Introduction to Corporate Finance

13: Capital Structure

■ In a world with tax-deductible interest

payments and only company-level taxation

of operating profits, the optimal corporate

strategy is to use the maximum possible

leverage. This minimises the government’s

claim on profits and maximises income

flowing to private investors.

■ When governments impose taxes at both

the corporate and personal level, debt’s tax

advantage usually is lower than when there is

a corporate income tax only; in some cases,

higher personal taxes on interest income

may lead to a net tax disadvantage for debt.

■ If insolvency resulted in a costless transfer of

ownership from shareholders to creditors,

then insolvency would have no important

consequence for a company’s capital

structure. It is because the insolvency

process triggers large direct and indirect

costs that insolvency creates a cost to using

debt.

■ Creditors know that corporate managers,

who operate their companies in the

interests of shareholders, have incentives

to expropriate creditor wealth by playing

certain games with the company’s

investment policy. Asset substitution is one

such game, and underinvestment is another.

Creditors protect themselves from these

games in several ways, especially by inserting

loan covenants into bond contracts.

■ There are several important agency costs

inherent in the relationship between

corporate managers and outside investors

and creditors. In some cases, using financial

leverage can help overcome these agency

problems; in others, using leverage

introduces other agency problems. The

modern trade-off model of corporate

leverage predicts that a company’s optimal

debt level is set by trading off the tax

benefits of increasing leverage against the

increasingly severe insolvency costs and

agency costs of heavy debt usage.

■ The pecking-order theory predicts that

managers will operate their companies in

such a way as to minimise the need to secure

outside financing – for example, by retaining

profits to build up financial slack. These

same managers will use the safest source of

funding, usually senior debt, when they must

secure outside financing.

IMPORTANT EQUATIONS

13.1 V=+ED=

EBIT

r

()

a

13.2 =+− 







rrrr

D

E

la()ad

13.3 =

−

V =

EBIT T

r

NI

r

[(1)]

u

c

aa

13.4

×

PV =×

TrD

r

(Interesttaxshields)= TD

()cd

d

c

13.5 Vl = Vu + PV (Interest tax shields) = Vu + TcD

13.6 =−

−−

−

















G ×

TT

T

1 D

(1 )(1)

(1 )

l

cps

pd

13.7 Vl = Vu + PV (Tax shields) − PV (Insolvency costs)

13.7b Vt = Vu + PV (Tax shields) – PV (Insolvency costs) – PV (Agency costs of outside equity)

− PV (Agency costs of outside debt)

LO 13.3

LO 13.4

LO 13.5