FINANCIAL ADMINISTRATION OF THE FIRM FIN 5043--930

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Chapter 12
Capital Structure Theory And Taxes
Del HawleyFIN 634
Fall 2003
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Overview Of Capital Structure Theory Practice

• The capital structure question can the mix of
  debt and equity a firm issues affect its total
  market valuation?
• Has been a key issue in finance theory practice
  since 1958
• Capital Structure patterns observed worldwide
• Similarities differences between US, other OECD
  countries
• The Agency Cost/Tax Trade-Off Theory of capital
  structure
• Not perfect, but works better than principal
  competitors
• Time wont allow examination of other two
  theories
• The Modigliani-Miller capital structure
  irrelevance propositions
• Perfect capital markets assumption underlying
  Proposition I
• Proposition IIs implications for corporate
  financial policy
• The impact of income taxes on the irrelevance
  propositions
• Corporate income tax 100 debt is optimal
• Irrelevance perhaps rescued by personal taxes

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Capital Structure Patterns Observed Worldwide

• Capital structures have strong industry patterns,
  and these are the same around the world.
• High debt-to-equity industries utilities,
  transport cos, and mature, capital-intensive
  manufacturing firms
• Low D/E industries service firms, mining
  companies, most rapidly growing or
  technology-based manufacturing firms
• Implies an industry's optimal asset mix
  influences CSs chosen by firms in that industry
  anywhere

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Market Value Debt Ratios, Selected U.S.
Corporations, July 2002
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Leverage Ratios For G-7 And Selected Developing
Countries, 1980-91
Source Rajan and Zingales, What do We Know
About Capital Structure Some Evidence
from International Data, Journal of Finance 50
(1995).
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CS Patterns Observed Worldwide (Continued)

• Leverage ratios are inversely related to the
  perceived costs of financial distress.
• Both across industries across countries, the
  more costly is financial distress, the less debt
  will be used.
• Companies rich in collateralizeable assets have
  higher leverage than firms rich in growth
  options.
• Within industries, leverage is inversely related
  to profitability
• In all industries, the most profitable companies
  typically borrow the least, suggesting that CS at
  least partly residual
• Corporate personal taxes influence capital
  structures, but they neither cause nor prevent
  corporate leverage.
• US corps used as much debt before 1913 as after
• Increased corporate tax rates yield increased
  debt usage
• Decreases in the personal tax rates on equity
  income yield decreased corporate debt usage.

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Market-Value Leverage Ratios (Total Debt-to-Total
Capital) For US Corporations, 1929-1993

1990
1980
1970
1960
1940
1950
1930
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Capital Structure Patterns Observed Worldwide
(Continued)

• Existing S/Hs consider leverage-increasing events
  "good news" and leverage-decreasing events "bad
  news"
• Stock prices rise when leverage-increasing events
  announced, but fall for leverage-decreasing
  events.
• Corporations that are forced away from a
  preferred capital structure tend to return to
  that structure over time
• Has occurred frequently, particularly for US
  firms that have taken on large amounts of new
  debt to finance takeovers.
• More generally, corporations like to operate
  within target leverage zones, and will issue new
  equity when debt ratios get too high and will
  issue debt if they fall too low.

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Theoretical Models Of Capital Structure

• First important theoretical model in corporate
  finance was Modigliani Millers (MM) capital
  structure model in 1958
• In frictionless capital markets, with no taxes or
  transactions costs, CS is irrelevant--doesnt
  affect valuation
• Todays best theoretical explanation for observed
  CS patterns is the Agency Cost/Tax Shield
  Trade-Off Model
• Assumes that observed CSs result from firms
  trading off the tax benefits of debt usage
  against the increasingly severe agency costs as
  debt ratios approach critical levels
• The Pecking Order Theory based on two key
  assumptions
• (1) managers are better informed about the
  investment opportunities faced by their firms
  than are outsiders (2) managers act in the best
  interests of existing shareholders.
• Signaling Model of CS also assumes asymmetric
  information
• but managers use debt as a costly signal to
  differentiate their firms from weaker competitors

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The MM Capital Structure Model

• Assumptions of the MM Capital Structure Model
• All physical assets are owned by corporations
• Frictionless Capital markets no corporate or
  personal income taxes, securities are traded
  costlessly, no bankruptcy costs
• Corporations can issue only risky equity and
  risk-free debt
• Both individuals and corporations can borrow or
  lend at the risk-free interest rate
• Investors have identical expectations about the
  future stream of corporate profits
• There is no growth all cash flow streams are
  perpetuities and
• All corps can be classified into one of several
  "equivalent return classes" with returns on
  shares of all firms proportional to, and
  perfectly correlated with, all other firms in
  that class.
• Seems absurdly unrealistic, but model very robust
• Only costless bankruptcy and no taxes are
  critical assumptions.

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MMs Proposition I Capital Structure Irrelevance
See Example Spreadsheet
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Table C Income Statements For Unleverco
Leverco With Corporate Income Taxes