Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Let’s begin our demonstration by assuming, as before, that the HTMC’s EBIT will be $1,000,000

next year, and that we are trying to decide whether to retain the company’s existing, all-equity capital

structure or adopt a proposed 50% debt/50% equity capitalisation. Assume that investors still require a

10% return on the company’s assets, so ra = 0.10, as before. However, we now propose that HTMC faces

a 35% corporate tax rate on earnings (Tc= 0.35). In computing taxable earnings, HTMC can deduct

interest expense.^6

Table 13.5 shows the after-tax cash flows to HTMC’s shareholders and debtholders under the

current and proposed capital structure if EBIT is $1,000,000, as expected. Company taxes reduce

the  amount of money that can be distributed to security holders under both capital structures, but

the effect is greater under the all-equity plan. In this case, HTMC pays taxes of $350,000, leaving only

$650,000 available for distribution to shareholders. EPS thus drops to $3.25 from $5.00 under the no-

tax scenario. Under the proposed capital structure, tax-deductible interest payments of $300,000 reduce

taxable profits to $700,000, and HTMC only pays $245,000 in corporate taxes. This leaves $455,000

in net income that can be distributed to shareholders, yielding an EPS of $4.55 from $7.00 under the

no-tax scenario. Note that under the proposed capital structure, HTMC is able to distribute $755,000

to investors ($300,000 interest to debtholders and $455,000 in dividends to shareholders). Under the

all-equity capitalisation, HTMC can only distribute $650,000 to investors (dividends to shareholders).

TABLE 13.5 CASH FLOWS TO SHAREHOLDERS AND BONDHOLDERS UNDER THE CURRENT AND PROPOSED

CAPITAL STRUCTURE FOR HTMC – WITH CORPORATE TAXATION (ASSUMING EBIT = $1,000,000

AND TC = 0.35)

Current capital structure:

all-equity financing

Proposed capital structure:

50% debt, 50% equity

EBIT $1,000,000 $1,000,000

Interest (6.0%) $0 $(300,000)

Taxable income $1,000,000 $700,000

Corporate taxes (Tc = 0.35) $(350,000) $(245,000)

Net income $650,000 $455,000

Shares outstanding 200,000 100,000

EPS $3.25 $4.55

We can now compute the value of both the unlevered and levered versions of HTMC, and define

these values as Vu and Vl, respectively. The basic valuation formula (Equation 13.1) used in the

absence of taxes to discount EBIT must now be modified to discount after-tax net income (NI), yielding

the following formula for the value of HTMC if it uses no debt (its unlevered value Vu):

Eq. 13.3 Vu =

[]−

== =

EBIT T

r

NI

r

(1 ) $650, 000

0.10

$6,500, 000

C

aa

6 This is the same logic Modigliani and Miller used in their 1963 ‘modified’ capital structure model, which explicitly incorporated a tax on

corporate profits and interest deductibility. See Franco Modigliani and Merton Miller, ‘Corporate Income Taxes and the Cost of Capital’,

American Economic Review 53 (June 1963), pp. 433–443.

LO 13.2