Scribd
Upload
63 views

Capital Structure With Market Imperfections: Prof - Joshy Jacob

This document discusses capital structure and market imperfections. It covers several topics in 3 paragraphs: 1) It examines a firm's value under different capital structure assumptions like constant perpetual debt vs a constant debt-to-value ratio. It finds the tax benefit of interest is lower under a constant D/V ratio. 2) It discusses the implications of corporate taxes on capital structure and notes real-world structures are not extreme. It also mentions other tax incentives that impact structure decisions. 3) It addresses potential conflicts between shareholders and bondholders like disagreeing on risky projects or liquidating distressed firms that could expropriate value from one group. Capital structure introduces different investor classes that may not always have aligned

Uploaded by

NishantShah
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
63 views

Capital Structure With Market Imperfections: Prof - Joshy Jacob

This document discusses capital structure and market imperfections. It covers several topics in 3 paragraphs: 1) It examines a firm's value under different capital structure assumptions like constant perpetual debt vs a constant debt-to-value ratio. It finds the tax benefit of interest is lower under a constant D/V ratio. 2) It discusses the implications of corporate taxes on capital structure and notes real-world structures are not extreme. It also mentions other tax incentives that impact structure decisions. 3) It addresses potential conflicts between shareholders and bondholders like disagreeing on risky projects or liquidating distressed firms that could expropriate value from one group. Capital structure introduces different investor classes that may not always have aligned

Uploaded by

NishantShah
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 11

Capital Structure with Market Imperfections

Prof.Joshy Jacob

Indian Institute of Management, Ahmedabad

January 31, 2017


Corporate Taxes Personal Taxes Conflicts Trade-offs

Firm value - Perpetual constant debt



Let VL be the total value of a levered firm with constant perpetual debt D facing
 
tax rate T

VL = VU + T D

Table: Market value balance sheet - levered firm

Assets 1500 Equity 750


PV(ITS) 250 Debt 1000
Total 1750 1750

Unrealistic to assume that firm would be able to maintain the same level of debt,
irrespective of its value.
More realistic would be to assume that it would maintain a constant proportion of its
value as debt, which implies:

D
Constant ratio
V
Corporate Taxes Personal Taxes Conflicts Trade-offs

Firm value - Constant D/V ratio


Assets VU Equity E
Tax shelter PV (ITS) Debt D
Total VL Total VL

VU PVITS E D
A + ITS = E + D
VL VL VL VL
D
When the firm maintains constant V
= 50% , tax rate is 25% and RD = 10%:

Firm value 2000 4000


Debt 1000 2000
Interest 100 200
ITS 25 50

Therefore,
A = ITS
Corporate Taxes Personal Taxes Conflicts Trade-offs

Firm value - Constant D/V ratio


ITS would be discounted at RA

Debt RD Tax
VL = VU +
RA

1625 = 1500 + 125

The estimate of PV (ITS) is lower than maintaining constant perpetual debt, why?
Corporate Taxes Personal Taxes Conflicts Trade-offs

Implication of corporate taxes on capital structure


Optimal capital structure should be EBIT = Interest

Real-world capital structure not very extreme (except in case of financial


institutions). Are they acting sub-optimally?
D
High growth firms would have low V
ratio?

Role of other incentives to reduce the overall taxation (ESOP, depreciation, tax
loss carry forwards)
Corporate Taxes Personal Taxes Conflicts Trade-offs

Personal taxes and capital structure

Equity Mostly debt


Pre-tax income EBIT EBIT
Post corporate tax EBIT (1 T ) Interest = EBIT
Post personal tax EBIT (1 T ) (1 TPE ) EBIT (1 TP )

When are personal taxes irrelevant?

I TPE = TP , only corporate taxes matter

I (1 TP ) = (1 T ) and no dividend taxes

I (1 T ) (1 TPE ) = (1 TP )

Personal tax rates not very relevant for capital structure


Corporate Taxes Personal Taxes Conflicts Trade-offs

Are there conflicts in firms?


Capital structure introduces different classes of capital providers in the firm.
Would it create conflicts of interest?

When no information asymmetry, complete contracts can be written to


prescribe actions for each state of the world

If contracts are implied or incomplete, conflicts can arise between:

I Shareholders and lenders

I Different shareholders

I Shareholders and executive management (agency problems)


Corporate Taxes Personal Taxes Conflicts Trade-offs

Shareholder-bondholder conflicts
Issue of debt = 1000

Table: Distressed firm

Assets 900 Debt 900


Equity 0

Table: New project and outcomes

Outcome prob. Debt Equity


Success 1300 50% 1000 300
Failure 300 50% 300 0
Expected 800 650 150
Corporate Taxes Personal Taxes Conflicts Trade-offs

Shareholder-bondholder conflicts

Table: Risk-free new investment

New investment 100

NPV 50
PV(FCF) 150

Table: New project outcome

Assets 1050 Debt 1000



Equity 50 
Total 1050 Total 1050

Would shareholders contribute equity to the project?


Corporate Taxes Personal Taxes Conflicts Trade-offs

Shareholder-bondholder conflicts
Shareholders refuse to liquidate

Expropriate outside shareholders

Empire building through wasteful acquisitions


Corporate Taxes Personal Taxes Conflicts Trade-offs

Trade-offs in capital structure


Value impact of leverage

VL = VU
+PV (ITS)
PV (Distress cost)
+PV (Agency benefits of debt)

You might also like