Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

finance in practice

THE HIDDEN COST OF PERSONAL DEBT

Many students use borrowed money to finance

their education and pay for necessities while they

are in university, just as companies borrow money

to finance capital investments and smooth out their

working capital needs over time. For Australian

citizens and residents, the Australian government

provides an effective lending function for university

students, so that students can borrow from the

government to pay their fees and then repay the

funds once they have graduated and their own

earnings are above a critical figure. There are

important measures of personal indebtedness

that are very similar to the measures of corporate

leverage.

Unfortunately, some students can become

all too familiar with personal debt while they are

in university. Today, many graduating Australian

students have loan repayments outstanding,

and the total amount of student loan debt is

rising. Furthermore, many graduates ran up

significant credit-card debt as students, so they

are beginning their careers with potentially

high debt. The Australian government loan

arrangements are intended to help students.

Called the FEE-HELP scheme, this is a loan

arrangement that assists eligible fee-paying

students pay all or part of their university tuition

fees by lending the money up to a limit. Of

course, graduates who do not repay the funds

borrowed then incur a bad debt record; and the

Australian taxpayer effectively pays the cost of

the loan shortfall.

In the corporate world, bondholders are generally sophisticated enough to take steps to prevent

managers from playing these games with their money. The most effective, preventive step that bond

investors can take is to write very detailed loan covenants into bond contracts, which are contractual

clauses that limit a borrower’s ability to expropriate the bondholders’ wealth. The downside of loan

covenants is that they make bond agreements costly to negotiate and to enforce. In any case, the agency

costs of debt are real, and they become more important as a company’s leverage ratio increases.

13 - 4c THE TRADE-OFF MODEL REVISITED

Our discussion thus far has shown that certain real-world factors – such as corporate income taxes and

agency costs of outside equity – give corporate managers an incentive to substitute debt for equity in

their company’s capital structure. Other factors, such as personal income taxes, insolvency and agency

costs of outside debt, give managers an incentive to favour equity financing. We are now ready to tie

together all these influences and present the trade-off model of corporate leverage. This model expresses the

value of a levered company as the value of an unlevered company, plus the present values of tax shields

and the agency costs of outside equity, minus the present value of insolvency costs and the agency costs

of debt, as follows:

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

• PV (Agency costs of outside debt)

Figure 13.5 describes how agency costs, insolvency costs and tax benefits of leverage interact to

determine a typical company’s optimal debt level. Starting from a capital structure with no debt, managers

can increase company value by replacing equity with debt, thus shielding more cash flow from taxation. In

the absence of insolvency costs and the agency costs of debt, managers would maximise company value by

borrowing as much as possible, a situation represented by the straight line in Figure 13.5. The curving line

loan covenants
Contractual clauses that limit
the actions that a borrower
can take, protecting the
lender’s wealth from being
expropriated

LO 13.3

trade-off model of
corporate leverage
According to this model
managers trade off the costs
and benefits of using debt to
choose the amount of debt
that maximises company
value as expressed in
Equation 13.7b