CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;

CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;

the greater the use of debt financing (vis-à-vis equity financing), the greater the risk. Another factor to consider is the role of taxes. In the U.S., income taxes play an important role in a firm’s capital structure decision because the payments to creditors and owners are taxed differ- ently. In general, interest payments on debt obligations are deductible for tax purposes, whereas dividends paid to shareholders are not deductible. This bias affects a firm’s capital structure decision.

In this section, we look at the capital structure decision. At first, we look at the base-case in which individuals and corporations have the same access to capital markets. In this case there are no tax advantages to debt financing (vis-à-vis equity financing), and both debt and equity securities are perfect substitutes from the perspective of the investor. Then we’ll take

a look at what happens once we add a little realism into the decision. The M&M Model

The value of a firm—meaning the value of all its assets—is equal to the sum of its liabilities and its equity (the ownership interest). Does the way we finance the firm’s assets affect the value of the firm and hence the value of its owners’ equity? It depends.

The basic framework for the analysis of capital structure and how taxes affect it was developed by two Nobel Prize winning economists, Franco Modigliani and Merton Miller. 2 Modigliani and Miller (M&M) reasoned that if the following conditions hold, the value of the firm is not affected by its capital structure:

Condition #1: Individuals and corporations are able to borrow and lend at the same terms (referred to as “equal access”). Condition #2: There is no tax advantage associated with debt financing (relative to equity financing).

2 Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Fi- nance, and the Theory of Investment,” American Economic Review (June 1958).

Capital Structure

Condition #3: Debt and equity trade in a market where assets that are substitutes for one another trade at the same price. This is referred to as a perfect market. If assets are traded in a perfect market, assets with the same risk and return characteristics trade for the same price.

Under the first condition, individuals can borrow and lend on the same terms as business entities. Therefore, if individuals are seeking a given level of risk, they can either (1) borrow or lend on their own or (2) invest in a business that borrows or lends. In other words, if an individ- ual wants to increase the risk of her investment, she could invest in a company that uses debt to finance its assets. Or, the individual could invest in a firm with no financial leverage and take out a personal loan—increasing her own financial leverage.

The second condition isolates the effect of financial leverage. If deducting interest from earnings is allowed in the analysis, it would be difficult to figure out what effect financial leverage itself has on the value of the firm.

The third condition insures that assets are priced according to their risk and return characteristics. Under these conditions, the value of Capital Corporation is the same, no matter which of the three financing alternatives it chooses. 3 The total income to owners and creditors is the same. For example, if the return on assets is expected to be 15%, the total income to owners and creditors is $4,500 under each alternative:

Total Income to Financing Alternative

Income to Income to

Owners

Creditors Owners and Creditors

$4,500 2. $5,000 equity, $5,000 debt

$4,500 Assume that the expected return on assets is 15%, for each period,

forever. It follows that the value of Capital Corporate can be deter- mined using the formula for the valuation of a perpetuity, PV = CF/r. Expressing this in terms of the value of the firm:

Expected earnings per period

Value of the firm = ---------------------------------------------------------------------------

Discount rate 3 The Modigliani and Miller models are explained within in this chapter through nu-

merical examples.

FINANCING DECISIONS