Lecture 11: Corporate Equity, Debt and TaxesLeverageXerox Corporation Consolidated Balance Sheet 1999 (in millions)Xerox Corporation Consolidated Balance Sheet 1999 Cont.Microsoft Balance Sheet 2000 (in $ millions)Microsoft Balance Sheet 2000 in $Millions Continued.Comparing Market CapsExpected Return on AssetsValue of Firm in Terms of rAFirm’s Objective: Maximize Overall Market Value VTraditional Position (Before Modigliani-Miller)Slide 12Slide 13Modigliani-MillerSlide 15Adding Taxes to M&MBankruptcy Costs Limit D/ERecent Trends in Corporate DebtSlide 19Other Motives for Issuing Corporate DebtLecture 11: Corporate Equity, Debt and TaxesLeverage•Corporate Leverage is measured by Debt D divided by equity E.•Highly levered firms court bankruptcy•Unlevered firms cannot go bankrupt (Microsoft owned $5.9 billion of other firms’ long-term debt and $23.8 billion in cash and short-term investments in 2000.Xerox Corporation Consolidated Balance Sheet 1999 (in millions)•Assets:–Cash $126–Receivables $15940–Inventories $2961–Buildings & equipment $2456–Other $7331–Total $28814Xerox Corporation Consolidated Balance Sheet 1999 Cont.•Liabilities–Short-term debt $3957–Long-term debt $10994–Deferred taxes $2263–Preferred stock $669–Other $6020–Shareholders equity $4911–Total $28814Microsoft Balance Sheet 2000 (in $ millions)•Assets:–Cash & equivalents $4846–Short-term investments $18952–Property & equipment $1611–Equity and debt investments $17726–Other $9015–Total assets $52150Microsoft Balance Sheet 2000in $Millions Continued.•Liabilities–Income taxes $585–Accounts payable $1016–Unearned revenue $4816–Other $4065–Stockholders equity $41368–Total $52150»No debt: no corporate bonds or bank loans!Comparing Market Caps•Xerox Market Capitalization = 667 million shares  $6.95/share = $4.6 billion 2/11/01 (compare with shareholders equity = $4.9b.)•Microsoft Market Capitalization = 5.3 billion shares  $59.13/share = $315.3b.(compare with stockholders equity=$41.4b)Expected Return on Assets•Expected return on assets = rA= weighted cost of capital = expected return on a portfolio consisting of all of a companies liabilities.EDArEDErEDDr)(DAAErrEDrr Value of Firm in Terms of rA•Suppose Dividends are constant =Div and debt is perpetual, paying Coupon C.•D=C/rD and E=Div/rE•Value of firm = V=D+E=C/rD+Div/rE•Value of firm = V = (C+Div)/rA•rA=weighted average cost of capital = (D/(D+E))rD+(E/(D+E))rEFirm’s Objective: Maximize Overall Market Value V•Present Value Model: V=(C+Div)/rA•Strategies: Increase C+Div, or lower rate of discount rA.Traditional Position (Before Modigliani-Miller)•Both rD and rE are not much affected by the ratio, probability of bankruptcy is so low that it is approximately zero.•Since rD<rE, so firms should borrow money and buy back shares to lower rA, thereby raising the value V of the firm.Modigliani-Miller •In absence of taxes, value of firm is independent of D/E.•D/E only affects division of income stream between C and Div, so one who buys all D and all E doesn’t care what D/E is. Hence, V is unaffected by D/E.Adding Taxes to M&M•Interest paid is deductible for corporate profits taxes, dividends paid are not.•Therefore, raising D/E raises numerator of V: firms can pay out more since their taxes are lower.•Conclusion: firms should make D=V?•Problem with that: if D/E= , the firm is bankrupt, and debt becomes equity.Bankruptcy Costs Limit D/E•If D/E gets too high, the probability of a bankruptcy gets too high.•Bankruptcies disrupt the operations of the firm.•Legal costs.•Conclusion: Each firm must judge how high it can push D/E against its risks and costs of bankruptcy.Recent Trends in Corporate Debt•Just as firms are paying less dividends to reduce taxes, they are also borrowing more.•Typical large firm in late 1990s purchased 2% of shares per year, issued 1%, so 1% net repurchase.•In first 11 months of 2000, firms issued $146 billion in equity, and $935 billion in corporate bond market•Debt is becoming riskier, more equity-likeOther Motives for Issuing Corporate Debt•Management Incentive Options – Management shares in up side, but does not lose in down side•Management has an increasing incentive to pursue a high-risk strategy in recent