FIN-3403 Lecture Notes - Lecture 16: Tax Shield, Capital Structure, Private Placement
- Case II: A World with Taxes
o Since interest is tax deductible, as debt increases, more cash flows
are reserved for the shareholders and debt holders. This increases
the value of the firm
o Annual Interest Tax Savings= D(RD)(Tc)
o Assuming perpetual debt, PV(interest tax savings)= D(RD)(Tc)/RD=
DTc
o VL = VU + DTc
o As a firm increases its debt-equity ratio, WACC declines
▪ WACC= (E/V)RE + (D/V)RD(1 – Tc)
- Case III: A World with Corporate Taxes and Bankruptcy Costs
o Key disadvantage of using of debt is bankruptcy costs
o Direct Bankruptcy Costs
▪ Legal and administrative expenses directly associated with
bankruptcy
▪ Generally quantifiable and measurable
o Indirect Bankruptcy Costs
▪ Difficulties in hiring and retaining good people because the
firm is in financial difficulty
▪ Hard to measure and generally take the form of foregone
revenues, opportunity costs
o As debt increases, the risk of bankruptcy and associated costs
increase
o The optimal capital structure is where these increased costs exactly
offset the interest tax shield
- The Static Theory of Capital Structure
o Firms borrow money because tax shields are valuable
o Borrowing is constrained by the costs of financial distress- firms with
less business risk have lower EBIT variability and can use more debt
with lower risk of bankruptcy
o The optimal capital structure balances the incremental benefits and
costs of borrowing
o There is an optimal D/E ratio
o Practical Considerations
▪ Tax shields are more important for firms with high marginal tax
rates
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