Brealey, Myers. Principles of Corporate Finance. 7th edition

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

ates a money-making opportunity. Firms and intermediaries will find some way to

reach the clientele of investors frustrated by the imperfection.

For many years the United States government imposed a limit on the rate of in-

terest that could be paid on savings accounts. It did so to protect savings institu-

tions by limiting competition for their depositors’ money. The fear was that de-

positors would run off in search of higher yields, causing a cash drain that savings

institutions would not be able to meet. This would cut off the supply of funds from

those institutions for new real estate mortgages and knock the housing market for

a loop. The savings institutions could not have afforded to offer higher interest

rates on deposits—even if the government had allowed them to—because most of

their past deposits had been locked up in fixed-rate mortgages issued when inter-

est rates were much lower.

These regulations created an opportunity for firms and financial institutions to

design new savings schemes that were not subject to the interest-rate ceilings. One

invention was the floating-rate note, first issued on a large scale and with terms de-

signed to appeal to individual investors by Citicorp in July 1974. Floating-rate notes

are medium-term debt securities whose interest payments “float” with short-term

interest rates. On the Citicorp issue, for example, the coupon rate used to calculate

each semiannual interest payment was set at 1 percentage point above the contem-

poraneous yield on Treasury bills. The holder of the Citicorp note was therefore pro-

tected against fluctuating interest rates, because Citicorp sent a larger semiannual

check when interest rates rose (and, of course, a smaller check when rates fell).

Citicorp evidently found an untapped clientele of investors, for it was able to

raise $650 million in the first offering. The success of the issue suggests that Citi-

corp was able to add value by changing its capital structure. However, other com-

panies were quick to jump on Citicorp’s bandwagon, and within five months an

additional $650 million of floating-rate notes were issued by other companies. By

the mid-1980s about $43 billion of floating-rate securities were outstanding,

though by that time the interest-rate ceiling was no longer a motive.

Interest-rate regulation also provided financial institutions with an opportunity

to create value by offering money-market funds. These are mutual funds invested

in Treasury bills, commercial paper, and other high-grade, short-term debt instru-

ments. Any saver with a few thousand dollars to invest can gain access to these in-

struments through a money-market fund and can withdraw money at any time by

writing a check against his or her fund balance. Thus the fund resembles a check-

ing or savings account which pays close to market interest rates.

These money-

market funds have become enormously popular. By 2001, their assets had in-

creased to $2 trillion.

As floating-rate notes, money-market funds, and other instruments became

more easily available, the protection given by government restrictions on savings

account rates became less and less helpful. Finally the restrictions were lifted, and

savings institutions met their competition head-on.

Long before interest-rate ceilings were finally removed, most of the gains had

gone out of issuing the new securities to individual investors. Once the clientele

was finally satisfied, MM’s proposition I was restored (until the government cre-

ates a new imperfection). The moral of the story is this: If you ever find an un-

satisfied clientele, do something right away, or capital markets will evolve and

steal it from you.

CHAPTER 17

Does Debt Policy Matter? 481

Money-market funds offer rates slightly lower than those on the securities they invest in. This spread

covers the fund’s operating costs and profits.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

SUMMARY

At the start of this chapter we characterized the firm’s financing decision as a mar-

keting problem. Think of the financial manager as taking all of the firm’s real as-

sets and selling them to investors as a package of securities. Some financial man-

agers choose the simplest package possible: all-equity financing. Some end up

issuing dozens of debt and equity securities. The problem is to find the particular

combination that maximizes the market value of the firm.

Modigliani and Miller’s (MM’s) famous proposition I states that no combi-

nation is better than any other—that the firm’s overall market value (the value

of all its securities) is independent of capital structure. Firms that borrow do of-

fer investors a more complex menu of securities, but investors yawn in re-

sponse. The menu is redundant. Any shift in capital structure can be duplicated

or “undone” by investors. Why should they pay extra for borrowing indirectly

(by holding shares in a levered firm) when they can borrow just as easily and

cheaply on their own accounts?

MM agree that borrowing increases the expected rate of return on shareholders’

investments. But it also increases the risk of the firm’s shares. MM show that the

risk increase exactly offsets the increase in expected return, leaving stockholders

no better or worse off.

Proposition I is an extremely general result. It applies not just to the debt–equity

trade-off but to any choice of financing instruments. For example, MM would say

that the choice between long-term and short-term debt has no effect on firm value.

The formal proofs of proposition I all depend on the assumption of perfect

capital markets.

MM’s opponents, the “traditionalists,” argue that market im-

perfections make personal borrowing excessively costly, risky, and inconvenient

for some investors. This creates a natural clientele willing to pay a premium for

shares of levered firms. The traditionalists say that firms should borrow to real-

ize the premium.

But this argument is incomplete. There may be a clientele for levered equity, but

that is not enough; the clientele has to be unsatisfied. There are already thousands

of levered firms available for investment. Is there still an unsatiated clientele for

garden-variety debt and equity? We doubt it.

Proposition I is violated when financial managers find an untapped demand

and satisfy it by issuing something new and different. The argument between MM

and the traditionalists finally boils down to whether this is difficult or easy. We lean

toward MM’s view: Finding unsatisfied clienteles and designing exotic securities

to meet their needs is a game that’s fun to play but hard to win.

Proposition I can be proved umpteen different ways. The references at the end of this chapter in-

clude several more abstract and general proofs. Our formal proofs have been limited to MM’s own

arguments.

FURTHER

READING

The pioneering work on the theory of capital structure is:

F. Modigliani and M. H. Miller: “The Cost of Capital, Corporation Finance and the Theory

of Investment,” American Economic Review, 48:261–297 (June 1958).

However, Durand deserves credit for setting out the issues that MM later solved:

D. Durand: “Cost of Debt and Equity Funds for Business: Trends and Problems in Mea-

surement,” in Conference on Research in Business Finance, National Bureau of Economic Re-

search, New York, 1952, pp. 215–247.

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

CHAPTER 17 Does Debt Policy Matter? 483

MM provided a shorter and clearer proof of capital structure irrelevance in:

F. Modigliani and M. H. Miller: “Reply to Heins and Sprenkle,” American Economic Review,

59:592–595 (September 1969).

A somewhat difficult article which analyzes capital structure in the context of capital asset pricing

theory is:

R. S. Hamada: “Portfolio Analysis, Market Equilibrium and Corporation Finance,” Journal

of Finance, 24:13–31 (March 1969).

More abstract and general theoretical treatments can be found in:

J. E. Stiglitz: “On the Irrelevance of Corporate Financial Policy,” American Economic Review,

64:851–866 (December 1974).

E. F. Fama: “The Effects of a Firm’s Investment and Financing Decisions,” American Economic

Review, 68:272–284 (June 1978).

The fall 1988 issue of the Journal of Economic Perspectives contains an anniversary collection of

articles, including one by Modigliani and Miller, which review and assess the MM propositions.

The summer 1989 issue of Financial Management contains three more articles under the head-

ing “Reflections on the MM Propositions 30 Years Later.”

QUIZ

1. Assume a perfectly competitive market with no corporate or personal taxes. Compa-

nies A and B each earn gross profits of P and differ only in their capital structure—A is

wholly equity-financed and B has debt outstanding on which it pays a certain $100 of

interest each year. Investor X purchases 10 percent of the equity of A.

a. What profits does X obtain?

b. What alternative strategy would provide the same result?

c. Suppose investor Y purchases 10 percent of the equity of B. What profits does Y

obtain?

d. What alternative strategy would provide the same result?

2. Ms. Kraft owns 50,000 shares of the common stock of Copperhead Corporation with a mar-

ket value of $2 per share, or $100,000 overall. The company is currently financed as follows:

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Book Value

Common stock $2 million

(8 million shares)

Short-term loans $2 million

Copperhead now announces that it is replacing $1 million of short-term debt with an

issue of common stock. What action can Ms. Kraft take to ensure that she is entitled to

exactly the same proportion of profits as before? (Ignore taxes.)

3. The common stock and debt of Northern Sludge are valued at $50 million and $30 mil-

lion, respectively. Investors currently require a 16 percent return on the common stock

and an 8 percent return on the debt. If Northern Sludge issues an additional $10 million

of common stock and uses this money to retire debt, what happens to the expected return

on the stock? Assume that the change in capital structure does not affect the risk of the

debt and that there are no taxes. If the risk of the debt did increase, would your answer

underestimate or overestimate the expected return on the stock?

4. Company C is financed entirely by common stock and has a of 1.0. The stock has a

price–earnings multiple of 10 and is priced to offer a 10 percent expected return. The

company decides to repurchase half the common stock and substitute an equal value of

debt. Assume that the debt yields a risk-free 5 percent.

a. Give

i. The beta of the common stock after the refinancing.

ii. The beta of the debt.

iii. The beta of the company (i.e., stock and debt combined).

␤

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

484 PART V Dividend Policy and Capital Structure

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b. Give

i. Investors’ required return on the common stock before the refinancing.

ii. The required return on the common stock after the refinancing.

iii. The required return on the debt.

iv. The required return on the company (i.e., stock and debt combined) after the

refinancing.

c. Assume that the operating profit of firm C is expected to remain constant. Give

i. The percentage increase in earnings per share.

ii. The new price–earnings multiple.

5. Suppose that Macbeth Spot Removers issues $2,500 of debt and uses the proceeds to re-

purchase 250 shares.

a. Rework Table 17.2 to show how earnings per share and share return now vary with

operating income.

b. If the beta of Macbeth’s assets is .8 and its debt is risk-free, what would be the beta

of the equity after the increased borrowing?

6. True or false? Explain briefly.

a. Stockholders always benefit from an increase in company value.

b. MM’s proposition I assumes that actions which maximize firm value also

maximize shareholder wealth.

c. The reason that borrowing increases equity risk is because it increases the

probability of bankruptcy.

d. If firms did not have limited liability, the risk of their assets would be increased.

e. If firms did not have limited liability, the risk of their equity would be increased.

f. Borrowing does not affect the return on equity if the return on the firm’s assets is

equal to the interest rate.

g. As long as the firm is certain that the return on assets will be higher than the

interest rate, an issue of debt makes the shareholders better off.

h. MM’s proposition I implies that an issue of debt increases expected earnings per

share and leads to an offsetting fall in the price–earnings ratio.

i. MM’s proposition II assumes increased borrowing does not affect the interest rate

on the firm’s debt.

j. Borrowing increases firm value if there is a clientele of investors with a reason to

prefer debt.

7. Note the two blank graphs in Figure 17.6. On graph (a), assume MM are right, and plot

the relationship between financial leverage and (i) the rates of return on debt and eq-

uity and (ii) the weighted-average cost of capital. Then fill in graph (b), assuming the

traditionalists are right.

8. Look back to Section 17.1. Suppose that Ms. Macbeth’s investment bankers have in-

formed her that since the new issue of debt is risky, debtholders will demand a return

of 12.5 percent, which is 2.5 percent above the risk-free interest rate.

a. What are and ?

b. Suppose that the beta of the unlevered stock was .6. What will be

and

after the change to the capital structure?

c. Assuming that the capital asset pricing model is correct, what is the expected

return on the market?

9. Capitale Netto s.a. is financed solely by common stock, which offers an expected return

of 13 percent. Suppose now that the company issues debt and repurchases stock so that

its debt ratio is .4. Investors note the extra risk and raise their required return on the

stock to 15 percent.

a. What is the interest rate on the debt?

b. If the debt is risk-free and the beta of the equity after the refinancing is 1.5, what is

the expected return on the market?

␤

, ␤

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

CHAPTER 17 Does Debt Policy Matter? 485

10. Executive Chalk is financed solely by common stock and has outstanding 25 million

shares with a market price of $10 a share. It now announces that it intends to issue $160

million of debt and to use the proceeds to buy back common stock.

a. How is the market price of the stock affected by the announcement?

b. How many shares can the company buy back with the $160 million of new debt

that it issues?

c. What is the market value of the firm (equity plus debt) after the change in capital

structure?

d. What is the debt ratio after the change in structure?

e. Who (if anyone) gains or loses?

Now try the next question.

11. Executive Cheese has issued debt with a market value of $100 million and has outstand-

ing 15 million shares with a market price of $10 a share. It now announces that it intends

to issue a further $60 million of debt and to use the proceeds to buy back common stock.

Debtholders, seeing the extra risk, mark the value of the existing debt down to $70 million.

a. How is the market price of the stock affected by the announcement?

b. How many shares can the company buy back with the $60 million of new debt that

it issues?

c. What is the market value of the firm (equity plus debt) after the change in capital

structure?

d. What is the debt ratio after the change in structure?

e. Who (if anyone) gains or loses?

Rates of return

Leverage

(

)

Rates of return

Leverage

(

)

FIGURE 17.6

See quiz question 7.

PRACTICE

QUESTIONS

1. Companies A and B differ only in their capital structure. A is financed 30 percent debt

and 70 percent equity; B is financed 10 percent debt and 90 percent equity. The debt of

both companies is risk-free.

a. Rosencrantz owns 1 percent of the common stock of A. What other investment

package would produce identical cash flows for Rosencrantz?

b. Guildenstern owns 2 percent of the common stock of B. What other investment

package would produce identical cash flows for Guildenstern?

c. Show that neither Rosencrantz nor Guildenstern would invest in the common

stock of B if the total value of company A were less than that of B.

2. Here is a limerick:

There once was a man named Carruthers,

Who kept cows with miraculous udders.

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

486 PART V Dividend Policy and Capital Structure

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He said, “Isn’t this neat?

They give cream from one teat,

And skim milk from each of the others!”

What is the analogy between Mr. Carruthers’s cows and firms’ financing decisions?

What would MM’s proposition I, suitably adapted, say about the value of Mr. Car-

ruthers’s cows? Explain.

3. Hubbard’s Pet Foods is financed 80 percent by common stock and 20 percent by bonds.

The expected return on the common stock is 12 percent and the rate of interest on the

bonds is 6 percent. Assuming that the bonds are default-risk free, draw a graph that

shows the expected return of Hubbard’s common stock ( ) and the expected return on

the package of common stock and bonds ( ) for different debt–equity ratios.

4. “MM totally ignore the fact that as you borrow more, you have to pay higher rates of

interest.” Explain carefully whether this is a valid objection.

5. Indicate what’s wrong with the following arguments:

a. “As the firm borrows more and debt becomes risky, both stockholders and

bondholders demand higher rates of return. Thus by reducing the debt ratio we can

reduce both the cost of debt and the cost of equity, making everybody better off.”

b. “Moderate borrowing doesn’t significantly affect the probability of financial

distress or bankruptcy. Consequently moderate borrowing won’t increase the

expected rate of return demanded by stockholders.”

6. Each of the following statements is false or at least misleading. Explain why in each case.

a. “A capital investment opportunity offering a 10 percent DCF rate of return is an

attractive project if it can be 100 percent debt-financed at an 8 percent interest rate.”

b. “The more debt the firm issues, the higher the interest rate it must pay. That is one

important reason why firms should operate at conservative debt levels.”

7. Can you invent any new kinds of debt that might be attractive to investors? Why do

you think they have not been issued?

8. It has been suggested that one disadvantage of common stock financing is that share

prices tend to decline in recessions, thereby increasing the cost of capital and deterring

investment. Discuss this view. Is it an argument for greater use of debt financing?

9. Figure 17.5 shows that increases as the debt–equity ratio increases. In MM’s world

also increases but at a declining rate. Explain why.

Redraw Figure 17.5, showing how and change for increasingly high debt–equity

ratios. Can ever be higher than ? Can decline beyond a certain debt–equity ratio?

10. Imagine a firm that is expected to produce a level stream of operating profits. As lever-

age is increased, what happens to

a. The ratio of the market value of the equity to income after interest?

b. The ratio of the market value of the firm to income before interest if (i) MM are

right and (ii) the traditionalists are right?

11. Archimedes Levers is financed by a mixture of debt and equity. You have the following

information about its cost of capital:

D/V  .5r

 18%r

 10%

␤

 ␤

 1.5

 r

 12%r

 

Can you fill in the blanks?

12. Look back at question 11. Suppose now that Archimedes repurchases debt and issues

equity so that . The reduced borrowing causes to fall to 11 percent. How do

the other variables change?

D/V  .3

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

17. Does Debt policy

Matter?

Companies, 2003

CHAPTER 17 Does Debt Policy Matter? 487

13. Schuldenfrei a.g. pays no taxes and is financed entirely by common stock. The stock has

a beta of .8, a price–earnings ratio of 12.5, and is priced to offer an 8 percent expected

return. Schuldenfrei now decides to repurchase half the common stock and substitute

an equal value of debt. If the debt yields a risk-free 5 percent, calculate

a. The beta of the common stock after the refinancing.

b. The required return and risk premium on the stock before the refinancing.

c. The required return and risk premium on the stock after the refinancing.

d. The required return on the debt.

e. The required return on the company (i.e., stock and debt combined) after the

refinancing.

Assume that the operating profit of the firm is expected to remain constant in

perpetuity. Give

f. The percentage increase in expected earnings per share.

g. The new price–earnings multiple.

14. Gamma Airlines is currently all-equity-financed, and its shares offer an expected return

of 18 percent. The risk-free interest rate is 10 percent. Draw a graph with return on the

vertical axis and debt–equity ratio (D/E) on the horizontal axis, and plot for different

levels of leverage the expected return on assets ( ), the expected return on equity ( ),

and the return on debt ( ). Assume that the debt is risk-free. Now draw a similar graph

with the debt ratio (D/V) on the horizontal axis.

15. Two firms, U and L, are identical except for their capital structure. Both will earn $150

in a boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely

equity-financed, and therefore shareholders receive the entire income. Its shares are

valued at $500. L has issued $400 of risk-free debt at an interest rate of 10 percent, and

therefore $40 of L’s income is paid out as interest. There are no taxes or other market im-

perfections. Investors can borrow and lend at the risk-free rate of interest.

a. What is the value of L’s stock?

b. Suppose that you invest $20 in U’s stock. Is there an alternative investment in L

that would give identical payoffs in boom and slump? What is the expected payoff

from such a strategy?

c. Now suppose that you invest $20 in L’s stock. Design an alternative strategy with

identical payoffs.

d. Now show that MM’s proposition II holds.

CHALLENGE

QUESTIONS

1. Consider the following three tickets: ticket A pays $10 if ____ is elected as president,

ticket B pays $10 if ____ is elected, and ticket C pays $10 if neither is elected. (Fill in the

blanks yourself.) Could the three tickets sell for less than the present value of $10?

Could they sell for more? Try auctioning off the tickets. What are the implications for

MM’s proposition I?

2. People often convey the idea behind MM’s proposition I by various supermarket analo-

gies, for example, “The value of a pie should not depend on how it is sliced,” or, “The

cost of a whole chicken should equal the cost of assembling one by buying two drum-

sticks, two wings, two breasts, and so on.”

Actually proposition I doesn’t work in the supermarket. You’ll pay less for an uncut

whole pie than for a pie assembled from pieces purchased separately. Supermarkets

charge more for chickens after they are cut up. Why? What costs or imperfections cause

proposition I to fail in the supermarket? Are these costs or imperfections likely to be im-

portant for corporations issuing securities on the U.S. or world capital markets? Explain.

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

18. How Much Should A

Firm Borrow

Companies, 2003

CHAPTER EIGHTEEN

488

HOW MUCH SHOULD

A FIRM BORROW?

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

18. How Much Should A

Firm Borrow

Companies, 2003

IN CHAPTER 17 we found that debt policy rarely matters in well-functioning capital markets. Few fi-

nancial managers would accept that conclusion as a practical guideline. If debt policy doesn’t matter,

then they shouldn’t worry about it—financing decisions should be delegated to underlings. Yet fi-

nancial managers do worry about debt policy. This chapter explains why.

If debt policy were completely irrelevant, then actual debt ratios should vary randomly from

firm to firm and industry to industry. Yet almost all airlines, utilities, banks, and real estate de-

velopment companies rely heavily on debt. And so do many firms in capital-intensive industries

like steel, aluminum, chemicals, petroleum, and mining. On the other hand, it is rare to find a

drug company or advertising agency that is not predominantly equity-financed. Glamorous

growth companies rarely use much debt despite rapid expansion and often heavy requirements

for capital.

The explanation of these patterns lies partly in the things we left out of the last chapter. We ig-

nored taxes. We assumed bankruptcy was cheap, quick, and painless. It isn’t, and there are costs

associated with financial distress even if legal bankruptcy is ultimately avoided. We ignored po-

tential conflicts of interest between the firm’s security holders. For example, we did not consider

what happens to the firm’s “old” creditors when new debt is issued or when a shift in investment

strategy takes the firm into a riskier business. We ignored the information problems that favor

debt over equity when cash must be raised from new security issues. We ignored the incentive ef-

fects of financial leverage on management’s investment and payout decisions.

Now we will put all these things back in: taxes first, then the costs of bankruptcy and financial dis-

tress. This will lead us to conflicts of interest and to information and incentive problems. In the end

we will have to admit that debt policy does matter.

However, we will not throw away the MM theory we developed so carefully in Chapter 17. We’re

shooting for a theory combining MM’s insights plus the effects of taxes, costs of bankruptcy and fi-

nancial distress, and various other complications. We’re not dropping back to the traditional view

based on inefficiencies in the capital market. Instead, we want to see how well-functioning capital

markets respond to taxes and the other things covered in this chapter.

489

18.1 CORPORATE TAXES

Debt financing has one important advantage under the corporate income tax sys-

tem in the United States. The interest that the company pays is a tax-deductible ex-

pense. Dividends and retained earnings are not. Thus the return to bondholders es-

capes taxation at the corporate level.

Table 18.1 shows simple income statements for firm U, which has no debt, and

firm L, which has borrowed $1,000 at 8 percent. The tax bill of L is $28 less than that

of U. This is the tax shield provided by the debt of L. In effect the government pays

35 percent of the interest expense of L. The total income that L can pay out to its

bondholders and stockholders increases by that amount.

Tax shields can be valuable assets. Suppose that the debt of L is fixed and per-

manent. (That is, the company commits to refinance its present debt obligations

when they mature and to keep rolling over its debt obligations indefinitely.) It

looks forward to a permanent stream of cash flows of $28 per year. The risk of these

flows is likely to be less than the risk of the operating assets of L. The tax shields

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

V. Dividend Policy and

Capital Structure

18. How Much Should A

Firm Borrow

Companies, 2003

depend only on the corporate tax rate

and on the ability of L to earn enough to

cover interest payments. The corporate tax rate has been pretty stable. (It did fall

from 46 to 34 percent after the Tax Reform Act of 1986, but that was the first mate-

rial change since the 1950s.) And the ability of L to earn its interest payments must

be reasonably sure; otherwise it could not have borrowed at 8 percent.

Therefore

we should discount the interest tax shields at a relatively low rate.

But what rate? One common assumption is that the risk of the tax shields is the

same as that of the interest payments generating them. Thus we discount at 8 percent,

the expected rate of return demanded by investors who are holding the firm’s debt:

In effect the government itself assumes 35 percent of the $1,000 debt obligation of L.

Under these assumptions, the present value of the tax shield is independent of the

return on the debt . It equals the corporate tax rate times the amount borrowed D:

Of course, PV(tax shield) is less if the firm does not plan to borrow permanently,

or if it may not be able to use the tax shields in the future.

⫽

⫽ T

PV1tax shield2⫽

corporate tax rate ⫻ expected interest payment

expected return on debt

⫽ r

⫻ D

Interest payment ⫽ return on debt ⫻ amount borrowed

PV1tax shield2⫽

.08

⫽ $350

490 PART V Dividend Policy and Capital Structure

Income Statement Income Statement

of Firm U of Firm L

Earnings before interest and taxes $1,000 $1,000

Interest paid to bondholders 0 80

Pretax income 1,000 920

Tax at 35% 350 322

Net income to stockholders $ 650 $ 598

Total income to both

bondholders and stockholders $0 ⫹ 650 ⫽ $650 $80 ⫹ 598 ⫽ $678

Interest tax shield (.35 ⫻ interest) $0 $28

TABLE 18.1

The tax deductibility of

interest increases the

total income that can be

paid out to bondholders

and stockholders.

Always use the marginal corporate tax rate, not the average rate. Average rates are often much lower

than marginal rates because of accelerated depreciation and other tax adjustments. For large corpora-

tions, the marginal rate is usually taken as the statutory rate, which was 35 percent when this chapter

was written (2001). However, effective marginal rates can be less than the statutory rate, especially for

smaller, riskier companies which cannot be sure that they will earn taxable income in the future.

If the income of L does not cover interest in some future year, the tax shield is not necessarily lost.

L can carry back the loss and receive a tax refund up to the amount of taxes paid in the previous three

years. If L has a string of losses, and thus no prior tax payments that can be refunded, then losses can

be carried forward and used to shield income in subsequent years.