Limits to the use of debtPersonal TaxesSlide 3Considering Personal Taxes in the Interest Tax ShieldValuing the Interest Tax Shield with Personal TaxesLimits to the Tax Benefit of DebtThe Low Leverage PuzzleThe Costs of Bankruptcy and Financial DistressDirect Costs of BankruptcyIndirect Costs of Financial DistressThe Tradeoff TheoryOptimal LeverageOptimal Leverage with Taxes and Financial Distress CostsOptimal LeverageExploiting Debt Holders: The Agency Costs of LeverageOver-InvestmentUnder-InvestmentDisciplinary Power of DebtAgency Costs and the Tradeoff TheoryDebt-to- Value Ratio [D / (E + D)] for Select IndustriesAsymmetric Information and Capital StructureIssuing Equity and Adverse SelectionImplications for Equity IssuancePayout PolicyHistorical ViewHistorical ViewAlong Came M&MDividend Irrelevance ExampleDividend Irrelevance ExampleDividend Irrelevance ExampleDividend Irrelevance ExampleDividend Irrelevance ExampleDividend Irrelevance ExampleEmpirical Observation 1Empirical Observation 2The Changing Composition of PayoutsEmpirical Observation 3Empirical Observation 4GM: 1985–2008Empirical Observation 5LIMITS TO THE USE OF DEBTPersonal Taxes•The cash flows to investors are typically taxed twice. Once at the corporate level and then investors are taxed again when they receive their interest or dividend payment. •For individuals:Interest payments received from debt have been taxed as ordinary income. Equity investors also must pay taxes on dividends and capital gains.•The price individuals will pay for a security depends upon the cash flows after all taxes have been paid.After-Tax Investor Cash Flows Resulting from $1 Received by Debt HoldersConsidering Personal Taxes in the Interest Tax Shield•In general, every $1 received after taxes by debt holders from interest payments costs equity holders $(1 − *) on an after-tax basis, where:Effective Tax Advantage of Debt:•When there are no personal taxes on debt income (i = 0) or when the personal tax rates on debt and equity income are the same (i = e ), the formula reduces to * = c. •When equity income is taxed less heavily (e is less than i ), then * (.15) is less than c (.34).(1 ) (1 ) (1 ) (1 ) (1 ) 1 (1 ) (1 )i c e c ei it t t t ttt t*- - - - - -= = -- -Valuing the Interest Tax Shield with Personal Taxes•With personal taxes and permanent debt, the value of the firm with leverage becomesIf * is less than c, the benefit of leverage is reduced in the presence of personal taxes. L UV V Dt*= +Limits to the Tax Benefit of Debt•The optimal level of leverage from a tax saving perspective is where interest equals EBIT.At the optimal level of leverage, the firm shields all of its taxable income and it does not have any tax-disadvantaged excess interest.•However, it is unlikely that a firm can predict its future EBIT precisely. If there is uncertainty regarding EBIT, there is a risk that interest will exceed EBIT. As a result, the expected tax savings for high levels of interest falls, reducing the optimal level of the interest payment.The Low Leverage Puzzle•It would appear that firms, on average, are under-leveraged. However, it is hard to accept that most firms are acting suboptimally. In reality, there is more to the capital structure story than discussed so far.•A key item missing from the analysis thus far is that increasing the level of debt increases the probability of bankruptcy. •If bankruptcy is costly, the expected costs offset the tax advantages of debt financing.The Costs of Bankruptcy and Financial Distress•With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt, rather bankruptcy simply shifts the ownership of the firm from equity holders to debt holders without changing the total value available to all investors.In reality, bankruptcy is rarely simple and straightforward. It is often a long and complicated process that imposes both direct and indirect costs on the firm and its investors.Direct Costs of Bankruptcy•The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive.Costly outside experts are often hired by the firm to assist with the bankruptcy process.Creditors also incur costs during bankruptcy.The direct costs of bankruptcy average about 3% to 4% of the pre-bankruptcy market value of total assets.•Workouts and pre-packaged bankruptcies may help reduce these small costs as well.Indirect Costs of Financial Distress•While the indirect costs of bankruptcy are difficult to measure accurately, they are often much larger than the direct costs.Loss of CustomersLoss of SuppliersLoss of EmployeesLoss of Management’s TimeFire Sale of AssetsDelayed LiquidationCosts to CreditorsIt is estimated that the potential loss due to financial distress (or the threat of distress) is 10% to 20% of firm valueThe Tradeoff Theory•The firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress and agency costs.•According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the expected tax savings from debt, less the present value of the expected financial distress costs. (Interest Tax Shield) (Financial Distress Costs)L UV V PV PV= + -Optimal Leverage•For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an increase in the interest tax shield.•As the level of debt increases, the probability of default increases. As the level of debt increases, the costs of financial distress increase, ultimately reducing the value of the levered firm.The rate at which the costs and benefits change are different across firms.Optimal Leverage with Taxes and Financial Distress CostsOptimal Leverage•The tradeoff theory states that firms should set their leverage to the level at which firm value is maximized.At this point, the tax savings that result from increasing leverage are perfectly offset by the increased probability of incurring the costs of financial distress.The tradeoff theory helps explain why firms choose debt levels that are too low to fully exploit the interest tax shield (due to financial distress costs) And helps explain differences in the use of leverage across