Debt policies
Modigliani and Miller: debt policy does not matter
But: taxes, financial distress, managerial incentives and information
In “perfect” capital markets: the total value of a firm should not depend on
how it is financed.
- Debt is cheaper than equity for a firm
- Levered equity/debt has higher risk
MM Proposition I: In a perfect capital market, the total value of a firm is equal
to the market value of the total cash flows generated by its assets and is not
affected by its choice of capital structure.
Leveraged Recapitalization: When a firm uses borrowed funds to pay a large
special dividend or repurchase a significant amount of outstanding shares.
E D
Leverage and the Equity Cost of Capital: RU = R + R
E+ D E E+ D D
D
R E=R U + (R −R D )
E U
MM Proposition II: The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is proportional to the market
value debt-equity ratio.
D
Cost of Capital of Levered Equity: r E=r U + (r −r )
E U D
E D
Weighted Average Cost of Capital (No Taxes): r wacc = r E+ r
E+D E+ D D
- r wacc =r U =r A
Unlevered Beta: A measure of the risk of a firm as if it did not have leverage,
which is equivalent to the beta of the firm’s assets.
E D
- βU= β E+ β
E+ D E+ D D
- Leverage amplifies the market risk of a firm’s assets, β U, raising the market
risk of its equity.
Holding cash: The opposite effect of leverage on risk and return and can be
viewed as equivalent to negative debt.
- Net Debt = Debt - Cash and Risk-Free Securities
Dilution: An increase in the total of shares that will divide a fixed amount of
earnings.
- Debt financing should be used instead
, Equity issuance: A company sells new ownership shares to investors to raise
capital (money).
- As long as the firm sells the new shares of equity at a fair price, there will
be no gain or loss to shareholders associated with the equity issue itself.
- If stock prices decrease first hour, signal bad operation and overvalued
company shares
- Buying own shares gives signal to outsiders of good results
Interest tax deduction: Interest payments are deductible from taxable
corporate income.
- Interest tax shield: The reduction in taxes paid due to the tax
deductibility of interest.
- Interest Tax Shield = Corporate Tax Rate × Interest Payments
MM Proposition I with Taxes: The total value of the levered firm exceeds the
value of the firm without leverage due to the present value of the tax savings
from debt.
- V L=V U + PV ( Interest Tax Shield )
E D
- r wacc = r E+ r ×(1−❑c )
E+D E+ D D
Personal taxes: Debt holders and equity holders have different taxes.
- Debt holders: $(1−❑i)
- Equity holders: $ ( 1−❑c ) (1−❑e )
¿ ( 1−❑i )−( 1−❑c ) (1−❑e )
Personal taxes in the interest tax shield: ❑ =
(1−❑i )
- When equity income is taxed less heavily (❑e is less than❑i ¿ , then
¿
❑ isless than ❑c.
- Belgium, corporate tax is 25% and personal tax on interest is 30%.
- Fixed or permanent debt: V L=V U +❑¿ D
Additionally we need to take into account …
1. If capital gains are taxed, can losses offset the gains
- These taxes are paid only when the investor sells the stock and realizes
the gain.
- In the US, investors can use accrued losses that they have to offset gains.
- Taxing unrealized capital gains without making unrealized capital losses
tax deductible may reduce risk-taking.
2. For firms with higher or lower payout ratios, the tax rate on
payouts may be different
3. Tax rates vary for individual investors, and many investors face
lower rates
4. Many investors face no personal taxes
Calculating the effective tax advantage of debt accurately is extremely
difficult.
Modigliani and Miller: debt policy does not matter
But: taxes, financial distress, managerial incentives and information
In “perfect” capital markets: the total value of a firm should not depend on
how it is financed.
- Debt is cheaper than equity for a firm
- Levered equity/debt has higher risk
MM Proposition I: In a perfect capital market, the total value of a firm is equal
to the market value of the total cash flows generated by its assets and is not
affected by its choice of capital structure.
Leveraged Recapitalization: When a firm uses borrowed funds to pay a large
special dividend or repurchase a significant amount of outstanding shares.
E D
Leverage and the Equity Cost of Capital: RU = R + R
E+ D E E+ D D
D
R E=R U + (R −R D )
E U
MM Proposition II: The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is proportional to the market
value debt-equity ratio.
D
Cost of Capital of Levered Equity: r E=r U + (r −r )
E U D
E D
Weighted Average Cost of Capital (No Taxes): r wacc = r E+ r
E+D E+ D D
- r wacc =r U =r A
Unlevered Beta: A measure of the risk of a firm as if it did not have leverage,
which is equivalent to the beta of the firm’s assets.
E D
- βU= β E+ β
E+ D E+ D D
- Leverage amplifies the market risk of a firm’s assets, β U, raising the market
risk of its equity.
Holding cash: The opposite effect of leverage on risk and return and can be
viewed as equivalent to negative debt.
- Net Debt = Debt - Cash and Risk-Free Securities
Dilution: An increase in the total of shares that will divide a fixed amount of
earnings.
- Debt financing should be used instead
, Equity issuance: A company sells new ownership shares to investors to raise
capital (money).
- As long as the firm sells the new shares of equity at a fair price, there will
be no gain or loss to shareholders associated with the equity issue itself.
- If stock prices decrease first hour, signal bad operation and overvalued
company shares
- Buying own shares gives signal to outsiders of good results
Interest tax deduction: Interest payments are deductible from taxable
corporate income.
- Interest tax shield: The reduction in taxes paid due to the tax
deductibility of interest.
- Interest Tax Shield = Corporate Tax Rate × Interest Payments
MM Proposition I with Taxes: The total value of the levered firm exceeds the
value of the firm without leverage due to the present value of the tax savings
from debt.
- V L=V U + PV ( Interest Tax Shield )
E D
- r wacc = r E+ r ×(1−❑c )
E+D E+ D D
Personal taxes: Debt holders and equity holders have different taxes.
- Debt holders: $(1−❑i)
- Equity holders: $ ( 1−❑c ) (1−❑e )
¿ ( 1−❑i )−( 1−❑c ) (1−❑e )
Personal taxes in the interest tax shield: ❑ =
(1−❑i )
- When equity income is taxed less heavily (❑e is less than❑i ¿ , then
¿
❑ isless than ❑c.
- Belgium, corporate tax is 25% and personal tax on interest is 30%.
- Fixed or permanent debt: V L=V U +❑¿ D
Additionally we need to take into account …
1. If capital gains are taxed, can losses offset the gains
- These taxes are paid only when the investor sells the stock and realizes
the gain.
- In the US, investors can use accrued losses that they have to offset gains.
- Taxing unrealized capital gains without making unrealized capital losses
tax deductible may reduce risk-taking.
2. For firms with higher or lower payout ratios, the tax rate on
payouts may be different
3. Tax rates vary for individual investors, and many investors face
lower rates
4. Many investors face no personal taxes
Calculating the effective tax advantage of debt accurately is extremely
difficult.
