Introduction to Corporate Finance

13: Capital Structure

4 Explain how Propositions I and II differ, as well as what they have in common.

5 What is the difference between levered and unlevered equity? What effect does substituting debt

for equity have on the required return on (levered) equity?

CONCEPT REVIEW QUESTIONS 13-2

13 -3 THE M&M CAPITAL STRUCTURE MODEL

WITH TAXES

M&M derived their propositions by assuming that companies operate in markets without taxes or

transactions costs. In this section, we look at what happens when we introduce corporate income taxes

and interest deductibility into the M&M framework.

13 -3a THE M&M MODEL WITH CORPORATE TAXES

In Australia and many other countries, companies can deduct interest payments to lenders as a business

expense. (Dividends paid to shareholders receive no similar tax advantage for the company.) The interest

deduction thus reduces the amount of taxes the company must pay to the government. Intuitively, this

should lead to a tax advantage for debt, meaning that managers can increase company value by issuing

debt. So, returning to our High-Tech Manufacturing Company (HTMC) example, we now demonstrate

how, with interest deductibility, adding debt to the company’s capital structure could increase the

company’s value by reducing the government’s tax claim on the company’s cash flow.

FIGURE 13.3 DO COMPANIES HAVE TARGET CAPITAL STRUCTURES?

Flexible

target

37%

Very strict

target

10%

Somewhat tight

target/range

34%

No target debt

ratio or range

19%

Source: Graham and Harvey (2001), ‘The Theory and Practice of Corporate Finance: Evidence From the Field,’ Journal of

Financial Economics, 60, pp. 187–243, copyright © 2001, with permission from Elsevier.