seems to be negative NPV, all
right. When companies issue equity, their stock price goes down, okay.

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Professors Heitor Almeida and Stefan Zeume

So, now we can also think about the other side, right? So, we know that stock prices
decline when firms issue equity. We can also try to measure what kind of financing an
average company uses in the real world, right. Instead of doing examples, we can look
at the data and try to measure if companies use equity, outside equity or bonds or bank,
some other type of debt financing, to finance their investment, right? The event study I
just showed you suggests that issuing equity is negative NPV, right? So, what would
you predict, probably what I would predict, is that companies trying to avoid issuing
equity, right? Because issuing equity reduces the stock price.

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Professors Heitor Almeida and Stefan Zeume

That is exactly what we see in the data. Let me explain you what this is. So, this is data
I got from the Federal Reserve System for US companies, okay. And this is very recent,
so I got this in 2016. Like I said, the evidence that equity going was full or describing
really hasn't changes, okay. So, what these bars measure is the source of financing for
companies’ expenditures. Okay, the blue bar measures internal funds. So those are
cases where, that's the average for companies that finance their investments using their
own cash flows, okay. So, you can see that the blue bar is by far the largest, okay. And
then, the red bar measures the fraction of investments that is financed with debt
issuance. And what you can see here is that this red bar is also significant. I'm not sure
you can see the numbers there, but the average red bar is about 20%. So, meaning that
companies finance, on average, 20% of their investment using nil debt financing. And
finally, this green bar is equity. And the striking feature here is that these green bars are
actually negative, right? What does that mean? It means that companies are, on
average, not issuing new equity to financing the estimates, right? In fact, what the
average company does is to repurchase shares. So instead of issuing new equity,
companies are buying back shares and reducing the amount of external equity that they
have. At least that's what the average company does, okay. So, this is consistent with
the idea that issuing equity reduces stock prices.

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Professors Heitor Almeida and Stefan Zeume

All right, we call this in corporate finance the pecking order of financing. What that graph
seems to suggest is that companies first use internal funds to finance their investments,
then they use that, and then they use equity. All right, and the aggregate net equity
issuance has in fact been negative, in almost every year, if you look at that graph, or if
you look at the Federal Reserve data yourself, is publicly available, if you want to check
my work, okay. So, the messages that companies are in fact reluctant to issue equity in
practice, okay.

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Professors Heitor Almeida and Stefan Zeume

There are some exceptions and one of them is in mergers and acquisitions. That's in
the final module of this class, Corporate Finance Two, we're going to talk about the
financing of M&A and one of the key points is going to be that when companies finance
large M&A deals, they are in fact issuing a significant amount of new equity. That's one
case when companies are going to issue a lot of new equity. There are other cases as
well, for example Venture Capital Industry, right, is based on equity. So, when a Venture
capitalist provides financing to a new venture, it's typically not going to be that financing
it's closer to equity, right. And of course, the other exception is when companies go to
the equity market, to the public equity market for the first time, we call that an IPO, okay.
So, in that case companies are definitely issuing new equity. But what that graph shows
are that these three exceptions here, they are important, but they are not enough to
overturn the general pattern that companies prefer to be issued debt rather than equity.

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Okay, the bottom line is that debt seems to be the most important source of external
funds for most companies, okay, which is a very important message to take away from
the data. What we're doing the next lecture is, we are going to try to dig deeper and try
to understand debt financing in detail. First, we're going to try to understand why is it,
that companies prefer debt to equity, right? We're going to try to see how debt affects
profits and value, okay. And then, in the next module, we're going to go very deeply into
the details about debt finance. We're going to talk about different aspects of debt
finance in the real world such as the pricing, collateral, ratings, etc. So, we're going to
try to really dig deep and understand how that financing works in the real world.

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Professors Heitor Almeida and Stefan Zeume
Lesson 1-5: The Effect of Leverage on Taxes and Profits

Lesson 1- 5.1: The Effect of Leverage on Taxes and Profits

The first thing we are going to do is to try to understand the relationship between debt,
profit, and value. That's going to take a bit of work for us, but it will be worth your time.
So, let's go back to the PepsiCo example. We're going back to this example where
PepsiCo was trying to decide whether to issue debt or equity. So, let's try to understand
how a debt issuance would impact PepsiCo’s profitability. To do that, we need to go
back to the financial statements. We want to compare what happens to profits without
the debt issue and with debt issue.

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Professors Heitor Almeida and Stefan Zeume

It turns out that we have done most of the work already. So, remember very early in this
course, we just forecasted Pepsi's financial statements without debt issue and then also
with debt issue, okay? We called that before and after, okay? So, the difference
between before and after is 280 million in interest payments, okay? That's 4% on
interest on our 7 billion debt issue, okay? $280 million interest payment, that's the key
difference. So, let's look at the impact on earnings, okay? We talked about this already,
but I want to make this very clear, okay? The interest payment is going to reduce the
company's earnings. It's very simple, okay? It's just accounting, mechanical. There's
nothing very deep going on here. Interest goes up, earnings go down.

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Professors Heitor Almeida and Stefan Zeume

So, here's a trick question for you, and I want you to work on this very carefully. Is
PepsiCo profitable after the debt issuance?

To know whether PepsiCo is profitable after the debt issuance, we need to go back to
Corporate Finance part I, okay? So, remember that our definition of profits, the definition
of profits that we would like to use is called OPAT, operating profit after taxes. OPAT,
operating profit after taxes, is defined as EBIT, your operating income before any

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adjustments, minus the tax payments. So, when you do the calculation, you will find that
OPAT goes up with leverage. So, PepsiCo is going to be more profitable after this debt
issue, okay? If you got that answer right, if you remember the definition of OPAT, I'm
really very happy, okay? If you have not taken Corporate Finance Part I, this may have
been a little bit more difficult to figure out.

In any case, let me show you what is going on here. So here at the bottom, I calculated
the OPAT for PepsiCo. I want to explain how we got from the top to that line at the
bottom. Before the debt issue, in December 2022, we had EBIT, earnings before
interest and taxes of $13.044 billion. We paid 1.695 billion in interest and then we
calculated a tax payment of $2.383 billion. Our earnings were $8.965 billion. Our OPAT
was $10.66 billion. After the debt issue, our EBIT is the same as before, but we now pay
more interest on the debt. In fact, we now pay $1.975 billion. This reduces our taxable
income. So, we now only pay 2.324 billion in taxes. It's a little bit less in taxes than
before. Overall, our OPAT goes up to $10.719 billion because we pay less in taxes.

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In fact, we pay $49 million less in taxes after the debt issue, so our OPAT goes up by
this $49 million.

So, to summarize, as we issue more debt, our tax payments go down and our OPAT,
that's the profit number we like to use, goes up.

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So, what that means is that PepsiCo becomes more profitable after the debt issue.

This picture on the slide shows you exactly what's going on. What is happening here is
that by issuing debt, companies take money away from the government, okay? So, the
main effect is that debt lowers the company's taxable income. So, we pay fewer taxes,
and we take money away from the government. So, it's a positive effect of debt, the fact
that profits go up. Now at this point, you might think, maybe I can take away even more

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Professors Heitor Almeida and Stefan Zeume
from the government. Why should I stop at $7 billion debt issue? If you issue 20 million,
for instance, you pay 800 million in interest. So, you save even more in taxes, okay? So,
you become even more profitable.

So, this is what the calculation on this slide is meant to show you. On the right we raised
20 billion in debt. This increases interest payments and reduces tax payments, OPAT
goes up. That's what the table shows, okay? We are getting a big tax deduction, so our
OPAT is going up even higher than before.

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Professors Heitor Almeida and Stefan Zeume

In fact, it's very easy to show that if a company is profitable, your operating profit after
taxes is going to increase with leverage. You can see it in this picture on the slide. I'm
going to start using these pictures throughout this lecture, okay? So essentially, what
we have here is leverage on the X-axis and profit and value on the Y-axis. So far, we
figured out that OPAT is going to increase as leverage goes up. So, the higher the
leverage, the more profitable companies are going to become. That's what the picture
shows.

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Professors Heitor Almeida and Stefan Zeume

So, let's get the mad researcher out of the lab again. Let's talk about the real world,
okay? Let's talk about evidence right from the field. So far, we saw that leverage
increases profits. So, let's see whether this is going on in the real world.

Our prediction is that leverage ratios should be very high, and if companies are
profitable, then they should be almost entirely financed with debt. Leverage ratios
should go up as firms become more profitable. But the problem is when you look at the

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data, this is not true. The average leverage ratio for companies in the US, well, it's
similar for other countries, is approximately 30%. And an interesting fact is that this
average leverage ratio is even lower for profitable companies. What this means is that
we are missing something. There is something else going on. Maybe leverage doesn't
just increase profitability. In fact, up to here in this course, if companies find a profitable
project, they should finance it entirely with debt, okay? But that's also not true in the
data in the real world, companies prefer debt more than issuing new equity. But the first
thing that companies do in the real world is they use their internal funds. That's called
pecking order. They first use internal funds, then debt, and then outside equity.

So, we are still missing something, okay? So, this is our conclusion so far, we are
missing something, okay? Debt increases profitability but there must be a hidden cost,
otherwise companies would use much more debt. So next, we will try to understand
where this hidden cost is. In essence, we are going to try to understand other
consequences of issuing debt for the company's financial statements.

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Professors Heitor Almeida and Stefan Zeume
Lesson 1-6: Leverage and Personal Taxes

Lesson 1-6.1: Leverage and Personal Taxes

So, we are looking for other consequences of issuing debt. The first consequence we
are going to talk about is personal taxes. We talked about the positive effect of debt on
profits, and that comes from corporate taxes, right? But issuing debt is also going to
change taxes that investors pay. And to get the full picture of how that affects profits, we
shouldn't just focus on corporate taxes. We need to focus on personal taxes as well.

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Professors Heitor Almeida and Stefan Zeume

Let me show you what personal taxes look like before and after issuing debt. And we
start with OPAT. Before using that, PepsiCo had an OPAT of $10.66 billion in 2022.

By examining the financial statements, we can also figure out where OPAT went. 1.695
billion were used to pay interest. That's from our earlier forecast. PepsiCo also paid
$6.843 billion in dividends. And then the rest of the cash must go somewhere. Well, in
this case it goes to retained earnings. And now what we need to think about is personal

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taxes on these three items. So, all these three items could generate taxes at the
investor level. The interest payment that goes to the debt holders will be taxed;
dividends are taxed.

Let's look at the debt holders first. So, they received $1.695 billion in interest. And the
specific tax that they pay is going to depend on many, many factors. One of them, the
most important one, is their marginal income tax rate. So, interest payments are
typically taxed at the personal income tax rate. They are just treated as regular income.
Now, in the US, this marginal income tax rate can be as high as 37%. That's the number
in red, okay?

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That's the current number. What this means is, the investors, if they paid this higher tax
rate, 37%, they would receive slightly over a billion dollars. The rest of the money goes
to the government. Now, remember, the reason why there are increased profits when
we issue debt, is that we take money away from the government, okay? But once the
company pays interest to investors, the government gets some money back. And we
must take this into account, okay?

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What about equity investors? They received $6.843 billion dollars in dividends, okay?
Talking about the US, the highest dividend tax rate is 20%. So, if you assume that
dividends are taxed at that rate, 20%, then these equity investors would receive a lower
amount. They would receive $5.475 billion.

What about retained earnings? Well, for retained earnings, there's no immediate tax.

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PepsiCo retains the earnings, and they pay no immediate tax. They might pay a tax
later, like if these retained earnings are distributed to equity investors. Let's say they pay
a future dividend, or they make a future share repurchase.

But for now, let's just say PepsiCo pays zero tax, okay? To retain your earnings, you
don't pay taxes for now.

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Professors Heitor Almeida and Stefan Zeume

So, let's summarize all these things. So, if you take personal taxes into account that
investors are getting some payoffs, equity investors are getting some payoffs, and we
have retained earnings. So out of the OPAT, of these 10.66 billion, investors get 8.665
billion and almost $2 billion dollars goes to taxes. This is the situation before PepsiCo
issued any new debt. Next, what I would like you to do is to consider what happens to
the after tax payoff, after the debt issuance.

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And let's use a bigger amount here, okay, just for the sake of the argument. Let's use a
$20 billion dollar debt issue instead of a 5 billion debt issue. Just so we see the
differences more easily. So, what's going to happen to the after tax payoff? Try to do the
calculation yourself. I give you most of the inputs here. So, try to figure out, what
happens to the after tax pay off.

Here's the answer. Using the same tax rates as before, the government will get a big

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chunk of it, okay? If you did the math correctly, you would get that out of our OPAT,
which is higher than before, investors now only get 8.537 billion. Because of taxes,
investors would end up getting $8.537 billion.

So, let's put all of this together in one slide, so we can compare, okay? Before the 20
billion debt issuance, OPAT was 10.66 billion and investors got 8.665 billion. After the
20 billion debt issuance, OPAT goes up 10.828 billion. But the after-tax income that
goes to investors, goes down to 8.537 billion in this case. So, OPAT increases, but the
after-tax payoff decreases when we issue debt. The government, they are really the key
player here. The government, okay? It's the government that gets more taxes. So, this
is our previous take away.

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As we issue debt, we think we are taking away money from the government.

But at the end of the day, the government bites back for personal taxes.

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Now, I will admit that our example was a little bit exaggerated. So, this is of course not a
generic example. There are many problems with the assumptions. One of them was
that investors are probably not taxed at the highest marginal tax rate. Many investors
hold bonds and tax deferred funds, for instance, okay? So, if you have retirement
money that you're saving for your retirement, this money might be invested in funds that
don't actually pay tax until you withdraw the money, okay, after your retirement. The
effective tax rate on retained earnings on the other hand, is also not really zero, okay?
Shareholders will eventually have to sell their shares to get cash back. So, either the
company has to do a chair of purchase, or shareholders have to eventually sell the
equity, or the company has to pay dividends. So, at some point shareholders are going
to pay tax. So, the zero-tax rate, there's also an exaggeration here.

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So, figuring this out in the data is actually very complicated. Fortunately, we don't have
to do this ourselves. There's some research out there. And so here comes the mad
researcher again.

There is research that we can draw in, okay? So, in fact, in this area of corporate
taxation, there's one researcher who is considered the world's expert, that's John
Graham at Duke, okay? He has done a lot of research trying to estimate what happens

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to company value, considering both corporate and personal taxes. And I'm just going to
give you the bottom line, okay?

So, remember our OPAT picture, we have leverage on the x-axis, profits on the y-axis,
and we have our OPAT. And OPAT goes up as we level up. That's the corporate tax
effect. What happens with personal taxes, is that this benefit becomes smaller? So,
profits do not increase as much with leverage as we would have thought, okay? But if
you look at the picture, what it shows is that there's still a positive slope. So what John
Graham shows, is that even after taking personal taxes into account, companies are on
net taking money away from the government when they increase leverage. And
companies give it to debt holders and shareholders.

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Lesson 1-7: Leverage and the Risk of Financial Distress

Lesson 1-7.1: Leverage and the Risk of Financial Distress

This picture summarizes what we have up to here. We have leveraged on the x-axis,
profits on the y-axis. What we've shown is that profits increase with leverage for
profitable firms. If the company is profitable, if the company can take the tax benefit,
leverage increases profits even after taking personal taxes into account. Your OPAT
goes up, your after-tax payoff goes up less, but they still go up with leverage. Basically,
tax benefits are a big reason why companies may like leverage.

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Let's next think about a very extreme example here. So far, after-tax profits increase as
you take on more debt. Why not increase debt even further? We might think of a slightly
crazy situation where Pepsi issues just about as much debt that the interest expense
eats up all their earnings. They might take up so much debt that their income before
taxes is zero. You pay zero taxes, and your OPAT is the same as operating income.

Does this sound all right? Probably not.

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Your intuition should tell you that this doesn't seem quite right.

Of course, it doesn't seem right, and we will talk about it. What will happen is that there
will be a cash shortage. If a company is in a situation like this, yes, you are not paying
taxes and that's great, but you're not going to have any profits to pay dividends, either.
There's no cash to pay dividends. There's no cash to make investments, R&D, any

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other expenses. A company in this situation where your interest payment is as high as
your operating income is a company that we call financially distressed. What we say in
corporate finances, that if a company is in the situation, the company is financially
distressed.

In practice, financial distress is not going to arise just from voluntarily increasing your
debt as much as in our example. Our example was a little bit exaggerated. PepsiCo
would probably never be able to issue that amount of debt anyway. But what tends to
happen in practice is that companies become financially distressed because of poor
performance. Maybe they expected to be able to pay interest when they issued the
debt, but then there was a big economic crisis, or maybe a crisis of their products.
Profits may have turned out to be lower than expected, interests’ expenses suddenly
become a burden, the company is financially distressed. This is an example of the
situation.

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Suppose that PepsiCo is distressed because the earnings before interest and taxes,
EBIT went down to about $10 billion. Now PepsiCo has an EBIT of $10 billion and
interest expenses are higher than that. Great news, the company is not paying any
taxes. That's good news. But there's also a big problem here. I'd like to give you just a
few minutes to think about this.

How should PepsiCo respond in this situation? What is the company likely going to do if

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they encounter a situation like on this slide? The answer is that something must
happen. If PepsiCo has cash, maybe they safe enough cash on the balance sheet, they
might be able to use that to finance their investments. If they have it, then they can do
that, but maybe they don't have it. Alternatively, PepsiCo try to refinance its debt. If the
problem is that interest payments are very high, PepsiCo can try to go to the bank or go
to the bond market and try to refinance there. As we talked about in Corporate Finance
One, refinancing a liability means that you must issue a new liability to buy back the old
one. Another way to give of this is to issue new equity. If none of this work, if you don't
have cash and can't raise new funds, then you can cut dividends or cut investments. In
any case, you end up having to manage a shortage of cash.

Importantly, most of the options we discussed, other than probably spending cash, most
of these options are likely to generate significant value losses for the company. If
PepsiCo goes to the debt markets to refinance debt, what will probably happen is that
you are going to have to refinance at a very high-interest rate. If you're financially
distressed, a bank is not going to give you new financing unless you pay a very high-
interest rate. We learned already that if PepsiCo issues equity, the stock price is likely to
go down. In fact, what people have shown us that the stock price effect is even larger
for firms that are financially distressed. If you're close to bankruptcy, financially
distressed and you issue new equity, you're going to have to pay for that. What happens
is that the stock price goes down quite a lot.

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Cutting dividends is also going to reduce the stock price. That's something we're going
to learn later in Module 2, that dividend cuts have a similar effect as equity issuance.
And finally, we learned in Corporate Finance Part 1 that cutting investments, if they are
positive NPV, is also going to reduce your stock price.

The bottom line is that most of these options create a value loss. If the company must
resort to any of these options, they will lose some of their value. This value loss caused

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by high debt is what we call the cost of financial distress. In corporate finance, we refer
to this as a cost of financial distress. It's very important that this must be driven by a
situation with high leverage. Bankruptcy is just a very extreme version. A company that
is bankrupt is a company that cannot find a way of repaying its liabilities. The company
must go to court and either liquidate or reorganize. That's a very extreme outcome. But
financial distress is even more likely to happen than bankruptcy. Bankruptcy is just the
extreme version. Financial distress happens much more often than outright bankruptcy.

One question you might be wondering about at this point is, how large these costs of
financial distress really are. How large are the costs of financial distress when we go out
there and try to measure them?

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There is, in fact, a very nice paper out there that was written in 1995, so long time ago,
but still very relevant today. That paper estimates the cost of financial distress for
companies that became distressed due to high leverage. What's shown in the paper is
that financial distress can cause a loss in value of 10-25 percent compared to the year
prior to financial distress. When a company becomes financially distressed, its value
tends to go down by 10-25 percent. Now, you might think this is quite a big range, 10-25
percent. But hey, the key takeaway is not just one or two percent. It's a sizable loss in
value. Now let's get back to the main topic of this module. The main topic is capital
structure. Before you watch this short video, leverage was great. It increases after-tax
profits.

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Now we have this new thing, the cost of financial distress. How will this cost of financial
distress, how will it affect our capital structure decision? The intuition should be clear.

What will happen is that higher leverage is going to increase the probability of financial
distress. When a company starts increasing leverage, on the one hand, you have tax
benefits from that. But on the other hand, the higher your interest payments get the

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greater risk of chance that you might not be able to pay them, or that you must cut
investment or dividends to pay them.

Like I said, this is usually driven by poor performance. But poor performance is a reality,
it might happen to anyone. What will happen is that if your company has high leverage,
the poor performance is more likely to cause a cost of financial distress.

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Lesson 1-8: The Trade-off Theory of Capital Structure

Lesson 1-8.1: The Trade-off Theory of Capital Structure

Let's go back to our picture. We have profits, value, and leverage. Again, leverage in the
x-axis, value, and profits in the y-axis. If you think about tax benefits, what we've shown
with the PepsiCo example is that your after-tax profits are going to increase with
leverage. So, PepsiCo becomes, or any company that is profitable, will likely become
more profitable as leverage increases, right? This increase in profitability will also
increase the company's value. So, I plotted the value here as well, instead of just profit
as we were doing before.

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However, we also learned about cost of financial distress. As your leverage increases,
what will happen is that the risk of bankruptcy, the risk of financial distress, is going to
go up, right? If financial distress happens, then all of those bad things happen. The bad
things we talked about, the company has to refinance, it has to issue equity, cut
investments, right? These actions will tend to reduce the company's value. What this
means is that as you increase leverage, value goes down through this financial distress
channel, right?

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If you put the two pictures together, what we get is what we call the trade-off model of
capital structure. It's the trade-off between the tax benefits of debt and the cost of
financial distress. So, the way that company should choose their optimal leverage, the
optimal amount of leverage to have, is by trading off the positive effect of taxes on
profits with the negative effect of leverage on financial distress costs, okay? What you
get is a picture that is going to give you, presumably, if we wanted to give you an
optimal leverage ratio, that we call L* here. In this case, that would be the optimal
amount of leverage that a company would have, okay?

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So, this is all very nice theoretically, right? And here, we bring back our researcher
again. How does this figure look like in the real world? Right, that's what we are
interested in. A very nice theory but let's see if we can figure out how this picture looks
like for real world company.

This is done in a very nice paper by a researcher called Arthur Korteweg. What he does

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is he estimates exactly that picture, the effect of leverage on value for firms of different
characteristics, okay?

And this is what Korteweg finds. Korteweg finds that there is a picture like that in the
real world. There is an optimal capital structure, which as we talked about already, the
average firm has a leverage of about 30%. Korteweg finds that the average firm tends
to have an optimal capital structure, and here's the important number. The average firm
in the US, the average company in the US, tends to gain 5% in value by moving from a
leverage of 0, by having no debt, to a situation where you have 30% of debt, okay? So,
you would gain 5% in value by moving from 0 debt to 30% leverage. That's how this
picture would look like in the real world, according to Korteweg, okay?

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And then of course, this is just an average picture. Not all firms are going to have the
same optional leverage. If you think about the model we just described, there are many
variables that are going to be important, right? For example, the volatility of cash flow.
Financial distress is going to happen if the company's performance becomes poor,
right? So riskier companies, companies that have higher cash flow volatility, are going
to have a higher chance of becoming financially distressed. The tangibility of assets
matters as well. If a company becomes financially distressed, and you have very
tangible assets like land, right? It's going to be easier for a company to raise financing
by selling the land, or by borrowing against the land. So, tangibility should also reduce
the cost of financial distress. Profitability, right, profitability also matters because, as we
discussed, only profitable firms should really have tax benefits of leverage, right? If you
don't have any profits to shield, there's no tax benefits to take advantage of. Size also
matters, right? Think about financial distress. If a large company becomes financially
distressed, it's probably going to be much easier for a large company to access financial
markets and refinance debt, issue new equity, than for a small company, right? So, size
should also affect this trade-off. And finally, the company's valuation, this is something
we talked about in Corporate Finance I as well. Is the market-to-book ratio, right? The
market-to-book ratio essentially what it measures is, it measures whether the company's
values lie in the future, right? Where the future profits matter a lot for this firm, right? So,
if you think about the market-to-book ratio, what should be the case is that companies
with high market to book ratio have a lot more to lose if they become financially useful,
okay?

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So, one way to think about these characteristics, for example, thinking about volatility,
right? We have that picture that we showed you for the medium firm for Korteweg's
paper. The medium firm will have an optimal leverage ratio of 30% and will be getting
5% of value by moving to the optimal leverage of ratio. If a firm has high volatility, then
this picture will be shifted lower, right? The high-risk firm will not have as many benefits
of having high leverage because of the increased risk of financial distress. Okay, so the
picture shifts down, meaning that optimal leverage is going to be lower for a firm with
high cash flow volatility, okay?

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The problem is that now we reach the limitation of what we know from the research. We
have this very nice model that describes capital structure, and it seems to be consistent
with real-world capital structures. But what we don't know is how much, going back to
that picture, what we don't know is how much lower should the leverage be, right? If you
look at that picture again, you'll see that we had a question mark. We really don't know
how much lower the leverage should be for the firm with high cash flow volatility. One
way to think about this is that the trade-off model is not good enough to give us a
precise quantitative structure. But you can still use the trade-off model as a qualitative
model.

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So, as we discussed, right, we have the medium firm has an optimal leverage ratio of
30%. But firms with high cash flow volatility, low tangibility, small size, etc., should have
less debt. So, you can use this model as qualitative guidance for how much leverage a
company should have in the real world. And what the research has shown is that, by
and large, these characteristics do seem to predict variation in leverage ratios in the
right direction.

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Lesson 1-9: Review and Graded Activities

Lesson 1-9.1: Module 1 Review

In this model, we talked about debt and equity financing, right? So, we started with a
simple example of how debt and equity financing affect income and cash flow
statements, the mechanical affect. Then we talked about the net present value of both
debt and equity issuance, the cost and benefits and we talked about this idea that if
debt and equity are priced and the NPV should be close to zero or maybe exactly zero.
Then we talked about two misconceptions that you should avoid when thinking about
real world capital structure. The first one is this notion of delusion. Delusion is an
illusion. Delusion does not really matter, and it's not the right way to think about
leverage, or equity issuance or any capital structure. The second one is that that
issuance does not mechanically reduce the cost of capital. The fact that the required
return on that is lower than the required return on equity, does not mean that a company
is going to reduce the cost of capital by issuing debt.

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That in fact was the motivation for the Modigliani and Miller result. Which is one of the
key results in cooperative finance, okay? The logic there is that that is going to increase
systematic risk. Higher leverage is going to increase the required return on equity and
the required return on that, meaning that after a company issues leverage, issues debt,
right? Because the company becomes riskier, the cost of capturing the end doesn't
change at all. Right? That's what Modigliani and Miller showed us, and we discussed it.
The logic behind them, in them on how to use it in practice to avoid making these
mistakes that we talked about. Then we moved onto the real world, and we talked about
the evidence that equity insurance causes a decrease in stock prices, right? And that is
consistent with the other finding that companies are usually reluctant to issue equity to
finance projects. So, the most important source of marginal financing to companies is
debt.

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Right? So given this, we moved on to really dip into what happens to a company when a
company issues debt. If a company issues new debt what's going to happen to profits,
risk etc. Right? We figured out the effect of leverage on taxes and OPAT, right?
Because of the tax advantage of debt, a company that increases leverage is going to
reduce taxes and increase profitability. Personal taxes mitigate this effect but don't
eliminate it. Right? So, the real trade-off between this tax-advantage and the cost of
financial distress, right? We discuss how cost, what cost of financial distress are, and
how leverage increases the risk of financial distress

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And then we learn how to put these two things together, tax and the stress cost, in a
trade-off model that allows us to analyze how firms make capital structure choices in the
real world.

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