Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

FIGURE 13.4 PIE CHART MODELS OF CAPITAL STRUCTURE WITH AND WITHOUT CORPORATE INCOME TAXES

Equity

100%

Value =

$10,000,000

Unlevered value = $10,000,000

Unlevered value = $6,500,000 Levered value = $8,250,000

Levered value = $10,000,000

Taxes

Panel A

With no taxes, the size of the pie, or the value of the firm, does not depend on the mix of debt and equity that the firm

chooses. Proposition I holds, and capital structure is irrelevant.

Panel B

With a corporate income tax, a portion of the firm's cash flows goes to the government, diminishing the value of claims

held by private investors. The government's slice of the pie shrinks the more debt a firm uses because the government

allows a deduction for interest payments. A company could shelter nearly all of its cash flows by financing its operations

almost entirely with debt. Therefore, capital structure matters because firm value is larger if the firm uses more debt.

Equity

50%

Value =

$5,000,000

Debt

50%

Value =

$5,000,000

Equity

50%

Value =

$3,250,000

Equity

100%

Value =

$6,500,000

Taxes

Debt

50%

Value =

$5,000,000

13 -3c THE M&M MODEL WITH CORPORATE

AND PERSONAL TAXES

Clearly, accounting for corporate income taxes leads us to favour the proposed 50% debt/50% equity

capital structure for HTMC. However, this isn’t the best possible outcome. If a 50% debt-to-capital

ratio increases HTMC’s total company value by $1,750,000 more than that of the unlevered version of

HTMC, and if each additional dollar of debt increases the value by $0.35, then shouldn’t the optimal

leverage ratio for the company be 100% debt? This implication, more than any other, lessened the initial

acceptance of the M&M propositions. How could the theory be correct if it predicted that all companies

should be highly levered, and yet, in the real world, many companies use little or no debt? Part of the

LO 13.2