Test 2 Assignment 2

• Date: May 12, Sunday • Research topic from agency issue, corporate
• Duration: 1 hour governance, payout and capital structure
policy
• Coverage: week 5 (part of payout decision), • Narrow down to a research question
week 6 & 8 (capital structure and valuation)
• Use AIs to research academic articles
• Format: 15 true/false/MCQ. Open book, close • Use AIs to co-pilot literature review
web
• Reflection of using AIs and summary of
literature review in written report and oral
presentation.
1 2

Plan next week

• Guest speaker on May 22 Monday, 7-8pm via
Zoom Topic 5
• No lecture on May 25 Thursday Capital Structure Decisions and
Valuation
Chapter 15, 21

3 4
 Include choice of a
target capital structure,
Determinants of Intrinsic Value: average maturity of Business Risk: Uncertainty in EBIT,
The Capital Structure Choice debt, and specific types
of financing.
NOPAT, and ROIC
• Business risk:
– Risk a firm’s common stockholders would face if
the firm had no debt (i.e., inherent in operations).
– Uncertainty in EBIT, NOPAT and ROIC.
• Depends on:
Affect Wd, Ws, rd, rs – Uncertainty/variability in demand, output prices,
(different theories
WACC = Wd(1-t)rd + Wsrs predict different input costs, etc.
impact on WACC, – Degree of operating leverage (DOL).
hence Vop)

Affect rsU (unlevered cost of equity) 5 6

Operating Leverage Business Risk versus Financial Risk

• Operating leverage is the change in EBIT caused by a • Business risk: Irrelevant to debt/equity mix
change in quantity sold.
– Uncertainty in future EBIT, NOPAT, and ROIC.
• The higher the proportion of fixed costs relative to
variable costs, the greater the operating leverage. – Depends on business factors such as competition,
• Higher operating leverage leads to more business risk. operating leverage, etc.
Small sales change causes a • Financial risk: Relevant to debt/equity mix
larger EBIT change.
– Additional business risk concentrated on common
stockholders when financial leverage is used.
Break-even quantity (QBE):
EBIT = PQ – VQ – F = 0 – Depends on the amount of debt and preferred
 QBE = F/(P-v) stock financing.

7
Two Hypothetical Firm U Firm L
Capital $20,000 $20,000 NOPAT, ROIC, and ROE
Firms Identical
EBIT $2,400 $2,400 ROIC isn’t affected by
Except for Debt Tax Rate 25% 25% financial leverage.

Equity $20,000 $16,000 Firm U Firm L

Debt $0 $4,000 EBIT = $2,400 $2,400
rd = 8% NOPAT = EBIT(1 − T) = $1,800 $1,800
Operating capital = $20,000 $20,000
Firm U Firm L ROIC = NOPAT/Op. Cap. = 9.0% 9.0%
EBIT $2,400 $2,400 Equity = $20,000 $16,000
Interest $0 $320 Net income = $1,800 $1,560
ROE = NI/Equity = 9.0% 9.8%
EBT $2,400 $2,080
Taxes (25%) $600 $520 ROE goes up; the expected return to shareholders increases.
NI $1,800 $1,560 ROEL > ROEU.

Firm U Firm L
Why did leverage Capital $20,000 $20,000 Impact of Leverage on Returns if
increase ROE? EBIT $2,400 $2,400 EBIT Falls to $1,600 or $1,200
Tax Rate 25% 25%
Lower equity in L. Equity $20,000 $16,000 Firm U Firm L Firm U Firm L
Debt $0 $4,000 EBIT $1,600 $1,600 $1,200 $1,200
rd = 8% Interest (8%) $320 $0 $320
$0
EBT $1,600 $1,280 $1,200 $880
Firm U Firm L
Taxes (25%) $400 $320 $300 $220
EBIT $2,400 $2,400
NI $1,200 $960 $900 $660
Interest $0 $320
ROIC 6.0% 6.0% 4.5% 4.5%
EBT $2,400 $2,080
Lower taxes paid by L. ROE 6.0% 6.0% 4.5% 4.1%
Taxes $600 $520
NI $1,800 $1,560 When EBIT = $1200, ROEL < ROEU.
More total dollar to L’s investors: Leverage only adds value if ROIC is greater than
U: NI = $1,800. The different ($80) is due to interest after-tax cost of debt, rd(1-T) = 8%(1-0.25) = 6%
L: NI + Int = $1,560 + $320 = $1,880 tax shield: 320(0.25) = 80
 Capital Structure Theory MM Theory: Zero Taxes
Assume total capital investment level is already
• MM theory determined, i.e., when new debt is issued, the • MM assume:
– Zero taxes same value of equity will be repurchased, so – (1) no transactions costs; no restrictions or costs to short sales;
firm’s total assets remain unchanged.
– Corporate taxes – (2) no taxes;
– (3) no bankruptcy costs;
– Corporate and personal taxes
– (4) individuals can borrow at the same rate as corporations;
– In imputation system – (5) no information asymmetry;
• Trade-off theory – (6) EBIT do not grow and not affected by use of debt.
• Signaling theory • MM prove that if the total CF to investors of Firm U and Firm L
• Pecking order are equal, then arbitrage is possible unless the total values of
• Debt financing as a managerial constraint Firm U and Firm L are equal: VL = VU.
• Windows of opportunity • Because FCF and values of firms L and U are equal, their
WACCs are equal.
• Therefore, capital structure is irrelevant. 15

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,000 Cash Flows and Firm Values
NI $3,000 $2,000
CF to shareholder $3,000 $2,000 • U’s annual CF = EBIT
CF to debtholder 0 $1,000
Total CF $3,000 $3,000
• The annual cash flows to L are the dividends
Annual CF to U’s Investors (CFU) Annual CF to L’s Investors (CFL)
plus the interest payments:
• CF to debtholders: no d/h • CFs to debtholders: interest
• CF to shareholders: payments = rdD L’s annual CF = (EBIT – rdD) + rdD = EBIT
– No growth, so dividends = • CFs to shareholders: zero – L’s CF = U’s CF; VL = VU.
net income (NI). taxes, so EBIT - rdD
– No interest payments or • CFL = rdD + (EBIT − rdD) = EBIT
taxes, so NI = EBIT. • Proposition I: VL = SL + D = VU = SU
• CFU = EBIT
16
 MM Proposition I with Zero Taxes Proof By Using an Arbitrage Argument
• Proposition I: VL = VU. • If VL ≠ VU, then an investor could:
– Sell the expensive asset
• Steps in proof:
– Buy the cheaper asset
– Show that total investor cash flows are the same – Have money left over
for both firms. – Have zero net future annual cash flow
– Show that if VL ≠VU, then investors can create • This would be arbitrage, which should not exist in
arbitrage profits. well-functioning markets.
– But this would lead to buying and selling activities – Selling (buying) pressure would cause stock price to
that would drive VL and VU to the same value. fall (rise)
– All of these would take place until VL = VU

Assume VL > VU “homemade leverage”

Assume VL < VU
• Sell 100% of L’s stock, borrow an amount equal to 100% • Sell 100% of U’s stock, lend an amount equal to 100% of
of D (at interest rate of rd), and buy 100% of U. D (at interest rate of rd), and buy 100% of L.
Initial CF Sell SL Borrow D Buy U Total Net Initial Initial CF Sell VU Lend D Buy SL Total Net Initial
CF CF
SL D −VU (SL + D) – VU VU −D −SL VU – D – SL
= VL − VU > 0 = VU − (SL + D)
= VU − VL > 0
Annual CF
Annual CF
Dividend −(EBIT−rdD) EBIT
Dividend −EBIT EBIT−rdD
Interest −rdD
Annual total 0 Interest rdD
Annual total 0
© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as © 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 MM Proposition II with Zero Taxes MM Theory: Corporate Taxes
rsU: unlevered cost of equity; cost of equity to
an otherwise identical but unlevered firm • Corporate tax laws allow interest to be
rD: cost of debt (assumed constant)
𝑉𝑈 =
𝐸𝐵𝐼𝑇 rsL: cost of equity to a levered firm deducted, which reduces taxes paid by levered
𝑟𝑠𝑈
firms.
𝐸𝐵𝐼𝑇 − 𝑟𝐷 𝐷 𝑟𝐷 𝐷 𝐸𝐵𝐼𝑇
𝑉𝐿 = 𝑆𝐿 + 𝐷 = + = • Therefore, more CF goes to investors and less
𝑟𝑠𝐿 𝑟𝑑 𝑊𝐴𝐶𝐶
⸪𝑉𝐿 = 𝑉𝑈 ⇒ 𝑊𝐴𝐶𝐶 = 𝑟𝑠𝑈 to taxes when leverage is used.
• In other words, the debt “shields” some of the
𝐷 𝑆
𝑊𝐴𝐶𝐶 = 𝑟𝑑 + 𝑟 = 𝑟𝑠𝑈 firm’s CF from taxes.
𝐷+𝑆 𝐷 + 𝑆 𝑠𝐿
𝐷
⇒ 𝑟𝑠𝐿 = 𝑟𝑠𝑈 + 𝑟𝑠𝑈 − 𝑟𝑑
𝑆 More debt (higher D/S) makes equity riskier
therefore increases rsL, offsetting the benefits
of cheaper debt to keep WACC constant. 23 25

U and L’s Annual Cash Flows MM Proposition I with Corporate Taxes

• U’s annual CF = EBIT(1 – T) VU = EBIT(1 – T)/rsU • L’s annual CF = EBIT(1 – T) + rdDT
– EBIT(1 – T) = U’s cash flows. Therefore, the first
term’s value = value of an unlevered firm, VU.
• The annual cash flows to L are the dividends
– rdDT is a perpetual stream of cash flows as the
plus the interest payments:
debt tax shield. MM assumed the appropriate
L’s annual CF = (EBIT – rdD)(1 – T) + rdD discount rate was the required return on debt, rd,
= EBIT(1 – T) + rdDT so the tax shield value = rdTD/rd = TD.
= EBIT(1 – T) + tax shield • So VL = VU+ TD Adjusted present value (APV) approach:
VL = VU + value of side effect
VL = EBIT(1 – T)/rsU + tax shield/rTS In FCF model, interest tax shield is
incorporated in WACC.
26 27
 MM relationship between value and debt when
corporate taxes are considered. MM Proposition II with Corporate Taxes
𝑉𝐿 = 𝑆𝐿 + 𝐷
𝐸𝐵𝐼𝑇 1 − 𝑇 𝑇(𝑟𝑑 𝐷) 𝐸𝐵𝐼𝑇 1 − 𝑇
𝑉𝐿 = 𝑆𝑈 + 𝑉𝑇𝑆 = + = + 𝑇𝐷
𝑟𝑠𝑈 𝑟𝑑 𝑟𝑠𝑈

𝐸𝐵𝐼𝑇 − 𝑟𝑑 𝐷 1 − 𝑇
𝑆𝐿 =
𝑟𝑠𝐿
⇒ 𝐸𝐵𝐼𝑇 1 − 𝑇 = 𝑆𝐿 𝑟𝑠𝐿 + 𝑟𝑑 𝐷 1 − 𝑇 (1) The required rate of return to a
levered stock is the unlevered
return plus a premium that
𝑆𝐿 𝑟𝑠𝐿 + 𝑟𝑑 𝐷 1 − 𝑇
𝑆𝐿 + 𝐷 = + 𝑇𝐷 depends on the tax rate, the
Under MM with corporate taxes, the firm’s value 𝑟𝑠𝑈 rate on debt, and the amount of
increases continuously as more and more debt is used. ⇒ 𝑟𝑠𝐿 = 𝑟𝑠𝑈 + 𝑟𝑠𝑈 − 𝑟𝑑 1 − 𝑇 𝐷/𝑆 debt.
(2) WACC  when D/S  as rsL
doesn’t increase as fast as it
would if there were no taxes.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Cost of Equity at Different Levels of Debt:

Miller’s Theory: Corporate and Personal Taxes
Hamada’s Formula
• MM theory implies that beta changes with • Personal taxes lessen the advantage of
leverage. corporate debt:
• bU is the beta of a firm when it has no debt – Corporate taxes favor debt financing since
(the unlevered beta) corporations can deduct interest expenses.
– Personal taxes favor equity financing, since no
• b = bU [1 + (1 - T)(wd/ws)]
gain is reported until stock is sold, and long-term
gains are taxed at a lower rate.
Double taxation system;
capital gain tax < dividend income tax
 U and L’s Annual Cash Flows Miller Model
• 3 tax rates: Ts is assumed < Td due to lower • L’s annual CF
– Tc = corporate tax rate and deferred capital gain tax 1−𝑇𝑐 1−𝑇𝑠
– Td = personal tax rate on debt income = EBIT(1 – Tc)(1 – Ts) + rdD(1 – Td) 1 − 1−𝑇𝑑
– Ts = personal tax rate on stock income – EBIT(1 – Tc)(1 – Ts) = U’s cash flows. Therefore, the first
term’s value = value of an unlevered firm, VU.
𝐸𝐵𝐼𝑇 1 − 𝑇𝑐 1 − 𝑇𝑠
• U’s annual CF = EBIT(1 – Tc)(1 – Ts) 𝑉𝑈 = – The second term, the debt tax shield, is a perpetual
𝑟𝑠𝑈 1 − 𝑇𝑠
stream of cash flows. Miller assumed the appropriate
discount rate was the (after-tax) required return on debt,
• The annual cash flows to L are the dividends plus the 1−Tc 1−Ts
interest payments: rd(1-Td), so the tax shield value = 1 − D
1−Td
L’s annual CF = (EBIT – rdD)(1 – Tc)(1 – Ts) + rdD(1 − Td) 𝟏−𝐓𝐜 𝟏−𝐓𝐬
• So 𝐕𝐋 = 𝐕𝐔 + 𝟏 − 𝟏−𝐓𝐝
𝐃
= EBIT(1 – Tc)(1 – Ts) + rdD(1 – Td)[1 – (1 – Tc)(1 – Ts)/(1 – Td)]

35 36

Conclusions with Personal Taxes MM under Imputation Tax System

• Use of debt financing remains advantageous, but • Investors are taxed on their total equity income
benefits are less than under only corporate taxes. before corporate tax at their marginal tax rate Ts, but
• Firms should still use 100% debt. they also receive a tax credit for the corporate tax
• Applications of Miller Model (VL = VU + paid on that equity income.
1−Tc 1−Ts
1− D): • To shield corporate income from corporate tax,
1−T d
companies could:
– If Tc = Ts = Td = 0: MM model without taxes
– If Ts = Td = 0: MM model with corporate taxes – use debt interest, or
– If Ts = Td: MM model with corporate taxes – pay the tax and then let shareholders recover it by paying
– If (1 – Tc)(1 – Ts) = (1 – Td): MM model without taxes out all the taxed earnings as an imputed dividend.

39
 Release MM’s
assumption of no
MM under Imputation Tax System (cont.) Trade-off Theory bankruptcy costs

• The imputation system confuses the basic MM • MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
argument of tax-induced preference toward debt. • Bankruptcy-related costs involve costs if distress
• If shareholders can’t fully utilise the benefit of occurs, and probability of financial distress
– Direct costs from bankruptcy filings: legal expenses,
imputation credit, corporate borrowing will offer accounting expenses, liquidation of asset at below
tax advantages again. market value.
– Indirectly costs: employee turnover, reduced
productivity, reduced product quality, reduced credit
by suppliers, loss of customers, higher borrowing rate.
Affect NOPAT and investment in capital

In FCF model, bankruptcy-related costs are incorporated in WACC.

Trade-off Theory (cont.) Tax Shield vs. Cost of Financial Distress

e.g. firms with volatile earnings or
higher operating leverage

• It implies that firms with higher probability of

bankruptcy and higher costs in bankruptcy should
use less debt. e.g. firms with more
illiquid or intangible asset
[APV model] VL = VU
• Conclusion: An optimal capital structure exists + value of tax shield –
that balances these costs and benefits. value of bankruptcy
related costs

[FCF model] tax shield

benefit and bankruptcy
related costs are included
in WACC to discount FCF.
 Release MM’s assumption of
no asymmetric information
Information Asymmetry between managers and
shareholders.
Information Asymmetry (cont.)
• Managers often have better information. • Signaling effect implies that firms should
• Signaling effect maintain a reserve borrowing capacity.
– Managers would sell stock (bond) if stock is – Use less debt under “normal” conditions than
overvalued (undervalued).
called for by the trade-off model.
– Investors understand this, so view new stock sales as a
negative signal. – Especially if firms have problems with asymmetric
• Pecking order theory information.
– Considering flotation costs and signaling effect, firms • Conclusion: firms should, in normal times, use
use internally generated funds first, then issue debt, more equity and less debt than is suggested
then use equity as a last resort of financing.
by the trade-off model.
46 48

Agency Costs and Debt Financing Market Timing Theory

• Use of debt reduces agency costs (overinvestment) • Managers try to “time the market” when
– Use debt as managerial constraint to bond FCF and force
discipline on managers to avoid perks and non-value issuing securities.
adding acquisitions.
• They issue equity when the market is bullish
• Use of debt increase agency costs (underinvestment)
– Debt increases risk of financial distress; managers may and after big stock price run ups.
avoid risky (but positive NPV) projects.
• They issue debt when the stock market is
• It implies consideration of investment opportunities:
– Firms with many profitable opportunities should use less
bearish and when interest rates are low.
debt suggested by trade-off model. Also, they issue issue ST debt when the
– Firms with few profitable opportunities should use high term structure is upward sloping and
levels of debt to impose managerial constraint. issue LT debt when it is relatively flat.
 Empirical Evidence Implications for Managers
• Tax benefits are important. • Take advantage of tax benefits by issuing debt,
• Bankruptcies are costly. especially if the firm has:
• Firms have targets, but don’t make quick corrections – High tax rate
when stock price changes cause their debt ratios to – Stable sales
change.
– Low operating leverage
• Lost value from being above target is bigger than lost
value from being below target. • Avoid financial distress costs by maintaining
• Firms may deliberately increase debt to above target to excess borrowing capacity, especially if the firm
take advantage of unexpected investment opportunity. has:
• After big stock price run ups, debt ratio falls. – Volatile sales
• Firms with growth options and asymmetric information – High operating leverage
problems tend to maintain excess borrowing capacity. – Less general-purpose assets that make good collateral

Implications for Managers (cont.)

• Avoid cost of signaling by maintaining excess
borrowing capacity, especially if the firm has:
– Many potential investment opportunities
– Higher asymmetric information costs
• Always consider the impact of capital
structure choices on lenders’ and rating
agencies’ attitudes.