Capital Structure Cost Considerations

Proposition I with Taxes: The Tax Shield

A tax shield is the deliberate use of taxable expenses to offset taxable income. The interest expense on debt provides a tax shield that results in savings that enhance the value of a company. Ignoring the practical realities of bankruptcy and financial distress costs, the value of a company increases with increased debt levels. The level of tax benefit reduces the actual cost of debt.

$$\text{After-tax cost of debt}=\text{Before-tax cost of debt}\times(1-\text{Marginal tax rate})$$

The MM Proposition I with taxes is:

$$\begin{align} \text{V}_{\text{L}} & =\text{V}_{\text{U}}+\text{tD} \\  \Rightarrow \text{V}_{\text{L}} & > \text{V}_{\text{U}} \end{align}$$

Where:

\(\text{V}_{\text{L}}=\) The value of the levered firm (debt in the capital structure).

\(\text{V}_{\text{U}}=\) The value of the unlevered firm (no debt in the capital structure).

\(\text{t}=\) The marginal tax rate.

\(\text{tD}=\) The debt tax shield.

According to Proposition I with taxes, value is maximized at 100% debt.

Proposition II with Taxes: The Impact on WACC and Return on Equity

By introducing taxes, the WACC is adjusted to reflect the impact of the tax benefit:

$$\text{r}_{\text{WACC}}=\bigg(\frac{\text{D}}{\text{V}}\bigg)\text{r}_{\text{d}}(1-\text{t})+\bigg(\frac{\text{E}}{\text{V}}\bigg)\text{r}_{\text{e}}$$

And the cost of equity will be:

$$\text{r}_{\text{e}}=\text{r}_{0}+(\text{r}_{0}-\text{r}_{d})(1-\text{t})\bigg(\frac{\text{D}}{\text{E}}\bigg)$$

We can see that the WACC for the company with debt is lower than the WACC for companies without debt. Therefore, debt financing is highly beneficial when considering taxes and ignoring financial distress and bankruptcy costs. As such, the firm’s optimal capital structure is still 100% debt.

In summary, in the Modigliani-Miller model, investors are less prone to negatively reacting to a firm taking additional leverage, as it creates a tax shields that boost the value of the company.

Example: MM Proposition I and II with Taxes

Let us use the example of Genghis Investments.

• The expected operating income is $6,000.
• The cost of equity, which also the WACC, is 12%.
• EBIT is perpetual.
• Genghis is planning to issue $18,000 in debt at the cost of 6% to buy back $18,000 worth of its equity.
• The corporate tax rate is 30%.

The value of Genghis is calculated as follows:

$$\begin{align*}\text{V}_{\text{U}}&=\frac{\text{EBT}(1-\text{t})}{\text{WACC}}\\&=\frac{$6,000(1-0.3)}{0.12}\\&=$35,000\end{align*}$$

The value of Genghis when it issues $18,00 in debt and buys back shares:

$$\begin{align*}\text{V}_{\text{L}}&=\text{V}_{\text{U}}+\text{tD}\\&=$35,000+0.3($18,000)\\&=$40,400\end{align*}$$

The value of equity after buyback is \($40,400 – $18,000 = $22,400\) and levered equity is:

$$\begin{align*}\text{r}_{\text{e}}&=0.12+(0.12-0.06)(1-0.3)\frac{$18,000}{$22,400}\\&=0.15375\\&=15.38\%\end{align*}$$

$$\text{V}_{\text{L}}=\text{D}+\text{E}=\frac{\text{r}_{\text{d}}\text{D}}{\text{r}_{\text{d}}}+\frac{(\text{EBIT}-r_{d}D)(1-t)}{r_{e}}$$

$$\text{V}_{\text{L}}=\frac{$1,080}{0.06}+\frac{($6,000-$1,080)(1-0.3)}{0.15375}=$40,400$$

The WACC of a levered Genghis is:

$$\text{r}_{\text{wacc}}=\bigg(\frac{$18,000}{$40,400}\bigg)0.06(1-0.3)+\bigg(\frac{$22,400}{$40,400}\bigg)0.15375=0.1039=10.39\%$$

$$\begin{align*}\text{V}_{\text{L}}&=\frac{\text{EBIT}(1-\text{t})}{\text{WACC}}\\&=\frac{$6,000(1-0.3)}{0.1039}\\&\approx$40,400\end{align*}$$

Arguments against the Modigliani-Miller Propositions

Miller argued that if investors face a higher personal tax rate on income from debt investments relative to stock investment, the cost of debt will increase as the investors demand a higher return on debt. Thus, in the Miller model, the effect of debt financing on a company’s value depends on the corporate tax rate, personal tax on dividends, and the personal tax on interest income. However, in practice, the value of a levered company is affected by factors other than the tax issue surrounding debt.

Costs of Financial Distress

The disadvantage of operating and financial leverage is that the earnings are magnified downwards during an economic slowdown. Lower earnings put companies under financial distress, which adds costs. The expected cost of financial distress is composed of:

1. The costs of financial distress and bankruptcy, in the event they happen.
2. The probability that financial distress and bankruptcy happen.

The costs of financial distress can further be classified as direct or indirect. Some of the direct costs include actual cash expense associated with the bankruptcy process, while indirect costs include agency costs associated with the debt, forgone investment opportunities, impaired ability to conduct business.

Companies with assets that have a ready secondary market have lower costs associated with financial distress. On the other hand, companies with less tangible assets have less liquidity and higher costs associated with financial distress. The probability of bankruptcy increases as the degree of leverage increases.

Agency Costs

Agency costs are the incremental costs arising from conflicts of interest between a principal and an agent. The agents (managers in a corporate context) may have perquisite consumptions such as subsidized dining and corporate jet fleet at the expense of shareholders. The larger the stake that managers have in the company, the more their share in bearing the cost of excessive perquisite consumption. Shareholders aware of the conflict will usually take measures such as auditing financial statements and managerial expenses to minimize these costs.

Agency cost of equity refers to the conflict of interest that arises between management and shareholders. The net agency costs of equity have three components:

1. Monitoring costs: The costs borne by owners to monitor the management of the company.
2. Bonding costs: The costs borne by management assure the owners that they are working in the owners’ best interest.
3. Residual loss: The costs are incurred even when there is sufficient bonding and monitoring.

Good corporate governance practices lead to higher shareholder value, reflecting that managers’ interests are better aligned with those of shareholders. Agency theory predicts that a reduction in net agency costs of equity results from an increase in the use of debt. Michael Jensen’s free cash flow hypothesis proposes that higher debt levels discipline managers, forcing them to take care of the company to make interest and principal payments, effectively reducing the amount of free cash flow available for misuse by the managers.

Costs of Asymmetric Information

Asymmetric information arises from the fact that managers have more information about the company’s future investment and current performance than outsiders. Companies with high asymmetric information have little financial accounting transparency, complex products, or lower levels of institutional ownership. Debt and equity capital providers demand a higher level of returns for companies with high asymmetric information because they have a greater likelihood of agency costs. Investors closely watch the behavior of managers to gain insight on insider opinions on the company’s prospects.

The pecking order theory developed by Myers and Majluf (1984) suggests that managers choose a method of financing starting with the least potential information content (internal funds) and lower preference to the form with the greatest potential information (debt and equity). Managers tend to issue equity when they believe the stock is overvalued; thus, additional issuance of stocks is often interpreted by investors as a negative signal.

We can therefore read the signals that managers provide in their choice of financing method. 

The Optimal Capital Structure

The optimal capital structure is the capital structure at which the value of the company is maximized. This is the point beyond which further increases in value from value-enhancing effects are offset completely by value-reducing effects.

Considering only the costs of financial distress and the tax shield provided by debt, the expression for the value of a leveraged company is:

$$\text{V}_{\text{L}}=\text{V}_{\text{u}}+\text{tD}-\text{PV (Cost of financial distress)}$$

The above equation represents the static trade-off theory of capital structure, which is based on balancing the expected costs from financial distress against the tax benefits of debt service payments. The static trade-off theory proposes an optimal capital structure with an optimal quantity of debt. Optimal use of debt is found at the point where any additional debt would cause financial distress costs to increase by a greater proportion than the benefit of the additional tax shield.

Business risk, combined with a company’s tax situation, corporate governance, and financial information transparency, contributes to a company’s optimal capital structure. The extent of debt used by a company should depend on the owner’s and manager’s risk appetite.

Once a company has identified its optimal capital structure, it can use this as its target capital structure. However, maintaining a target capital structure is difficult due to expensive flotation costs and potentially adverse market conditions.

Question

Which of the following is most likely true about the effect of asymmetric information on the cost of equity?

1. Companies with lower asymmetry of information have a greater likelihood of agency cost.
2. Some degree of asymmetric information exists because investors never have as much information as managers.
3. Managers choose methods of financing according to a hierarchy that gives preference to the method with the most potential information content.

Solution

The correct answer is B.

Managers have more information about the company’s current performance and its future potential investments than investors.

A is incorrect. Companies with lower asymmetry of information have less likelihood of agency costs.

C is incorrect. Managers choose financing methods according to a hierarchy that gives preference to the method with the least potential information content.

Reading 15: Capital Structure

LOS 15 (b) Explain the effects on costs of capital and capital structure decisions of taxes, financial distress, agency costs, and asymmetric information..